Entries Tagged 'economics' ↓

There is a widespread myth that search engines have taken profits away from news websites. A few months ago, Rupert Murdoch said: “Google has devised a brilliant business model that avoids paying for news gathering yet profits off the search ads sold around that content.”

The reality is that news is a lousy business. Period. Even Google doesn’t make money on it. For example, here are Google’s search results for the phrase “afghanistan war”:

Notice there aren’t any ads on the page. This is because ads for “afghanistan war” generate such low revenues per query that Google doesn’t think it’s worth hurting the user experience with a cluttered page. Google can afford to do this on news queries (along with many other categories of queries) because their real business is selling ads on queries where the user likely has purchasing intent. Big money-making categories include travel, consumer electronics and malpractice lawyers. News queries are loss leaders.

It’s an historical accident that hard news categories like international and investigative reporting were part of profitable businesses. The internet upended this model by 1) providing a new delivery method for classified ads (mainly Craigslist), 2) increasing the supply of newspapers from 1-2 per location to thousands per location, thereby driving the willingness-to-pay for news dramatically down, and 3) unbundling news categories, making cross subsidization increasingly hard.

The internet exposed hard news for what it is: a lousy standalone business. Google arguably contributed to this in many indirect ways, including by helping users find substitute news sources. But the idea that Google takes profits directly from newspapers is simply misinformed.

It is almost religious orthodoxy in the tech community that “open” is better than “closed.” For example, there have widespread complaints about Apple’s “closed” iPhone app approval process. People also argue Apple is making the same strategic mistake all over again versus Android that it made versus Windows*. The belief is that Android will eventually beat the iPhone OS with an “open” strategy (hardware-agnostic, no app approval process) just as Windows beat Apple’s OS in the 90’s.

With respect to requiring apps to be approved, consider the current state of the iPhone platform. There are over 100,000 apps and thus far not a single virus, worm, spyware app etc. (I don’t count utterly farfetched theoretical scenarios). As a would-be iPhone developer, I can report firsthand that the Apple approval process is a nightmare and should be overhauled. But what’s the alternative? Before the iPhone, getting your app on a phone meant doing complicated and expensive business development deals with wireless carriers. At the other end of the spectrum: If the iPhone OS were completely open, would we really have better apps?  What apps are we missing today besides viruses?

With respect to the strategic issue of tightly integrating the iPhone/iPad software and hardware, a strong case can be made that Apple’s “closed” strategy is smart. Clay Christensen has given us the only serious theory I know of to predict when it’s optimal for a company to adopt an open versus closed strategy for (among other things) operating systems. The basic idea is that every new tech product starts out undershooting customer needs and then – because technology gets better faster than customers needs go up - eventually “overshoots” them. (PC’s have overshot today – most people don’t care if the processors get faster or Windows adds new features). Once a product overshoots, the basis of competition shifts from things like features and performance to things like price.

The key difference today between desktop computers and mobile devices is that mobile devices still have a long way to go before customers don’t want more speed, more features, better battery life, smaller size, etc. Just look at all the complaints yesterday about the iPad - that it lacks multitasking, a camera, is too heavy, has poor battery life, etc. This despite the fact that Apple is now even building their own semiconductors (!) to squeeze every last bit of performance out of the iPad. Until mobile devices compete mainly on price (probably a decade from now), tight vertical integration will produce the best device and is likely the best strategy.

*It’s worth noting that Steve Jobs wasn’t the one who screwed up Apple. Jobs co-founded Apple in 1976. He was pushed out in in May 1985 when the company was valued at about $2.2B. He returned in 1996 when Apple was worth $3B. Today it is worth $187B.

Sarah Lacy has a very interesting post on TechCrunch where she conjectures that the internet is finally starting to disrupt Wall Street. I’d love nothing more than to see Wall Street get nailed by the internet the way, say, publishing and advertising have.

While I agree on the big picture, I disagree with some of her specifics. She cites Mint and Square as examples of startups that potentially disrupt Wall Street. As I see it, these companies have merely built nice UI’s to Wall Street: Mint connects to your banks and Square to Visa and Mastercard and the bank that issued the credit card. If people at farmers’ markets use credit cards instead of cash, that means more money for Wall Street, not less.

