Paradigm Shifts - Principles of Management

A paradigm shift occurs when a new technology or business model comes along that dramatically alters the nature of demand and competition. Faced with paradigm shifts, incumbent enterprises have to adopt new strategies to survive. Paradigm shifts appear to be more likely in an industry when one or more of the following conditions are in place.

Paradigm Shifts

First, the established technology in the industry is mature and approaching or at its natural limit. Second, a new disruptive technology has entered the marketplace and is taking root in market niches that are poorly served by incumbent companies that use the established technology. Third, a company develops a new business model that is radically different from that used by competitors, enabling it to capture more demand and put its rivals on the defensive.

NATURAL LIMITS TO TECHNOLOGY

Richard Foster has formalized the relationship between the performance of a technology and time in what he calls the technology S-curve (see Figure above ). This curve shows the relationship over time between cumulative investments in R&D and the performance (or functionality) of a given technology. Early in its evolution, R&D investments in a new technology tend to yield rapid improvements in performance as basic engineering problems are solved.

After a while diminishing returns to cumulative R&D begin to set in, the rate of improvement in performance slows, and the technology starts to approach its natural limit where further advances are not possible. For example, one can argue that there was more improvement in the first 50 years of the commercial aerospace business following the pioneering flight by the Wright Brothers than there has been in the second 50 years.

The first 50 years took us from Kitty Hawk to the jet age—from slow propeller-driven planes made of wood, wire, and cloth to the Boeing 707, the world’s first successful commercial jetliner. Today’s commercial jetliners, such as the Boeing 787, although far more efficient than the 707, are recognizable as direct descendants of the 707.

In commercial aerospace we are now in the region of diminishing returns and may be approaching the natural limit to improvements in the technology of jetliners. What does this have to do with paradigm shifts? According to Foster, when a technology approaches its natural limit, research attention turns to possible alternative technologies.

Eventually one of those alternatives might be commercialized and replace the established technology. That is, the probability that a paradigm shift will occur increases. Thus sometime in the next decade or two another paradigm shift might shake the foundations of the computer industry as a new computing technology replaces silicon-based computing. If history is a guide, when this happens many of the incumbents in today’s computer industry will go into decline and new enterprises will rise to dominance.

Foster pushes this point further, noting that initially the contenders for the replacement technology are not as effective as the established technology in producing the attributes and features consumers demand in a product. For example, in the early years of the 20th century, automobiles were just starting to be produced.

They were valued for their ability to move people from place to place, but so were the horse and cart (the established technology). When automobiles originally appeared, the horse and cart were still quite a bit better than the automobile at doing this (see Figure below). The first cars were slow, noisy, and prone to breakdowns. Moreover, they needed a network of paved roads and gas stations to be useful, and that network didn’t exist.

Thus for most applications the horse and cart were still the preferred mode of transportation—and cheaper. However, in the early 20th century automobile technology was at the very start of its S-curve and was about to experience dramatic improvements in performance as major engineering problems were solved (and those paved roads and gas stations were built). In contrast, after 3,000 years of continuous improvement and refinement, the horse and cart were definitely at the end of their technology S-curve.

The result was that the rapidly improving automobile soon replaced the horse and cart as the preferred mode of transportation. At time T 1 in Figure below the horse and cart were still superior to the automobile. By time T 2 the automobile had surpassed the horse and cart.

Established and Successor Technologies

Established and Successor Technologies

Foster notes that because the successor technology is initially less efficient than the established technology, established companies and their customers often make the mistake of dismissing it, only to be caught off guard by its rapid performance improvement. A final point here is that often there is not one potential successor technology but a swarm of potential successor technologies, only one of which might ultimately rise to the fore (see Figure below ).

When this is the case, incumbent enterprises are at a disadvantage. Even if they recognize that a paradigm shift is imminent, they may not have the resources to invest in all the potential replacement technologies. If they invest in the wrong one—something that is easy to do given the uncertainty that surrounds the entire process—they may be locked out of subsequent development.

DISRUPTIVE TECHNOLOGY

Clayton Christensen has built on Foster’s insights and his own research to develop an influential theory of disruptive technology. Christensen uses the term disruptive technology to refer to a new technology that gets its start away from the mainstream of a market and then, as its functionality improves, invades the main market. Such technologies are disruptive because they revolutionize industry structure and competition, often causing the decline of established organizations. They cause a technological paradigm shift.

