Summary:

• The key insight to understanding high-end disruption is that innovation improves products either by increasing performance or by increasing affordability.
• While low-end disruption occurs through improvements in performance, high-end disruption occurs through improvements in affordability.
• While incumbents chase profit margins in low-end disruption, incumbents chase market volume in high-end disruption. In both cases, incumbents are acting rationally by improving their profitability through sustaining innovations — at least at first.
• Christensen’s low-end framework can be modified to visualize high-end disruption by changing the vertical axis from performance to affordability.
• In low-end disruption, consumers are price-choosers and performance-takers. While in high-end disruption, consumers are performance-choosers and price-takers. Low- and high-end disruption are idealized special cases of a general phenomenon of disruptive innovation.

So, in short, the master plan is:
· Build sports car.
· Use that money to build an affordable car.
· Use that money to build an even more affordable car.
Don’t tell anyone.
— Elon Musk

The purpose of this article is to present a case for disruptive innovation from high-end products. This article is intended for readers who are already familiar with the classic theory of low-end disruption as described by Clay Christensen.

Intuitively, we know that industries can be disrupted with (what are initially) high-end products. For example, iPods were a high-end disruptor to CD players, and iPhones were then a high-end disruptor to iPods (among many other things). And there are countless other examples (see the end of this post). In these cases, incumbents were displaced by disrupting entrants, despite the strength, market power and resources of the incumbent. However, the classical theory of disruptive innovation developed by Clay Christensen only explains disruptive innovation from the view of low-performing products. We need a way to approach disruptive innovation from the view of high-performing products.

To understand high-end disruption, we must first take note of a stylized fact: Innovation improves a product by either improving performance or by improving affordability. There is, of course, a direct relationship between product performance and price, but innovation does not imply better performance, necessarily. Instead, innovation can also manifest in the form of a lower price. This distinction is the key insight to understanding high-end disruption: Whereas low-end disruptors enter the market with a low-performing, low-price product and then work to improve performance, high-end disruptors enter the market with a high-performing, high-price product and then work to improve price. In each case, the entrant eventually takes over the entire market with a high-performing, low-price product.

We can adjust the Christensen low-end disruption framework to visualize high-end disruption simply by changing the measure of innovation from performance to affordability. If you are already familiar with the Christensen low-end disruption framework, everything is straightforward once you make this change.

To start, we can simply think of affordability as the inverse of price. That is:

Affordability = 1/Price

Similar to the performance needs distribution, consumers will fall into the affordability needs distribution.

In the Christensen low-end case, the left-tail of the performance needs distribution comprises consumers that value affordability and are willing to pay for it with low performance. In the high-end case, however, the left-tail of the affordability needs distribution comprises consumers that value high performance and are willing to pay for it with low affordability. In both cases, the entrants are competing against non-consumption — although under-consumption may be a better term for the high-end consumers.

In Christensen’s low-end theory, low-end disruptors enter the market with a product that is low-performing but highly affordable. Low-end entrants initially under-serve the performance needs of the majority of the market, but are good enough for the low-end which values affordability. Established incumbents are under-serving the low-end of the market because it is simply not attractive in terms of profit margin. For the entrant, however, the profit margin of the low-end market is attractive. Entering the market with an already highly affordable product, low-end entrants move up the market by increasing performance through sustaining innovations. As low-end entrants improve performance, their product becomes good enough for more and more of the market, eventually over-taking the entire market. As Christensen describes, established incumbents are unable or unwilling to adopt the new disruptive technology because they are incentivized against competing with low-end entrants, and instead move further up the market towards higher performance in order to attain higher profit margins. Incumbents facing low-end disruption are seemingly acting entirely rational by ceding the lower-end of the market, since achieving higher profit margins through sustaining innovation boosts profitability — at least at first, and until it doesn’t, when it is too late to pivot to the disruptive innovation.

