The Disruption Dilemma

Disruption is an over-used term these days, rendered almost useless as a conveyer of meaning. We need to shed the additional baggage that comes with the term as it is used today — in particular, the notion that the stumbles of every established firm are the consequence of disruption. At the same time, we need to hold onto the term’s essence, because disruption is something that firms the world over remain at risk of.

For the purposes of my research, I define disruption as ‘what a firm faces when the choices that once drove its success become those that destroy its future’. This allows us to see disruption as a legitimate phenomenon, but also provides a means of explaining when a situation facing a firm is not in fact disruption, but something else entirely.

From Blockbuster to Disaster

If disruption has a modern poster-child, it is surely Blockbuster video. In 2004, Blockbuster dominated the U.S. video/DVD rental market (and others around the world) with 9,000 stores, taking just under two decades to get to that position. By 2010, it had filed for bankruptcy, with its number of outlets shrinking to just a third of its peak.

Blockbuster was built on the wave of the home video revolution that started in the 1970s and progressed throughout the 1980s, with the videocassette recorder (VCR) becoming a common household product. Video libraries sprung up everywhere, allowing people to rent movies at prices that depended on whether the film was a recent release or not. Blockbuster invested heavily in a global retailing brand that allowed it to dominate the video library market through to the 1990s — often using its power to negotiate favorable deals with suppliers of videos and DVDs.

The usual narrative on Blockbuster’s failure is a relatively simple one. It began with a technological trigger: the DVD. In the late 1990s, a start-up, Netflix, entered the video rental market off the back of the new DVD standard that was just taking off. Up until that time, if you wanted to rent a movie, you had to travel to a store, select a DVD (or video), watch it, and then return it to the same store.

Netflix’s idea was to use postal delivery instead. DVDs were lighter and cheaper than their video cassette counterparts, making delivery potentially cost effective. Crucially, Netflix’s initial model only appealed to some consumers, as it required people to plan their DVD watching a few days ahead of time. It also, initially, could not guarantee the movie you wanted — potentially leaving you high and dry on a Saturday night.

While the idea for Netflix was motivated by late fees charged for video rentals to its founder, Reed Hastings, Netflix initially also charged those fees. In 2000, it changed its business model, moving to a subscription service that allowed consumers to keep DVDs for as long as they wanted. In effect, people could borrow as often as they liked, without thinking beyond a set monthly fee. Consumers loved this model, and Blockbuster and the bricks and mortar video rental industry were doomed.

What makes this a possible story about disruption goes a bit further than the ‘entrant supplies product that consumers prefer to incumbent’ narrative. That’s because there was nothing stopping Blockbuster from imitating what Netflix did. In hindsight, it didn’t have to be destroyed. Indeed, in 2000, Blockbuster decided to pass on the opportunity to buy Netflix for a mere $50 million; today, Netflix is worth over $26 billion.

In 2002, facing concerns about Netflix’s growth, Blockbuster told its shareholders that Netflix was ‘not financially viable’ and was ‘only serving a niche market’. By 2004, at the peak of Blockbuster’s success, it hedged its bets by offering a DVD-by-mail service with an additional option of allowing in-store exchanges. Despite this, Netflix led, and never fell back in total subscribers.

The Blockbuster story highlights three key aspects of a firm failing because it is being disrupted:

1. Disruption is often associated with a new technological opportunity. In Blockbuster’s case it was the DVD, and later, streaming on the Internet, that changed the economics of video delivery and search. We will term this the disruptive event.

2. The incumbent has a similar ability to exploit the new opportunity as others. While this is often the case, it is not always the case. For instance, an entrant may hold a lock-hard patent on the new opportunity, or it may require a completely different set of technical know-how that the incumbent does not possess.

3. The failure to take advantage of that opportunity cannot be recovered. Blockbuster ceded the new business model to Netflix in such a way that there was nothing left of value in its business. That does not always occur when new firms enter a market: there may be something still of value in the incumbent firm, which can mean the difference between being disrupted or not.

