Moats in business and innovation
Value is created through innovation, but how much of that value accrues to the innovator depends partly on how quickly their competitors imitate the innovation. Innovators must deter competition to get some of the value they created. These ways of deterring competition are called, in various contexts, barriers to entry, sustainable competitive advantages, or, colloquially, moats.
Excess profit and imitation
…when an innovation that creates a better product or a cheaper way of making the product comes about, the innovator can reap some of the innovation’s value as excess pro fit. This excess only lasts until competitors catch on and imitate the innovation. One of the strategic tasks of an innovator is to deter imitation for as long as possible.
Types of state granted advantages:
Governments choose to restrict competition for a range of reasons, from encouraging a certain type of behavior (patents, for instance) to economic protectionism (tari ffs, national champions) to politics itself (a quid pro quo, the fear of displeasing a powerful constituency, or even just simple political favoritism.)
Pros and cons of state granted advantages
Ideally, the state’s enforcement of a moat is a non-market system. This means the durability of the moat is whatever the government says it is. In some cases this leads to a lack of predictability, and in others quite a bit of predictability.
Exclusive access to knowledge and power to control its diffusion
Exclusive access to something is only possible when you have the power to control that access. Access of knowledge or know-how must be limited by keeping that knowledge secret. But how? Know-how is in the heads and hands of people, and people generally have the right to change employers, aside from the limited circumstances where NDAs and non-competes apply (Non-competes are invalid in some jurisdictions, and NDAs are hard to enforce in practice.)
Restrict: trade secrets and contractual prohibitions. Diffusion: employee movement
While the government sometimes tries to prevent this sort of thing through trade secret law, and companies can try to enforce contractual prohibitions against it, knowledge di ffusion through employee movement is common.
Knowledge diffusion is usually a year
One study of knowledge di ffusion of new industrial technology found that “information concerning the detailed nature and operations of a new product or process generally leaks out within about a year.” Closely held knowledge is usually a fleeting competitive advantage.
Tacit knowledge
A more enduring advantage is tacitly held knowledge. Tacit knowledge is knowledge that can’t be easily communicated; it can’t be easily transferred, e.g. verbally or through writing. The classic example is riding a bike: you can’t read a book or watch a video to learn how. To learn to ride a bike, you must attempt to ride a bike.
Examples of tacit knowledge
In a company tacit knowledge can include manufacturing techniques and other procedural knowledge (this is highly important in exacting environments such as integrated circuit production), customer insight, supplier dynamics, and paths for continuing innovation. Any field of which it can be said “there is more art than science” is probably one where tacit knowledge is important. This sort of knowledge can’t be obtained by competitors through industrial espionage and not always by hiring away employees.
Pros: Complex tacit knowledge
Complex tacit knowledge is usually formed over some period of time through hands-on-work using trial and error and is maintained in the organization through mentorship.
Cons: Individual tacit knowledge
Individual tacit knowledge, while always valuable, is a weak competitive advantage as an organization gets larger because it is hard to scale. It is also only sustainable until a competitor hires the individual who has it.
Pros: Organizational tacit knowledge
Some tacit knowledge is not contained within the head or hands of individuals but embodied in an organization. All companies have undictated and undocumented means and paths to get things done. Two people may have tacit knowledge about how to work most effectively with each other’s role, or three people, or whole organizations. The organizational routines of these companies are a difficult to replicate advantage because they are not describable in words, in any deep sense, and they are not held within the head of a single person.
Pros: Complementary knowledge
Some of this knowledge is how to do the work itself–this then becomes individual tacit knowledge–but some of it is how to effectively work with each other and within the firm. This knowledge is only useful if others within the same firm have complementary knowledge. Even if star individual performers or whole teams are hired away, only a part of the collective tacit knowledge moves with them, rendering it much less useful.
Cons: Special know-how
Special know-how is a weak moat for startups. Founders often start a company because they know something very few others do: they might be experts at some leading-edge technical subject, they might have learned something valuable from previous work and realize few others know it, or they might have come up with a novel solution no one else seems to have thought of yet. But if the knowledge is easily transferred or imitated, any advantage it lends to the startup will be fleeting, unless it can be effectively kept secret for a long period of time. The ability to do this has proved to be rare in the real world.
Pros: Collective tacit knowledge
Collective tacit knowledge, on the other hand, is a great moat but it takes time to build, so a startup needs to a nd some interim way to deter competition.
Decreasing unit cost
Decreasing unit costs are also sometimes available at scale because the company has more bargaining power with suppliers. Walmart, for instance, is famous for extracting better deals from suppliers than the suppliers offer to others.
Network effects
In addition to lowering costs, scale can also increase the value of a product. This is often called network effects (regardless of whether there is a ‘network’ or not.) Telephone service is worthless if you are the only one with a telephone.
2-sided marketplace and platforms
Two-sided marketplaces and platforms are often lumped into network effects, though they don’t really create networks. Marketplaces, like eBay or the New York Stock Exchange, create more value from scale because scale creates both more supply and more demand for the products sold through the marketplace. This creates a virtuous cycle—sellers want more buyers rather than fewer, buyers want more sellers rather than fewer—so a small advantage in scale can become self-reinforcing. Platforms, in a similar fashion, garner value from other companies creating uses for them, and those companies would prefer to create uses for large platforms rather than smaller ones. The users of those platforms, meanwhile, prefer more uses to fewer. This makes it difficult for competing platforms to get a foothold. Apple’s iPhone with its App Store is a good example.
Early stage of industry
The beneficiaries of returns to scale are often determined early in an industry’s life. When a product is new and there are few, if any, competitors, a company can charge enough to offset the high cost of low scale. Or it can offer a product that is the highest quality only because it is the only product competing on that measure of quality. For instance, when Facebook started it offered the ability to network with people you knew and who had to use their real names. This was somewhat unique among social networks at the time. So while the value of the network was quite low if you were one of the first 20 or so users, it was still higher on that quality metric than its competitors.
Change is hard
These are advantages that arise because change is hard in a complex or highly interlinked system. If changing from one product to another also requires changing other things—other products, routines, skills, etc.—the total cost of the change may outweigh the benefits so the product already embedded in the system can maintain an advantage over similar entrant products that are not (or not yet) interconnected. I will call this system rigidity.
Change == Cost of learning, changing, searching
In the first instance the cost of change must include the cost of learning or the cost of changing established work routines. In the second the cost must include the cost of searching for the alternative.
Why incumbents might have it easier for customers
System rigidity can be a quite durable source of advantage in an environment of incremental change. Products that are the same as existing ones, or even somewhat better, will not give the customer enough additional value for them to switch if the switching costs are high. Startups entering an environment like this have a hard time getting their solution adopted at all, and incumbents who are already embedded in the system can get the idea adopted more cheaply, raising their interest in finding a way to copy it.
Uncertainty becomes a moat for startups
Uncertainty can be seen everywhere in the startup process: in the people, in the technology, in the product, and in the market. This analysis shows something more interesting though: uncertainty is not just a nuisance startup founders can’t avoid, it is an integral part of what allows startups to be successful. Startups that aim to create value can’t have a moat when they begin, uncertainty is what protects them from competition until a proper moat can be built. Uncertainty becomes their moat.