Schumpeterian Innovation for Regulated Natural Monopoly
as a Corporate Strategy
Frank T. Lorne* and Lawrence WC Lai**
*New York Institute of Technology, Vancouver, [email protected]
**Department of Real Estate & Construction, University of Hong Kong, [email protected]
Abstract: This paper explains how the ideas of Schumpeter on innovation can be generally
applied as a corporate strategy entailing intrapreneurship for companies competing to become
natural monopolies.
Introduction
It is well recognized that a key decision for
corporate strategy is value chain management.
Technological advances in digital computation, the
internet, e-commerce, and network externalities have
exemplified the effect of the scale factor in many
corporate mindsets for achieving big is beautiful,
while a ‘winner takes all’ approach can be an implicit
influence for many corporate strategies.i
This phenomenon long existed even before the
advent of the digital economy, which is described in
economics as a natural monopoly problem.ii The
problem describes a generic condition of scale
economies in production and delivery, which
coincides with the concept of value chain
management. Both are statements for achieving the
best value per unit of output delivery. However,
economists’ treatment of the subject has been static
in nature in that most textbook treatments of it have
emphasized the need for regulated prices for a
natural monopoly, whereas management literature
emphasizes the strategies needed for achieving the
precondition of a natural monopoly.
The difference in these approaches could be
narrowed by noting that companies competing for
scale are only part of the story. Continuous
innovative efforts can shift the cost curve uniformly
downward, while at the same time pushing for a
larger minimum efficient size of a company. The
process for this to materialize entails what we would
argue in this paper as a Schumpeterian innovation –
in that it takes on a dual process of an
inside-versus-outside flow of activities to achieve
sustainable development. Indeed, the nature of
competition can often be characterized by companies
competing to become natural monopolies, sometimes
by political means.iii
To be sure, Schumpeter himself did not address
the concept of a natural monopoly when he
published his classic doctrine on development. But
the notion that scale factors are as important as shift
factors in affecting per unit costs of output can
suggest an extension of his Theory of Economic
Development, possibly providing additional insights
for corporate strategies.
Schumpeterian innovations can also contribute to
an understanding of the genesis of a natural
monopoly in that it suggests that the development
process does not necessarily have to come from the
outside of an organization. Creative destruction can
be internalized in the form of “intrapreneurship” (as
opposed to entrepreneurship),iv which can be a paid
employee within an organization. Furthermore,
conceptualizing the innovative process as an
inside-versus-outside circular flow of activities can
bring out the distinction between the static concept
of a natural monopoly – an achievement of scale
economies – versus a dynamic concept of a natural
monopoly, which is a shifting of the overall cost
structure of a firm.
This paper utilizes a regulated natural monopoly
of a public utility (transportation), the China Motor
Bus Company (CMB) in Hong Kong, to provide
additional insights into how the strategies came
about or ought to be formulated.
Although
seemingly a perfect textbook example of a regulated
natural monopoly that can often suffer from poor
management, the history of the company actually
shows numerous design changes involving
improvisation and experimentation for medium scale
expansions. The success and the failure of CMB
case provides an illustrative tool for some of the
concepts mentioned in this paper.
The Dynamic Natural Monopoly
We shall define a dynamic natural monopoly as a
company that perceives value chain management as a
continuous process for improve operation for every
scale of its operation. The difference between this
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notion of a natural monopoly and that in economics
textbooks can be illustrated by Figure 1.
Let’s begin with a demand curve, D0, intersecting a
long run average cost (LAC0) and a short run average
cost (SAC0) for a regulated natural monopolist at
point A. The regulated price is at PA. With
population and income growing, the demand curve
will shift to D1, intersecting SAC0 at Point B.
Notice that between Point A and Point B, there is a
range of demand increases in which the natural
monopolist would make a short run profit even at
regulated prices. Increases beyond D1, however,
will result in losses for the natural monopolist, and
some readjustments would be expected.
A static natural monopolist at Point B may
perceive a tremendous incentive to increase plant
size along its LAC0 with the increased demand
condition of D1, which has its regulated price fixed at
PA. The per-unit savings in costs is the vertical
difference between B and C, where Point C denotes
the tangency of the long run average cost with an
expanded capacity of a larger plant’s short run
average costs of SAC00. This incentive for the
monopolist to expand, however, is not driven by
innovation, but merely via an expansion of the scale
of operation, as the company remains on the same
envelope of LAC0.