The Origins of Disruption

If disruption has a figurehead, his name is Joseph Schumpeter.

Although he ended up a professor in Harvard’s Economics department, Schumpeter is a far cry from your ivory tower stereotype. Born and raised in Austrian aristocracy in the 1880s, he held posts around the world including in Egypt, Japan and Austria and proclaimed that his life’s goal was ‘to be a great lover, horseback rider and economist.’

In his academic work, Schumpeter was very concerned that capitalism would turn out to be a lot more boring than his predecessors like Karl Marx had described. His early work considered the operation of capitalism as something that, left to ordinary workers and pure owners of capital, would reach a steady state without growth and without anything that looked like profit.

Economists then, as now, tended to think of capital goods like machines as earning their own due, but Schumpeter could not imagine a world where people who did nothing but own a machine actually earned a living from it. Those returns would be competed away by the owners of other machines and the competition for workers to operate them. Instead, the only people who were doing something that could generate a profit were those generating and bringing ideas to market: entrepreneurs.

Entrepreneurs are their heroes of Schumpeter’s world, and his image of them lives on in the view of many today. But for all their worth in keeping the system alive and growing, the entrepreneurial reward was itself fleeting. Put simply, once an idea was ‘out there’, it could be copied by others. Thus, we have a picture of entrepreneurial pioneers foraging for transient rewards and, in the process, keeping the system going; although later in life Schumpeter did forecast that those talented individuals would wise up, routinize innovation and drive the interesting bits of the system away in a corporate malaise.

In 1942, in his book, Capitalism, Socialism and Democracy, he introduced the concept whose lineage to disruption can be most clearly seen: Creative Destruction. For Schumpeter, the term was a description of what he believed to be an endemic feature of capitalism: that it made room for creativity by destroying what had come before it.

Like Marx before him, Schumpeter found evolution rather than equilibrium to be the appropriate narrative for what was occurring in the economy. In fact, the changes from agriculture to industry he saw as “a history of revolutions.” The opening up of new markets, foreign or domestic, and the organizational development from the craft shop and factory to such concerns as U.S. Steel illustrate the same process of industrial mutation that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one. He goes on: “This process of Creative Destruction is the essential fact about capitalism.”

Schumpeter was not trying to explain why successful firms fail. Instead, his goal was to challenge the perception many economists and politicians held at the time, and demonstrate that big businesses operating in monopolistic conditions were not as menacing as many were making them out to be. Once it was understood that their moment was somewhat fleeting, economists could focus on whether the system was performing well over the long-run. It is here that was born the notion that success in the capitalism system is precarious, and that there is no natural birthright to a lifelong annuity of profitability.

The Technological Link

By the 1980s, it was obvious to many economists that some firms could hold their positions in industries for many decades, seeming to respond to new technologies and innovations quite well. For example, after Netflix dominated the DVD subscription business, it was able to easily migrate its consumers over to Internet video streaming. But, as the Blockbuster example shows, there are other types of innovations that incumbents fail to respond to. The disruptive innovation for Blockbuster was not just DVDs but, on a broader level, an alternative business model for getting DVDs to consumers.

In the generation following Schumpeter, researchers wondered: what types of technological change would spell trouble for incumbents? The natural starting point was to look at ‘technological discontinuities’. Italian researcher Giovanni Dosi argued that there appeared to be ‘technological paradigms’ that were akin to Thomas Kuhn’s ‘scientific paradigms’ and performed a similar role in changing everything. Sailboat manufacturers, for example, were left in the wind as steam proved faster. Dosi argued that those businesses on the old technological path were focused (as they had to be), but that also made them blind to objectively evaluating the new path.

This notion was reinforced by McKinsey Director Richard Foster, who observed that many broad technologies exhibited an ‘S-Curve’ relationship between effort devoted to improvements and the rate of improvement in the performance of those technologies on any given metric.

