Uber, disruptive innovation, and regulated markets


Jun 16, 2016

In “Disrupting law school,” Michele Pistone, a law professor at Villanova University, and I argue that regulations—such as bar licensure and restrictions on the unauthorized practice of law—will not protect lawyers and law schools from disruption in the long term.

Lessons from regulated industries show that disruptors can topple the incumbents in these industries by first innovating outside of the reach of regulators; as the up-starts accumulate a sufficient number of customers, regulators cave ex post facto to the new reality in reaction to the innovator’s success.

One of the examples we cited to illustrate the point was Uber. Yet some have said Uber isn’t a good example because it’s not disruptive relative to taxis. Clayton Christensen himself said as much in a recent Harvard Business Review piece titled, “What is Disruptive Innovation?” that did a great job of explaining what is and isn’t disruptive innovation.

Although whether Uber is disruptive relative to taxis is ultimately not salient in judging whether it is successful—disruptive innovation is just a strategy to help entrants dislodge long-time incumbents—it is important to be able to diagnose whether it is disruptive to provide better advice for managers in reliably predicting what actions will lead to what results in other circumstances.

Central to the arguments that Uber is not disruptive to taxis is that it does not meet the classic tests of a disruptive innovation because it did not originate in a low-end or new-market foothold and because it caught on with the mainstream quite rapidly in a way that has been described as being “better than” the incumbents.

These are compelling arguments, but there is another side to the conversation that is worth working through. Reading Uber’s moves differently suggests that Uber has followed a disruptive path to its success so far.

Before taking on taxis, Uber started in the black limousine car market. There appears to be more widespread agreement that Uber is disruptive relative to black limousine car services, but it’s still worth analyzing Uber in this context because its origins are critical for understanding what I believe is its unique up-market path. When judging whether something is disruptive relative to something else, I’ve found six tests to be of use.

1. Does it target nonconsumers or people who are overserved by an incumbent’s existing offering in a market? Yes, Uber began by serving people who wanted to have a black car service but could not afford it—classic nonconsumers.

2. Is the offering not as good as an incumbent’s existing offering as judged by historical measures of performance? Once again, the answer is yes. The Uber version of a black car was not as good or reliable as booking through a traditional black limousine service, but it was better than the alternative for the nonconsumers of those services—no black car service. An example of Uber’s inferiority to traditional black car services comes from its recent announcement that it is experimenting with allowing users to schedule a ride “anywhere from 30 minutes to one month in advance”—a classic sustaining innovation to move closer to the performance traditional black car services offer.

3. Is the innovation simpler to use, more convenient, or more affordable than the incumbent’s existing offering? In the case of Uber Black, it was far more affordable than a traditional black limousine car service.

4. Does the offering have a technology enabler that can carry its value proposition around simplicity, convenience, or affordability upmarket and allow it to improve? The answer here is, once again, yes. Uber’s mobile technology platform that it built alongside of mobile phones’ GPS technology, which allows drivers to navigate passengers to their destinations, has allowed it to improve over time in terms of reliability, quality of service, and availability without adding the fixed costs of owning cars and having a manual middleman dispatch service. Its up-market move to try and leverage its platform to allow users to schedule rides in advance even though it does not own the cars in its service illustrates this nicely.

5. Is the technology paired with a business model innovation that allows it to be sustainable with its new value proposition? No technology is inherently disruptive. A technology can be used as a sustaining innovation to improve an existing service or it can be deployed in a new, viable business model that allows the entity using the technology to come to market with a simpler, more convenient, or more affordable value proposition than existing offerings. Central to the Uber question is whether its low pricing has been used just as a marketing technique to enable it to acquire new customers or whether it is in fact housed in a business model that allows it to sustainably offer its services at lower cost. Without access to Uber’s financials, we don’t know for sure, but the answer appears to be that Uber has a sustainable business model that is lower cost than its black car service competitors, as Uber has said it is profitable in the United States. Uber pioneered its technology in a facilitated network business model—in which customers exchange things with one another—which is radically different from the traditional business model black car services use.

6. Are existing providers motivated to ignore the new innovation and not threatened at the outset? Disruptive innovation is a theory of competition with game theory at its heart; it posits that if you take a “disruptive” action, then the incumbents will be motivated to ignore or flee from you initially—and when they do fight, it will be largely futile. Uber passes this test with the black car services. A key reason why is that Uber actually created business for the drivers of the black limousines, as it increased their utilization and allowed them to make money by driving when they would have been otherwise idle—an example of “tapping excess capacity” that has “been paid for, but from which new value could be found,” as Robin Chase, the founder of Zipcar, noted in her own piece about why Uber is disruptive. This insight has been one of the key elements that has allowed Uber to price its offerings so much lower than the incumbents—both in the limo and taxi markets.