The above situation can contrast with a scenario
induced by a Schumpeterian innovation, which turns
the static natural monopolist into a dynamic natural
monopoly. For a dynamic natural monopolist, the
whole long run average cost will shift down to LAC1.
The perceived reduction in per unit costs due to the
innovation is the vertical difference between Point A
and Point E, which may be larger or smaller than the
vertical difference between Points B and C (the
incentive to expand as a passive response to demand
growth).
Whether a natural monopolist should passively
wait for a growth in demand or proactively adopt
Schumpeterian innovations can be a strategic choice,
to be decided depending on how fast demand is
growing, how much cost savings is expected to be
realized by a mere scale expansion (the steepness of
LAC0), and how effective is the innovative effort in
reducing long run average costs (expected magnitude
of the vertical shift of LAC relative to inventive
costs) Thus, it will be inaccurate to assume that all
natural monopolists are either all static or all
dynamic in nature.
But regardless of which
strategy a monopolist pursues, the vertical difference
between B and C (the per unit cost savings of a scale
expansion) is always smaller than the vertical
difference between B and F (the per unit cost savings
for a Schumpeterian innovation). Thus, the choice
of opting for a Schumpeterian venture also depends
on how fast demand is expected to grow (i.e., how
soon in the future demand can increase from D0 to
D1).
The provision for making the strategy choice for
the above analysis is contingent on a price (rate)
regulation that will not be immediately altered as
cost and demand conditions change. It is, therefore,
also important to evaluate the legal environment for
particular types of natural monopoly in terms of what
parameters would be considered by the regulatory
agent to be relevant for price (rate) re-adjustment
considerations.
There is a political economy
dimension for this problem of which all enterprises
experiencing the benefits of increasing returns must
also be aware.
Schumpeterian Innovations
Our next step is to evaluate the salient features of
Schumpeterian innovations for drawing a
correspondence with the natural monopoly
framework in the last section. Schumpeter drew a
distinction between routine, repeated, reproducible,
and regular types of activity (normal circular flow
activities) versus those that are unusual, variant, and
creative (outside circular flow activities). The
former presupposes a fixed chosen production
function, while the latter can be interpreted as a quest
for new production functions.v
The distinction was emphatically described in an
early (1911) version of The Theory of Economic
Development, which Swedberg (2007) summarized
in a table we slightly modified in Table I. It is
useful to mention the personalities associated with
the inside vs. outside circular flow notion of
Schumpeter’s theory because it has a direct impact
on corporate strategies. Readers might find the
categorization to be a bit extreme in that successful
managers from their personal experience do not
adopt an either/or type of attitude. Indeed, that
reflection begs additional digging into the concept of
Schumpeterian innovations along the dimension of
strategy formulations that we can summarize and
extend in the following ways:
a.
Innovations do not have to come from
outside an organization, and indeed, can be
generated from intrapreneurs who are paid
employees.
b. The sustainable development strategy of a
corporation may call for diverting resources
out of the circular flow, as well as back into
the circular flow.
In other words,
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innovation is as important as adoption.
c.
Successfully innovative companies need to
manage a personality conflict between “The
Man of Action” and “The Static Person”.
This is so for activities diverted out of the
normal circular flow (development), as well
as for activities that are returned to the
circular flow (adoption).
d. A product’s life cycle can be perceived as
the successive overlapping life cycles of
products in and out of the circular flow, with
innovations and “obsolescence” happening
simultaneously at a particular point in time
within an organization.
e.
The inside-outside property of development
suggests a duality, and, indeed, a balance of
product development, as well as the
adoption of new product into wide spread
usages within an organization.
The first three propositions are quite intuitive, and
casual observations would suggest that they are
practiced
in
many
organizations
already.
Propositions (e) and (f) are assertions beyond what
Schumpeter described in the Theory, but based on
the cumulative thinking of the subject by the two
authors in this article over the years (Lai and Lorne
(2003); Lai and Lorne (2006); Lorne (2009)), those
are what would make the organization sustainable.