A brief refresher on S-Curves: the ‘S’ refers to the fact that when a technology is new, it takes lots of effort to improve performance even slightly; however, at some point, that relationship flips and small amounts of effort lead to rapid improvement. Sadly, this process reaches a conclusion with a flip back in the relationship, eventually leading to a plateauing technological limit to performance.

For Foster, combining the S-curve with the notion of a technological discontinuity raised an important issue for managers of established firms. Namely, it was often the case that a new technology path (or S-Curve) had lower performance than the existing one. In other words, as an incumbent, you would rationally make a decision to continue to focus on the existing S-curve rather than the new.

Foster argued that new entrants into an industry were not so encumbered with the focus issue and so were more willing to explore the new technology path; if they could do so until the S-curve bent upwards and control the technology through that point, the entrant would eventually outcompete the incumbents. That is, if they attacked the new technology with effort, they could take over the advantage.

The notion of multiple S-curves was the starting point for Harvard Professor Clayton Christensen who, at once, both narrowed and expanded Foster’s notion. He narrowed it by divorcing it from many preceding theories on technological discontinuities. In particular, Christensen believed that not all technological discontinuities led to worse performance of the products of incumbent firms. In fact, some incumbents appeared to have developed radical technological changes that integrated smoothly into their existing products.

In other words, a technological discontinuity and a move to a new S-curve was not always associated with underperformance, as Foster had emphasized; instead, the change in performance could be upwards. Christensen also dramatically expanded on the factors that may pose risks for incumbents. While, in his initial work, a technological change seemed to precipitate incumbent challenges, he later saw that innovations in their broadest terms — including technologies, new markets and new business models — could all pose difficulties for incumbents.

Christensen saw a particular sort of technology as posing a challenge to established firms, and its definition is instructive:

[These technologies] have two important characteristics: first, they typically present a different package of performance attributes — ones that, at least at the outset, are not valued by existing customers. Second, the performance attributes that existing customers value improve at such a rapid rate that the new technology can later invade those established markets.

A technology satisfying these criteria was termed by Christensen as ‘disruptive’, while all others were considered ‘sustaining’; that is, they improved the performance of established products.

Two Sources of Disruptive Innovation

In The Innovator’s Solution, Christensen and co-author Michael Raynor distinguished between two sources of disruptive innovation: low-end and new market.

Low-end disruption was captured by the definition given here in that the entrant’s product was able to capture some fringe of the customers of the established firms; usually because those customers were purchasing a product that was too expensive relative to the value they were receiving.

New market disruption occurred when the firm introducing the new disruptive innovation was able to capture customers who were not consuming the product of established firms at all (i.e., the new innovation was able to attract people in from non-consumption).

A quick note here for entrepreneurs seeking to enter a market with a disruptive innovation: it is a useful process to think about who is underserved by established firms and who is poorly served by them. Either way, this is a point of vulnerability for established firms.

Christensen’s primary example of a disruptive technology came with new generations of hard-disk drives that offered a smaller size but at the initial expense of lower capacity, only to recover that performance gap in a few years.

The disruptive innovation in DVD rentals is harder to objectively see. For DVD rentals, the performance dimensions were in the product space and positioning rather than pure technology. Netflix sacrificed the ‘impulse’ nature of DVD rentals that Blockbuster had built their business on, choosing not to compete with its brick-and-mortar outlets. By contrast, Netflix offered a superior outcome to those who were happy to plan ahead or doubted their ability to return DVDs to a store on time. Initially, this was a niche customer segment in the video rental market, with most consumers continuing their old video renting habits of heading to a local video store.

To complete the story, however, we need to identify where Netflix caught up. Until on-demand video streaming arrived, it did not catch up with regard to impulse viewing; DVDs by post could never satisfy that requirement. But Blockbuster was already having trouble before streaming dominated video delivery. Instead, Netflix, like so many online retailers, was able to trump brick-and-mortar outlets on the basis of variety. Netflix could bring viewers the ‘long tail’ of video content — offering many times more titles than were available in a Blockbuster store.