Taking on taxis

Uber’s move to take on the taxi industry seems counterintuitive at first for students of disruptive innovation because, from the outside, it appears to be a march down-market as opposed to up-market. But in disruptive innovation theory, how a company measures its profitability determines what is up-market, not how consumers perceive the value of the service. For airlines, for example, going up-market doesn’t mean better service or more first-class seats, but flying longer routes. Given Uber’s unique facilitated network business model, I suspect that any move to increase volume and scope is likely an up-market step (although, given its financials are not public, we don’t know for sure), as it increases the utilization of its technology platform, which in many ways represents a fixed cost. In other words, because every ride has a low marginal cost for Uber given that Uber doesn’t own any cars, the more people use Uber, the more valuable and profitable the service is. Each additional ride through Uber represents almost pure profit. Leaked internal company slides from 2014 that Business Insider reported helps illustrate the point, as UberX actually has a higher average fare per driver hour than does UberBlack, which arguably makes it more profitable from Uber’s perspective.

Moving through the tests is key though to see whether it is disruptive relative to taxis.

1. Does it target nonconsumers or people who are overserved by an incumbent’s existing offering in a market? Yes. As hard as it may be to believe, many people are overserved by traditional taxi services. The medallion systems enacted originally (and debatably) to protect the public safety and welfare, as so many regulations are, isn’t worth the cost it creates for many consumers. That this notion that a customer is paying for a safer experience is an important part of the taxi value proposition can be seen in the many campaigns against Uber and in how taxis publicize any safety incident that occurs with one of Uber’s drivers—and in some people’s hesitation to adopt Uber over taxis. In addition, UberX’s drivers are in many cases less skilled than taxi drivers, but good enough, as essentially anyone with a license, a car, requisite insurance, and the ability to pass a background check can get on Uber’s platform and offer on-demand car services. UberX’s users have traded off on the “expert” value of taxi drivers’ experience and knowledge of local roads—expertise that holds back more people in the United States from adopting Uber than many outside of London might expect—in favor of the lower prices and, in certain cases, great convenience that Uber offered. Lastly, Uber has also served some nonconsumers of taxis who previously had opted for mass transit as well as those for whom taxis have been inaccessible.

2. Is the offering not as good as an incumbent’s existing offering as judged by historical measures of performance? I believe the answer here is also yes. In addition to the above points, although many have said that Uber was better than taxis from the get-go—a strike against something being a disruptive innovation—this analysis ignores the fact that Uber’s availability in many areas and at many times was and, in many cases, is far less reliable or predictable than the local taxi option, particularly in situations where a customer would want to reserve a taxi in advance for a specific time, when customers needed a ride from an airport, in suburban areas just outside of cities, or in circumstances in which ordinary drivers did not want to be driving.

3. Is the innovation simpler to use, more convenient, or more affordable than the incumbent’s existing offering? Once again, yes. From the beginning UberX has been significantly more affordable than taxis. It’s more affordable almost everywhere worldwide, from the United States to Vietnam. And in many cities it’s often more affordable even when surge pricing is in effect.

4. Does the offering have a technology enabler that can carry its value proposition around simplicity, convenience, or affordability upmarket and allow it to improve? Yes. By having a technology enabler that allowed it to strip out many of the costs of the taxi services, Uber has been able to improve rapidly, retain its low-cost value proposition, and introduce new services—such as UberPOOL—that further increase the utilization of its platform and thus its profitability. By increasing capacity rapidly with the aid of its technology platform and its capacity for dynamic surge pricing, Uber has continued to improve along the same trajectory it did when it launched UberX after UberBlack and tackle more complicated problems where there is less population density, timing is critical for customers, there are fewer cars at a particular hour or in a particular circumstance, or people want to carpool for cost or environmental reasons. And the seemingly high-end offering that Uber already had—its successful black car service—boosted Uber’s reputation and likely reduced its marketing cost to acquire both customers and ordinary drivers, many of whom had never before driven to earn money, in the early going of the new UberX service. These dynamics likely made UberX more profitable than observers who doubt that UberX represents an up-market move from UberBlack might imagine.

Uber’s business model allowed it to use mobile phones’ GPS technology to help many of their drivers overcome their lack of knowledge and provide a good-enough service—and as many who have ridden an Uber can attest, the company is still working to improve its navigation services to match the best of a local taxi driver. In addition, its technology where customers rate the performance of their driver allows Uber to provide feedback to and prune poorer drivers and thus continue to improve on the whole—and, over time, weed out unsafe drivers as well. Thus, although many may now describe Uber as being better than a taxi service in many areas and situations, it wasn’t always so. The slope of Uber’s improvement has just been extremely rapid (see Clayton explain why this matters here).

5. Is the technology paired with a business model innovation that allows it to be sustainable with its new value proposition? The same answers addressed in the UberBlack analysis apply here. UberX is significantly less expensive to the consumer, operates at a lower cost than taxis with its facilitated network business model, and Uber is profitable in the United States with UberX comprising a large part of its business. As with its black car service, Uber took advantage of excess capacity from drivers who already own their cars and were now leveraging their downtime from earning income—a powerful advantage because it eliminates the fixed costs of buying medallions or owning taxi cabs. Along those lines, its technology also eliminates the need for the taxi companies’ middleman dispatch services, which have to scale in line with increased demand in contrast to Uber’s platform where support staff only have to increase as it experiences something closer to exponential growth.

