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The 'Innovator's Dilemma' - Why incumbent businesses often fail in times of rapid change: Speech

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The Hon Malcolm Turnbull MP

Minister for Communications

The 'Innovator’s Dilemma' - Why incumbent businesses often fail in times of rapid change

9 November 2013

When Professor Christensen published the Innovator's Dilemma 16 years ago, he broke new ground with his ideas that have had, and are still having, a very profound impact on the way businesses think and operate. His work is centred on some key premises: why do big companies fail; why is success so hard to sustain; how is it that one day, a business formula that has served a company so well for so long can stop working.

While others who have tried to answer these questions have looked at what organisations do wrong, Professor Christensen has developed another approach. He says companies fail because they are failed. Companies fail because they do everything right, according to the pre-existing order. His argument seems counter-intuitive, but there are so many examples of it playing out in the economy that it's one that we have to pay close attention to.

Professor Christensen says that when companies continue to focus on sustaining innovations, improving existing products and selling them for higher profits to the top end of the market, they create space for other companies to step in, and that, of course, is disruptive innovation, a phrase first coined by the professor and now part of the business lexicon. I notice Professor Rupert Murdoch was drawing on disruptive innovation extensively in his speech to the Lowy Institute last week, and of course, he confessed that he had been accused of being at least disruptive on many occasions, perhaps, and, as always, sought to be innovative.

I might say apropos of Rupert Murdoch, Rupert has always, when I've raised this with him, has always denied that he said it, but he did say it years ago. He said once that the internet will destroy more profitable businesses than it will create. I doubt whether that's true, but speaking from the point of view of a publisher and with those big legacy businesses, old technology businesses, if you like, you can understand that point of view, and this is - this really is the - poses the problem, the innovator's dilemma that Professor Christensen considers.

Do we invest to protect the least profitable end of our business so that we can retain our least loyal, most price sensitive customers, or should we invest to strengthen our position in the most profitable tiers of our business with customers who reward us with premium prices for better products? Or put it another way, should business managers cannibalise their existing highly profitable businesses to ride the next big wave of innovation, especially if the new wave will involve lower barriers to entry, more intense competition and lower margins.

Now, one of - there are two classic case studies that I will just reflect on. One that's incredibly familiar - painfully familiar, in some cases - to people in Australia, and the other one less so. The one that Professor Christensen often refers to is Kodak, which filed for

bankruptcy recently. After inventing the digital camera in 1975, Kodak aggressively invested in digital photography but with a model that drove up prices. Professor Christensen suggested they make the technology affordable and simple in order to introduce new consumers to the product.

Kodak set up a new business unit. They developed a new camera which was, indeed, profitable. Their share of the digital camera market went from 8 to 28 per cent. When a new chairman was brought in, he combined the film and digital camera businesses in order to cut overheads. The price of the digital cameras went up, volume declined, the market share dropped from 28 per cent to 12 per cent. Incredibly, an icon of the industry which failed to adapt and read the market has perished.

Another great example of the innovator's dilemma is, of course, the newspaper industry, the print industry, magazines, as well. In 2000, Fairfax - this is the publishers of the Sydney Morning Herald and the Age, Professor - turned down the opportunity to purchase stakes in and, presumably under the impression that people would not buy houses or cars without a physical copy of the Sydney Morning Herald.

Three years later, they turned down an opportunity to buy These were expensive decisions, to say the least. What Fairfax didn't realise was that consumers found online classifieds a much more compelling medium for transactions. Probably what they did realise was that to compete in this new world, you would have to swap news print dollars for digital dimes. Well, what was the alternative? If you look at the market caps of the four companies now, consequences are stark. valued at $5.4 billion; CarSales, $2.4 billion; Seek, $4.4 billion; Fairfax, $1.4 billion. Now, the lesson there is very simple: that if you are not prepared as an existing business, an existing, successful business with an incredibly good business model, if you are not prepared to be as disruptive as those who are seeking to challenge you, then you will perish. You have to be prepared to cannibalise your own business, painful though it is.

You have to look every day at what you are doing, challenge all of your preconceptions, never, ever accept the proposition that because you've done it successfully for five years, therefore - or 50 years or 500 years - therefore, it is going to be successful in the future. Because every day - every day is a new world, because we are living in a time of such disruptive change. I mean, the key feature of the times in which we live is volatility. Unpredictable change. And the answer to that is that you have to be - the professor will speak more knowledgeably about this in a little while - you have to be, in my judgement, at all times nimble.