Christensen’s greatest insight is that established companies are often aware of the new technology but do not invest in it because they listen to their customers, and their customers do not want it. Of course this occurs because the new technology is early in its development and thus only at the beginning of its technology S-curve. Once the performance of the new technology improves, customers want it; but by this time, it is new entrants, as opposed to established companies, that have accumulated the knowledge required to bring the new technology into the mass market.

Christensen supports his view with several detailed historical case studies. One concerns the story of how disruptive technology revolutionized the market for excavation equipment. Excavators are used to dig foundations for buildings and trenches to lay pipes for sewers and the like.

Before the 1940s the dominant technology used to manipulate the bucket on a mechanical excavator was based on a system of cables and pulleys. These mechanical systems, known as “steam shovels,” could lift large buckets of earth; but the excavators themselves were large, cumbersome, and expensive. Thus they were rarely used to dig small trenches for house foundations, irrigation ditches for farmers, and the like. In most cases small trenches were dug by hand.

Swarm of Successor Technologies

Swarm of Successor Technologies

In the 1940s a new technology appeared: hydraulics. In theory hydraulic systems had advantages over the established cable and pulley systems. Most important, their energy efficiency was higher: For a given bucket size, a smaller engine would be required using a hydraulic system. However, the initial hydraulic systems also had drawbacks. The seals on hydraulic cylinders leaked under high pressure, effectively limiting the size of bucket that could be lifted using hydraulics.

Notwithstanding this drawback, when hydraulics first appeared, many of the incumbent firms in the mechanical excavation industry took the technology seriously enough to ask their primary customers whether they would be interested in products based on hydraulics. Because the primary customers of incumbents needed excavators with large buckets to dig the foundations for large buildings and trenches, their reply was negative. For this customer set, the hydraulic systems of the 1940s were not reliable or powerful enough.

Consequently, after consulting with their customers, these established companies in the industry made the strategic decision not to invest in hydraulics. Instead they continued to produce excavation equipment based on the dominant cable and pulley technology.

It was left to a number of new entrants, including J.I. Case, John Deere, J.C. Bamford, and Caterpillar, to pioneer hydraulic excavation equipment. Because of the limits on bucket size imposed by the seal problem, these companies initially focused on a poorly served niche in the market that could use small buckets: residential contractors and farmers.

Over time these new entrants solved the engineering problems associated with weak hydraulic seals; and as they did this they manufactured excavators with larger buckets. Ultimately they invaded the market niches served by the old-line companies: general contractors that dug the foundations for large buildings, sewers, and so on.

At this point Case, Deere, Caterpillar, and their kin rose to dominance in the industry, whereas the majority of established companies from the prior era lost market share. Of the 30 or so manufacturers of cable-actuated equipment in the United States in the late 1930s, only four survived to the 1950s.

In addition to listening too closely to their customers, as the manufacturers of cableactivated excavators did, Christensen identifies a number of other factors that make it difficult for established companies to adopt a new disruptive technology.

He notes that many established companies have declined to invest in new disruptive technologies because initially these technologies served such small market niches that they seemed unlikely to affect company revenues and profits.

As the new technologies started to improve in functionality and invade the main market, companies’ investment was often hindered by the fact that exploiting the new technology required a new business model different from the established model, which was thus difficult to implement.

Both of these points can be illustrated by reference to one more example: the rise of online discount stockbrokers during the 1990s such as Ameritrade and E*Trade. The enterprises used a new technology, the Internet, to allow individual investors to trade stocks for a very low commission fee; at full-service stockbrokers, such as Merrill Lynch, orders had to be placed through a stockbroker who earned a larger commission for performing the transaction.

Christensen also notes that a new network of suppliers and distributors typically grows up around the new entrants. Not only do established companies initially ignore disruptive technology, but so do their suppliers and distributors. This creates an opportunity for new suppliers and distributors to enter the market to serve the new entrants. As the new entrants grow, so does the associated network.

Ultimately, Christensen suggests, the new entrants and their network may replace not only established enterprises, but also the entire network of suppliers and distributors associated with established companies. Taken to its logical extreme, this view suggests that disruptive technologies may kill entire networks of enterprises.

NEW BUSINESS MODEL

The term business model refers to the way in which an enterprise intends to make money. For example, the business model of Hewlett-Packard’s printer division has been to sell printers at cost and then make money by selling replacement ink cartridges at a price far in excess of their cost of production. This is known as the razor and razor blades business model because it was pioneered by Gillette, which would sell razors at cost and then sell replacement blades for a substantial premium.

