When Is Market Destruction Creative?

Stan Liebowitz is the Ashbel Smith Professor of Economics at the University of Texas at Dallas, School of Management.

Economists and non-economists alike tend to be familiar with the phrase “creative destruction” and its implications that, although established firms may bemoan new innovation upsetting apple carts in their industry, and government may try to protect them from those changes, in the end we are all better off because of the creative commotion which is part and parcel of the competitive process and the march of invention.

When, for example, television became popular, movie admissions shrank by 80 percent as the new, superior (the convenience of being entertained in one’s living room) technology usurped a large portion of the market from the older technology.  This was a good thing for consumers even if it was harmful to the movie studios (which would eventually produce many television programs, ameliorating some of the harm).

Unfortunately, not all destruction that occurs in markets is of the creative variety.  Unfortunately, confusion between good destruction and bad destruction is especially problematic in markets dominated by intellectual property.

The reason for this profound confusion in the case of intellectual products is that property rights are less well protected for many intellectual products as compared to their real-property alternatives.  The lack of property rights will cause just about any market to fail, as is normally understood.

The problem for intellectual products is that it is often a new technology that weakens the property rights and that new technology is confused with a technological improvement.  It is easy to demonstrate that not all new technology is necessarily good.  A new, cheap and easy-to-build device that destroys all computer chips hooked up to a power grid would not be creative destruction although it would be destructive and the innovation itself might have been “creative.”  The same would be true for the creation of a new virus that killed everyone on the planet.  Creative, yes.  Destructive, yes.  But not a good thing.

Of course, these are the easy cases.  The more difficult cases, and the ones in which I am interested, are those where it is less clear that the creative component is actually harmful.

Take TIVO, for example, and a simplified version of its history that I am going to provide.  It provided a new and superior method of recording television programs for later playback.  It also, at least for a while, allowed the removal of commercials.  These two characteristics, recording and removal of commercials, are not inseparable and are best thought of as two distinct “improvements.”  On the recording side, there is little to disagree about.  If the TIVO were superior to video recorders and other recording devices of the time, it would all be for the better if the TIVO replaced the outmoded and inferior recording technologies.  This would be creative destruction at work.

But what about the ability to skip commercials?  Viewers certainly value that characteristic.  But is that an improvement?  The answer is “no.”  The reason is relatively straightforward, although the point seems to be lost surprisingly often and by persons who should know better.

Someone has to pay for the television programming.  That someone in the non-subscription television market happens to be the community of advertisers.  Viewers are given the ability and the choice to watch television with its commercials or not, but this option depends on advertisers being able to communicate their advertisements to viewers.  Sitting through the commercial is essentially the price of admission for watching television.

It is theoretically possible that potential viewers would find advertising so annoying that they would prefer to give up watching the programs or would cover their ears and eyes during commercials. But we know that this was not the case for the great majority of viewers because almost everyone used to watch advertising-based television, and advertisers found their commercials to be effective. Viewers revealed, through their behavior, that they valued the programming more than they disliked the advertising.

Of course, even the viewers who value the programs more than they dislike the commercials would prefer not to have commercial interruptions.  But this is just an example where consumers would prefer a better deal.  I would prefer new Lexus automobiles to cost $5.  But, even without that option, I am still better off being able to purchase one for $50,000 as long as my value of the car is significantly higher than the price.  The fact that consumers would prefer television without advertising is predictable and tells us nothing useful regarding the value of TIVO.

Early adopters of the TIVO commercial-deletion function hoped to free ride off of other viewers who still saw the commercials.  But it is clear that removal of commercials jeopardizes the financial model of broadcast television.  If everyone skips the commercials, broadcast television as we know it would end since there would be no funding mechanism.

If given the choice between no television or not being able to skip advertisements, most TIVO owners would accept the commercials – but these owners were not being given that choice.  Eventually, TIVO owners and other potential consumers of broadcast television would be worse off when broadcast television disappeared.  The innovation of seamlessly skipping commercials would have destroyed the market.  Creative destruction?  Obviously not.

