From those first days when a business opens its doors—or, probably more apt these days, goes ‘live’—the struggle to survive is all-encompassing. Doing things better, cheaper, and faster is at the center of every decision the business owner makes…and with good reason. Grabbing market share is increasingly difficult as technology blows down barriers and opens completely new universes of consumer choice. Like the running of the bulls, the doors open, and the bulls start throwing all their weight into each other just trying to stay upright and hopefully even get ahead of the pack. Think of how much easier it would be for the bull (but maybe not the runner) if he just…turned.
Finding Blue Oceans
The idea of finding uncontested space is at the core of Kim and Mauborgne’s Blue Ocean Strategy. For those unfamiliar, the authors use shark-infested waters as an analogy to illustrate how businesses operate. In their example, businesses in markets with tight competition are like sharks and need to ruthlessly battle for position. Hence, the competition-heavy waters turn red with blood. One business’s profits are only gained by taking those from another. Differentiation is largely achieved by competing on price or by adding features, two strategies that negatively impact the bottom line. Instead of engaging in this battle for position, businesses would be better served by pouring their energy into finding uncontested market space, or blue oceans, to maximize their profit potential. In a blue ocean, there is no direct competition. Rather than focusing on factors that are historically competed upon (and are usually out of date), companies can instead focus on those needs that are unmet in the eyes of the customers. Firms can look across current markets, adjacent markets, and new market space to find common problems that are not being addressed by current solutions.
The benefit of discovering uncontested market space is remarkable. Profits are maximized, and a company launching in an uncontested space can enjoy its competitive advantage for years because it creates the boundaries of the market and the rules by which anyone entering it will play. Other entrants to the space are forced to compete with a market leader, a costly and somewhat futile endeavor as the market leader will be considered the original innovator. We can see this play out with established companies like Apple, which was known for the Macintosh computer when they created the smartphone market with the creation of the iPhone. Blue ocean strategies can also be grown from the startup space. Uber created the “blue ocean” of the ride-sharing market when it launched its app in 2009. These consumer-facing companies were visionaries in discovering and then capturing unmet consumer needs. But there’s another repository of blue ocean strategy potential that is not driven by the consumer at all: government regulation.
Regulatory Markets
Regulations are created to serve a common good or to benefit a specific political interest group (Stigler, 1971). Historically, the intended purpose of regulations is to dissuade certain behaviors or reward others to change the trajectory of an outcome that is seen as negatively affecting the public at large (Ahmed, 2009). While advancing the public good is the primary goal of regulations, a side effect in some cases is the creation of new market opportunities or new markets altogether. Through regulation, the government manufactures a new problem that must be solved but does not provide the mechanism to solve it. In that way, the opportunity for a blue ocean is spontaneously created from thin air. Not born from consumer demand nor competitive market pressure, a regulation creates demand that would not exist otherwise. I have created the term “artificial demand” to quickly encapsulate this idea, which Miller (1986) and Shaffer (1995) explore in depth in their work.
The quickening pace of regulation creation has not slowed. The Code of Federal Regulations (CFR) was first published in 1938 and in 1949 it boasted 19,335 pages. Between 1949 and 2005 that jumped to 134,261 pages. And while not every regulation in those thousands of pages will yield a business opportunity, companies should be aware of the enormous potential of regulations as a catalyst for economic growth. One qualitative example of this is the evolution of real-time printing technology, which manifested when the United States began mandating “best before” dates and tracking codes on many perishable packaged foods. Overnight, a need emerged in the real-time printing business that has created a market worth $1.7 billion. The banking and financial services industry yields another qualitative example. The Health Insurance Portability and Accountability Act (HIPAA) was another far- reaching regulation that has provided opportunities related to data storage, security, and disaster recovery. In each of these cases, artificial demand born from regulation fueled each industry’s growth.
