Invisible and Disruptive Entrepreneurs

While the popular mentality has shifted over the past couple of decades to recognise if not admire entrepreneurs, economic theory has largely ignored them according to The Economist's article Searching for the invisible man. And who would know better than The Economist?

Many people bicker over the definition of entrepreneurship, but the literal translation The Economist cites is quite satisfying.

Translated literally, entrepreneur means one who undertakes—one of life's doers. To start a firm you need gumption, and to succeed you need an eye for a gap in the market. That in turn demands alertness, as Israel Kirzner, of New York University (NYU), has pointed out. But it does not always demand much originality or power of invention. The fresh-born firm may be a mere clone of another one in a neighbouring town.

Replace the word town with country, and that last sentence is pretty close to Fabrice Grinda's international idea arbitrage concept.

The article focuses on the distinction in innovation between incremental improvements (making a slightly better version of what's already out there) and "discontinuous breakthroughs" (they cite the incandescent lamp, alternating electric current or the jet engine as examples). Through seemingly only large corporations would have resources and R&D budgets to make breakthrough innovations, the article points out that most come from entrepreneurs.

Why? The article gives two reasons:

The first explanation seems paradoxical. Breakthroughs are, by definition, more difficult than routine innovations. Surely, they should be beyond the meagre means of the independent entrepreneur? But as Mr Baumol points out, building the Kitty Hawk was much cheaper, and less complicated, than upgrading the Boeing 737 to the 747. Genuinely new ideas are often breathtakingly simple. They grow more elaborate as improvements and modifications are laid on top of them. If you are the first to discover a tree, you get to pick the lowest-hanging fruit.

The second explanation is more intuitive. Revolution is a risky endeavour. Of 1,091 Canadian inventions surveyed in 2003 by Thomas Astebro, of the University of Toronto, only 75 reached the market. Six of these earned returns above 1,400%, but 45 lost money. A rational manager will balk at such odds. But the entrepreneur answers to his own dreams and demons. Mr Baumol thinks a “touch of madness” is probably one of the chief qualifications for the job.

The first reason, that simplicity defies established companies, would surely be appreciated by Jason Fried. The second reason, that entrepreneurs are irrational, seems like a fine explanation too as evidenced by the many guests we've had on this show who've shunned high-paying and stable career options in favor of startups (of course, their irrationality is up for debate after they succeed).

I think the article missed one reason: That many breakthrough innovations are disruptive. A disruptive business can grow by making one dollar for every five it takes from its antiquated competitors. Craigslist only makes tiny amount of money (if any) on users who would otherwise spend a lot of money with a newspaper. The same relationship exists between TerraCycle and Miracle-Gro, and John Bogle's index funds and traditional high-expense ratio mutual funds. Disruptive innovations are on the side of the angels, better for consumers and will ultimately defeat their fat targets.

Why would a profitable corporation want to make a disruptive breakthrough? And if they did make such a discovery, fear would likely keep them from bringing it to market. In fact, Xerox PARC made many breakthroughs such as the mouse and advanced graphical user interfaces. It didn't have an incentive to cannibalize its dominant paper copy business, so it didn't put much effort into spreading those innovations. Steve Jobs had nothing to lose from building products on those innovations (except for the long-term health of one of his investors, Xerox, but that didn't matter to him), and ultimately computers progressed to the point that fewer paper copies were needed.

Similarly, I imagine that newspapers would not have developed Craigslist had they thought of it first (even if such a site was inevitable), Miracle-Gro would not brew TerraCycle had they thought of it and high-expense ratio mutual funds would not have organized the first index fund.

Entrepreneurs don't only have an edge because they're crazier and can come up with simpler solutions. Established players are made great because of large profit margins and don't want even their own disruptive breakthroughs to eliminate those margins. That's the entrepreneur's job.