Optionality, flexibility, dynamism, creativity have never, ever been more important. And if you think about it - of those of you involved in financial markets, you will know, the more volatile markets are, the more valuable optionality is. We have to be, in Nicholas Nassim Taleb's term, antifragile. We have to develop approaches, concepts, businesses, institutions, governments, dare I say, that are strengthened by change, that, like the muscle in your body, becomes stronger with exercise and responding to dynamic conditions, as opposed to being fragile so that when there is a change to the operating environment, you break.

Now, you know, the great economist Joseph Schumpeter, of course - I once accused another economist of being Schumpeter's trumpeter, so I don't want to be his trumpeter today. But

Schumpeter's, of course, insights into creative destruction arguably may make him the most influential economist of the 21st century, notwithstanding that he has long left us. He recognised that while competition was a key driver, the critical element to the economy was not so much competition but innovation.

I will just quote from his work, Capitalism, Socialism and Democracy: the competition from the new commodity, the new technology, the new source of supply, the new type of organisation, competition which commands a decisive cost or quality advantage and which strikes, not at the margins of the profits and the outputs of the existing firms, but at their foundations and their very lives, that was the key creative force, hence the term creative destruction. So he put the innovative entry of entrepreneurs at the centre of economic growth.

Now, this proposes a very big challenge for governments. How do governments respond to this? The most established businesses are always - well, almost always - the most vulnerable to disruption, not only because the more established they are, the more their market share is attractive to innovators, but also because they tend to be focused on protecting their legacy business. They almost always tend to have considerable political clout. They're major employers. Politicians like to stand up and say they are saving jobs, and, of course, if a factory closes, it's very visible, it's very telegenic in that sense.

You can see the gates being closed, you know, the padlocks - the chains and the padlocks being locked and people losing their work. The thousands of new jobs being created in an innovative society, a few here, a few there, a few somewhere else, are much harder to document, and there is much more pain, political pain, for governments with a hundred jobs being lost by the closure of this plant than there is political benefit from having policies, in a purely political sense - I'm not talking what's good public policy or good economics - but in a purely political sense, there's not an equal amount of benefit from a hundred or even a thousand new jobs and new opportunities being created in a more diverse set of industries and businesses.

Now, governments can't legislate innovation, that is, the idea that the government is going to tell you how to be innovative is, frankly, absurd. But what we can do and what we should do is create an environment where businesses can do their best rather than being told what's best. The critical thing for us to ask, as politicians and as ministers, is what can we do to make it easier for you to innovate? What can we do to make it easier for you to use your creativity, your dynamism to build new jobs, new opportunities?

So we have to have a very, very hard to look at the regulation and red tape that stifles innovation. In my own ministry, in my own department, the regulatory framework that underpins the communications sector, for example, was formed in another era when technologies and business models were relatively stable and, you know, telecommunications was overwhelmingly about fixed line telephony, when broadcasting was about television and radio. All of those - that context has completely changed, and so we're taking a first principles look again at regulation in the communication sector to see if the policy objectives behind it are still valid and if it still serves a useful purpose, and if not, the regulation should go.

If the objective is still a valid one, then we've got to ask ourselves what is the most low cost, least distorting method of achieving the outcomes we want. It's important to remember that some of the biggest defenders and beneficiaries of government regulation are invariably the

big established businesses. There's a couple of reasons for that: one is because they have often created the regulations. You know, they're the - in other words, the government has been captured by the businesses, the industries they are supposed to be seeking to regulate, just through force of advocacy and, you know, political muscle the big companies can exert.

And secondly, in terms of the compliance costs, big companies are much better able to deal with regulation than smaller businesses, because they will typically - if anyone - you know, talking to the chief information officer of Westpac here - I'm not suggesting that Westpac is a company that favours greater regulation - but Gail Kelly does not have to deal with all of the regulation and red tape that the owner or the manager of a business with 100 employees does, because she has, like any big company CEO, she has an army of lawyers and company secretaries and bean counters and HR officers and people to handle all that stuff. Regulation is much more damaging to smaller businesses, so it is, by its very nature, an obstacle to innovation.

Now, we have been seeking submissions from industry, and we've had quite a lot, and we would like to get more. We're very, very open-minded. I don't - I am absolutely determined that the communications department, which, as you know, it also includes responsibility for the digital economy, are very committed that we will play a very big part of our overall government's objective, the overall Abbott Government objective, of cutting $1 billion a year from the cost to Australian businesses and individuals, community organisations, and so forth, of the burden of regulation and red tape.

So if you've got some ideas, you know, if you - any of you here think that there are regulatory burdens on you where the - where the public policy objective is either not at all clear to you, in which case, let us know. Or where you think the objective is no longer valid, or you think it can be achieved in a much more cost effective way, then let us know. Please do that.