Otherwise, Schumpeter’s notion of creative
destruction is likely to cannibalize the status quo of
an organization leading to a wholesale replacement
or the young replacing the old. vi Sustainable
development is a new concept generally worked to
promote win-win outcomes between business, the
environment, and society. The concept can be
practiced by the country as a whole, as well as by an
enterprise or a corporate entity.
Schumpeterian Natural Monopoly
We can now elaborate on how the strategic choice
of a static vs. a dynamic natural monopoly can be
influenced by Schumpeterian economics in light of
growing demand or any induced network effects on
the demand side – a term more akin to strategy
discussion for the new economy. Refer back to
Figure 1 for illustration, as we explained in early
section that the movement from A to B is a
movement along an original SAC0 curve. This
represents a natural monopoly that is managed by the
most static personality.
Operations under this
management style expand by incurring only variable
costs. They do not foresee a scale expansion in
light of demand growth. The positive profit they
enjoy is protected by a regulated price of the industry.
The sustainability of this type of natural monopoly is
likely to be the short, as demand growth will simply
turn them into an operation that eventually suffers
decreasing returns. Indeed, they are likely to be
replaced, either by cost overruns or by a new entrant
outbidding the incumbent for a renewed franchised
contract.
It will be useful to bring in the discussion of
Schumpeter’s innovation in terms of the changes in
production function for Figure 1, as production is the
duality of costs. The perceived change by the static
monopolist from Points B to C entails a manager that
is less static than that from A to B, as moving to
Point C involves the changing of plant size, which is
a scale expansion that could be “based on history” or
“motivated by needs” (see Table 1). But those
changes are well within the realm of inside circular
flow in that SAC00, the plant size adopted by moving
from Point B to C has to eventually face decreasing
returns and be subjected to the same fate as the most
static natural monopolist like SAC0. The expansion
is also within the “old” long run envelope of LAC0,
and is thus not sufficiently Schumpeterian.
The production function approach to the inside vs.
outside circular flow of development can be made to
further cast light on the development cycle.
Suppose an enterprise pursues the dynamic natural
monopoly strategy of lowering the long run average
costs to LAC1 as early as at Point A (when the
demand is still low). This is a decision that will
divert resources from normal production activities by
emphasizing a new method of doing things that can
be only potentially applied to all levels of the scale of
operation. This is an outside circular flow action
that, if successful, will move the operation, even for
low demand at D0, to Point E.
There is, of course, no assurance that a new
production function can work in practice, and indeed,
during the testing stage of a new device, its intensity
of usage is likely to low, thus costing more than E
(i.e., a point to the left of E up the LAC1). Indeed,
Point E denotes only the maximum use intensity for
demand condition D0 which, if achieved, can be
considered a successful innovation even though the
gain from doing so could be less than that derived
from the most static mentality of operation (scenario
not drawn on the graph). However, as shown in the
previous section on dynamic natural monopoly, the
gain of a Schumpeterian innovation is always higher
than that of a static natural monopoly when demand
has increased to D1.
The process of how a Schumpeterian innovation is
completed is as important as how it starts.
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Associated with Point E is a SAC1curve that, when
demand increases to D1, can expand to SAC11. This
situation is shown in Figure 2.
Notice the
movement from E to F is similar to that from A to C,
meaning it entails the mentality of something less
than a “man of action,” but requires only a slightly
motivated static person. The source of the cost
reduction from SAC1 to SAC11 could be the result of
learning by doing, duplicating operations to share
overheads, utilizing anticipated channels in the value
chains of the original design in the shifting of LAC,
etc., all of which pertain to a replica of actions that
are characteristics of growth as opposed to
development.
If Schumpeter is to be credited with the concept of
development, he should also be credited with the
concept of growth in his articulation of the normal
circular flow activities. There are some things that
every enterprise (or individual) can become more
skilled at over time when the same activity is
repeated on a day-in, day-out basis. The growth
concept also has a biological connotation, as a child
will grow to become an adult by eating, sleeping,
and performing daily routines. The child’s mere
size will grow without intervention; but activities
responsible for growth are conceptually different
from development activities that deal with education,
search for soul and mind, and the training for
specific performances of the body, etc. that will
ultimately define the character of the individual
holistically.
