Innovation and the Creative Destruction of Capitalism

By Dennis Zakas of Zakas and Leonard, LLP, Transformational Law

My past two postings discussed the dramatic evolution of the recording industry. These changes demonstrate the creative destruction of capitalism. The term is identified with economist Joseph Schumpeter and states that innovations destroy and supplant prior technologies and processes. As a result, there are winners and losers. Apple (through iTunes) has been a winner, while the music industry as a whole has been a loser. In 1999, sales of recorded music were estimated at $44 billion, but today they are around one-third of that.

The ultimate winners are consumers. Consumers don’t have to leave home to get music, video or books. Almost anything imaginable is available digitally, accessible through a variety of devices. Consumers own vastly more content than ever and have the advantage of portablity.

Joseph Schumpeter derived the concept from Marxist thought. In Capitalism, Socialism and Democracy, Schumpeter defines “creative destruction” as follows:

Capitalism … is by nature a form or method of economic change and not only never is but never can be stationary…. [Emphasis added.] The fundamental impulse that sets and keeps the capitalist engine in motion comes from the new consumers’ goods, the new methods of production or transportation, the new markets, the new forms of industrial organization that capitalist enterprise creates…. The opening up of new markets, foreign or domestic, and the organizational development from the craft shop and factory to such concerns as U.S. Steel illustrate the same process of industrial mutation … that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one. This process of Creative Destruction is the essential fact about capitalism. It is what capitalism consists in and what every capitalist concern has got to live in.

Innovation is essential to the process of creative destruction. Schumpeter believed that only larger, more established, companies had the resources to fund the research and development necessary for disruptive innovations. Today’s economists argue that this is no longer the case. Established companies have a vested interest in the status quo, and thus are less likely to embrace new technologies. Startup companies are more able now, than in Schumpeter’s day, to attract capital from angels, venture capitalists and other financing sources.

Exceptions can occur. For example, Apple was certainly an established company—albeit not yet the world’s most valuable company — when Steve Jobs promoted the development of the iPod and iTunes. Perhaps the exception proves the rule. At that time, Apple was not a “player” in music. In fact, Jobs thought he might have missed the digital revolution because for a time you couldn’t burn CDs on iMacs.

According to Schumpeter, capitalism can never be stationary. And so it is unlikely that Apple will continue its market dominance forever.

It is difficult to predict the next source of destruction in the music industry. Could it be music streaming? There are many services, such as Pandora, Slacker Radio (which also powers AOL Radio), Turntable, Sony Music Unlimited, Last.FM, Songza, Jango and Grooveshark, but I like Spotify. For $10 per month, Spotify gives you unlimited access to 15 million songs, on your desktop and mobile device. It also facilitates easy sharing of playlists with members of your network.

According to TechCrunch (www.techcrunch.com/2012/04/13/despite-889m-in-revenue-this-year-theres-no-ipo-in-spotifys-cards-though-ek-wouldnt-say-no-to-more-funding/) Spotify has 13 million active users in the United States, of which three million are paying customers. It is projected to have revenues of $889 million this year, up 160 percent in 2011.

Yet in 2011 Spotify had net losses of around $60 million. Part of the reason is that about 70% of Spotify’s revenues from paying subscribers is paid to record labels.

Perhaps the next source of creative destruction in the music industry won’t be music-streaming services, after all. Perhaps Spotify and iTunes are really competing with illegal downloads, competition which they may not be able to win in the long run. According to www.didyouknow.org, “40 billion songs are downloaded illegally every year, that’s some 90% of all music downloads. The music industry generates about $4 billion in online music but loses about $40 billion to illegal downloads.” Did Apple really save the recording industry, or is it on life support?

Perhaps the music industry will change in ways that we can’t imagine. That change could be technological, or it could be a change in processes, or new ways to reward artists. We won’t know until it happens. That’s the frightening, and exciting, thing about creative destruction.