Creative Destruction: How this economic principle affects you and how to use it to your advantage (Moncrieff show podcast)
During my economics slot with the Sean Moncrieff show on Newstalk recently (listen to the podcast here), I discussed the economic principle known as “creative destruction”. Creative destruction is one of the reasons income inequality comes about. How?
What is creative destruction?
Put simply, it is “out with the old and in with the new”. A small corner shop sets up in a sleepy little town in the United States to serve its customers so that local people can buy milk, bread and the paper. It passes on from generation to generation.
In another small town, there is a man looking at his profit margins. He sees that if he saves a little, borrows a little and spends a little, he can build another shop in the next town. He can then buy another two shops and so on exponentially. This allows him to approach his suppliers with larger and larger orders, and as a result he can negotiate larger and larger discounts.
His negotiating advantage is that if he was to make good on a potential threat to move his business, the seller would be left with a hole where the large order used to be. Therefore, as he looks to spread his wings into more nooks and crannies in the States, he has a competitive advantage: he can source goods at a lower price than the traditional family-run shops.
The ambitious young man I’m talking about is Sam Walton, of Walmart fame. He is creative in that he finds a way to lower his prices. But he is destructive in that he puts the “Mom and Pop” shop of the 70s in America out of business.
Creative destruction in our life: friend or foe?
Walton’s ideas can be traced right through to the current day with Tesco offering their “own brand” at prices that crowd out the small farmer in Kerry; or with the large multiples that squeeze the margins of the mushroom grower in Meath.
However, there is a much larger “creative destruction” at play today: the advances of technology. We are truly living in a “man versus machine” culture. But hasn’t technology made us more productive, and our work much easier?
I was thinking about the absolutely everyday tasks that I do very frequently as a business person, that just a couple of years ago would have required the specialist knowledge of a trained professional: creating a web site, managing a blog, podcasting, digital marketing, hosting documents and data in the cloud, animating graphics, etc.
While Microsoft launched its first Office version just seventeen years ago, could any of us today really imagine composing a document without automatic spellcheck, or putting together a presentation without PowerPoint templates, or not being able to copy and paste data from one Excel spreadsheet to another?
We don’t even call it “technology” anymore – we just expect it to work! Even think of the person who might previously have spent half a day and a couple of prayers to St. Anthony to find an important file; now all they have to do is type some keywords into the search caption beside the magnifying glass. This tiny icon has become synonymous with the search function that zips through millions of e-mails in a nano-second.
Resist change at your peril
Innovation and cost reduction are both positive, aren’t they? Indeed! Firstly, we don’t have any choice to innovate or the world will move right past us. Kodak had to learn, to its detriment, that people will actually replace their film camera with a digital camera or even a lower quality, mobile phone camera without too much thought: the company went bankrupt in 2012, even though its market leadership had been a given for 130 years.
Radio stations can’t just rely on people physically turning on the “wireless” to hear their broadcaster, but they need to podcast, join the conversation on Twitter, run FaceBook competitions, encourage app downloads and sell advertising. Without innovation, we wouldn’t have apps, the internet, electricity or even the engine. How far back do you want me to go?!
Secondly, as in the case of Walmart, if the price of basic foods like rice, sugar and bananas are falling, this makes survival and even progression more possible for those who are the poorest in our society. If it’s so positive then to embrace creative destruction, and so risky to oppose it, why does it have us so worried?
Adapting does require venturing
out of our comfort zone
Creative destruction, as the name indicates, is destructive. The Mom and Pop shop can’t compete against Walmart. That person who can type 100 words per minute on a typewriter but doesn’t know how to connect a printer wirelessly to an iPad, can’t help but feel that many of their skills are unappreciated and even obsolete.
In fact, if we bring this very point to its natural conclusion, this creative destruction as led by the capitalist markets leads directly to (growing) income inequality. The shop owner ends up working on the checkout at Walmart with capped wages, as opposed to being able to grow his own business selling goods at an acceptable margin.
The person who can’t afford to go on a digital marketing course, after pouring their early adult savings into doing a BComm in traditional marketing ten years ago, will find themselves at a disadvantage, even though the BComm course was supposed to be their passport to permanent employment.
Technology has required us to keep up with its breakneck speed and if we don’t, well then we get left behind. If your business doesn’t have a website now, it’s probably not in business. If your newspaper is only available in print, how long has it got left? It would have to have an extremely strong value proposition to survive.
Let’s go another step; previously one interview candidate only had to compete with the other people who applied for the same job. Now, in some cases, the entire payroll has to compete with other potential employees all over the world. Since technology has made communications so fast and effective that “the world is flat”, jobs can be outsourced to a cheaper location for a fraction of the price, without ever needing to move premises!
Who benefits from creative destruction?
Let’s bring it full circle – somebody has to be gaining from all of this increased productivity surely? That is true, and it falls to the market participants who have the capital to be productive. Those who have money to invest in businesses that can cut costs and increase efficiency. The farmers who have land which can yield far greater crops than their ancestors would have dreamed. The young graduate who can make €1000 per day as a consultant on developing apps, because she has the time, the aptitude and the money to learn how to do so. The startup that doesn’t need the cost-heavy delivery vans, desktop computers and footfall-likely location to open a company – a smartphone with some free apps will do!
This reinforces how creative destruction leads to income inequality, unless the welfare state can make sure the successes of the few can trickle down and benefit the democracy of the many.
So does this mean that larger companies have the upper hand then? They’re smiling all the way to the investment bank as they plan their imminent IPOs? No actually, because multinationals have greater amounts of competitors than the Mom and Pop shop. A big multinational can “lose” to a smaller, more “agile” competitor.
According to research done in 2012:
1. US corporations in the S&P500 in 1958 remained in the index for an average of 61 years.
By 1980, the average tenure of an S&P500 firm was 25 years, and by 2011 that average shortened to 18 years based on seven year rolling averages. In other words, the churn rate of companies in the S&P500 has been accelerating over time. It’s not because you’re among the biggest and greatest that you are safe and can rest on your laurels.
2. On average, an S&P 500 company is now being replaced in the index about once every two weeks.
3. At the current churn rate, by 2027, 75% of the firms on the S&P500 list in 2011 will have been replaced by new firms.
4. In 2011, a total of 23 companies were removed from the S&P500, either due to declines in market value (for instance, Radio Shack’s stock no longer qualified as of June) or through an acquisition (for instance, National Semiconductor was bought by Texas Instruments in September).
In summary, creative destruction is in fact a straightforward oxymoron: it can have a destructive effect on those who think the world will sit idly by and forever appreciate their skills, or on people who dismiss a new innovation as just a fad (e.g. the ATM, the smartphone, social media) and don’t engage.
However, it can also point to immense opportunity for individuals and society at large as we are put through our paces to remain relevant and come up with cheaper, cleaner, faster, easier or otherwise value-adding solutions to problems that will be forgotten as soon as they’re efficiently solved.
Are you on the list?