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Tuesday, July 2nd, 2013

Strangling Innovation: Tesla vs. Rent Seekers

[ If you’re at all involved with tech, then you probably know Steve Blank, who pioneered the customer development concept, is a must read on lean startups, and much more. I’d encourage you to check out his blog. If you’re thinking about starting a tech company, his book “The Four Steps to the Epiphany” is a must read – though I should warn you there’s a heckuva lot more than four steps in there! Steve recently weighed in on rent seeking after reports that car dealers are ganging up on Tesla to try to make direct Tesla sales illegal (which is probably already the case in most states). Urbanists frequently see the absurdity of rent seeking regulations when it comes to cool stuff we like like Teslas, Uber, or AirBnB. The challenge is to maintain that same anti-rent seeking ardor in more prosaic examples. Thanks to Steve for letting me repost this – Aaron. ]

The greatest number of jobs is created when startups create a new market – one where the product or service never existed before or is radically more convenient. Yet this is where startups will run into anti-innovation opponents they may not expect. These opponents have their own name – “rent seekers” – the landlords of the status-quo.

Smart startups prepare to face off against rent seekers and map out creative strategies for doing so…. First, however, they need to understand what a rent seeker is and how they operate…

———-

Recently, the New York and North Carolina legislatures considered a new law written by Auto Dealer lobbyists that would make it illegal for Tesla to sell cars directly to consumers. This got me thinking about the legal obstacles that face innovators with new business models.

Examples of startups challenging the status quo include: Lyft, Square, Uber, Airbnb, SpaceX, Zillow, Bitcoin, LegalZoom, food trucks, charter schools, and massively open online courses. Past examples of startups that succeeded in redefining current industries include Craigslist, Netflix, Amazon, Ebay and Paypal.

While Tesla, Lyft, Uber, Airbnb, et al are in very different industries, they have two things in common: 1) they’re disruptive business models creating new markets and upsetting the status quo and 2) the legal obstacles confronting them weren’t from direct competitors, but from groups commonly referred to as “rent seekers.”

Rent Seekers

Rent seekers are individuals or organizations that have succeeded with existing business models and look to the government and regulators as their first line of defense against innovative competition. They use government regulation and lawsuits to keep out new entrants with more innovative business models. They use every argument from public safety to lack of quality or loss of jobs to lobby against the new entrants. Rent seekers spend money to increase their share of an existing market instead of creating new products or markets. The key idea is that rent seeking behavior creates nothing of value.

These barriers to new innovative entrants are called economic rent. Examples of economic rent include state automobile franchise laws, taxi medallion laws, limits on charter schools, auto, steel or sugar tariffs, patent trolls, bribery of government officials, corruption and regulatory capture. They’re all part of the same pattern – they add no value to the economy and prevent innovation from reaching the consumer.

No Regulation?

Not all government regulation is rent or rent seeking. Not all economic rents are bad. Patents for example, provide protection for a limited time only, to allow businesses to recoup R&D expenses as well as make a profit that would often not be possible if completely free competition were allowed immediately upon a products’ release. But patent trolls emerged as rent seekers by using patents as legalized extortion of companies.

How Do Rent Seekers Win?

Instead of offering better products or better service at lower prices, rent seekers hire lawyers and lobbyists to influence politicians and regulators to pass laws, write regulations and collect taxes that block competition. The process of getting the government to give out these favors is rent-seeking.

Rent seeking lobbyists go directly to legislative bodies (Congress, State Legislatures, City Councils) to persuade government officials to enact laws and regulations in exchange for campaign contributions, appeasing influential voting blocks or future jobs in the regulated industry. They also use the courts to tie up and exhaust a startup’s limited financial resources.

Lobbyists also work through regulatory bodies like FCC, SEC, FTC, Public Utility, Taxi, or Insurance Commissions, School Boards, etc. Although most regulatory bodies are initially set up to protect the public’s health and safety, or to provide an equal playing field, over time the very people they’re supposed to regulate capture the regulatory agencies. Rent Seekers take advantage of regulatory capture to protect their interests against the new innovators.

PayPal – Dodging Bullets

PayPal consistently walked a fine line with regulators. Early on the company shutdown their commercial banking operation to avoid being labeled as a commercial bank and burdened by banks’ federal regulations. PayPal worried that complying with state-by-state laws for money transmission would also be too burdensome for a startup so they first tried to be classified as a chartered trust company to provide a benign regulatory cover, but failed. As the company grew larger, incumbent banks forced PayPal to register in each state. The banks lobbied regulators in Louisiana, New York, California, and Idaho and soon they were issuing injunctions forcing PayPal to delay their IPO. Ironically, once PayPal complied with state regulations by registering as a “money transmitter” on a state-by-state basis, it created a barrier to entry for future new entrants.

