Good businesses create epistemic monopolies

Innovation wants to be exploitable

Good businesses exhibit characteristics of localized monopolies.

In broad economic theory, monopolies are bad for society. Yet, most companies would love to be one.

Since there are regulations to prevent total monopolies, most companies are satisfied with being monopoly-ish, finding small ways to exhibit monopolistic behavior.

With the creation of Michael Porter’s “Five Forces” in 1979, it became apparent that competitive success often looks like achieving this monopolistic behavior to whatever point regulations allow. The Five Forces: competition in the industry, potential of new entrants, power of suppliers, power of customers, and threat of substitute products. These five forces give a framework for firms to understand the competitive landscape, and in practice, shape their businesses to be as monopolistic as possible.

Bruce Greenwald and Judd Kahn expand on the “strongest force” of the five in their book released in 2005, focusing on barriers to entry. They refer to barriers to entry as the competitive advantage an incumbent player has, or in other words, an economic moat. This economic moat creates sustained monopolistic behavior “locally”, or within a specific market.

The most proliferated example of a business utilizing localized monopolies is Walmart, which slowly crept from its home in Arkansas to an international chain, dominating markets everywhere. Walmart strategically only expanded near their stores and distribution centres, so even when entering a new town, they offered big-chain low prices. When Walmart opens up in a new town, it offers those lowest prices, but even more importantly, it fatigues the market. The market likely cannot support another Walmart, nor will it support the mom-and-pop shop that it has run out of business. Walmart can now behave like a monopoly within that market without ever being recognized as one.

A simple example would be your local coffee shop selection. If there is only one place to get coffee on your walk to work, let’s say Starbucks, then Starbucks has a ‘local monopoly’ on the market of people who walk along that same path. Can regulators do anything about this? No, nor should they, and so Starbucks can charge higher prices in this local market. Unless something significantly changes, like you making coffee at home, you are at the whims of this monopoly-ish market for coffee.

Importantly, localized monopolies are not necessarily a geographic concept, but just where businesses exhibit monopolistic behavior in a specific market due to some qualitative distinction. For example, Apple is able to entirely restrict the software downloaded onto iPhones, and then charge exorbitant prices through their App Store. This type of limitation isn’t due to a geographical difference, but simply leveraging their closed ecosystem to replicate monopoly-ish behavior.

I want to introduce the concept of an epistemic monopoly, and why good (and innovative) businesses create them.

Typically, industries have standard dimensions of value that they compete on, such as costs, quality, service, etc. With localized monopolies, a firm will have leveraged some qualitative difference to get a sustainable competitive advantage within these dimensions. Each competitor will create some unique mix of these factors as a strategy to distinguish themselves. The market will decide what it likes and the companies are rewarded with proportionate market share. In this type of situation, you can chart the players on a Pareto curve, albeit a curve sometimes with more than two dimensions.

For example, a fast food burger chain may have the dimensions of cost and quality. At the lowest cost, you have the lowest quality, and at the highest cost, you have the highest quality. The best players in the market will be on the curve, providing the most quality for the lowest cost as is feasible. Worse competitors will fall below the curve, still grabbing some market share, but the balance between cost and quality could still improve.

But what happens when a company innovates outside of these dimensions?

McDonald’s launched an app, and while it may have impacts on cost or other present metrics such as order turnaround, most would recognize it as a qualitative distinction. The new app created a new modality, a new channel, and hoped to create a new metric to compete on: personalization and loyalty.

This app innovation occurred outside of the traditional dimensions of quality and cost, creating new knowledge for the industry: an epistemic innovation.

When McDonald’s introduced their app, one might imagine Burger King and Wendy’s reacting, “We can do apps now?” It was not a present competitive dimension, but the knowledge now exists in the industry. With this, fast food restaurants can now compete on who will make the best app as a dimension of their prowess.

Epistemic innovation happens constantly, players introduce a new competitive dimension and everyone else follows suit. However, companies want to be monopoly-ish: they want to be the only beneficiary of their new idea. With epistemic innovation they may receive first-mover advantage, but this is not sustained. Something else is missing if we want to create an epistemic monopoly.

When Walmart enters a town, it fatigues the market. When innovation occurs, fatiguing the market can create monopoly-ish behaviors in a similar way.

How many apps are people willing to download?

Not an endless number, as customers face app fatigue. They do not care enough to download more applications.

McDonald’s was able to get a significant number of downloads because it was an epistemic innovation and the first of its kind. The McDonald’s app was seeing downloads that well exceeded their burger-based peers as well as all other food apps in general. This success is not just determined by the fact that they moved first, but because by moving first they have staked a claim in a new rivalrous market, the home page.

An epistemic innovation where the inventor moves first and is able to fatigue the market is an epistemic monopoly.

This is a new competitive advantage that McDonalds has introduced, and not in a dimension anyone was already competing in. Now, the app has cemented itself into a real moat. By competing on this new front, the restaurant has expanded what value they gather from this program, now able to collect more data than ever before to create the most personalized experience possible.

They have a localized monopoly, and behave monopoly-ish when considering the apps.

Instead of owning Main Street, they own screen time. Instead of competing in a 100-man race, they compete where no one else is even looking.

With innovation and market fatigue, good businesses can create epistemic monopolies.