On the other hand, high-end disruptors enter the market with a product that is low in affordability but high-performing. High-end entrants initially under-serve the affordability needs of the majority of the market, but are cheap enough for the high-end which values performance. Often times, this niche high-end market is comprised of hobbyists and enthusiasts — although not always. Established incumbents are under-serving the high-end of the market because it is simply not attractive in terms of volume. For the entrant, however, the potential volume of the high-end market is attractive. Entering the market with an already high-performing product, high-end entrants move down the market by increasing affordability through sustaining innovations. As high-end entrants improve affordability, their product becomes cheap enough for more and more of the market, eventually over-taking the entire market. Established incumbents are unable or unwilling to adopt the new disruptive technology because they are incentivized against competing with high-end entrants, and instead move down the market towards higher affordability in order to attain higher sales volume. Incumbents facing high-end disruption are seemingly acting entirely rational by ceding the higher-end of the market, since chasing sales volume through sustaining innovation boosts profitability — at least at first, and until it doesn’t, when it is too late to pivot to the disruptive innovation.

It is important to note that both low-end and high-end disruptors enter the market by serving consumers that are under-consuming given their preference for performance and affordability. Whether starting from the low- or high-end, the disruptor eventually takes over the market with a product that is both better performing and more affordable. High-end disruption could thus also be described as ‘low-affordability disruption’.

In low-end disruption, consumers are price-choosers and performance-takers: they choose their desired price level and receive the corresponding performance. In high-end disruption, consumers are performance-choosers and price-takers: they choose their desired level of performance and pay the corresponding price. This distinction between low- and high-end disruption is similar to the distinction between Cournot competition (quantity-choosers/price-takers) and Bertrand competition (price-choosers/quantity-takers) in oligopoly theory. Readers familiar with oligopoly theory will know that both Cournot competition and Bertrand competition are useful for understanding different types of markets in the real world. Bertrand competition is useful for understanding Pepsi and Coca Cola, for example, while Cournot competition is better for understanding cartels such as OPEC. Similarly, low-end disruption and high-end disruption are useful for understanding different types of innovations for different jobs-to-be-done.

The famous key phrase for thinking about low-end disruption is good enough, while the key phrase for thinking about high-end disruption is cheap enough. To reiterate: Established incumbents that are being disrupted from the low-end chase profit margins, while incumbents being disrupted from the high-end chase sales volumes. The same incentives that encourage incumbents to move up the market in search of higher profit margins in low-end disruption also encourage incumbents to move down the market in search of larger sales volumes in high-end disruption. In each case, incumbents are (initially) increasing their profitability, until it is too late. And in each case, the entrant is competing against non- or under-consumption in the consumer needs distribution.

Let me thus emphasize that low-end disruption and high-end disruption are idealized cases of a general phenomenon of disruption, where price and performance both interact within consumer preferences. That is to say, we need to synthesize the theories of low-end and high-end disruption. More to come on that in the future.

Christensen famously dismissed the iPhone as a non-disruptor since it was not starting from the low-end. I have recently noticed that Horace Dediu dismisses Tesla’s strategy in the auto market for similar reasons. Of course, looking through the lens of affordability, we can see that both the iPhone and Tesla are high-end disruptors. (The iPhone case is a little tricky — maybe I will explain in a future post. Update: here it is.) This mistake is actually unfortunate because Christensen’s low-end theory never provided a case against high-end disruption, but only provided a framework that explained low-end disruption. Measuring innovation using affordability instead of performance, however, explains high-end disruption very well. I have graphed several cases of high-end disruption at the end of this post. You will notice that high-end disruption is actually quite common. The best example of high-end disruption is the general-purpose computer — viewed as an entire group, including mainframes, PC’s and smartphones — which has disrupted many industries from the high-end on the back of Moore’s Law. Indeed, the importance of Moore’s Law is due to the phenomenon of high-end disruption. An example of high-end disruption outside the realm of transistors is the light bulb (with electricity), which disrupted candles from the high-end. A modern example is Chipotle, which is disrupting McDonald’s from the high-end. (Yes, Chipotle has become more affordable over the years — you must remember to account for inflation and income growth.)