It remains to be seen how Netflix’s story will play out. This suggests that, while Christensen’s two criteria for a disruptive innovation are easy to describe, it can be difficult to identify precisely whether they have been satisfied for a given individual case.

An Alternative Perspective

There is a final chapter in the story of disruption’s origins. At the same time as Christensen was working on his PhD at Harvard, another student, Rebecca Henderson, was interested in the same phenomenon and set forth a research program that impacted a generation of management scholars.

Henderson was concerned, specifically, with the difficulties incumbent firms had in responding to entrants. For her, it was not so much that those firms chose at critical points not to respond (i.e. Christensen’s focus) but that there were some sorts of technologies or innovations that they could not respond to. Along with her collaborator, Kim Clark, she termed these ‘architectural innovations’.

Henderson and Clark pointed out that a ceiling fan is made up of blades, motors, a blade guard, control system and mechanical housing. Each of these are components, but how they are designed to work together is a fan’s architecture. For Henderson, many firms become successful because they can out-compete rivals in product improvements. The quickest way to do that is to organize for component innovation. But what happens if a new technology comes along that changes the architecture of a product — that is, how the components relate to one another? For successful firms organized around ‘component innovation’, thinking about how to recognize and deal with new architectures is a challenge.

In a sense, Netflix’s innovation involved a new architecture. Blockbuster had become excellent in managing inventory and processes to ensure customers had a satisfactory experience in its stores. However, what Netflix was doing was ensuring that it had a new logistical approach that could efficiently deliver DVDs directly to people’s homes. That involved machinery to sort and deliver DVDs to post offices and then to handle the DVDs as they returned to Netflix. It also required, eventually, a new business model based on subscriptions.

Blockbuster’s business model defined success by ensuring regular flow through its physical stores. Thus, the entire organization was designed to ensure that consumers came in and walked out with something, leaving some money behind. To graft onto that an alternative channel was difficult, as that channel would not only challenge the economics of the stores, but also the incentive structures that supported them. This is precisely why new architectures can be more readily brought to market by entrants than incumbents.

We now have two types of innovation that can lead to disruption: for Christensen, the innovations are ‘customer-disruptive’ in that they initially under-perform, but then rapidly improve performance for an established firm’s customers; and for Henderson, the innovations are ‘architecturally-disruptive’ in that they initially make it hard to innovate on component improvements, but then later allow for rapid improvements as the new architecture is understood. I refer to Christensen’s customer-disruptive innovation as disruptive innovation and Henderson’s disruptive innovation as architectural innovation.

Seen in this light, what Netflix brought to the industry was an innovation that was both disruptive and architectural. For Blockbuster to respond, it had to be convinced (a) that its current customers wanted what Netflix had to offer; and (b) that it should re-organize its entire business to respond to the threat.

Suffice to say, at the time, it was not clear to anyone at Blockbuster that those conditions had been met.

In closing

In 2011, satellite broadcasting provider Dish Network purchased Blockbuster for $320 million: an amount less than its annual late fee revenues when Netflix was gaining initial traction. So, Blockbuster actually lives on as a brand with Dish’s Blockbuster On Demand service. From an industry giant to a brand on a broadcasting channel, the Blockbuster case reveals many of the nuances related to disruption.

Successful firms who are disrupted are not complacent or poorly managed. Instead, they choose to continue on the path that brought them to success. And it is precisely because of this that they are disrupted.

Joshua Gans is the Jeffrey Skoll Chair of Technical Innovation and Entrepreneurship and Professor of Strategic Management at the Rotman School of Management. He is the author of The Disruption Dilemma (MIT Press, 2016), from which this article is adapted. He blogs at digitopoly.org.