The economic potential is clear, but an executive can’t just take the CFR, close their eyes, flip to any page, and point at a regulation that will generate positive economic results. One element that indicates if a regulation has true economic potential is the presence of one of three behavioral drivers: 1) Carrot (incentives); 2. Stick (penalties or fines); or 3. Intrinsic moral values, such as the feeling that compliance is for the greater good. I would argue that the carrot or the stick are the most powerful elements that drive artificial demand and therefore economic potential quickly, as intrinsic moral value often requires behavioral change on a mass scale that is difficult to predict. You can see this effect when the United Kingdom attempted to ban the selling of beef on the bone following outbreaks of Creutzfeld- Jakob’s disease that were linked to contaminated meat. However, the eating of beef on the bone was not prosecuted so most British homes continued their cultural practices of eating beef. This continued consumer demand incentivized those in the beef industry to sidestep the law. We see these behavioral drivers again in Australia, where research shows there is a widespread view that not paying income tax when you are paid in cash is not only acceptable but that the likelihood of being caught evading income tax this way is extremely low. So, of course, people largely don’t. Without any pressure to comply, a regulation becomes the government just whistling in the wind.
Another key element to a regulation having economic potential is whether it is a “must do”, “can do”, or a “must stop”. When a new regulation is enacted that requires something a business or citizen “must do”, economic opportunities arise. As in the earlier examples with on-demand best-by dates and HIPPA, the regulations exerted pressure on the food and healthcare industries to make changes. Out of those required changes, new markets were born. This is not usually the case when regulations state we simply “must stop” something. A new market is not immediately created when the government tells the public they cannot smoke in public places. These are regulations that usually decrease markets that already exist in the declared interest of improving the greater good. In addition, Artificial Demand does not apply to new regulations or laws that make it legal to do something (“can do”) that was previously illegal. The legality of smoking marijuana in California (and many other states) is an example of a “can do” law that “allows” a market to become legal. The market demand was already known, it just wasn’t legal to provide those services.
Business Model Impact
It would appear that regulations create opportunities for new markets, provided there is an adequate incentive for them to be followed. Rita McGrath wrote in 2010 that “business owners need to discover where and how these opportunities might occur to take advantage of them”. McGrath also noted that business owners’ approach toward these opportunities must also be discovered rather than assume they follow a similar pattern to a market-driven opportunity. Indeed, market opportunities created by artificial demand are different than consumer-driven opportunities and must be approached as such.
Alex Osterwalder (2004) noted that the legal environment is one of these forces exerting pressure on business models. In his new book “The Invincible Company”, Osterwalder talks about the need to explore new space to create competitive advantages and new revenue streams. In my research, I sought to uncover how to create those competitive advantages by examining the impact different business models have on regulation-driven market opportunities.
To study the effects of regulations on business model success, I examined the California “Smog Check” market. I studied that program because, in California, the Smog Check program is the broadest- reaching regulation that affects Californians aside from taxes. If you want to register your car and it fits certain criteria, you must get a smog check performed to do so. Since California has a large population of 39,538,223 according to the 2020 census, that requirement means the Smog Check market is big business. In 2013 alone, the California Smog Check market was worth more than $500 million (Bureau of Automotive Repair, 2013). And it was all created in a moment in 1982 when California Senate Bill (SB) 33 mandated the creation of a vehicle inspection and maintenance (Smog Check) program.
Proof Of a New Market
After SB33, the Smog Check program was revised in 1994 with the passing of SB119 and SB1195. The initial Smog Check program was deemed ineffective, so SB119 and SB1195 created a new program to improve outcomes and named it Smog Check II. When it went into effect in 1996, Smog Check II allowed for emissions testing to be done by test-only shops in addition to the test-and-repair shops that were included in the initial program.
In 2002, the NAICS code of 811198 was given to “all other automotive repair and maintenance” (NAICS, 2013). Within this category and code, “emissions testing without repair, automotive” was noted. This code of 811198 does not exist in the 1997 NAICS classification system, nor does the category of emissions testing. This data appears to be the first quantitative research to prove that a regulation created a new market.
Business Model Comparison
The Smog Check program also provided the opportunity to explore two approaches to solve the problem that SB 33 introduced. The first was an incremental approach where Smog testing was added to an existing automotive repair business. This was the ‘test and repair’ business model. The second approach was by businesses who solely provided Smog testing, or ‘test only’ shops. These were businesses that were created after SB 33 and that provided the bare minimum to consumers who needed to meet the Smog requirement to register their vehicles. For my research, I examined all vehicle emissions testing businesses in California from June 1998 through July 2015.
