The tradeoff between open and closed

When having the “open vs closed” debate regarding a technology platform, a number of distinctions need to be made. First, what exactly is meant by “open.” Here’s a great chart from a paper by Harvard professor Tom Eisenmann (et al).:

(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.

Twitter and third-party Twitter developers

I can’t remember the last time the tech world was so interesting. First, innovation is at an all time high.  Apple, Google, Facebook, Twitter and even Microsoft (in the non-monopoly divisions) are making truly exciting products. Second, since the battles are between platforms, the strategic issues are complex, involving complementary network effects.

Twitter’s moves this week were particular interesting.  A lot of third-party developers were unhappy. I think this is mainly a result of Twitter having sent mixed signals over the past few years. Twitter’s move into complementary areas was entirely predictable – it happens with every platform provider. The real problem is that somehow Twitter had convinced the world they were going to “let a thousand flowers bloom” – as if they were a non-profit out to save the world, or that they would invent some fantastic new business model that didn’t encroach on third-party developers. This week Twitter finally started acting like what it is: a well-financed company run by smart capitalists.

This mixed signaling has been exacerbated by the fact that Twitter has yet to figure out a business model (they sold data to Microsoft & Google but this is likely just one-time R&D purchases). Maybe Twitter thinks they know what their business model is and maybe they’ll even announce it soon. But whatever they think or announce will only truly be their business model when and if it delivers on their multi-billion dollar aspirations. It will likely be at least a year or two before that happens.

Normally, when third parties try to predict whether their products will be subsumed by a platform, the question boils down to whether their products will be strategic to the platform. When the platform has an established business model, this analysis is fairly straightforward (for example, here is my strategic analysis of Google’s platform).  If you make games for the iPhone, you are pretty certain Apple will take their 30% cut and leave you alone. Similarly, if you are a content website relying on SEO and Google Adsense you can be pretty confident Google will leave you alone. Until Twitter has a successful business model, they can’t have a consistent strategy and third parties should expect erratic behavior and even complete and sudden shifts in strategy.

So what might Twitter’s business model eventually be?  I expect that Twitter search will monetize poorly because most searches on Twitter don’t have purchasing intent.  Twitter’s move into mobile clients and hints about a more engaging website suggest they may be trying to mimic Facebook’s display ad model. (Facebook’s ad growth is being driven largely by companies like Zynga who are in turn monetizing users with social games and virtual goods.  Hence it’s no surprise that a Twitter investor is suggesting that developers create social games instead of “filling holes” with URL shorteners etc.) Facebook’s model depends on owning “eyeballs,” which is entirely contradictory to the pure API model Twitter has promoted thus far.  So if Twitter continues in this direction expect a lot of angst among third-party developers.

Hopefully Twitter “fills holes” through acquisitions instead of internal development. Twitter was a hugely clever invention and has grown its user base at a staggering rate, but on the product development front has been underwhelming.  Buying Tweetie seemed to be a tacit acknowledgement of this weakness and an attempt to rectify it. Acquisitions also have the benefit of sending a positive signal to developers since least some of them are embraced and not just replaced.

What’s Facebook doing during all of this?  Last year, Facebook seemed to be frantically copying Twitter – defaulting a lot of information to public, creating a canonical namespace, etc. Now that Twitter seems to be mimicing Facebook, Facebook’s best move is probably just to sit back and watch the Twitter ecosystem fight amongst itself.  As Facebooker Ivan Kirigin tweeted yesterday: “I suppose when your competition is making huge mistakes, you should just stfu.”

Disclosure: As with everything I write, I have a ton of conflicts of interest, some of which are listed here.

Search and the social graph

Google has created a multibillion-dollar economy based on keywords.  We use keywords to find things and advertisers use keywords to find customers.  As Michael Arrington points out, this is leading to increasing amounts of low quality, keyword-stuffed content. The end result is a very spammy internet. (It was depressing to see Tim Armstrong cite Demand Media, a giant domain-name owner and robotic content factory, as a model for the new AOL.)

Some people hope the social web — link sharing via Twitter, Facebook etc — will save us.  Fred Wilson argues that “social beats search” because it’s harder to game people’s social graph.  Cody Brown tweeted:

On Twitter you have to ‘game’ people, not algorithms. Look how many followers @demandmedia has. A lot less then you guys: @arrington @jason

These are both sound points. Lost amid this discussion, however, is that the links people tend to share on social networks – news, blog posts, videos – are in categories Google barely makes money on. (The same point also seems lost on Rupert Murdoch and news organizations who accuse Google of profiting off their misery).

