Institutions, Instruments, and the Innovator’s Dilemma

I have written several posts that use Carroll Quigley’s “institutional imperative” as a lens for understanding contemporary events. [1] Mr. Quigley suggests that all human organizations fit into one of two types: instruments and institutions. Instruments are those organizations whose role is limited to the function they were designed to perform. (Think NASA in the 1960s, defined by its mission to put a man on the moon, or the NAACP during the same timeframe, instrumental to the civil rights movement.) Institutions, in contrast, are organizations that exist for their own state; their prime function is their own survival.

Most institutions start out as instruments, but as with NASA after the end of the Cold War or the NAACP after the victories of the civil rights movement, their instrumental uses are eventually eclipsed. They are then left adrift, in search of a mission that will give new direction to their efforts, or as happens more often, these organizations begin to shift their purpose away from what they do and towards what they are. Organizations often betray their nature when called to defend themselves from outside scrutiny: ‘instruments’ tend to emphasize what their employees or volunteers aim to accomplish; ‘institutions’ tend to emphasize the importance of the heritage they embody or even the number of employees they have.

Mr. Quigley’s institutional imperative has profound implications for any democratic society especially a society host to so many publicly funded organizations as ours. Jonathan Rauch’s essay, “Demosclerosis” is the best introduction to the unsettling consequences that come when public organizations transform from instruments into institutions. [2] While Mr. Rauch does not use the terminology of the Institutional Imperative, his conclusions mesh neatly with it. Describing the history and growth of America’s bureaucratic class, Mr. Rauch suggests its greatest failing: a bureaucracy, once created, is hard to get rid of. To accomplish whatever mission it was originally tasked with a bureaucracy must hire people. It must have friends in high places. The number of people who have a professional or economic stake in the organization’s survival grows. No matter what else it may do, it inevitably becomes a publicly sponsored interest group. Any attempt to reduce its influence, power, or budget will be fought against with ferocity by the multitude of interests who now depend on it. Even when it becomes clear that this institution is no longer an instrument, the political capital needed to dismantle it is just too high to make the attempt worth a politician’s time or effort. So the size and scope of bureaucracies grow, encumbering the country with an increasing number of regulations it cannot change, employees it does not need, and organizations that it cannot get rid of.

I used to think that the naked self-interest described by Mr. Rauch was the driving force behind the Institutional Imperative. It undoubtedly plays a large role (particularly when public funds are involved), but there are other factors at play. One of the most important of these is what business strategists call Marginal Thinking.

Clayton Christenson, professor of Harvard Business School, explains the problems of marginal thinking in his book, How Will You Measure Your Life? He introduces the topic by relating the demise of Blockbuster, king of the traditional video rental stores, at the hands of Netflix, then an unknown upstart.

“A little upstart called Netflix emerged in the late 1990s with a novel idea: rather than make people go to the video store, why don’t we mail DVDs to them? Netflix’s business model made profit in just the opposite way to Blockbuster’s. Netflix customers paid a monthly fee—and the company made money when the customers didn’t watch the DVDs they had ordered. As long as the DVDs sat unwatched at customer’s homes, Netflix did not have to pay return postage—or send out the next batch of movies that the customer had already paid the monthly fee to get.

It was a bold move: Netflix was the quintessential David going up against the Goliath of the movie rental industry. Blockbuster had billions of dollars in assets, tens of thousands of employees, and 100% brand recognition. If Blockbuster decided it wanted to go after this nascent market, it would have the resources to make life very difficult for the little start up.

But it didn’t.

…When it compared Netflix’s numbers to its own, Blockbuster’s management concluded, “Why would we bother?” The market Netflix was pursuing was smaller; it might get bigger, but it was unclear how big it had the potential to be. More troubling for Blockbuster’s management, though, was that Netflix’s profit margins were substantially smaller than what Blockbuster was used to. If Blockbuster did decide to attack Netflix, and if it was successful, those efforts would most likely cannibalize sales from Blockbuster’s very profitable stores….

Netflix, on the other hand, thought this market was fantastic. It didn’t need to compare it to an existing and profitable business: its baseline was no profit and no business at all. Compared to that, Netflix was very happy with their relatively low margins and their “niche market.” [3]

Americans know what happened next: the niche market became the main market and Blockbuster lost all of its business. It declared bankruptcy in 2010. Mr. Christensen comments on the flawed principles behind Blockbuster’s disastrous strategy:

“Blockbuster followed a principle that is taught in every fundamental course in finance and economics: that in evaluating alternative investments… base decisions on the marginal costs and marginal revenues (the new costs and revenues) that each alternative entails.