The duality of inside vs. outside activities as a
corporate strategy is analogous to the balance of
body and mind stressed in many health guides for
our daily lives. But Figure 2 can also show how
this balance can work for enterprises looking to
escape from the dilemma of decreasing returns as the
end of a product’s life cycle draws near. The way
to seek sustainable development, as opposed to pure
development in the Schumpeterian sense of the
outside circular flow of activities, is to seek a
balance between movement along an LAC curve and
a shift of it. In that sense, a truly sustainable
strategy for industries with increasing returns is to
think of a balance of resources of moving from
Points E to F (growth), as opposed to a movement
from Points E to G (development). Indeed, it may
be through a combination of the two directional
developments, seen as a vector combination of the
two arrows, that a truly Schumpeterian natural
monopoly can be achieved.
demonstration does not have to resort to the new
digital economy, and indeed, serves as a better
illustrative tool when it resorts to a “primitive” case
of natural monopoly, as technology is less driven by
jargons, and the network effect on the demand side
can be abstracted to focus only on the supply side.
The China Motor Bus (CMB) case in Hong Kong
is interesting in that the choice of a static versus a
dynamic natural monopoly can be seen as an internal
battle within a corporation in which a compromise
has ultimately propelled the organization to a higher
level (or a lower level in terms of costs). It is also
interesting in terms of its energy efficiency
implication, particularly for cities with high
population densities. The capacity/mass ratio of
double-deckers is the highest when compared to
other forms of road transportation.vii Thus, it could
be right for the wrong reason in that it led to the
adoption of double-deckers for this once colonial
city under the British rule.
In 1933, CMB won an exclusive geographical
licence from the Hong Kong Government, but had to
pay a royalty as a quid pro quo for running public
buses on hilly Hong Kong Island for a period of 15
years. Prior to 1933, several operators ran buses in
the Crown Colony. The licence, frustrated by the
Japanese occupation of Hong Kong from December
1941 to August 1945, was renewed without
interruption till 1998, when New World First Bus and
CityBus took over all Hong Kong Island routes from
CMB. The saga of CMB revealed reasons for its
success and subsequent failure from the perspective
of strategy formulation.
CMB made profits without any direct government
subsidy, although its bus fares were regulated from
1933 to 1998. The first major fare increases did not
occur until the mid-1970s – long after the
geographical franchise guarantee was compromised
by the government’s legalisation of privately operated
“minibuses” and the concept of licensing by route was
substituted. The reasons for these changes are not the
focus of this paper, so suffice it to say that the political
economy of the situation has a definite bearing. The
interesting institutional arrangement imposed by the
Colonial Government was that CMB, like its
counterpart across the harbour in the Kowloon, KMB,
had to be a listed company. The details of its
directors and accounts can be tracked. However, for
the sake of focusing on a regulated natural monopoly
with a fixed price in this paper, that will not be our
direction of inquiry.
Insights from a Case Study
There are many industries that exhibit increasing
returns or at least strive to achieve them. The
What can be reported for this study is the extent of
Schumpeterian innovations for this industry and how
they came about. Our study of CMB between 1963,
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when it started operating double-deckers on two
urban routes (Nos. 2 and 10) on Hong Kong Island
after having convinced the government that they were
suitable, and 1985 reveals that this was a highly
innovative period (Lai 2004, Lai, Davies, and Cheung
2011, Lai and Lorne 2011) in terms of increasing bus
capacity and operational efficiency in spite of keen
competition and great political and business
uncertainties. Of great importance was CMB’s
comprehensive adoption of one-man bus operation
(OMO) before Kowloon Motor Bus, and its
conversion of single-deckers into double-deckers to
operate even on hilly routes (Lai and Lorne 2011
forthcoming). Such innovations were improbable
cases of excellent intrapreneurship that overcame
mental, as well as cultural, differences in the
management styles of major Chinese shareholders
with a strategy that cannot be considered explicitly
planned, but evolved from a dynamic process
corresponding to the description of a Schumpeterian
process described earlier.
How did CMB behave in terms of Figure 1?