Ben Thomson distinguishes between disruption and obsoletion, and also makes the case that disruption does not apply to personal consumer markets because people have infinite wants — but that’s not right either. Infinite wants simply means that there are infinite jobs-to-be-done, whereas disruption theory only exists in the realm of one job-to-be-done at a time. I think that what Thomson classifies as obsoletion is simply the phenomenon of high-end disruption.

To finish, below I have graphed case examples of high-end disruption for several jobs-to-be-done. If you liked this article, please share, follow me on twitter or subscribe to RSS.

So, will bitcoins ever become money? It’s tricky… I would like to discuss a scenario where bitcoins (or something like it) would be money, why central banks would want to create their own crypto-currency protocols, and how monetary policy would be conducted in such a world.

Imagine that a private entity with significant resources and credibility implements a crypto-currency (like Bitcoin) that it backs with real, hard, good old-fashioned central bank currency. So imagine Google creates a protocol similar to Bitcoin called gCoin, and publishes the protocol publicly so that anyone can use it. In particular, anyone is able to mine gCoins by contributing computational power to the network. At the same time, Google says that it will buy unlimited gCoins in exchange for dollars, say at a price of 1 for 1, and that it will also sell gCoins that it has already mined for the same price. Thus gCoin would initially derive its value from Google’s promise to exchange gCoins for real dollars at any time.

First off: Why would Google do this? Who knows! Google is very well known for building useful services that it isn’t yet sure how to monetize. And gCoin is useful: Like Bitcoin, using gCoin to buy and sell goods on the internet is faster and much cheaper than using a credit card. A simple way to monetize gCoin would be for Google to provide a ‘wallet’ service that helps facilitate the use of gCoin, which you could just think of as a chequing account for gCoins. You would “deposit” your gCoins with Google, use their online service to keep track of them and transact them, and Google would charge you a monthly fee just like a regular bank. Google would also have a reserve amount of gCoins that it initially mined before publicly releasing the protocol, which would be very valuable if the use of gCoin became widespread. I’m sure there are other and better ways to monetize crypto-currencies that we can’t even imagine yet — we don’t need to discuss this.

Now, who would use gCoins? Only someone who had faith in their value. If people believed Google would always convert their gCoins into dollars, they would gladly accept gCoin as payment. But as you see, we are in the same situation as we were with the gold-backed bank notes in the 19th century: What if there is a bank run on Google? And if other organizations like Amazon, Facebook, Apple (and PayPal?) have their own digital currencies, a bank run on just one of them could cause bank runs on the others — the same financial contagion effect that paper currencies experienced. Privately issued crypto-currencies are susceptible to the same problems as privately issued bank notes.

You can thus imagine that, just like what happened with paper currencies, central banks will eventually step in to create their own crypto-currency protocols and forbid the use of any others. For simplicity, let’s call the central bank crypto-currency protocol BitDollar. Of course, these BitDollars would always be redeemable in regular dollars by the central bank, at least at first.

The exchange rate between BitDollars and regular dollars does not necessarily have to be 1 for 1. In fact, the central bank could adjust this exchange rate in order to conduct monetary policy, although there is a better, more natural way to do monetary policy — more on that in a minute. Assuming the exchange rate is fixed, say 1 for 1, the distinction between dollars and BitDollars no longer exists. Just think of dollars as an abstraction which can be manifested in traditional paper form and now digital form. And like original gold-backed currency, we eventually won’t even need regular dollars to back BitDollars, as long as the network effects of BitDollars exist to justify their value — though this transition will happen gradually.