This point has been missed even by some trained economists.  It appears to me that these economists focus on the fact that when consumers are given the choice to zap the commercials, they choose to zap them.  Thus, these economists conclude that preventing consumers from doing something that they wish to do (zapping commercials) infringes on consumer sovereignty.  But that is missing the forest for the trees.

If consumers are better off without TIVO commercial-zapping abilities, then preventing these abilities from coming to market should be encouraged.  That would probably mean legislation against devices to zap commercials.

Although this seems hard to stomach for some, it really is no different than having a collective decision that it is a good idea to have traffic lights to help speed up driving and prevent accidents.  Surely, most drivers would prefer to be able to go through red lights when they thought it was safe.  One might conclude, therefore, that drivers should be allowed to cross intersections at their own discretion and traffic lights should be eliminated.

But this is not how we structure traffic rules for the simple reason that a breakdown in traffic would occur at all busy intersections if drivers were left to their own devices.  Drivers would be worse off.  We restrict driver sovereignty because, in this case, it makes drivers better off.

We should be equally realistic when it comes to behavior that encourages free riding and the destruction of markets.  Thus, it is not only commercial zapping that should be banned but file-sharing as well, which has the same “free-riding” motif whereby the pirates get the music (without paying) only because there are still individuals willing to pay for it.

But the library of new music is smaller than it would be due to the free riding of pirates, and if everyone were a pirate the creation of new music would diminish significantly. Other technologies that threaten other markets in the same way by allowing free riding should be similarly discouraged.

This article orginally appeared on The Media Institute’s IP Viewpoints blog.

  1. The fundamental problem in the cases described above really seems to be that people don’t always act rationally. While consumers may get frustrated that there are regulations that appear to restrict what is in their best interest, the problem is that consumers don’t always know what is in their best interest. There will always be conflict in these areas of law as mentioned above so long as people encourage market destruction that is not “creative” market destruction.

  2. The assumption of a rational actor (be they a seller or purchaser) has always been problematic – however, even IP rights themselves are premised on the notion that actors will behave in a state of perfect information, and in a rational manner.

    The question of whether consumers are “better off” is a very difficult one. Mr. Liebowitz argues that such a decision should be made collectively as opposed to individually. Not an unreasonable proposition. Unfortunately, I am not familiar with any instance of IP laws being based on a popular referendum (I would be very interested to hear about such events). [To argue that elected representatives are the equivalent would be disingenuous, as such representatives often represent a collection of positions, not all of which the voter may agree; or may take positions post-election with which the voter did not agree).]

    In fact, developments in the past decade suggest that any such referendum to create/strengthen exclusive rights would not be approved by the populace. One can argue, I suppose, that people (as a collective) should not be listened to. At that point, however, one believes herself to be a in a privileged position of decisions making – and presumes the right to make decisions against the will of the people because she believes it to be in their best interest. A very slipper slope.

    Schumpeter saw “creative destruction” as a force that sustained long-term economic growth *even as it destroyed value of established business models.* Just because new technology destroys an existing market does not mean that it is not beneficial in the long-term. In fact – according to him – it makes economies grow in the long-term. As Schumpter stated, such technological changes strike “at th[e] foundations and th[e] very lives of [existing firms].” Just because the printing press radically changed the economics of making copies and changed the world of books as we know it, does not make the introduction of such technology “bad.”

    Mr. Liebowitz examples of red-lights (interesting because a good deal of research shows that sign-less cities incur fewer accidents than those with signs), viruses and hardware destroying chips are bizarre, as they are not examples of business models destroying other business models. These examples just use the phrase “creative destruction” as if the phrase did not have a particular, accepted meaning as a term of art in economic theory.

    The statement that “if everyone skips the commercials, broadcast television as we know it would end since there would be no funding mechanism” may be true, but does not reveal why this is “bad.” It also cannot predict the shape that “television” will ultimately take – what comes after television “as we know it?” Who would have predicted that the decline in live performances of music brought on by AM, FM, television, cassette-tapes, CDs and DVDs would be turned around by the internet?

    What if people as a collective decide that it is good that television as we know it should end because we watch too much TV, or is not sufficiently democratic? Would this be a valid reason to create laws which prevent the current broadcast-advertise business model? What if people as a collective decide that the harms of IP outweigh its benefits?