Another example of a business model is the search-based paid advertising model popularized by Google. Google offers free Web-based search products, but it makes money from the advertising associated with each search—particularly the “sponsored links” that pop up whenever anyone enters a search term into Google.

Advertisers pay Google a small fee every time someone clicks on one of the sponsored links and is directed to the sponsor’s Web site. Advertisers bid against each other to appear high on the list, with the advertiser featured on the top of the list paying the most.

The development of a new business model can radically alter the competitive playing field, disrupting competition by capturing demand from established enterprises. In other words, the development of a new business model can cause a paradigm shift. Google’s search-based advertising model, for example, is creating problems for traditional media (from television to print magazines) as they see advertising dollars diverted toward Google and its competitors (Yahoo and Microsoft’s MSN).

Similarly, Southwest Airlines created a new business model in the airline industry that has seriously disrupted competition. Southwest decided to bypass hubs and fly “point to point” between cities, often from smaller airports not used by established airlines.

Customers value the convenience and speed associated with this business model. The company also stripped costs dramatically by not offering meals during flights or assigned seating, departure lounges at airports, or baggage transfers to other airlines. So Southwest and its imitators such as Jet Blue and Europe’s Ryan Air have taken progressively more market share from established airlines, many of which are now in financial trouble.

Another example is Dell Computer, which pioneered the business model of direct selling in the personal computer industry. Dell’s rivals, which sell through retail channels, have been struggling to find their equilibrium since Dell took advantage of the superior value proposition and low costs associated with its business model to grab market leadership.

What Google, Southwest Airlines, and Dell have done (and are continuing to do) is reshape competition in their respective markets by developing novel business models that offer more value to consumers, enabling them to take demand from established enterprises.

The development of new business models is often predicated on the emergence of a new technology. Thus Google’s business model could not have existed until the Web had emerged and until the technology for searching Web pages had been perfected. Similarly, the emergence of Web browsing made Dell’s direct selling model particularly powerful and disruptive.

Technological innovation, in other words, offers fertile ground for the development of new business models. But new business models can sometimes emerge in the absence of new technology: No new technology underlay the business model developed by Southwest Airlines.

PUNCTUATED EQUILIBRIUM

Paradigm shifts are episodic events in the history of an industry. Studies have revealed that most industries are characterized by long periods of stability in which the development of technology proceeds along a well-established trajectory (a given S-curve) and established business models are adopted by all; but these periods of stability are interspersed with periods of rapid change. Normally such change is due to the emergence of a new technology, a new business model, or some combination of these that triggers a paradigm shift.

This view of the evolution of an industry, referred to as punctuated equilibrium, holds that long periods of equilibrium, when an industry’s structure is stable, are punctuated by periods of rapid change when industry structure is revolutionized by innovation.

Figure below shows what punctuated equilibrium might look like for one key dimension of industry: competitive structure. From time t 0 to t 1 the competitive structure of the industry is stable and highly concentrated, with a handful of companies sharing the market. At time t , a major innovation is pioneered by either an existing company or a new entrant.

The new technology lowers barriers to entry into the industry; new companies enter the market using the new technology; and the industry structure becomes more fragmented and competitive. After a while incumbent companies that cannot adapt go out of business, as do the new entrants that cannot gain enough market share to reap economies of scale. By time t 2 the industry becomes consolidated again, but now different firms dominate the market.

Thus there is a period of turbulence between t 1 and t 2 , after which the industry settles down into a new equilibrium with different industry leaders.

During a period of rapid change when industry structure is being revolutionized by a technological innovation, value typically migrates to business models championed by new entrants and based on new strategies. In the photography industry value has migrated away from a business model based on the sale of film and film processing services and toward digital imaging.

Punctuated Equilibrium

Punctuated Equilibrium

Kodak was the champion of the old business model; Hewlett-Packard and Sony have championed the new model (and now makers of wireless phones, such as Samsung, are getting into the market with camera phones). In the stock brokerage industry value migrated away from the full-service broker model championed by the likes of Merrill Lynch to the online trading model championed by E*Trade.

In the book-selling industry value has migrated away from small neighborhood bookshops toward large bookstore chains like Barnes & Noble and online bookstores such as amazon.com, both of which reap enormous economies of scale. As value migrates during these periods of change, many incumbent enterprises go into decline or at least go through periods of wrenching change such as the one Kodak is experiencing.


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