The commons leads to overuse and destruction; the anticommons leads to underuse and waste. In the cultural sphere, ever tighter restrictions on copyright and fair use limit artists’ abilities to sample and build on older works of art. In biotechnology, the explosion of patenting over the past twenty-five years—particularly efforts to patent things like gene fragments—may be retarding drug development, by making it hard to create a new drug without licensing myriad previous patents. Even divided land ownership can have unforeseen consequences. Wind power, for instance, could reliably supply up to twenty per cent of America’s energy needs—but only if new transmission lines were built, allowing the efficient movement of power from the places where it’s generated to the places where it’s consumed. Don’t count on that happening anytime soon. Most of the land that the grid would pass through is owned by individuals, and nobody wants power lines running through his back yard.

From The Permission Problem, James Surowiecki, The New Yorker Magazine.  A very worthwhile read.

Allocation investing has a number of perverse effects on financial markets. For example, in the 80s and 90s venture capital was deemed to be a successful, independent asset class. As a result, many funds decided to allocate some portion of their capital to VC. These pools of capital were so large that they caused the VC industry to grow orders of magnitude larger – many say larger than it should be. In turn, this led to many bad venture investments that drove down returns in the industry (these problems were further exacerbated by the fee structure of VC that encouraged funds to get large and rapidly “put money to work”).

Another perverse effect caused by allocation investing happens in public stock markets when investors decide to allocate a portion of their funds to specific sectors. I recently heard some money managers saying they wanted to allocate portions of their funds to “social media”. Combining this “allocated” demand with a constrained supply (due to the small float of many of these IPOs) can lead to prices that are disconnected from fundamental values. In this scenario, supply will try to match demand, which means mediocre social media companies will go public and non-social media companies will reposition themselves as social media companies or acquire social media companies. They will be chasing the “social premium.”

We saw this happen in the 90s with the rush of companies to reposition themselves as internet companies. In that case, many non-professional investors ended up owning shares in crappy companies when the music stopped. The primary difference now is that the flagship companies like LinkedIn and Facebook have excellent fundamentals. Hopefully this time the market will be discerning and value investing will win out over allocation investing.

Platforms succeed when they are 1) financially sustainable, and 2) have a sufficient number of developers that are financially sustainable. Fostering a successful developer community means convincing developers (and, possibly, investors in developers) that the platform is a worthwhile investment of time and money.

Developers who create applications for platforms take on all the usual risks related to launching a new product, but in addition take on platform-specific risks, namely:

1. Platform decline: the platform will decline or go away entirely.
2. Subsumption risk: the platform will subsume the functionality of the developer’s application.

The most successful platforms try to mitigate these risks for developers (not just the appearance of these risks). One way to mitigate platform decline risk is to launch the platform after the platform’s core product is already successful, as Facebook did with its app platform and Apple did with its iOS platform. Platforms that are not yet launched or established can use other methods to reassure developers; for example, when Microsoft launched the first Xbox they very publicly announced they would invest $1B in the platform.

To mitigate subsumption risk, the platform should give developers predictability around the platform’s feature roadmap. Platforms can do this explicitly by divulging their product roadmap but more often do it implicitly by demonstrating predictable patterns of feature development. Developers and investors are willing to invest in the iOS platform because – although Apple will take 30% of the revenue – it is highly unlikely that Apple will, say, create games to compete with Angry Birds or news to compete with The New York Times. Similarly, Facebook has thus far stuck to “utility” features and not competed with game makers, dating apps, etc.

Platforms that are controlled by for-profit businesses that don’t yet have established business models have special challenges. These companies are usually in highly experimental modes and therefore probably themselves don’t know their future core features. The best they can do to mitigate developers’ risks are 1) provide as much guidance as possible on future features, and 2) when developer subsumption is necessary, do so in a way that keeps the developer ecosystem financially healthy – for example, by acquiring the subsumed products.

The least risky platforms to develop on are successful open platforms like the web, email, and Linux. These platforms tend to change slowly and have very public development roadmaps. In the rare case where a technology is subsumed by an open platform, it is usually apparent far in advance. For example, Adobe Flash might be subsumed by the canvas element in HTML5, but Adobe had years to see HTML5 approaching and adjust its strategy accordingly. The predictability of open platforms is the main reason that vast amounts of wealth have been created on top of them and investment around them continues unabated.

Hold on a second. Are you super sure you want to import your contact information for your friends into a service that won’t let you get it out?

Facebook allows users to download their personal information (photos, profile info, etc) but has been fiercely protective of the social graph (you can’t download friends, etc). The downloaded data arrives in a .zip file – hardly a serious attempt to interoperate using modern APIs (update: Facebook employee corrects me/clarifies in comments here). In contrast, Google has taken an aggressively open posture with respect to the social graph, calling Facebook’s policy “data protectionism.”

