Why Extractive Business Models Fail

If you force me to choose, I pick the invention of quartz watch movements as one of the more astonishing examples of creative destruction in business. Once quartz arrived, the value propositions of most of the luxury Swiss watchmakers was instantly destroyed.

Pre-quartz, they competed on accuracy. But quartz watches were 10 times more accurate than the best of the hand-made Swiss watches. What was left? Not much. Many of the Swiss watchmakers went out of business, and that end of the watch industry has gone through an unbelievable amount of concentration – dominated now by Swatch, Richemont and LVMH.

If you do the math and check the sum against an economics text, that adds up to an oligopoly. Swatch has already used their market position to start to put the squeeze many of the remaining independent watchmakers – which puts enormous pressure on their already shaky business models. The powerful watchmakers appear to be switching to an extractive business model.

In their new book Why Nations Fail: The Origins of Power, Prosperity, and Poverty,Daron Acemoglu and James Robinson look at what distinguishes nations that successfully drive economic development from those that fail. William Easterly summarises their main points in a good review of the book:

Success comes, the authors say, when political and economic institutions are “inclusive” and pluralistic, creating incentives for everyone to invest in the future. Nations fail when institutions are “extractive,” protecting the political and economic power of only a small elite that takes income from everyone else.

Inclusive political institutions mean both a broad distribution of political power and limits to that power, such as democratic elections and written constitutions. Inclusive economic institutions encompass property rights, contract enforcement, ease of starting new companies, competitive markets, and freedom for citizens to enter the occupation and the industry of their choice. The billionaire telecommunications mogul Carlos Slim, we’re told, does not fall into this category. He is extractive, “a master at obtaining exclusive contracts,” winning economic monopolies through political connections, but he enriches primarily himself, not Mexico. Bill Gates, by contrast, enriches both himself and the U.S. because he can make money only by creating products that are better or more popular than those produced by rivals.

Just as inclusive institutions feed on each other, so do their opposites: Extractive political institutions support the economic institutions that protect the interests of the elite against new entry from competitors. The wealth of the elite so created can make the hierarchical, authoritarian state even larger and more repressive, increasing elite wealth even more. This vicious cycle means that bad history persists into bad present outcomes.

Compare that story to what is happening in watches, and Richemont and company don’t look very inclusive. In fact, extractive business models are one of the hallmarks of monopolies and oligopolies. Furthermore, by their very nature, extractive business models kill innovation. Lack of innovation causes big problems over the long term – both for countries, as Acemoglu and Robinson show, and for firms.

If you don’t innovate, what’s left? Extraction. In watches, this has now extended beyond independent watchmakers to independent watch repairers. Here’s a video that shows what is happening:

Nicholas Hacko, a watchmaker in Sydney, explains how this extractive behaviour is leading the Swiss watchmakers to miss the next wave of disruption in the industry. First, he describes some of the coming innovations in smart watches, then:

…here is my key point: the battle is not about the technology, or price, or even performance, this battle is all about that precious “piece of real-estate” – your wrist!

The smart technology is no longer happy to place your gadget in your bag, or back pocket. The smart watch wants to be placed on one and only one spot it deserves – YOUR WRIST. This is what the battle is all about.

You may have a bunch of watches, but you can wear only one at the time.

And you need not be clairvoyant to figure out which one will take that well deserved spot: a smart one, which represents free spirit, creativity, ever changing design, a watch which talks to you, and represents the new age of NO RESTRICTION; or the other one, which is a product of Swiss monopoly whose main concern is how to stop everyone else from entering the market (including fellow Swiss makers), restrictive to the extreme and arrogantly treat the most loyal supporters as ignorant, and whose only business model is this: “if it does not sell, double the price.” A watch made by a company which refuses to sell you a spare part, spare bracelet, even a spare link! A maker so arrogant who can afford to upset even the most loyal customers and brand promoters.

Quartz watches were a classic disruptive innovation. The incumbents were either unwilling or unable to respond to the new technology. Now it is happening again. Why is Sony driving this new technology rather than Swatch? Why would you miss out on something like this?

I don’t know. The same mistakes are repeated – this is what makes studying innovation both fascinating and frustrating.

Extractive business models fail for several reasons. They destroy the ecosystems that support them, they stop innovating, and then they are ambushed by a disruptive innovation. Fortunately, this happens a bit more easily in markets than in nations.

Make way for the innovators.

Note: Many independent watch repairers are trying to fight the cut-off of supply. You can find out more about this at www.save-the-time.org. I signed their petition, so you can see where my sympathies lie.

Student and teacher of innovation - University of Queensland Business School - links to academic papers, twitter, and so on can be found here.

Please note: I reserve the right to delete comments that are offensive or off-topic.

8 thoughts on “Why Extractive Business Models Fail

  1. Great article Tim. A very interesting example of creative destruction in business.

    Personally, I still prefer my Tag Heuer Swiss watch providing a number of value benefits, including quality, elegence, precision and reliability.

    Are some of us moving back to Swiss-made watches having experienced the cheaper quartz watches from Asia? Besides if I want “smart” I turn to my smart phone or iPad.


  2. Thanks John. It’s an interesting question. There is still a value proposition there for the Swiss watchmakers, but after talking with Nick last week, I really do wonder if they are seriously eroding their value propositions. It will continue to be an interesting industry to follow…

  3. Yeah, that’s another good example – thanks for the link.

    Thanks also for the feedback. I appreciate the summaries that you often post on your site as well.

  4. Hi Tim.

    This is something that I have been thinking about for a while, but I do think that there is a problem with nomenclature. The term “extractive industries” is confusing because the term is already used for drilling and mining.

    I like to refer to them as “incumbent industries” and I think that there is another important, albeit political, ramification.

    When politicians take on supposedly “pro-business” policies, they are often not pro-business at all, but pro-incumbency.

    The needs of innovative industries are much different. They care less about tax breaks (after all, start-ups aren’t profitable yet) and much more about infrastructure, education, government support of basic research and the ability of smart, talented people to immigrate.

    – Greg

  5. Thanks Greg. Definitely agree about nomenclature. I used extractive here because it parallels the usage in Acemoglu & Robinson, but it does introduce some confusion.

    Your point about incumbent industries and pro-business policies is dead-on though. The recent SOPA episode illustrates that perfectly.

  6. Like the term of art ‘extractive’ (though I do see the potential for confusion) because it draws the mind to Dutch Disease. I can ‘feel’ strong parallels between oligarchy and Dutch Disease.

    (I see this when I work for multinationals — they are so REMARKABLY inefficient and wasteful that it’s hard to see how they would make any money without a massive amount of oligarchical clout and the gravity of their rents. The Dutch Disease part is that I can’t imagine how their profligacy wouldn’t pollute the water of price-signals we all have to swim in. They strengthen the currency of idiots.)

    I can’t find it anywhere now, but there was a brilliant piece (erm, somewhere) talking about ‘The Problem of Namibia’ (or something similar) which wondered why Namibia wasn’t much, much richer. (I’ve written about it here: http://noshoku.net/2011/the-right-word-is-unfinished.) It basically concluded that the adjacent possible of ‘extractive’ industries (in Namibia’s case, as @Greg points out, real extractive industries as opposed to ‘extractive industries’) is much smaller, probably due to their concentrative/centripetal tendencies.

    Phew. Long comment. tl:dr; I like, I agree.

  7. Thanks Simon. The parallel with Dutch disease is interesting. That is a good part of the problem that Acemoglu & Robinson are trying to get at. Their conclusion is that rather than a resources curse, the problem is faulty institutions. Interestingly, they say that most countries with bad institutions have only changed them under threat of or through actual revolution.

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