I would argue the best way to try to disrupt Wall Street is to look at how it currently makes money and attack it there. Here are some of the big sources of revenue.

1) Retail banks. Retail banks make money on fees and by paying low interest rates on deposits and then doing stuff with those deposits (buying stocks, mortgages, issuing credit cards, etc) that gets them a much higher return. To disrupt them you need to get people to stop depositing money in them. Zopa and Prosper are trying to do that. Unfortunately the regulatory system seems to strongly favor the incumbents.

2) Credit cards. Charging 20% interest rates (banks) and skimming pennies off every transaction (Visa and Mastercard) is a very profitable business. Starting a new payment company that doesn’t depend on the existing banks and credit card companies could be disruptive. Paypal seems to have come the closest to doing this.

3) Proprietary trading. A big trend over the last decade is for more of big banks’ profits to come from “proprietary trading” – which basically means operating big hedge funds inside banks (this trend is one of the main causes of the financial crisis and why the new “Volcker rule” is potentially a very good thing). For example, most of Goldman Sachs’ recent massive profits came from proprietary trading. Basically what they do is hire lots of programmers and scientists to make money on fancy trading algorithms.  (Regrettably, I spent the first four years of my career writing software to help people like Goldman do this).  Given that the stock market was flat over the last decade and hedge funds made boatloads of money, the loser in this game are mostly unsophisticated investors (e.g. my parents in Ohio). Any website that encourages unsophisticated investors to buy specific stocks is helping Wall Street. Regular people should buy some treasury bonds or maybe an S&P 500 ETF and be done with it. That would be a huge blow to Wall Street.

4) Trading. The more you trade stocks, the more Wall Street makes money. The obvious beneficiaries are the exchanges – NYSE, NASDAQ etc. There were attempts to build new exchanges in the 90’s like Island ECN. The next obvious beneficiaries are brokers like Fidelity or E-Trade. But the real beneficiaries aren’t the people who charge you explicit fees; it’s the people who make money on your trading in other ways.  For example, the hot thing on Wall Street is right now is high frequency “micro structure” trading strategies, which is basically a way to skim money off the “bid-ask spread” from trades made by less sophisticated investors.

5) Investment banking. Banks make lots of money on “services” like IPOs and big mergers. A small way to attack this would be to convince tech companies (Facebook?) to IPO without going via Wall Street (this is what Wit Capital tried to do). Regarding mergers, there have been endless studies showing that big mergers only enrich CEOs and bankers, yet they continue unabated. This is part of the massive agency problem on Wall Street and can probably only change with a complete regulatory overhaul.

6) Research. Historically, financial research was a loss leader used to sell investment banking services. After all the scandals of the 90’s, new regulations put in stronger walls between the research and banking. As a result, banks cut way back on research. In its place expert networks like Gerson Lehrman Group rose up. LinkedIn and Stocktwits are possible future disrupters here.

7) Mutual fund management. Endless studies have shown that paying fees to mutual funds is a waste of money. Maybe websites that let your peers help you invest will disrupt these guys. I think a much better way to disrupt them is to either not invest in the stock market or just buy an ETF that gives you a low-fee way to buy the S&P 500 index.

This is by no means an exhaustive list and I have no idea how to solve most of these problems. But I’d love to see the financial industry be one of the next targets of internet innovation.

In Clay Shirky’s brilliant essay “Newspapers and thinking the unthinkable” one line stood out to me as odd:

“The Wall Street Journal has a paywall, so we can too!” (Financial information is one of the few kinds of information whose recipients don’t want to share.)

It is true that The Wall Street Journal is one of two newspapers (along with the Financial Times) that seems to have been pretty successful getting people to pay. It’s not clear why Shirky thinks people don’t want to share financial information. Hopefully he doesn’t think business people want to keep the Journal to themselves to keep some competitive advantage. Pretty much everyone in finance and business that I know reads the Journal every day – no one would seriously consider anything in there a competitive advantage. People send Journal links to each other all the time. It is background knowledge that everyone is expected to know.

