Elasticity to innovation

I’ve been doing a book club with a few friends on The Idea Factory, a history of Bell Labs. I’ve previously written about this book, but in thousand ideas around it came across the concept that I hadn’t thought of before.

The obvious question that comes up when thinking about Bell Labs is “what made Bell Labs awesome, and what are the analogous institutions today?” Some of these factors are obvious. Bell Labs was most creative during the period when innovation information technology was one of the most dynamic fields of science; they were lucky because they picked the field that had a lot of low hanging fruit and which was not, in the end, regulated to death, unlike medicine and aerospace. They also had the benefit of recruiting a lot of top talent during a period when bright Midwestern kids were being recruited to places like Caltech MIT for the first time. In a previous article, I suggested that one hidden advantage was that Bell Labs had a very specific planning horizon that let it look farther than the next quarter but didn’t let it have its heads entirely in the clouds.

Another idea that came up, though, is the notion that Bell Labs also had a high “elasticity to innovation.” That is, the company was positioned in a way so that every innovation ended up having a large effect on the company’s bottom line.

There are two reasons why this is the case. One, which we’ve mentioned before, is that the company was a monopoly. There weren’t any phone companies of comparable size, and so that meant that there was no worry that any innovation they adopted would be quickly adopted by its competitors as well. If Dell adopted a new way to make computers, they’d only have a short window before HP did the same, but if you’re a monopoly, that by definition means you get dibs on the innovation forever.

In the second and more interesting reason is that this period of history is one where the telephone network was just beginning to really take off. Less than 10% of homes had a telephone, and this meant that the company knew that if they could improve the telephone experience, they were looking at a 10x increase in phone adoption and a 100x increase in call volume.  Innovation meant dollars, lots of them. And rather than taking innovation to be some magical, highly contingent process, we could think of it as something that responds to incentives, and appears only when it’s really needed.

This helps shed some light on why some monopolies are innovative and others aren’t. This is a question that I had struggled with earlier, and which Peter Thiel also touched on in his book Zero to One. Clearly, some of the really innovative companies have been monopolies, but lots of monopolies didn’t innovate much at all. I think that this notion of elasticity to innovation helps to explain the difference. If you are a diamond mine or the only bridge across the river, there’s no way for you to increase your revenue by 10x by adopting some new process. Your main asset is your location and monopoly status. Rationally, then, these companies would invest mostly in maintaining their monopoly status and exploiting their pricing power, giving relatively little thought to innovation. Only in its monopolies where you are creating the market as you go along, such as Bell Telephone or early airplane manufacturers, do you have a strong incentive to innovate. And indeed, we see that monopolies in these areas tend to be the ones that we think of as innovators.

This theory helps us make some predictions about which modern monopolies we might expect to be unusually productive. Companies like Microsoft for enterprise software or Google for search we wouldn’t expect to be extraordinarily productive, despite the monopoly status. However, the same companies may end up being innovative in different areas. Googles self-driving car, for example, is a case where the market, and by extension the company’s revenues, will only exist in as much as they were able to create meaningful innovation. Disruptive companies are innovative for the same reason; their market only exists in as much as they can wrench it from the control of incumbents. But there’s no special DNA in disruptive companies that will prevent them from being stagnant once they have become the kings of the hill.

This also lets us make some predictions in medicine. In this age of hospital consolidation, there are several companies, such as Kaiser and UPMC, which have local monopolies. By virtue of their location in consolidation, they basically have a lock on the medical care of patients in their geographic region. However, crucially, they can’t actually make a great deal more money by being better hospitals. Even if they came up with a new kind of robotic surgery, or reduce hospital infections in half, there’s only a limited extent to which patients would come specifically to them. And so, while I think it’s possible to see some process innovations from economies of scale, we wouldn’t expect explosive medical innovation to take root in these monopolies. On the other hand, there are some companies that are creating the market as they go along. This includes concierge physicians, which are trying to disruptively grab market share from established healthcare systems, as well as services like 23andme and Foundation Medicine, which are premised on creating entirely new markets for genomics and cancer diagnostics. Of course, we can’t predict whether or not these companies will succeed, but this model does predict that they have the incentives to make a valiant effort.