We are, you know, we are very, very determinedly are reaching out, and I don't want to have, you know, endless inquiries and reviews and so forth. What I'm focused on is getting some quick, decisive moves to cut the burden of regulation from you.

Also, of course, there is the opportunity for government to play its part in making available the data sets that of course can be exploited by everybody, anyone, I should say, in terms of the big data revolution, which of course, as you know, is the combination of, I guess, three factors: enormous growth in processing power; enormous growth in the availability and the cost - or the affordability of storage; and the third one, which is always the scarcest resource in this part of business, and indeed, every part, imagination.

So the government is perhaps not necessarily going to be the most imaginative, provide the most imagination. But there are a lot of data sets that we should provide, and we're looking at this very closely. Just to give you an example, in Australia, the private sector's interest in leveraging public data has been limited simply because of the lack of data available. The 514 data sets available at, compared to more than 210,000 at the US government's, and almost 10,000 at the British government's So we've got a long way to go.

And of course, state governments who have - which have [indistinct] data sets, some of which have been made available. Look at the - look at all the - look at the - just I mentioned the ferry earlier today, and I will just digress a little bit just to look at the power of making

public data available. Making timetables - timetable data available and actual running times available has enabled so many apps to be developed. I'm sure those of you that use public transport would use them. You know, TripView is one. There are plenty of others, no doubt.

But what that - that actually revolutionises public transport usage. You know, I've had a long interest in mass transit economics for many years, and the received wisdom used to be that mass transit was only ever going to be really effective if the frequency was so - was such that would be riders, passengers, did not need to look at a timetable to see when the bus or the train or the street car was arriving.

However, if you have a real time app, so you know that the 8.17 bus is running eight minutes late, you are then in a position to make a call, you know, talk to your friends, have a coffee or whatever, and you can manage your day so much more effectively. So it actually - it is - it inevitably drives greater usage and more efficient usage in terms of your time of public transport. Cost to government? Nothing. They've made the data available. Huge benefits, no doubt, in additional ridership. Of course, that then leads to pressure to spend more money on public transport, which would be a good thing.

Now, another area that is - has been a controversial one is the issue of employee share schemes. Now, there - we know that there are concerns regarding the current tax arrangements for employee share options. Professor, just to give you - you're probably not aware of this, because it would be - no one would ever imagine this would be the case, but the previous government created a regime where if any of the entrepreneurs here started a business and gave their employees some stock.

You know, in - you know, in, which of course the founders believe is heading for a $10 billion IPO any time soon, that more likely than not will fail. But that's alright, that's good. That's good. You learn failure is good. You learn a lot from it. And [indistinct] the critical thing in this area, in the innovative area, is, you know, old story, don't ever invest with an innovator that hasn't had a few failures under his or her belt. But anyway, in our system at the moment, you give the employee that stock, they have to pay tax on its value at the time of receipt, even though it is completely [indistinct].

And so the - naturally, no one - very few people will take that, because the whole idea of employee stock schemes, whether they're options or shares, is to enable people with high aspirations a - often a degree of irrationally exuberant bias, optimism bias, to work for low - [indistinct] low wages and a share of the future Nirvana if it arrives. I mean, that's - that's part of the dynamic. The law has deprived them of that. Now, the - there is a review going on of that, and we are currently considering that.

Obviously, there are budgetary implications, and as you know, money is tight, but this is - we're very alert to it and very much on the agenda. The - the truth is that we should have the - the goal should be at the appropriate time and when it's affordable, and I don't want to trespass on Mr Hockey's area, but we should have an employee share scheme that is comparable to the regime, for example, in the United States. It's crazy not to, because otherwise you're just creating another reason for people to start their business in America rather than here.

We're also looking at crowd funding models. The Corporations and Markets Advisory Committee is currently conducting a review of how crowd sourced equity could be part of the

Australian business funding system as a means of encouraging new investment models. Obviously, the - you know, there's a need to, as the United States has done, to get the appropriate balance between harnessing this terrific potential of crowd-funding for new businesses versus the, you know, the risks, the consumer risks, the investor risks.

Interestingly, some of you may have heard or met Jon Medved, who was here. An Israeli entrepreneur who has one of the crowd funding sites called OurCrowd, which has raised so far about $25 million for Israeli startups. You know, lots of investors in small licks, that ability to aggregate, has enormous potential.

Another area, of course, is cloud computing. There are terrific opportunities for government there to improve service delivery. The great opponent of cloud computing services is of course the box hugging IT department, which does not want its server taken away, because they fear - well, they - they know exactly what's happening. They know what's happening. This is where it is very important, it's really important for CEOs to - you can't - if you're not a software engineer or a telecoms engineer, you - it's unlikely if you're running a business that you're going to have the time to go off and do that degree.

