There's money to be made when a new industry disrupts an established one.
Herbert Hoover summed up the importance of competition and innovation to the economy when he said that "competition is not only the basis of protection to the consumer, but is the incentive to progress."
What drives the modern capitalist economy is competition and, to paraphrase the economist Joseph Schumpeter, the essential fact about capitalism is the process of creative destruction.
Creative destruction happens when a new product, technology or way of doing things severely reduces the profitability of businesses which are already operating in a particular market. Sometimes an innovation can be so revolutionary that those existing firms who are now in competition with it have to completely restructure or will be forced into bankruptcy.
While creative destruction is generally bad news for the incumbent firms' employees and shareholders, it is good news for those in the upstart companies and for society which benefits from these new products.
Investors should be on the lookout for innovative businesses which may inflict creative destruction upon existing markets because these make great investments should they happen to work as promised. But you should also keep one eye open for firms and new technologies that may affect companies in which you are invested.
Candles and the Internet
In the early 19th century, candle making was a very good business to be in because lots of people needed some light to see by in the evenings and at night. Then a Canadian geologist called Abraham Gesner invented paraffin distillation; this led to the portable kerosene lamp and the candle-making industry was never the same again.
Do you think that society should have protected the candle makers' jobs and businesses by banning kerosene lamps? What about banning electricity and the light bulb because of the effect they then had upon kerosene lamp makers? In hindsight these are preposterous suggestions, yet similar ideas are taken seriously by politicians and much of the public whenever an established business or industry comes under attack from a disruptive competitor.
The Internet has been a major force of creative destruction ever since it emerged from the lab and parked itself firmly on the desktop. Many industries, most notably newspapers and record companies, have been severely damaged by the internet and some are clamouring for government subsidies and protectionist policies.
An example of this is the recent announcement that Carla Bruni's husband, President Nicholas Sarkozy, is considering a recommendation that the French government taxes internet search engines because of the effect that they are having upon some businesses.
When your business is being attacked in this manner it is literally a case of innovate or die.
Some more examples
Disruptive innovations can reshape entire industries whilst creating new opportunities for those who are prepared to adapt.
The increased use of motor cars in the early 20th century eliminated many people's need for horses which in turn reduced the demand for blacksmiths, farriers and buggy whips. But the car in turn created several new industries and dramatically increased the demand for mechanics, metals and rubber.
British Airways (LSE: BAY) and the state-owned airlines are being hammered by the disruptive low-cost carriers such as Ryanair (LSE: RYA) whose business models rely on cost-cutting to a level where BA and others cannot compete because of their high legacy costs and outmoded working practices.
Increasingly television companies such as ITV (LSE: ITV) are finding that their business is exposed to many varieties of overseas competition from the Internet.
The information technology business is one of the most exposed to creative destruction. In the late 1980s a small company called Microsoft effectively toppled the firmly entrenched industry giant IBM because Microsoft's MS-DOS operating system had led to the creation of the personal computer industry. IBM was able to survive and prosper because it adapted by recognising that many of its old methods no longer worked and it moved into new markets.
The human cost
It is true that creative destruction damages many lives by throwing people out of work. But what are the alternatives?
Permanent job protection, favoured by many, means that firms become very reluctant to hire staff in the first place and this well-meaning policy tends to entrench unemployment (Spain in particular has high youth unemployment in large part because of job protection laws).
Imposing restrictions upon innovation and the deployment of new technologies reduces the incentives to entrepreneurs and ultimately will harm the economy.
The irony is that many people whose jobs are affected by creative destruction will ultimately benefit from the economic growth that it produces. Unfortunately the short-term pain of unemployment appears much earlier than the economic benefits.
Allowing industries to fail and be replaced benefits society as a whole because it ensures that the economy becomes more efficient at allocating resources. However, investors should try to ensure that they aren't on the wrong side of creative destruction.
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