    I have reason to suspect that the same people who would support a society-decided market distortion (banning of certain technology) would be vehemently against a society-decided “ban on TV” (to simplify) or removal of State-legislated artificial scarcities. In fact, if one observes carefully – the same industries calling out for regulation that would benefit them call out against regulation that would harm them. The arguments proposed tend to be far from altruistic: appeals to a given philosophy, principle or economic model are made based on the convenience of the day, not on any principle.

    The truth is, we don’t know the actual end-effects of any disruptive technology. We only know the current short-term effects on existing business models. Creating artificial market distortions creates the problem that Communism faced: the State does not have the necessary information to intervene in the market in this fashion. We may perpetuate poor business models because some have not figured out how to adapt.

    Mr. Liebowitz concludes with the following (Luddite-like?) statement: “technologies that threaten other markets in the same way by allowing free riding should be similarly discouraged.”

    Firstly, the problem of what amounts to “free riding” (paying less than ‘fair value’) is incredibly difficult, as what amount to a fair value can become a circular question. In theory, it should be the value that a person is willing to pay. But, as we have seen, that amount can (and should!) change with advances in technology (the amount does not remain static). Measuring the value of that good/service without that technology is an artificial distortion of the market, and does not let you find “fair value.” It only lets you determine that a person is willing to pay without the existence of that technology.

    Secondly, when technological changes strike at “th[e] foundations and th[e] very lives of [existing firms] ,” the response should be to change the business model – not to artificially distort the markets by way of State intervention. When entire industries base their business models on entirely artificial scarcities created by the State, it is little wonder that such markets are easily disrupted. Contrary to Mr. Libowitz’s statement, technology doesn’t weaken rights. It may weakens business models, but the rights remain the same.

    To continually protect such business models would require ever-increasing intervention by the State to establish legislation whose intrusiveness will have to match the rate of technological development. An untenable proposition, one would hope.

  3. The argument ‘commercial-skipping is bad because it will doom broadcast television’ is deceptively narrow in scope: why do we need to keep broadcast television at all?

    There is no freestanding societal need for the existence of television-based commercial advertising, and there are already-existing, successful models by which new television programmes are paid for through subscription fees, pay-per-view fees, and direct sales (e.g., DVDs, iTunes downloads).

    Perhaps viewers would be better off if all television programmes were produced under such systems. Viewers might pay more in direct costs to watch television, to make up for lost commercial revenue, but it would also become easier for producers to cater to viewers, rather than advertisers.

    The commercial-skipping feature of PVRs could itself become obsolete!

    The fact that advertisers currently pay for the creation of much television programming simply does not lead to the conclusion that it would be bad for viewers if broadcast television as we know it were destroyed.

  4. Mr. Kaufman and Mr. Drapeau both make the same mistake that I criticized in my post. Both suggest that there might be no value in the broadcast television model and thus allowing its demise might not cause any harm.
    But the very fact that consumers choose to watch advertising based television implies that they receive value. In particular it means that viewers received more net value than they would have received in any other activity that they could have chosen in its place, otherwise they would have chosen the other activity and not watched broadcast television.
    To suggest that consumers might prefer subscription television flies in the face of the fact that they have such a choice and have chosen to watch mainly advertising based television.
    An outside observer willing to supplant the tastes of individuals with his own taste might suggest that such viewers are better off without broadcast television. Such paternalism is not my cup of tea and is not what I am arguing for. My suggestion is that if viewers were confronted with the true choice (tivo without advertising based television or no tivo with advertising based television) they would choose the latter, which is consistent with their recent pre-tivo behavior. I merely wish to arrive at the same point they would arrive at if they were confronted by the actual implications of their behavior. I am not trying to impose my beliefs on them, or anyone else’s beliefs on them.

    Only if you believe that you know what consumers (viewers) want better than the viewers do not understand their own utility could you argue otherwise since watching television is a simple private decision.

    Nor do I want to perpetuate bad business models. The advertising based tv model was not a bad model. It was a good model, where goodness and badness are measured by the value created (in markets). Nor is it being destroyed by a superior business.