U.S. Auto Makers – Death by Rent Seeking

The U.S. auto industry is a textbook case of rent seeking behavior. In 1981 unable to compete with the quality and price of Japanese cars, the domestic car companies convinced the U.S. government to restrict the import of “foreign” cars. The result? Americans paid an extra $5 billion for cars. Japan overcame these barriers by using their import quotas to ship high-end, high-margin luxury cars, establishing manufacturing plants in the U.S. for high-volume lower cost cars and by continuing to innovate. In contrast, U.S. car manufacturers raised prices, pocketed the profits, bought off the unions with unsustainable contracts, ran inefficient factories and stopped innovating. The bill came due two decades later as the American auto industry spiraled into bankruptcy and its market share plummeted from 75% in 1981 to 45% in 2012.

unplug tesla

Innovation in the Auto Industry

According to the Gallup Poll American consumers view car salesmen as dead last in honesty and ethics. Yet when Tesla provided consumers with a direct sales alternative, the rent seekers – the National Auto Dealers Association turned its lobbyists loose on State Legislatures robbing consumers in North Carolina, New York and Texas of choice in the marketplace.

In these states it appears innovation be damned if it gets in the way of a rent seeker with a good lobbyist.

Much like Paypal, it’s likely that after forcing Tesla to win these state-by-state battles, the auto dealers will have found that they dealt themselves the losing hand.

Rent seeking is bad for the economy

Rent seeking strangles innovation in its crib. When companies are protected from competition, they have little incentive to cut costs or to pay attention to changing customer needs. The resources invested in rent seeking are a form of economic waste and reduce the wealth of the overall economy.

Schumpeter’s theory of creative destruction – that entry by entrepreneurs was the disruptive force that sustained economic growth even as it destroyed the value of established companies – didn’t take into account that countries with lots of rent-seeking activity (pick your favorite nation where bribes and corruption are the cost of doing business) or dominated by organized interest groups tend to be the economic losers. As rent-seeking becomes more attractive than innovation, the economy falls into decline.

Startups, investors and the public have done a poor job of calling out the politicians and regulators who use the words “innovation means jobs” while supporting rent seekers.

What Does This Mean For Startups?

In an existing market it’s clear who your competitors are. You compete for customers on performance, ease of use, or price. However, for startups creating a new market – one where either the product or service never existed before or the new option is radically more convenient for customers – the idea that rent seekers even exist may come as a shock. “Why would anyone not want a better x, y or z?” The answer is that if your startup threatens their jobs or profits, it doesn’t matter how much better life will be for consumers, students, etc. Well organized incumbents will fight if they perceive a threat to the status quo.

As a result disrupting the status quo in regulated market can be costly. On the other hand, being a private and small startup means you have less to lose when you challenge the incumbents.

impossibleIf you’re a startup with a disruptive business model here’s what you need to do:

Map the order of battle

  • Laughing at the dinosaurs and saying, “They don’t get it” may put you out of business. Expect that existing organizations will defend their turf ferociously i.e. movie studios, telecom providers, teachers unions, etc.
  • Understand who has political and regulator influence and where they operate
  • Figure out an “under the radar” strategy which doesn’t attract incumbents lawsuits, regulations or laws when you have limited resources to fight back

Pick early markets where the rent seekers are weakest and scale

  • For example, pick target markets with no national or state lobbying influence. i.e. Craigslist versus newspapers, Netflix versus video rental chains, Amazon versus bookstores, etc.
  • Go after rapid scale of passionate consumers who value the disruption i.e. Uber and Airbnb, Tesla
  • Ally with some larger partners who see you as a way to break the incumbents lock on the market. i.e. Palantir and the intelligence agencies versus the Army and IBM’s i2, / Textron Systems Overwatch

For example, Airbnb, thrives even though almost all of its “hosts” are not paying local motel/hotel taxes nor paying tax on their income, and many hosts are violating local zoning laws. Some investors and competitors may be concerned about regulatory risk and liability. AirBNB’s attitude seems to be “build the business until someone stops me, and change or comply with regulations later.” This is the same approach that allowed Amazon to ignore local sales taxes for the last two decades.

When you get customer scale and raise a large financing round, take the battle to the incumbents. Strategies at this stage include:

  • Hire your own lobbyists
  • Begin to build your own influence and political action groups
  • Publicly shame the incumbents as rent seekers
  • Use competition among governments to your advantage, eg, if New York or North Carolina doesn’t want Tesla, put the store in New Jersey, across the river from Manhattan, increasing New Jersey’s tax revenue
  • Cut deals with the rent seekers. i.e. revenue/profit sharing, two-tier hiring, etc.
  • Buy them out i.e. guaranteed lifetime employment

Lessons Learned

  • Rent seekers are organizations that have lost the ability to innovate
  • They look to the government to provide their defense against innovation
  • Map the order of battle
  • Pick early markets and scale
  • With cash, take the battle to the incumbent

This post originally appeared in Steve Blank’s blog on June 24, 2013.