The economic logic behind these positions is a straightforward application of Metcalf’s law, which states that the value of a network is the square of the number of nodes in the network*.  A corollary to Metcalf’s law is that when two networks connect or interoperate the smaller network benefits more than the larger network does. If network A has 10 users then according to Metcalf’s law its “value” is 100 (10*10).   If network B has 20 users than it’s value is 400 (20*20). If they interoperate, network A gains 400 in value but network B only gains 100 in value. Interoperating is generally good for end users, but assuming the two networks are directly competitive – one’s gain is the other’s loss – the larger network loses.

A similar network interoperability battle happened last decade among Instant Messaging networks. AIM was the dominant network for many years and refused to interoperate with other networks. Google Chat adopted open standards (Jabber) and MSN and Yahoo were much more open to interoperating. Eventually this battle ended in a whimper — AIM never generated much revenue, and capitulated to aggregators and openness.  (Capitulating was probably a big mistake – they had the opportunity to be as financially successful as Skype or Tencent).

Google might very well genuinely believe in openness. But it is also strategically wise for them to be open in layers that are not strategic (mobile OS, social graph, Google docs) while remaining closed in layers that are strategic (search ranking algorithm, virtually all of their advertising services).

When Google releases their long-awaited new social network, Google Me, expect an emphasis on openness. This could create a rich ecosystem around their social platform that could put pressure on Facebook to interoperate. True interoperability would be great for startups, innovation, and – most importantly – end users.

* Metcalf’s law assumes that every node is connected to every node and each connection is equally valuable. Real world networks are normally not like this. In particular, social networks are much more clustered and therefore have somewhere between linear and exponential utility growth with each additional user.

Businesses that target two-sided markets are extremely hard to build but also extremely hard to compete against once they reach scale. Tech businesses that have created successful two-sided markets include Ebay (sellers and buyers), Google (advertisers and publishers), Paypal (buyers and merchants), and Microsoft (Windows users and developers). In some cases individuals/institutions are consistently on one side (buyers and merchants) while in other cases they fluctuate between sides (Ebay sellers are also often buyers).

In almost every two-sided market, one side is harder to acquire than the other. The most common way to attract the hard side is the ladies’ night strategy: reduce prices for the hard side, even to zero (e.g. Adobe Flash & PDF for end-users), or below zero (e.g. party promotors paying celebrities to attend). Rarer ways to attract the hard side is 1) getting them to invest the platform itself (e.g. Visa & Mastercard), and 2) interoperating with existing hard sides (e.g. Playstation 3 running Playstation 2 games).

If you are starting a company that targets a two-sided market you need to figure out which side is the hard side and then focus your efforts on marketing to that side. Generally, the more asymmetric your market the better, as it allows you to market to each side more in serial than in parallel.

He often spends $3,000 for a weekend of food for Mr. Schwarzman and his wife, including stone crabs that cost $400, or $40 per claw.

Mr Schwarzman pays a lower tax rate than police officers, firefighters, soldiers, doctors, and teachers. This is the due to the fact that money managers’ “carry fees” are treated as capital gains instead of ordinary income.

Last week the House passed a bill that would partly close this loophole. Sadly, with few exceptions, VC’s are lobbying against this bill, arguing it would hurt innovation, small businesses, and lots of other good stuff.  As one prominent VC recently said:

[H]aving those higher taxes be levied against venture capital investments in small businesses strikes me as self-defeating when it is the single largest job growth area.

The argument seems to be that this tax will hurt small businesses. The phrase “small business” is chosen deliberately by VC lobbyists: most people, when they hear it, think of hard working immigrants pursuing the American Dream. In reality, the only thing this bill will hurt are money managers. As Fred Wilson says:

Changing the taxation of the managers will not reduce the amount of capital going to productive areas. The sources of the capital; wealthy families, endowments, pension funds, and the like, will still put the capital in the places where they will get the highest after tax return. And these sources of capital, if they are tax payers, will still get capital gains treatment on their investments in hedge funds, buyouts, and venture capital. And the fund managers will still have to compete with each other to get access to that capital and their incentives will still be to produce the highest returns they can produce, regardless of whether they are paying capital gains or ordinary income on their fees.

As Fred also argues, removing this tax break will encourage more people to go into jobs that produce tangible goods:

We have witnessed financial services (think asset management, hedge funds, buyout funds, private equity, and venture capital) grow as a percentage of GNP for the past thirty years. The best and brightest don’t go into engineering, science, manufacturing, general management, or entrepreneurship, they go to wall street where they will get paid more. And on top of that, we have been giving these jobs a tax break. That seems like bad policy. If we force hedge funds and the like to compete for talent on a more level playing field, then maybe we’ll see our best and brightest minds go to more productive activities than moving money around and taking a cut of the action.

Fred is absolutely correct. For me, though, removing this loophole just comes down to basic fairness. A fireman who runs into burning buildings shouldn’t pay a higher tax rate than a financier sunbathing on a yacht eating $400 crabs.