Searches related to news, blog posts, funny videos, etc. are mostly a loss leaders for Google. Google’s real business is selling ads for plane tickets, dvd players, and malpractice lawyers. (I realize this might be depressing to some internet idealists, but it’s a reality). Online advertising revenue is directly correlated with finding users who have purchasing intent. Google’s true primary competitive threats are product-related sites, especially Amazon. As it gets harder to find a washing machine on Google, people will skip search and go directly to Amazon and other product-related sites.

This is not to say that the links shared on social networks can’t be extremely valuable.  But most likely they will be valuable as critical inputs to better search-ranking algorithms. Cody’s point that it’s harder to game humans than machines is very true, but remember that Google’s algorithm was always meant to be based on human-created links. As the spammers have become more sophisticated, the good guys have come to need new mechanisms to determine which links are from trustworthy humans. Social networks might be those new mechanisms, but that doesn’t mean they’ll displace search as the primary method for navigating the web.

What carries you up will also bring you down

In Rules of Thumb, Alan Weber quotes legendary venture capitalist John Doerr discussing the original business plans for companies he invested in such as Google, Intuit, and Amazon:

In every case you can find the one sentence or paragraph that describes their unique business model advantage.  It could be their unique distribution system or the retailing model.  It’s the factor that accounts for their success. It turns out the factor that explains their success at the beginning is what accounts for their failure later.

As a former philosophy student, I was reminded of Aristotle’s concept of “hamartia,” sometimes known as a “fatal flaw”:

In Aristotle’s understanding, all tragic heroes have a “hamartia,” but this is not inherent in their characters, for then the audience would lose respect for them and be unable to pity them; likewise, if the hero’s failing were entirely accidental and involuntary, the audience would not fear for the hero. Instead, the character’s flaw must result from something that is also a central part of their virtue, which goes somewhat awry, usually due to a lack of knowledge.

It’s an interesting exercise to apply this principle to technology companies:

1) Google’s strength is its uber-engineering mindset.  This seems to increasingly be a liability as the web becomes ever more social.

2) Yahoo’s strength was its breadth.  Now they call it the “peanut butter” problem.

3) AOL’s strength was being a closed garden.  As users became internet savvy, they were no longer afraid of venturing outside of it.

4) Apple’s strength lies in its genius, authoritarian leader.  Apple’s decline will begin when he leaves (sadly).

5) Facebook’s strength is authenticity and privacy – your friends are (mostly) your real friends, and only they see your activity.  Facebook has been trying to respond to Twitter’s rise with “open” features like the public micro-messaging.   It remains to be seen whether they can successfully go against their own core strengths.  I’m skeptical, but give them credit for trying.

6) Twitter’s strength is its simplicity and openness.  Will its openness be its downfall?  For example, will Twitter end up fighting its apps?  Or will it be its simplicity?

This principle also implies how to use incumbents’ strengths against them (sometimes called the “Judo Strategy”).  In the chess game of competitive strategy, you can usually bet that incumbents won’t make moves that undermine their core strengths – until it’s too late.

The new economy

According to the Business Insider, Facebook is “‘Beating The S— Out Of Its Numbers’ Thanks To Zynga’s Virtual Goods.”  I wanted to try to understand this new, emerging economy.

It all starts when a user sees an ad on Facebook:

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After clicking and installing the app, she gets a little farm where she can grow tomatoes and such.

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Game seems pretty fun.  But she runs out of seeds, and wants more.  So she goes shopping for virtual goods.

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Let’s say our protagonist is too young to have a credit card, so she decides instead to buy coins by signing up for a free offer.

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She decides to download a toolbar.  Free greeting cards seem like fun.

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The download puts an Ask.com search toolbar in the user’s browser.  Ask.com makes money off search ads.  Ask probably paid $1 to $2 for the install.  Some portion of that goes to Zynga, and then back to Facebook when Zynga advertises.

Farmville apparently does not advertise on Ask.com:

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Thereby preventing the entire new internet economy from imploding in an endless cycle of circularity.