The Eastman Kodak Company is a great case study on how to build a moat. Founded in 1888, Kodak dominated the camera market for a hundred years. It arguably had significant moat protection in all the categories mentioned above, successfully fending off competitors and reaping outsized profits for a century:
Protected intellectual property: It held many photography patents and trade secrets.
Specialized skills or business processes that take a long time to develop: They had a vertically integrated supply chain serving all sides of the market, from cameras to film to printing.
Exclusive access to relationships, data, or cheap materials: It had many exclusive business deals, and being the biggest in the industry, it could negotiate to secure supplies more cheaply than competitors.
A strong, trusted brand built over many years: Everyone knew the name of Kodak and what it specialized in.
Substantial control of a distribution channel: It had the prime shelf space at retail locked in.
A team of people uniquely qualified to solve a particular problem: In Kodak Research Laboratories, it had the widest expertise in its technology areas and developed many advances in the field.
Network effects or other types of flywheels / A higher pace of innovation: While Kodak had no real network effects, it had a major flywheel going with its research and development department. Since it made outsized profits, it could invest more than anyone else in research and development, which kept its outsized profits going via faster innovation.
When assessing your possible sustainable competitive advantages, be explicit. A list like the one above can be a big help. What are you doing that competitors can’t copy? What will keep the competition at bay and allow you to exercise your market power for the long term?
Any single advantage could serve as the basis for your moat, but, as you can see from the Kodak example, several advantages can also work together, amplify one another, and produce an even bigger moat (force field). As we will see in a bit, though, even the biggest moats don’t last forever.
These same moat types can apply to your personal place in an organization or field as well. For example: You can have the biggest personal network (exclusive access to relationships). You can build a personal following (strong, trusted brand). You can become the expert in an in-demand area (unique qualifications). You can create a popular blog (substantial control of a distribution channel). Each of these and more can create a moat that protects your place in a competitive landscape.
Organizations and individuals that control working moats create lock-in when customers are locked in to their services because perceived switching costs are so high. There are many ways to create switching costs, such as cancellation fees, trusted relationships, new equipment costs, learning curves, network effects (see Chapter 4), brand affinity, etc.
Many people feel locked into Facebook because this is how many of their friends and family choose to share photos and updates of what is going on in their lives. Employers can feel locked into certain key employees, which gives these employees leverage to ask for raises or other benefits. Some employees are so critical to a business’s operations that there is a whole class of insurance products called key person insurance, which pays out if these key people become incapacitated.
These concepts also apply well beyond business situations. Many people feel locked into personal relationships, since the perceived costs (including emotional and psychological costs) of these changes are so high. Or you may feel locked into your housing situation, given the costs of physically moving and the opportunity cost (see Chapter 3) of spending your time on picking a new place, packing your things, making new friends, etc. Even countries get locked into diplomatic arrangements with high switching costs, as in the case of Brexit.
A related pair of concepts resulting from moats are barriers to entry and barriers to exit, which prevent people or companies from either entering or exiting a situation or market. A new mobile operating system wanting to compete with Apple’s iOS or Google’s Android would need to re-create an app store populated with thousands of useful apps, a large barrier to entry. Some careers have high barriers to entry, such as expensive years of schooling required. Similarly, some personal contracts, such as noncompetes, partnership agreements, or even marriage, create significant barriers to exit.
As with switching costs, barriers to entry and exit can come in many forms, such as trade secrets, like the Coca-Cola formula; high capital investment, like the cost of a huge factory; and government regulations that protect incumbents. A specific model centered on barriers to entry due to regulation is called regulatory capture, in which regulatory agencies or lawmakers get captured by the special interest groups they are supposed to be regulating, ultimately protecting these entities from competition.
In 2012, Jeff Donn reported on a year-long Associated Press investigation of the U.S. Nuclear Regulatory Commission [NRC], resulting in a lengthy four-part series that noted:
Federal regulators have been working closely with the nuclear power industry to keep the nation’s aging reactors operating within safety standards by repeatedly weakening those standards, or simply failing to enforce them. . . .
Examples abound. When valves leaked, more leakage was allowed—up to 20 times the original limit. When rampant cracking caused radioactive leaks from steam generator tubing, an easier test of the tubes was devised, so plants could meet standards.
Failed cables. Busted seals. Broken nozzles, clogged screens, cracked concrete, dented containers, corroded metals and rusty underground pipes—all of these and thousands of other problems linked to aging were uncovered in the AP’s yearlong investigation. And all of them could escalate dangers in the event of an accident.
Yet despite the many problems linked to aging, not a single official body in government or industry has studied the overall frequency and potential impact on safety of such breakdowns in recent years, even as the NRC has extended the licenses of dozens of reactors.