(Eisenmann acknlowledges the iPhone isn’t fully open to the end user – in the US you need to use AT&T, etc.  I would argue the iPhone is semi-open to the app developer and mobile app development was effectively closed prior to the iPhone. But the main point here is that platforms can be open & closed in many different ways, at different levels, etc.)

The next important distinction is whose interest you are considering when asking what and when to open or close things.  I think there are at least 3 interesting perspectives:

The company: Lots of people have written about this topic (Clay Christensen, Joel Spolsky, more Eisenmann here).   In a nutshell, there are times when a company, acting solely in its self-interest, should close things and other times they should open things.  As a rule of thumb, a company should close their core assets and open/commoditize complementary assets. Google’s search engine is their core asset and therefore Google should want to keep it closed, whereas the operating system is a complement that they should commoditize (my full analysis of what Google should want to own vs commoditize is here). Facebook’s social graph is their core asset so it’s optimal to close it and not interoperate with other graphs, whereas marking up web pages to be more social-network friendly (open graph protocol) is complementary hence optimal for FB to open.  (With respect to social graphs interoperating (e.g. Open Social), it’s generally in the interest of smaller graphs to interoperate and larger ones not to – the same is true of IM networks).  Note that I think there is absolutely nothing wrong with Google and Facebook or any other company keeping closed or trying to open things according to their own best interests.

The industry: When I say “what is good for the industry” I mean what ultimately creates the most aggregate industry-wide shareholder value.  I assume (hope?) this also yields the maximum innovation.  As an active tech entrepreneur and investor I think my personal interests and the tech industry’s interests are mostly aligned (hence you could argue I’m talking my book).  Unfortunately it’s much easier to study open vs. closed strategies at the level of the firm than at the level of an industry, because there are far more “split test” cases to study.  What would the world be like if email (SMTP) were controlled by a single company?  I would tend to think a far less innovative and wealthy one. There are a number of multibillion dollar industries built on email: email clients, webmail systems, email marketing, anti-spam, etc.  The downside of openness is that it’s very hard to upgrade SMTP since you need to get so many parties to agree and coordinate.  So, for example, it has taken forever to add basic anti-spam authentication features to SMTP.  Twitter on the other hand can unilaterally add useful new things like their recent annotations feature.

Here’s what Professor Eisenmann said when I asked him to summarize the state of economic thinking on the topic:

With respect to your question about the impact of open vs closed on the economy, the hard-core economists cited in my book chapter have a lot to say, but it all boils down to “it depends.” Closed platform provides more incentive for innovation because platform owner can collect and redistribute more rent and can ensure that there’s a manageable level of competition in any given application category. Open platform harnesses strong network effects, attracting more application developers, and  thus stimulates lots of competition. There’s some interesting recent work that suggests that markets may evolve in directions that favor the presence of one strong closed player plus one strong open player (consider: Windows + Linux; iPhone + Android). In this scenario, society/economy gets best of both approaches.

Society:  I tend to think what is good for the tech industry is generally good for society.  But others certainly have different views.  Advocates of openness are often accused of being socialist hippies.  Maybe some are.  I am not.  I care about the tech industry.  I think it’s reasonable to question whether moves by large industry players are good or bad for the industry.  Unfortunately most of the debate I’ve seen so far seems driven by ideology and name calling.

Most financial markets start out with a productive purpose. Derivatives like futures and options started out as a way for companies to reduce risk in non-core areas, for example for airlines to hedge their exposure to oil prices and transnationals to hedge their exposure to currency fluctuations. The sellers of these derivatives were aggregators who pooled risk, much like insurance companies do. The overall effect was a net reduction in risk to our economy without hampering growth and returns.

Then speculators entered the market, creating more complicated derivative products and betting with borrowed money.  This was defended as a way to increase liquidity and efficiency. But it came at the cost of making the system more complicated and susceptible to abuse. Worst of all, these so-called innovations increased the overall risk to the system, something we saw quite vividly during the recent financial crisis.

Venture capital is a shining example of capitalism just like Adam Smith pictured it, where private vice really does lead to public virtue.  Consider, for example, two of the largest areas of venture investment: biotech and cleantech.  Here we see the best and brightest – top science graduates from places like MIT and Stanford – devoting their lives to curing cancer and developing new energy sources.  These students may be motivated by good will, but need not be, since they will also get rich if they succeed.

A strong case can be made that the financial industry needs significantly more regulation, particularly around big banks and derivatives markets. But it would be a tragic mistake to create regulations that hinder angel investing and venture capital.  From the outside, VC and Wall Street might appear similar, but the closer you get, the more you understand how different they really are.

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.

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.

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.

“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.

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.

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.

The most important question to ask before taking seed money link

The challenge of creating a new category link

Man and superman link

The new economy link

Why content sites are getting ripped off link

Software patents should be abolished link

Climbing the wrong hill link

Google and newspapers: the false choice of opting out link

New York City is poised for a tech revival link

To make smarter systems, it’s all about the data link

The one number you should know about your equity grant link

Why you shouldn’t keep your startup idea secret link

Ideal first round funding terms link

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.

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.

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.