Some point to the fact that Uber has raised so much more capital than, say, Airbnb, as evidence that it is in a head-on—that is non-disruptive—battle with taxi incumbents, which is costly. This analysis, however, ignores that Uber’s real fight for drivers and passengers is no longer with taxi companies, but with Lyft, Didi Chuxing, and other competitors that may enter the market. According to the Economist, for example, ride-sharing services “accounted for 46 percent of business ‘ground transportation’ trips in America. … That compares with 40 percent for car-hire and a piddling 14 percent for taxis. … That will leave only one battle worth watching: that between Uber and Lyft.”

6. Are existing providers motivated to ignore the new innovation and not threatened at the outset? This appears to be trickiest question to answer—and a question on which reasonable people can disagree. Uber now clearly threatens taxis; taxi companies have reacted accordingly. A reaction alone doesn’t show that Uber is not disruptive though. Most incumbents at some point try and fight disruptive threats. Toyota, which was disruptive relative to Ford, General Motors, and Chrysler, also provoked a reaction, as the Detroit car companies fought to erect tariff barriers to keep the Japanese disruptors out of the market. Ultimately Toyota figured out a way around those regulatory barriers though, and the American car companies were unable to innovate their business models to take on Toyota’s disruptive, lower cost value proposition. Similarly, while taxis protest the rise of Uber and are using all of their regulatory might to keep them out of airports and cities like Austin, Texas, the history of disruptive innovation suggests that these regulations that preserve the status quo will likely fade away over time, and Uber will improve to serve these situations as well with its lower cost value proposition—a powerful lesson for law firms, law schools, and all incumbents in highly regulated markets. Likewise, we can predict that taxis will be unable to compete with Uber by innovating in their business model. Indeed, as taxi companies have introduced ride-hailing apps or other technology solutions, they are missing and not responding to the fundamental innovation Uber’s technology platform has allowed, which is the elimination of the middleman taxi company that owns taxi medallions and, often, the cars themselves, as well as the role of the dispatcher. Indeed, the addition of technology has in many cases served to increase the taxi companies’ costs, not reduce them, a key point because it is never the mere presence of technology that causes something to be disruptive, but instead the business model in which the technology is used. Uber’s offering simply looks unattractive from the perspective of the traditional taxi companies’ business models.

The question perhaps then shifts to whether taxis were threatened from the outset or did this reaction develop over time. Because the slope of Uber’s improvement has been so rapid and it has scaled so quickly into the mainstream of taxi’s businesses, this may be a hard question to answer definitively. One reason why Uber was smart to avoid buying medallions at the outset was that that would have placed it in head-on competition with taxi companies—and Uber likely would have lost that regulatory battle. Going around the regulations by avoiding being a taxi company and owning medallions was savvy and heeded the lessons from disruptive innovation.

Similarly, although Uber made its intentions of displacing the taxi market known early on—the company’s name was initially UberCab—by starting in the black car segment and then moving up-market in a counterintuitive fashion by launching UberX, taxi companies arguably didn’t perceive Uber as directly competitive with their core market at the outset. My colleague Efosa Ojomo makes one of the more interesting counter arguments here, however, which is that just a few months after its founding, Uber received a “cease and desist” letter from the California Public Utilities Commission because it was thought to be operating an unlicensed taxi business—meaning that asymmetric motivation was not present and taxis had a desire to fight immediately. But as another of my colleagues Tom Bartman has noted, this action was largely toothless, resulted in a small $20,000 fine two years later that was then rescinded, and had no material impact on Uber. Indeed, the regulator ultimately embraced Uber and its competitors in the spring of 2013.

Ultimately it seems to me that Uber passes this last test.

The fact that UberX is significantly lower cost than taxis and powered by a technology enabler that allows it to move up-market and improve extremely rapidly inside of a business model innovation that makes it almost impossible for taxis to respond effectively feels like a classic disruptive innovation relative to taxis once accounting for the counterintuitive up-market move it made from UberBlack to UberX.

Although the theory of disruptive innovation was discovered to solve a mystery—why well-run incumbents struggle to sustain success—the theory does not imply that a company has to be well run to be disrupted. In short, a better understanding of Uber’s origins, business model, and asymmetric advantages over taxi companies seen through the theory of disruptive innovation helps explain the company’s rapid rise. It is disruptive relative to black car services and taxis. And Uber’s powerful need to continue to climb up-market makes me think it is worth watching its larger ambitions of replacing car ownership as well. This disruptive story is not yet over. And it should serve as a cautionary tale for all who think regulations can prevent disruption from occurring.

Michael is a co-founder and distinguished fellow at the Clayton Christensen Institute. He currently serves as Chairman of the Clayton Christensen Institute and works as a senior strategist at Guild Education.