But what you must do is be curious about technology. I mean, many of you have worked with me in different capacities over the years, and I practice what I preach. I take a lot of notes, and I really commend that approach. Find smart people who understand the technologies, talk to them, ask them lots of questions. You don't have to be an expert to question an expert. That's a very, very important point. You do not have to be an expert to question an expert.

You can, as an intelligent layman, you can learn an enormous amount about technology and systems simply by asking questions and, you know, noting down the answers. Because the more familiar you are with it, the more you will realise what the opportunities are. Remember, the rarest, the most valuable commodity in this whole equation of innovation, particularly in the technology space is not the technology itself. It's the technological imagination. And sometimes, the most technically qualified people are not necessarily the most imaginative.

So that's the - and that is often, you know, is the distinction that marks out a leader. But you've got to - you can't just say, “That's all too hard, I will leave that to the IT department,” or, “I will leave that to the CEO - the CIO or the CTO”.

Now, we are committed, as you know, from our digital policy, and I commend that to you, to getting all major government services and interactions with individuals online or able to be online by 2017. The private sector is so far ahead of us in that regard. I was talking to Michael Harte, the CIO of Commonwealth Bank just the other day, and in fact, I had a discussion with him which you might have seen, I put up on my video blog. He's saying that CBA, and I'm sure Westpac is no different, is conducting 95 per cent of its transactions virtually.

That is where government has got to get - has got to move into that space as well. We have to recognise that as another, you know, innovator in this field said to me the other day, we have to some extent become almost - become what he called “inferior cyborgs”.

That's not a very nice description, but what he was trying to say was that the ubiquitous smart phone, the fact that we have in our hands, almost all of us, a device that enables us to

communicate potentially with anyone or most or all of billions of other people, access any amount of data from anywhere, these devices have absolutely - are absolutely transforming the way we live. So many paradigms are being shattered, and we have to be constantly stepping back and rethinking how we see received wisdom and old paradigms.

Now, this - there's so many that we can talk about, but I want just leave you with one, I mean, just consider this: this is a very relevant for your teenagers - your teenage children. The default in all of human history, until today, has been to forget, hasn't it? You know, that's why we took the pictures of our little darlings in the - you know, when they were babies and put them in the photo album. That's why our ancestors painted pictures, and their ancestors painted pictures on walls, and you know, great stories, the Norse men, you know, an oral tradition, memorised long ballads and passed them on from generation to generation. The challenge was always to remember, because the default was to forget.

In a digital world, you can't forget anything. You can't delete anything. So you now - we're now in a situation where the - that fundamental paradigm has been changed. You may forget your - what happened at the party at university 10 years ago. You may well do. And there may actually be, you know, very good physiological reasons for you forgetting.


May have even been, sort of, almost chemically impossible for you not to forget.


But sadly, the pictures you uploaded onto Facebook will not be forgotten, and worse still, the ones your friends loaded up into Facebook and tagged will not be forgotten. And they will not be forgotten by the headhunting firm that checks you out when you're applying for that very grown-up job some years later. This is all - it's a different world. That's one of many paradigms.

Now, let me - I gave a speech, more heavy sort of economic speech about this issue some time ago, which went down completely flat, I might say. And for this - well, this part of it went down - the numbers were all right, but the - and I said, trying to get - grab a metaphor, I said that we have to be less like King Canute and more like Stephanie Gilmore. Now, Stephanie Gilmore, as you know, is a great Australian surfing champion, and King Canute was the guy that, you know, mocked his courtiers by saying, “Well, look, let's see how powerful I am, let's see if I can hold back the time.”

In - just like a surfer takes advantage of the individuality, the nuance, the variability of every single wave and adjusts to it flexibly and dynamically, in other words, embraces that volatility and uses it to win, and to get that perfect ride, that's the approach we need to have. So the key - the key seems to me, Professor Christensen has written the book, several books, in fact, on this. The key is open mindedness, nimbleness, flexibility, anti-fragility. Recognising that you cannot stop the volatility. You cannot hold it back anymore than Canute can.

You have to embrace it or it will bury you. Our strength - we have to be strengthened by volatility. Strengthened by change. Constantly open minded. Never, ever say, we've always done it this way. Strike that out from your lexicon and everyone who works with you. Never,

ever allow the not invented here syndrome to perpetuate. All the companies and businesses that think like that will be buried. This is a wonderful, exciting age we live in, this age of innovation, of disruptive innovation, of creative destruction. It's - this - there could not be a more exciting time to be alive. But you have to be alive to take advantage of it and to enjoy it. Thank you very much.