According to an initial study by Lai, Chau, and
Cheung (2011), it enjoyed economies of scale from
1946 to 1998. viii Thus, it certainly moved away
from A in a rightward direction over a long period of
time. Did it move from A to C or A to F? Our
view is that the conversion of single deckers into
double deckers inside CMB’s garages due to
shortages of new UK buses during the early 1970s
was surely a movement from A to C, whereas the
adoption of OMO and the purchase of new bus
models with increasing capacity were acts that
shifted the long run AC curve downward.
The improvisation caused by shortages perhaps
also revealed the exogenous factors leading to
changes in strategies, an element of consideration
that is important for all strategy formulation.
“Shortages” occurred because the costs of additional
supply did not justify the “needs”. This can be
interpreted as an unintended movement along the
SAC0 curve beyond Point B, as D1 continued to
expand. Price could not adjust along SAC0 beyond
Point B, as it had to be fixed at PA. In short, it was
simply not economical for CMB to remain a static
natural monopolist when demand expanded beyond
D1. The profit figures of CMB around 1971 as
reported in Table 2 seem to conform to this
interpretation.
The role of intrapreneurs was invaluable during
this transition and beyond. The most successful
years of CMB were when expatriate bus engineers
were recruited and retained. The key personalities
were Chief Engineer Trevor William and his
successor John Blay, who came from Swedish
Motors in Bangkok and was previously an engineer
with London Transport; and Traffic Manager Lyndon
Rees. Rees had substantial industrial experience in
South Wales, where double-deckers operated on
routes that ran in steep-sided valleys with sharp
bends, which were similar to those on Hong Kong
Island’s roads (Davis 1994: p.60). They were able
to persuade the family-operated CMB to embark on
bold plans of innovation.
It is interesting also to note that during this period,
CMB maintained a cordial relationship with the
government, with which exchanges of human capital
were common. Rees had worked in the Transport
Department and Blay later went to the Transport
Department.
What came after 1985 seemed to be a different
story. CMB fell so far behind the competition in
the increasingly congested market of public
transportation that eventually, some of its routes
were revoked by the government and that led to its
demise.
First of all, the strategy of CMB had changed. It
went in the direction of real estate in its exploration
of new stations for new routes. Costs of operation
are but one factor in the public transportation
business; others include the ability of a transport
provider to add new routes and the associated land
and structural-related development along with it.
The intrapreneurial skill of that aspect of
development is arguably different from that of
engineering, and changes to the internal structure of
a company would reflect that. But that aspect of a
development, however, has nothing to do with the
focus with which a government franchise arguably
should be granted.
CMB’s reported profit has always been in black, a
rare find of public utility companies around the world
as they often entail government subsidies. Also, it
seems that the loss of its franchised bus business in
1998 did not affect CMB’s profitability, as it shifted
its major revenue source to real estate development in
strategic partnership with Swire Properties starting in
1993. That year, on the grounds that CMB bus
management had lagged behind the times, the
government’s Transport Department re-assigned 26 of
its lucrative Southern District routes, which were
insulated from the reach of the rival Island Line of the
Mass Transit Railway (MTR), to CityBus. Both
MTR and CityBus were fully or mostly
air-conditioned, but CMB’s bus fleet only partially so.
In any event, as soon as the Island Line commenced
operation in 1985, CMB’s passenger count and
revenue fell sharply.
ISME2011 (August 22-25, 2011)
The most costly mistake that CMB made, as far as
its transportation business was concerned, was,
perhaps, to allow its engineering intrapreneurs too
much freedom in their own development without a
proper contractual arrangement.
By not
recognizing that Schumpeterian innovations require
activities out of the circular flow, as well as back into
the circular flow, CMB committed the fatal mistake
of having either too lax a personnel policy or perhaps
not rewarding its key personnel in engineering
sufficiently, which meant that it lacked a long term
visionary plan for its transport business. By tacit
agreement, in 1979, Rees was given a free hand to
help build CityBus as a private coach company that
aimed to take advantage of the then-new
cross-border transport business. Thus began an
awkward period of “co-opetition” between CMB and
CityBus, during which both companies experimented
with triple-axle British buses. Its loss of Rees was
likely a major factor in CMB’s eventual loss of its
franchise bus arm.