Indeed, a similar type of network effect is what most Bitcoin startups today are betting will give bitcoins their value in the future, and they are building services that allow customers to easily transact regular bitcoins instead of building their own protocols. You can think of these startups as Bitcoin banks: They provide banking services for bitcoins. Currently these banks operate with 100% reserve ratios because they record your ownership of bitcoins on the official Bitcoin blockchain. We will have to wait to see how the value of bitcoins plays out and what banking business model emerges, but it is clear to me that Bitcoin banks and the Bitcoin network will be just as prone to bank runs as Google’s gCoins would be, or traditional banks were before the days of central banking. More simply: Bitcoin needs a central bank. And BitDollar would be the answer to that.

But what type of protocol would BitDollar be? Well certainly, the central bank needs the ability to conduct monetary policy, so it would need a protocol where it could easily adjust the money supply at will. It would also need the ability to be the lender of last resort, which means access to an unlimited supply of BitDollars.

The simplest way for a central bank to create its own crypto-currency is for it to fork the Bitcoin protocol into a new protocol that is unchanged in every way except that, going forward, the central bank would set and adjust the block mining reward at its discretion. (Remember, the block reward is arbitrary in Bitcoin and other crypto-currency protocols, and can change to anything that the network agrees upon going forward.) In this world, the central bank can conduct monetary policy by changing the block reward, which in turn changes the future supply of base money. In particular, increasing the block reward corresponds to loosening monetary policy, and decreasing the block reward corresponds to tightening monetary policy. A more intuitive way to think about this is that increasing the block reward decreases transaction costs, while decreasing the block reward increases transaction costs — for every single transaction. For central banking, this is the key to understanding crypto-currencies. And like paper currency, the central bank’s crypto-currency would be both decentralized (in transaction) and cenralized (in supply).

Why would people start using the BitDollar protocol and not the original Bitcoin protocol? Again, it’s simply a matter of network effects, and the fact that BitDollar would be legal tender under the law, including the requirement to pay taxes with them. The answer to this question is the same answer to: Why do people US dollar bills instead of notes printed by private banks? It’s tautological: People use US dollar bills because people use US dollar bills.

We still need to resolve how the central bank can access an unlimited supply of BitDollars so that it can continue to act as a lender of last resort. The central bank can create unlimited BitDollars for itself by leveraging the the network effect — let me explain. Remember, BitDollars can only be created by solving a block in the blockchain (i.e. processing transactions) and, as we have discussed, the reward for solving a block is now set by the central bank. But also remember, the transaction history in the blockchain is impossible to change, so the central bank can only change the reward for future blocks. So to create BitDollars for itself, the central bank would announce two things to the network, both at its discretion: (1) It announces a future transaction block, and (2) It announces a one-time reward amount for that block. Once that transaction block comes to pass, the central bank will solve the block and announce the updated official blockchain to the network, walking away with the reward. Anyone else that tries to solve that block will not be recorded as such on anyone else’s copy of the blockchain because everyone else will be using the official blockchain released by the central bank. Again, why would people using the protocol simply agree to this? Because…networks. The central bank said so. In fact, the central bank doesn’t even need to solve the block itself for this process work, simply by also providing an additional transaction reward for whoever processes the block.

Of course, with the ammunition of unlimited BitDollars, there is no need for the central bank to change how it conducts monetary policy by using the block reward method I described previously. But I think that adjusting the block reward is a much more natural way to change future money supply and conduct monetary policy because it affects every transaction in the economy — it is very broad based.

A smooth transition from paper-currencies to crypto-currencies will require central banks to understand the importance of crypto-currencies early on, as they develop. If central banks wait too long, there will be risks of bank runs and financial instability from privately issued crypto-currencies. It is important that central banks recognize this and respond accordingly.

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This is Part 4 of a discussion on the economic consequences of Bitcoin. You can access the remaining parts here:

1.  A Friendly Introduction for Economists to the Bitcoin Protocol
2.  A Monetarist View of Money and Bitcoin
3.  A Brief History of Paper Currency and Central Banking
4.  Will Bitcoins Ever Become Money? A Path to Decentralized Central Banking