The reason people are willing to pay for the Journal has nothing to do with their unwillingness to share or pirate financial information. It’s quite simply the fact that the Journal is a valuable business input that can’t be found anywhere else. Most people, when presented with something of value that is scarce and reasonably priced, don’t pirate (especially when they can charge it to their business). The revenue-maximizing price of any good – including digital goods – is determined by value and scarcity, not what it costs to produce it.

The fact that the cost of distributing newspapers is dropping to near zero only affects the price of newspapers if the content is commoditized. The problem the New York Times has isn’t that people are willing to share or pirate their content.  It’s that with the advent of the internet, competition for general news went from one or two per market to thousands per market. (The other big blow was classifieds getting decoupled from newspapers).

Most business people I know consider the Times an essential daily read, not just for its business and finance news, but also its section A news and op-eds. If you are a running an operating company or investment firm you want to know not just narrow business news but the broader context of what’s happening in the world.

Most smaller newspapers will go out of business over the next few years, vastly increasing the scarcity of news. If the Times creates content that is scare and valuable – and remains an essential “business input” – it can have the same success online as the Journal.

One of the amazing things about the internet economy is how different the list of top internet properties today looks from the list ten years ago.  It wasn’t as if those former top companies were complacent – most of them acquired and built products like crazy to avoid being displaced.

The reason big new things sneak by incumbents is that the next big thing always starts out being dismissed as a “toy.”  This is one of the main insights of Clay Christensen’s “disruptive technology” theory. This theory starts with the observation that technologies tend to get better at a faster rate than users’ needs increase. From this simple insight follows all kinds of interesting conclusions about how markets and products change over time.

Disruptive technologies are dismissed as toys because when they are first launched they “undershoot” user needs. The first telephone could only carry voices a mile or two. The leading telco of the time, Western Union, passed on acquiring the phone because they didn’t see how it could possibly be useful to businesses and railroads – their primary customers. What they failed to anticipate was how rapidly telephone technology and infrastructure would improve (technology adoption is usually non-linear due to so-called complementary network effects). The same was true of how mainframe companies viewed the PC (microcomputer), and how modern telecom companies viewed Skype. (Christensen has many more examples in his books).

This does not mean every product that looks like a toy will turn out to be the next big thing. To distinguish toys that are disruptive from toys that will remain just toys, you need to look at products as processes. Obviously, products get better inasmuch as the designer adds features, but this is a relatively weak force. Much more powerful are external forces: microchips getting cheaper, bandwidth becoming ubiquitous, mobile devices getting smarter, etc. For a product to be disruptive it needs to be designed to ride these changes up the utility curve.

Social software is an interesting special case where the strongest forces of improvement are users’ actions. As Clay Shirky explains in his latest book, Wikipedia is literally a process – every day it is edited by spammers, vandals, wackos etc., yet every day the good guys make it better at a faster rate. If you had gone back to 2001 and analyzed Wikipedia as a static product it would have looked very much like a toy. The reason Wikipedia works so brilliantly are subtle design features that sculpt the torrent of user edits such that they yield a net improvement over time. Since users’ needs for encyclopedic information remains relatively steady, as long as Wikipedia got steadily better, it would eventually meet and surpass user needs.

A product doesn’t have to be disruptive to be valuable. There are plenty of products that are useful from day one and continue being useful long term. These are what Christensen calls sustaining technologies. When startups build useful sustaining technologies, they are often quickly acquired or copied by incumbents. If your timing and execution is right, you can create a very successful business on the back of a sustaining technology.

But startups with sustaining technologies are very unlikely to be the new ones we see on top lists in 2020. Those will be disruptive technologies – the ones that sneak by because people dismiss them as toys.

Mary Meeker’s presentation this year on internet trends was all about mobile. Inasmuch as data-heavy research report from a major investment bank can be said to have a “climax,” it was probably these slides:

The assertion seems to be that there is something special about the mobile internet that compels people to pay for things they wouldn’t pay for on the desktop internet.  It is this same thinking that has newspapers and magazines hoping the Kindle or a tablet device might be their savior.