    Finally, a technology whose sole purpose is to help consumers avoid payment is not a productive technology. If a new technological device could fool gas pumps into thinking that no gas was being pumped when a fill up occured, such a device would have no social value and might make automobile travel imposible (since gas stations would disappear). It is not luddite to try to keep such devices from being used.

  5. My point, as stated, was not that the traditional broadcast model might have no merit, but rather that no logical basis was offered that a decrease in overall consumer utility is a necessary consequent of the destruction of that model’s success.

    Suggesting that broadcast television will continue to provide similar relative utility to consumers in the future as it has in the past simply is not a credible claim. It is analogous to suggesting that the horse and buggy will continue to provide similar relative utility after the advent of the automobile since (at that time), the horse and buggy had a strong market position and had for a long time provided consumer utility.

    It should be obvious that such (undisputed) historical patterns of consumers’ own choices are indeed exactly what are disrupted by the rise of a destructively creative innovation, and so cannot be claimed as evidence that the innovation is detrimental to overall utility.

    Further, the current evidence is that people in fact are changing their television viewing habits in ways that move away from the traditional advertiser-pay broadcast model (see, for example, this recent report in the Washington Post: ‘Click, Change: The Traditional Tube Is Getting Squeezed Out of the Picture’, ).

    In Canada, according to the CRTC, from 2006 to 2007, ‘Pay, PPV, VOD and specialty services represented the largest growth area [in the television broadcasting industry’ (source: ‘Communications Monitoring Report
    2008’, ).

    Apparently people’s private decisions are indeed pointing to the superiority of alternative business models.

  6. Mr. Liebowitz, I appreciate that you took the time to discuss this issue. I find it very positive that the author of an article would engage with the community.

    I believe that neither I nor Mr. Drapeu stated that there was no ‘value’ received by a viewer. What I did state (and I believe this is Mr. Drapeu’s statement as well) is that there is no indication that breaking the current business model is bad.

    The proposition that ‘good’ business models should not be permitted to fail due to technological developments (‘good’ being defined by creating value) would put us into a technological standstill. Virtually every huge business model that was supplanted was ‘good’ according to this criteria. It eventually failed in the face of new technology. It was after this failure that new models emerged.

    To argue that a person was willing, under different circumstances, and with different information, to pay a different amount does not reveal anything about current ‘value.’ ‘Value’ is only revealed at every transaction.

    Now, you can create laws which would make such transactions illegal or effectively impossible, but these create artificial distortions in the market, and this leads to inefficiency in the distribution of resources.

    “My suggestion is that if viewers were confronted with the true choice (tivo without advertising based television or no tivo with advertising based television) they would choose the latter, which is consistent with their recent pre-tivo behavior.” This is a false dichotomy – it assumes that there are no other options but these two.

    The actual implications of a person’s PVRing behaviour might actually be quite different than any of us expect. Given that a free market tends to be an efficient system in developing markets and business models, it is quite likely (just as in the countless instances before), a new – different – business model would be found. By restricting certain technology, you are preventing those business models from developing.

    The theory behind creative destruction does not foresee that each business model will be supplanted fluidly. The new business model will develop once the other is sufficiently broken. Stopping the technology that would break the existing model is also stopping the development of new models.

    As regards analogies with the consumption or destruction of physical goods (as the gas example is), these must fail. What we refer to as intellectual ‘property’ is non-excludable, and non-rivalrous, unlike classical goods or services. IP is the prohibition against using one’s own property in a particular way (e.g., to use one’s own pencil and paper to write out the lyrics of an existing song). Therefore, a comparison of PVRing, to ‘avoiding payment’ for a physical good is specious.

    Lastly, if broadcasters are concerned about the use of such technology, they can use contract law to address such issues (E.g., contract to the cable company, which would contract with the subscriber). The clumsy interventions of the State should have no role in this. A contracting regime would permit broadcasters to decide whether or not they are – overall – better in entering into such contracts (but possibly losing viewers), or not. As long as the market is sufficiently competitive, market forces would decide what is the preferable approach (hopefully some would use such contracts, others would not) without the creation of laws which are unresponsive to technological and market realities and changes.

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