Innovators Succeed Outside of Regulators' Boxes

Bloomberg View , December 12, 2016

The New York officials and hotel interests who want to drive Airbnb Inc. out of the city call the rentals “unregulated hotels” or “illegal hotels.” These accommodations do, of course, compete with hotels. That’s why Mike Barnello, the chief executive of LaSalle Hotel Properties, told analysts that New York’s draconian new law, which imposes fines of up to $7,500 on absent Airbnb hosts, “should be a big boost in the arm” for his business, “certainly in terms of the pricing.”

But no one who has stayed in an Airbnb -- and I have stayed in many -- would confuse them with hotels.

When your hotel toilet clogs, you simply call the desk. When your flight is delayed and you arrive at 2 a.m., you know someone will be there to check you in. You will never be stuck at midnight unable to get into your hotel because the lock box is frozen shut. Nor will you discover every inch of closet and drawer space occupied by the owner’s clothes. Staying in an Airbnb requires resilience, and sometimes an emergency hotel room.

Despite the occasional difficulties, Airbnb offers a different kind of value for travelers. It’s like the meal kits sold by companies such as Blue Apron Inc.: It gives you the ingredients for a local living experience, but you still have to do some work. Hotels, by contrast, are like restaurants. They prepare everything for you. New York Airbnbs may be illegal, but they are definitely not hotels.

Airbnb and Blue Apron are but two examples of the “permissionless innovation” that is so important to economic growth. Entrepreneurs need the freedom to test ideas that don’t conform to existing categories. New value often comes from trade-offs and combinations that regulatory definitions never envisioned and might not approve. A better name for these businesses might be “category-free” or “uncorseted” innovation.

Take restaurants like Panera Bread Co. Offering no waiter service but higher-quality ingredients than casual chains, they’re neither sit-down restaurants nor fast food. Hence the need for the new term “fast casual.” Over the past decade, satisfied customers have made fast-casual restaurants the fastest-growing industry segment. But this new definition of quality can, believe it or not, produce regulatory problems.

To some neighborhood activists near the University of California at Los Angeles, the only good restaurant is one with sit-down service and china plates. Anything else is fast food, appealing to (ugh) students and hospital workers, and must be strictly limited by law. So the now-defunct Chili’s and Acapulco restaurants were OK. But after city planners approved Panera, an activist appeal blocked it from opening for two more years.

This rigidity isn’t an isolated example. Not so long ago, Starbucks Corp. created a radical new concept in American retailing: a neighborhood watering hole where, in the words of founder Howard Schultz, “no one is carded and no one is drunk.” When the company wanted to open stores in San Francisco, it discovered that many neighborhoods had banned the conversion of retail spaces into restaurants, reflecting a surprisingly common city-planning prejudice against eating out. Starbucks could sell coffee to go, but it couldn’t give customers anywhere to sit unless it located in busy shopping districts away from where people lived. Already a well-established company, Starbucks lobbied to get a new zoning category created, “beverage houses.” Now you can find all sorts of coffeehouses in San Francisco neighborhoods where they were once forbidden. But that only happened because a wealthy company had the resources to survive in less desirable locations while it worked to change the rules.

Rigid categories hamper all sorts of unanticipated business ideas. Every new financial product must get shunted into an existing regulatory classification, regardless of its uniqueness. African-style hair braiders find themselves subject to licensing standards designed for hairdressers who use chemicals. Eyebrow threaders run into similar problems.

Or consider medicine. Facing the terrifying prospect of bacteria that resist even the strongest antibiotic drugs, the world desperately needs new ways to fight infections. One potential alternative is phage therapy, which uses tailored and dynamic cocktails of bacteria-attacking viruses. But this approach doesn’t fit into how the U.S. regulates new drugs. Microbiologist Eric C. Keen writes that

The FDA has essentially grafted its traditional antibiotic regulatory protocols onto phage therapy, meaning that all components of a phage cocktail must go through individual clinical trials and that the composition of these cocktails cannot be altered without re-approval. This policy does not reflect the fundamental differences between phages and antibiotics, and would, if perpetuated, likely render phage therapy both prohibitively expensive and significantly less effective.

Although phage therapy does face other economic and technical obstacles, labeling it a “drug” hinders innovators who might make it viable. Instead of demanding new trials for each new combination, Keen proposes a workaround: regulating the process by which the cocktails are produced, the way the Food and Drug Administration  checks each year’s FluMist vaccine.

Finding such clever ways to assign new ideas to existing regulatory categories is all-too-often crucial to survival. Uber Technologies Inc. initially avoided hostile local taxi commissions by getting itself regulated by the California Public Utility Commission as a “pre-arranged” black car service. Its app simply made the pre-arrangement nearly instantaneous. Lyft Inc. (and now-defunct Sidecar), meanwhile, pioneered the ride-sharing model with nonprofessional drivers by declaring passengers’ payments “donations.” This transparent ruse gave the concept enough time to build public support and get the utility commission to give ride-hailing services their own regulatory category.

The toughest challenge in economic life is discovering what consumers want that doesn’t already exist and making it happen. The world of potential goods and services has an infinite number of incremental trade-offs and combinations of features, any one of which might be the next big thing. Regulatory power, by contrast, requires a finite number of rigid categories into which every new idea must be crammed, no matter how it is deformed in the process. The more regulations extend throughout the economy, the tighter the corset hampering innovation.