Industry and government officials defend their actions, and insist that no chances are being taken. But the AP investigation found that with billions of dollars and 19 percent of America’s electricity supply at stake, a cozy relationship prevails between the industry and its regulator, the NRC.
The disheartening part about this example is that nuclear power done right can be a safe and essentially unlimited source of low-carbon energy. Not regulating it effectively foments fears of nuclear energy and sets back the entire industry.
Nobel Prize–winning economist Joseph Stiglitz pioneered the model of regulatory capture. One reason for its common occurrence is that special interest groups often collectively lobby regulators via lobbyists, whereas the individuals affected do not tend to put together strong lobbying efforts due to their lack of organization. Another reason is that the regulators themselves often operate in a revolving-door pattern in which, after their time as regulators, they take highly compensated jobs in the industry they were just regulating.
Regulatory capture can happen outside the government as well, such as in occupational licensing, where certain occupations restrict the supply of professionals through control of their licensing boards and processes. For example, according to a Brookings report, in the U.S. about one-quarter of current jobs require a license, up from just 5 percent in the 1950s. These licenses cover occupations that you might think they should, such as medicine, and also those you might not think of, such as cosmetology. Critics contend that while some licensing can make sense, the trend is to require too much money and time to acquire these licenses, which protects people who already have them at the expense of competition. For example, they found the “number of days to obtain a cosmetology license varies from 232 in New York to 490 in Iowa.”
Another common example is nonprofit or community boards that get overrun by the personal interests and motivations of friends or family. In its worst form, regulatory capture is just plain corruption, though it often also occurs naturally with goo
d-faith intentions through regulators not seeking broad enough input from their constituents or not conducting comprehensive impact assessments (see availability bias and confirmation bias in Chapter 1).
There are ways to diminish regulatory capture. As U.S. Supreme Court justice Louis Brandeis famously wrote in Other People’s Money, “Sunlight is said to be the best of disinfectants,” meaning that allowing people to see and understand regulation and its effects—increasing transparency—can lead to less regulatory capture by special interests. When people are held accountable and made to explain their actions, change can more easily occur.
Strong moats, including those built upon regulatory capture and especially those built on network effects, can also lead to winner-take-most markets. This is where one company, once it reaches critical mass (see Chapter 4) through its network or dominant position based on another sustainable competitive advantage, effectively wins the market by taking most of the customers within it. For example, with more than two billion people on Facebook, a competitor won’t find it easy to re-create that network and compete with Facebook’s core offerings.
Just because you won the market, however, doesn’t mean you will win in perpetuity. Andy Grove, former CEO of Intel, famously wrote in his 1999 book of the same name, “Only the paranoid survive.” Intel’s early dominance was in memory chips; however, by the mid-1980s, Japanese manufacturers had effectively erased much of its competitive advantages in this market. But at the height of its dominance, Intel foresaw this existential competitive threat.
As a result, it pivoted the focus of the company into microprocessors and reestablished a long-lasting moat (“Intel Inside”). Grove’s words serve as a reminder that even if you establish a working moat, you must be constantly evaluating the strength of it, and even when you have a strong product/market fit, your moat may give way and you may need to eventually pivot. And Intel’s new moat did in fact eventually give out with the rise of the chips that power the smartphone and other smaller devices.
Remember Kodak? Its moat was also disrupted, though it didn’t pivot in time as Intel did from memory chips. In the 1990s, Kodak was rapidly disrupted by digital photography, and it ultimately declared bankruptcy in 2012 after a century of market dominance. You might think that it got caught off guard, but that isn’t true, just as it usually isn’t true in similar cases.
As mentioned, Kodak’s investment in research and development was part of its moat. Kodak actually developed the very first digital camera, way back in 1975! But the timing wasn’t right for digital photography to prosper then, due to lack of a supporting ecosystem—graphics cards were not fully developed, physical hard drive size was too big, etc. Meanwhile, Kodak had been making most of its money from selling film. Digital photography of course has no film, and once it prospered, it fundamentally disrupted Kodak’s profitable analog model.
When disruptive technologies like this first emerge, they are usually inferior to the current technologies in the ways that most buyers care about. For decades, digital photography was comparatively expensive and produced lower-quality photographs than film; however, its convenience (in not having to develop pictures) appealed to some buyers and allowed the market to progress. Slowly but surely, the price and performance gap between digital and film closed. Once it crossed the tipping point (see Chapter 4) of being attractive to most consumers, the digital camera market exploded.
Consumer Camera Sales
Analog vs. Digital, 1995-2012
Kodak wasn’t blind to these developments either. Initially it was even the market leader in digital cameras too, with a 27 percent share in 1999. However, it didn’t invest heavily enough in the technology relative to its competitors, the way Intel did when pivoting to microprocessors. Kodak simply wasn’t paranoid enough.