It’s a dangerous way of thinking. Almost always, such analysis shows that the marginal costs are lower, and the marginal profits higher, than the full cost. This doctrine biases companies to leverage what they have put in place to succeed in the past, instead of guiding them to create the capabilities they will need in the future. If we knew the future would be exactly the same as the past, that approach would be fine. But if the future is different—and it almost always is—then it is the wrong thing to do.

Blockbuster and Netflix revenue, 2004-2010 Image source

Blockbuster looked at the DVD postal business using a marginal lens: it could only see it from the vantage point of its own existing business. When viewed like this, the market Netflix was going after did not look at all attractive. Worse, if Blockbuster did go after Netflix successfully, this new business was likely to kill Blockbuster’s existing business. No CEO wants to tell shareholders that he wants to invest to create a new business that is going to be responsible for creating existing businesses, especially if it is more profitable.

…

[Thus] Blockbuster believed that the alternative to not pursuing the postal DVD market was to happily continue doing what it was before, at a 66% profit margin. But the real alternative to not going after Netflix was, in fact, bankruptcy. The right way to look at this market was not to think, “How can we protect our existing business?” instead, Blockbuster should have been thinking: “If we did not have an existing business, how could we best build a new one? What would be the best way for us to serve our customers?” Blockbuster couldn’t bring itself to do it, so Netflix did instead. And when Blockbuster declared bankruptcy in 2010, the existing business that it had been so eager to preserve by using marginal strategy was lost anyway.” [4]

Blockbuster fell victim to the institutional imperative. Its management forgot that a good business aims to accomplish “a job [that needs] to get done,” not milk existing assets. [5] Blockbuster focused on preserving its institution at the cost of becoming the instrument consumers wanted. Consumers chose the instrument over the institution. We can glean a few insights from this account of marginal thinking and disruptive innovation that can be applied outside the business world.

In environments of real competition, institutions lose out to instruments. If we want to free our society from the burden of rent-seeking institutions and fill it with instruments useful to humanity, then we must do everything that we can to ensure that the environments in which organizations do their work are competitive. As the story of Blockbuster and Netflix suggests, the marketplace is an ideal environment for the contest of instruments and institutions; the pressures of the free market are hostile to the existence of firms who have lost their instrumental value. This is the genius of the market system: it forces decrepit institutions to face “the innovators dilemma” or fall to the wayside.  It is also why state intervention in the system can be so destructive. Economic policies or government action that reduces competition either by subsidizing its winners or by bailing out its losers will inevitably lead to the creeping “institutionalization” of free enterprise. [6]

Applying these principles to government bureaucracies, regulatory agencies, or other organs of the state not subject to market pressures is more difficult.[7] In an age of fast passed disruptive innovation particularly on the part of terrorists and other organizations that pose a national security concern this is a serious matter. Those willing to consider the question face a two-pronged problem:

1. How do we discourage governmental organizations from adopting “marginal strategies” when their instrumental usefulness begins to fade?

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2. How do we create the type of competitive environment for publically funded organizations that will be just as hostile to “institutions” as the market is? Is creative destruction possible in the public sphere?

This essay was originally published on The Scholar’s Stage on 1 March 2013.

[1]  T. Greer. “Dreaming Grand Strategy” The Scholar’s Stage. 12 May 2010.
And T. Greer. “The Death of a Nation.” The Scholar’s Stage. 30 January 2010.

[2] Jonathan Rauch. “Demosclerosis” National Journal. 5 September 1992.

[3] Clayton Christensen, James Allworth and Karen Dillon. How Will You Measure Your Life? (New York: Harper Collins Publishers). 2012. pp. 179-180

[4] Ibid. pp. 181-183

[5] This is another idea Clayton Christensen likes to stress. See Carmen Noble, “Clay Christensen’s Milkshake Marketing.” Harvard Business School: Working Knowledge. 14 February 2011.

[6] See Ashwin Parameswaran, “Cause and Impact of Crony Capitalism: The Great Stagnation and the Great Recession“, MacroEconomic Resilience, (24 November 2010) for a longer (and denser!) explanation of this problem in its current context. It is a regular theme for his work; check the tag ‘cronyism’ for his more recent posts on the subject.

[7] I realize that the simplest solution to this problem is to not create organizations dependent on public funds, especially if they compete directly with private organizations. I will leave the discussion of which organizations rightly belong in the government and which ones do not for a different day. Whatever your opinion on the matter (save perhaps if you are the rare anarchist) we can agree that it is in our best interests to ensure that any organization the government creates (be it a research department, regulatory agency, foreign office, or military command) is an instrument, not an institution.