CMB ceased to operate as a regulated natural
monopoly after 1998, and indeed, its business focus
changed so radically that its full name, China Motor
Bus, serves as the lone reminder of the company's
original mission.
Conclusion
This paper provided a framework for evaluating
corporate strategies by relying on the theory of
Schumpeterian innovations in terms of the theory’s
pedagogy of inside-versus-outside circular flow.
The analytical framework was made easy by the
assumption that the regulated natural monopoly price
is fixed, which fitted the legal environment of the
case we used for a demonstration of the analysis.
Increasing-return-enterprises cannot continue to
enjoy increasing returns unless Schumpeterian
innovations are strategically adopted. Otherwise, the
fate of CMB could be the common finality of many
increasing return industries.
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The Static
Person
dynamic
Deviate from an
Equilibrium
Creative, new
Static
Seeks an
Equilibrium
Routine,
repetitive
Passive
Follower
Resistance to
Changes
Hostile to new
actions
Choices base on
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Motivated by
Needs
Easily satisfied
Proactive
Leader
Engineer Changes
Battle Resistances
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The Man of
Action
Make Intuitive
decisions
Motivated by Power
Joy in Creation
Source: Table modified base on Swedberg (2007)
Year
Profit Before Tax in HK$
1968
5,399,985
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“Intrapreneurship strategy for internal markets –
corporate, non-profit and government institution
cases,” Strategic Management Journal, Vol.6,
No.2, pp.181–189, 1985.
1969
8,080,776
1970
5,296,630
1971
692,686
1972
1,263,516
[22] Porter, Michael E., “Strategy and the Internet,”
Harvard Business Review, March 2001.
1973
12,173,823
1974
8,458,288
Table II: CMB
Profit 3-yrs before
and after 1971
[23] Teece, David, Dynamic Capabilities and
Strategic Management, New York: Oxford
University Press, 2009
[24] Schmalensee, Richard, “Antitrust Issues in
Schumpeterian Industries”, The American
Source: Various issues of Annual Company Reports
of CMB
ISME2011 (August 22-25, 2011)
Figures:
i
Arthur (1996); Hill (1997); den Hartigh and
Langerak(2001);Porter(2001);McGee
and
Sammut-Bonnici (2002); Teece (2009)
ii
E.g. Mankiw (2004), p.316-317; Colander (2008),
p.272-274, p.332-334.
iii
Schmalensee (2000), in preparing his testimony for
the Anti-trust case of the century, US vs. Microsoft,
characterized many of these industries as
“Schumpeterian”.
This view of competition is
significantly different from that which prevailed in the
economics profession prior to the case. Indeed, the
Austrian view of competition went so far as to deny the
concept of a natural monopoly (see DiLorenzo (1996)).
This paper makes no normative statement about a
natural monopoly, but endorses Schmalensee’s
characterization of “winner takes most” to be more
appropriate than “winner takes all” for the discussion of
corporate strategies.
iv
Nielsen,Peters and Hisrich (1985); Antonic and
Hisrich (2003); claims have been made that the term
was first used by Gifford Pinchot III and Elizabeth S.
Pinchot in 1978.
v
In this sense, Schumpeterian innovation is more than
just a probability statement characterized by
evolutionary
economics.
See
Arena
and
Dangel-Hagnauer (2002), Becker and Lazaric (2003),
Festré and Lazaric (2006); viewing the process as a
change in production function has been emphasized in
Lai and Lorne (2003, 2006), Lorne (2009).
vi
The idea of creative destruction is another important
concept by Schumpeter (1942), of which some
incompatibility can be found with sustainable
development.
vii
More information on the energy implications of
alternative modes of commuting can be found on:
http://www.hk-phy.org/energy/transport/vehicle_phy03
_e.html.
viii
Bus aficionados also echoed this impression: “The
Guy UF buses left a legacy of high capacity public
transportation in Hong Kong between 1954 and the late
1970's, replacing a fleet of smaller half-cab Tilling
Stevens buses (25 feet and 27 feet), long before the
perfection of the rear engined, multi-axle double-decker
buses and low floor models.”
http://www.anthonyyao.com/ayao88c/link5.html
ISME2011 (August 22-25, 2011)