The overall market for photography quickly and fundamentally shifted from the high-margin film business to a highly commoditized digital camera business, and Kodak simply wasn’t fast enough to adapt. It didn’t use its flywheel from the film business to fuel its path to domination in digital, and its share of the exploding digital photography market fell as a result. In 2007 Kodak was number four in digital photography and by 2010 they fell to seventh, at 7 percent market share, behind Canon, Sony, Nikon, and others.
Just as this happened, these same digital camera manufacturers were similarly disrupted by Apple, Samsung, and others producing smartphone cameras. Same story: First, these new “cameras” were relatively expensive and produced lower-quality photographs, but they were more convenient. Over time, however, the quality kept increasing and there were more and more reasons to have a smartphone, leaving not enough reasons to have a separate digital camera.
It is an interesting question in counterfactual thinking (see Chapter 6) to ask what would have happened if Kodak had tried to develop the digital photography market earlier. Would it have been able to dominate that market? Would we all have had digital cameras years earlier? Could it have eventually pivoted into a role powering the cameras in most smartphones or pivoted even more drastically and created a product like Instagram? We’ll never know.
Consumer Camera Sales
Digital vs. Smartphone, 2002-2016
In Clayton Christensen’s seminal work The Innovator’s Dilemma, he lays out the framework for how such disruptive innovations ripple through industries, ushering new industry entrants into power while leaving dead incumbents in their wake.
The incumbent’s dilemma is whether to embrace the disruptive technology, usually at the great cost of the existing business. That’s what Intel did but Kodak didn’t do. If Kodak had more readily embraced digital camera technology, it would have directly cannibalized its outsized profits in analog film technology. Similarly, many companies are right now facing difficult decisions about whether to embrace new disruptive innovations like artificial intelligence, solar power, streaming video, driverless vehicles, and electric cars.
Individual workers face comparable issues. Over the past decades, globalization has dramatically changed the job responsibilities and prospects for many across a wide swath of industries. Employees who were essential at one time saw their moats destroyed. Similarly, automation and artificial intelligence are poised to disrupt many more jobs over the coming decades.
If you see disruption on the horizon in your field, you ought to prepare to respond sooner rather than later. Maybe that means investing in a new set of skills; maybe it means switching responsibilities; maybe it means pivoting to another field altogether. Unfortunately, truly embracing a disruptive innovation usually means major upheaval to the company or person itself: major losses of revenue in the short term, retraining from the ground up—a major pivot.
There have been many instances where pivots have been advisable at the height of market dominance or earning potential. Unfortunately, market dominance can correspond with complacency. That’s why only the paranoid survive—you have to be paranoid to perceive the threat of something so small or far off in the future when you are in such good shape. When you embrace this model, you must therefore pay attention to a lot of small threats, most of which will turn out to be harmless. How do you distinguish the signal from the noise?
One approach is to closely monitor the progression of new threats as they progress from being used just by early adopters to being taken up by the mainstream, along the curve of the technology adoption life cycle as described in Chapter 4. Many technologies or ideas often capture some interest by innovators or early adopters, but very few actually make the jump to the early majority of the mainstream.
Business strategist Geoffrey Moore named this jump crossing the chasm in a book by the same name. The chasm here refers to the fact that many ideas, companies, and technologies fail to make it from one side to the other. That’s because there is a huge gulf in expectations between early adopters and the early majority, which most things fail to meet. Early adopters like to tinker with things or are a small subset of people who really need something, bu
t to cross the chasm into the early majority, a product has to solve a real ongoing need for a lot more people. And most products just aren’t compelling enough to cross this gulf and truly spread into the mainstream.
Crossing the Chasm
But if you think a competitive threat does have a decent chance of crossing the chasm, you should pay close attention. That’s because if they do cross the chasm, it will mark a tipping point of significant and much more rapid adoption. You need to be prepared when that happens, not caught off guard like Kodak.
This process of maintaining your market power is never ending. You are constantly assessing new threats, bolstering the strength of your moats, and pivoting as needed over time. If you let your guard down, you will surely be disrupted. On the other hand, if you focus on maintaining your market power, which may involve some major pivots, you may be able to reap its benefits indefinitely.
KEY TAKEAWAYS
Find a secret and build your career or organization around it, searching via customer development for product/market fit (or another “fit” relevant to the situation).
Strive to be like a heat-seeking missile in your search for product/market fit, deftly navigating the idea maze. Look for signs of hitting a resonant frequency for validation.
If you can’t find any bright spots in what you’re doing after some time, critically evaluate your position and consider a pivot.
Build a moat around yourself and your organization to create sustainable competitive advantage.
Don’t get complacent; remember only the paranoid survive, and keep on the lookout for disruptive innovations, particularly those with a high probability of crossing the chasm.
Super Thinking Page 35