5 Comments
Topics: Economic Development, Public Policy, Technology, Urban Culture

5 Responses to “Strangling Innovation: Tesla vs. Rent Seekers”

  1. Jon Seisa says:

    This analysis is so true and this desperate “rent seeker” modus operandi has been around for decades, called other names, like “the dinosaurs” refusing to face extinction. Ultimately, despite their obstructionism and waste of millions of dollars for legal finagling to thwart innovation and change to sustain yet another meager year, they eventually lose in the end, big time; and simultaneously are left in the dust, having missed the crest of the wave of change, the new innovative paradigm shift.

    I personally saw this happen at Disney during Disney’s lawsuit against the Sony Corp. in the late 70s over the revelation of the emerging infant home video market and the conversion of feature films into marketable commodity. Disney fought this tooth and nail with their skewed and Neanderthal mentality of resistance for what would eventually become inevitable. Disney’s shortsighted battle against Sony seemed utterly obtuse to me at the time. They perceived the new direction as a threat to their franchise and film IP library that they controlled with systematic and methodical periodic decadal theater releases, thinking that gave more value and equity to the releases; and the idea to market the films continually was perceived as an erosion of their value and would cheapen them.

    I thought how strange that a company once known as an innovative maverick refused to embrace technological innovation and attempt to restrategize their approach to enter the new consumer product home entertainment era. Eventually they did, with great reluctance, after losing the lawsuit. But most strange, today they have gone in the complete polar opposite direction, slapping those redundant Mickey Mouse Ears on virtually anything with unbridled marketing blitzkrieg, literally marketing everything under the sun that isn’t nailed down and in endless multiple incarnations until our bleeding eyes fall out.

  2. PeterW says:

    I think that there’s no better example of rent seeking than the protections that automobile dealers have.

    Having said that, though, I think it’s also important to keep in mind that not every regulation exists to promote rent seeking, and that startups which are able to operate more cheaply by ignoring safety requirements are not a good thing (even if the safety requirements incidentally make it more difficult to enter the market (which every safety requirement does, to some extent).

    I.e., when Lyft began originally, it did not have liability insurance for its operators, a requirement that traditional taxicab owners were required to have. Ignoring the insurance requirement is no part of being innovative, and regulators were correct to object to this. AFAICT, as of 2013, Lyft, Uber, and Sidecar all now provide insurance.

    AirBNB has run into zoning issues, but from what I’ve read (mostly from the NY Times article), these issues haven’t come from existing hotel chains, but from other people who live in the apartment building being used for airBNB purposes – so not exactly an example of rent seeking.

  3. bettybarcode says:

    Many thanks for the succinct, everyday language definition of rent-seeking, along with contemporary examples. I have heard this phrase bandied about and I found Wikipedia’s entry to be unhelpfully abstruse.

    Perhaps related to this discussion is an observation from a friend that innovation is no longer about producing a better product or service but about successful cost-shifting.

    An example is our public TV station, who is hectoring us to “go green” by downloading the program guide from their website instead of having a (cheap, compact, newsprint) paper guide delivered in the mail. They have no app designed for the digital environment.

    So, 50,000 households should now print a guide on twice as much paper, because double-sided print jobs at home end in miserable suicide-inducing, paper-wasting failure. In the aggregate, the electricity to run those 50,000 print jobs exceeds what one professional uses to do a bulk job.

    They will soon discontinue delivery of the newsprint guide, because they can. Cost-shifting is rent-seeking’s up and coming baby brother.

  4. Rod Stevens says:

    A superb post. I was interested to see the author include school boards and school unions as part of the establishment that exists change. That’s certainly been my experience, in trying to get more from the schools to keep my child challenged. This week in Washington state, the teachers unions, which are among the strongest in the state, effectively stopped a legislative measure which would have given principals the power to not accept a bad teacher being transferred from another school. The same unions effectively opposed the creation of any new charter schools until recently, and even now their numbers are limited. The genius in this article is the recognition that there is no such thing as a “free market”, that almost everything we buy or use is somehow regulated. I don’t oppose that, but the degree of regulation calls in the political factor. One of the quiet but unrecognized changes here in Washington state is a new law for higher ed, that allows community colleges to grant four-year degrees. This will give the traditional four-year colleges a run for their money, but they don’t really know it yet.

  5. Robert Munson says:

    I agree with two of Rod Stevens’ summaries.
    1) This is a great post.
    2) “that almost everything we buy or use is somehow regulated.”
    Urbanists cannot forget this lesson because many urban advantages from compactness and economies of scale are undermined by the inefficiencies caused by undue influence upon regulators and public services. Rod points to public education and he is certainly correct about teachers preventing competition from better providers.
    The same is true for transit systems.
    Nowhere are the decades of anti-competitive public services more evident than in Chicago in which, finally, ineffective — and wasteful — schools are finally being closed.
    Another test will be if the CTA is the operator of the proposed Bus Rapid Transit lines.
    The list goes on the more I think about this.
    Thanks again for stimulating my thoughts!

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