It is certainly true that today people are paying for things on iPhones and Kindles that they aren’t paying for on the desktop internet. Personally, I’ve bought a bunch of iPhone games that I would have expected to get for free online. I also paid for the New York Times and some magazines on my Kindle that I never paid for on my desktop.

But longer term, the question is whether this is because of something fundamentally – and sustainably – different about mobile versus desktop or whether it is just good old fashioned supply and demand.

I think we are in the AOL “walled garden” days of the mobile internet. Demand is far outpacing supply, so consumers are paying for digital goods. I don’t pay for news or simple games on the desktop internet because there are so many substitutes that my willingness to pay is driven down to zero.

What are the arguments that the mobile internet is sustainably different than the desktop internet? One of the main ones I’ve heard is habit: digital goods providers made a mistake in the 90’s by giving stuff away for free. Now people are habituated to free stuff on the desktop internet. Mobile is a chance to start over.

I think this habit argument is greatly overplayed. The same argument has been made for years by the music industry: “kids today think music should be free” and so on. Back in the 90s, I bought CDs, not because I was habituated to paying for music, but because there was no other reasonably convenient way to get it. If tomorrow you waved a magic wand and CD’s were once again the only way kids could buy the Jonas Brothers and Taylor Swift, they’d pay for them. It’s the fact that there are convenient and free substitutes that’s killing the music industry, not consumers’ habits.

As the supply of mobile digital goods grows — the same way it did on the desktop internet — consumers’ willingness-to-pay will drop and either advertising will emerge as the key driver of mobile economic growth or the mobile economy will disappoint. I was going to buy a Chess app for my iPhone this morning but when I searched and found dozens of free ones I downloaded one of those.  At some point there will be lots of Tweetie, Red Laser, and Flight Control substitutes and they too will be free.

I’ve been trying to set up a “Popular Posts” widget on the sidebar of this blog but somehow repeatedly failed.  So instead I’ll just post them here:

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People who criticize Obama’s economic policies forget that, around the beginning of this year, a lot of serious people thought we were entering a second Great Depression.  Here are the Google News mentions of the words “Great Depression” (in blue) and “economic recovery” (in red) over the last three years:

Moreover, most experts thought we were being led into a Great Depression not by “fundamentals” but by the collapse of the financial system.

Back around when Obama proposed his bank bailout plan (which was mostly an extension of Bush and Bernanke’s plan) he was widely criticized.  The consensus criticism was succinctly summarized by Nobel Laureate Joseph Steiglitz:

Paying fair market values for the assets will not work. Only by overpaying for the assets will the banks be adequately recapitalized. But overpaying for the assets simply shifts the losses to the government. In other words, the Geithner plan works only if and when the taxpayer loses big time.

Around this time, I happened to bump into an old friend who was working at a hedge fund where his full-time job was trading these so-called toxic assets (CDSs, CDOs, etc).  I asked him the trillion dollar question:  what did he think the “fair market value” for these assets was? Were they worth, say, 80 cents on the dollar as the banks were claiming, or 20 cents on the dollar as the bidders in the market were offering.

His answer:  These assets are essentially bets on home mortgages, which in turn are dependent on housing prices, which in turn are dependent on the economy, which in turn is highly dependent on whether the banks stay solvent, which is dependent on what these assets are worth.

This circularity is not unique to these particular assets.  As George Soros has argued for decades, all economic systems are profoundly circular, a property that he calls reflexivity.

The bank bailouts were extremely distasteful in many ways.  Lots of underserving people got rich.  Institutions that should have failed didn’t.  Dangerous “moral hazard” precedents were set. But the fact remains:  by altering perceptions, the Bush/Obama/Bernanke plan seems to have turned the second Great Depression into “merely” a bad recession.

The Dow passed the symbolic milestone of 10,000 recently.  People who say it’s an illusion and doesn’t reflect economic fundamentals don’t understand that in economics, perception and fundamentals are inextricably linked.

What’s the relationship between price – the ability to charge for your product – and cost – how much it costs you to produce it?

Price is a function of supply and demand.  Notice the word “cost” doesn’t occur there.  It is true that cost is, over the long term, a lower bound for price – otherwise you’d go out of business.  It is also true that high upfront fixed costs can create barriers to entry and therefore lower supply.