At first glance, test and repair stations have some advantages. In some cases, they have brand recognition, as they had an existing customer base before adding Smog testing services. They are also able to repair vehicles that fail an initial Smog test, another possible advantage. Test-only stations, on the other hand, had neither advantage. From the eyes of the consumer, they were new to the automotive space, and they could only perform the Smog test itself and not make any corrections. That meant if the consumer’s vehicle failed the test, they would need to seek repairs elsewhere and then get another test performed (and pass it) to register their vehicle. Traditionally, this would seem to put test- only stations at a major disadvantage in the consumer space. However, the business opportunity that came out of the Smog check regulation was created by artificial demand, not by consumer demand.
Whether those apparent obstacles would be disadvantages was not a foregone conclusion.
To uncover what impact artificial demand has on business model success, I explored the revenue generated by test-only shops compared to test and repair shops. I determined that the consumer cost between test-only and test-and-repair shops was not significantly different a mere $0.94 per test. Cost differentiation could therefore be eliminated as the key driver of any difference in revenue generation between the two types of shops.
With no cost difference, less brand recognition, and a smaller suite of services, on the surface it seems that test-only stations are at a clear disadvantage. And perhaps in a traditional, consumer-driven market, reality would have born that out. When I explored the SMOG test revenue generated by the businesses in the test-only versus test-and-repair market, I discovered a clear winner. Surprisingly, the test-only stations generated more than three times the revenue as test-and-repair businesses. The results in Table 1 show that the mean revenue per station over the life of the California Smog Check market was 3.29 times greater for test-only stations than for repair & test stations. These numbers represent millions of tests. The significant difference between the business model revenue was consistent throughout the life of the market data analyzed.
Table 1. Business Model Performance Comparison
|
Month |
Year |
Test Only Revenue Per Station | Repair & Test Revenue Per Station | Test-Only Performance
Factor |
| June | 1998 | $17,573.45 | $5,117.09 | 3.43 |
| June | 2007 | $10,742.29 | $2,406.01 | 4.46 |
| June | 2015 | $2,911.06 | $884.05 | 3.29 |
Without any bells and whistles or clear consumer-facing benefits, test-only stations dominate test-and-repair shops when it comes to revenue from SMOG tests. It’s clear, then, that there is a final component needed to generate optimal business growth in a market created by regulation: carrot or stick, and the right business model. In my findings, the business model that had the greatest level of success was the model that offered the bare minimum to consumers: just enough to fulfill the obligations of the regulation.
Executives are charged with steering their companies toward future success, a weighty responsibility in a world that seems to be more and more connected and driven by consumer choice. Blue oceans represent a path forward but finding them can be challenging. The data seems to quantitatively prove that regulations can create significant revenue opportunities for private sector businesses, making government regulations potential blue oceans. The research also shows that those opportunities exist only for those savvy enough to approach those new opportunities by first understanding the influence of Artificial Demand. That requires tossing out preconceived ideas formed from the historical framework of traditional business models because consumers driven by Artificial Demand do not follow the same patterns of purchasing behavior. The greatest success in the “must do” government-regulation-driven market space means figuring out what the consumer will need to meet the mandate and delivering exactly (and only) that.
About the Author
Dr. Brian K. Gladden is the founder and CEO of The Strategy & Innovation Institute (Si2), a management consulting firm that helps mid-sized businesses grow, innovate, and execute. Si2 provides strategy creation, strategy execution, business model innovation, and purpose/vision services. We help firms exploit their core capabilities and create competitive advantages so they can compete more successfully.
Brian is also a professor and Entrepreneur in Residence for Sacramento State University, Carlsen Center for Innovation & Entrepreneurship, and the College of Continuing Education. In his work for Sac State, Dr. Gladden creates and facilitates workshops on leadership, culture, strategy, organizational design, and execution of goals. He created the University’s Innovation & Entrepreneurship Certificate program as well as their Social Innovation Series.
Over his 35-year career, Dr. Gladden has led successful corporate innovation engagements with firms such as IBM, Hewlett Packard Enterprise, Roche, and NEC, and coached hundreds of startups in creating successful go-to-market strategies. He also currently works with the State of California to support specific agencies in achieving their strategic objectives. As a certified speaker for Vistage Worldwide and REF peer advisory groups, Dr. Gladden speaks to executives across the United States about business strategy and innovation. Brian is one of only a handful of business coaches who is certified by multiple leading strategic innovation firms, such as Strategyzer, LeanStack, OKRs.com, and the Blue Ocean Academy.
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