The only case in which price is determined by (variable) costs is in a commoditized market.  A market is commoditized when competing products are effectively interchangeable and therefore customers make decisions based solely on price.  In commoditized markets, price tends to converge toward cost.

In non-commoditized markets, variable costs have no effect on price.  Most information technology companies are not commoditized, therefore variable cost and price are unrelated.  That is why there can exist companies like Google and Microsoft that are so insanely profitable.  If the cost of producing and distributing a copy of Microsoft Office dropped tomorrow, there is no reason to think that would affect their pricing.  The most profitable industry historically has been pharmaceuticals, because they are effectively granted monopolies, via patents, reducing the supply of a given drug to one.

There are two ways people get confused about cost and price – a rudimentary way and a more advanced way.  The rudimentary way is confusing fixed and variable costs.  People who gripe about the price/cost gap of SMS messages seem to not realize the telecom industry is like the movie industry in that they make huge upfront investments but have relatively low marginal costs.   I, for one, have always thought movies are a great deal – they spend $100M making a movie, I pay $12 to see it.  It would be silly to compare how much you pay to see a movie to the variable cost of projecting the movie.

The more advanced way people get confused about cost and price is to think that because costs are dropping, prices will necessarily follow. For example, the cost of distributing newspapers has dropped almost to zero.  This is not the primary cause of the downfall of the newspaper industry.  The downfall of newspapers has been caused by a number of things – losing the classifieds business was huge – but mainly because when newspapers went online and were no longer able to partition the market geographically, supply in each region went up by orders of magnitudes.  Once the majority of newspapers go out of business causing supply to go way down, pricing power should return to the survivors.

When I was in business school I remember a class where a partner from a big consulting firm was talking about how they had done extensive research and concluded that broadband would never gain significant traction in the US without government subsidies.  His primary evidence was a survey of consumers they had done asking them if they were willing to pay for broadband access at various price points.

Of course the flaw in this reasoning is that, at the time, there weren’t many websites or apps that made good use of broadband.   This was 2002 – before YouTube, Skype, Ajax-enabled web apps and so on.  In the language of economics, broadband and broadband apps are complementary goods – the existence of one makes the other more valuable.  Broadband didn’t have complements yet so it wasn’t that valuable.

Complement effects are one of the main reasons that technology adoption is non-linear. There are other reasons, including network effects, viral product features, and plain old faddishness.

Twitter has network effects – it is more valuable to me when more people use it.  By opening up the API they also gained complement effects – there are tons of interesting Twitter-related products that make it more useful.  Facebook also has network effects and with its app program and Facebook Connect gets complement effects.

You can understand a large portion of technology business strategy by understanding strategies around complements.  One major point:  companies generally try to reduce the price of their products complements (Joel Spolsky has an excellent discussion of the topic here).   If you think of the consumer as having a willingness to pay a fixed N for product A plus complementary product B, then each side is fighting for a bigger piece of the pie. This is why, for example, cable companies and content companies are constantly battling.  It is also why Google wants open source operating systems to win, and for broadband to be cheap and ubiquitous.

Clay Christensen has a really interesting theory about how technology “value chains” evolve over time.  Basically they typically start out with a single company creating the whole thing, or most of it.  (Think of mobile phones or the PC).  This is because early products require tight integration to squeeze out maximum performance and usability.  Over time, standard “APIs” start to develop between layers, and the whole product gains performance/usability to spare.   Thus the chain begins to stratify and adjacent sections start fighting to commoditize one another.   In the early days it’s not at all obvious which segments of the chain will win.  That is why, for example, IBM let Microsoft own DOS.  They bet on the hardware.   One of Christensen’s interesting observations is, in the steady state, you usually end up with alternating commoditized and non-commoditized segments of the chain.

Microsoft Windows & Office was the big non-commoditized winner of the PC. Dell did very well precisely because they saw early on that hardware was becoming commodotized.  In a commoditized market you can still make money but your strategy should be based on lowering costs.

Be wary of analysts and consultants who draw lines to extrapolate technology trends.  You are much better off thinking about complements, network effects, and studying how technology markets have evolved in the past.