Deconstructing McKinsey

Arnold Kling, "Arguing in My Spare Time," No. 19

May not be redistributed commercially without the author's permission.

Index

What I call a McKinsey business plan is a plan that starts out with costs much larger than revenues for one or two years, and then has revenues grow much more rapidly than costs forever. The result--on paper--is that once the business has reached the breakeven point, it is on a trajectory to earn ever-increasing profits.

The core economic idea behind the McKinsey business plan is this:

1. In some situations, standardization and inter-operability are critical. For example, the fact that many people today would prefer a computer with the fastest modem to a computer with the largest hard disk is an indication that inter-operability with the Internet is highly valuable.

2. Once many people have adopted a standard, it can be costly to get them to switch to a different standard, even though all of them might be better off with the new standard.

3. A competitor who moves quickly to establish a standard can raise huge barriers to entry to any follower, even someone with a better product.

4. Therefore, it makes sense to go all-out to establish one's brand as a standard, even if this means losing money for a year or two. Once your brand is the standard, your competitors are helpless and you have a clear shot at very high profits.

The first two propositions are valid. In the economics literature, the terms used to describe them include "increasing returns" (the term Paul Krugman prefers), "network economies" (the currently-fashionable term), "path dependency," and "switching costs."

Each term conveys an aspect of the phenomenon. "Increasing returns" suggests that the more people who adopt a standard, the lower the cost (or greater the benefit) to others of adopting the same standard. "Network economies" suggests that the value of a network is higher the more people are on the network. "Path dependency" suggests that what people choose to use today may depend on what they chose to use yesterday. "Switching costs" suggests that it may be costly to get adoption of a new standard.

The flaw in the McKinsey business plan stems from the third proposition, which states that barriers to entry are high once a standard has been created. This is not often the case.

Take Internet directories as an example. Suppose that we declare Yahoo the current leader in the Internet "portal" race. What strategies are available to other companies which might reduce Yahoo's potential to earn enough profits to justify its multibillion dollar market capitalization?

1. Build an equivalent product. If you had $1 billion to invest in developing and marketing an Internet directory, would you buy a portion of Yahoo or try to build a competing product from scratch? I suspect that one could build an outstanding Internet directory for less than $100 million, which would leave $900 million for marketing and promotion.

2. Disintermediation from companies higher in the food chain. For example, people often go first to the Netscape home page, making it higher in the food chain than Yahoo. Netscape chose to drop Yahoo from its prime position on Netscape's home page, thereby reducing Yahoo's value. Internet Service Providers and computer companies in turn could dislodge Netscape's home page and/or Yahoo in order to promote any Internet directory of their choice. Yahoo may end up having to get into a bidding war with its rivals for positioning with these companies that are higher in the food chain.

3. Disintermediation from companies lower in the food chain. Yahoo charges companies for steering traffic via ads or prominent positioning within the directory. Ultimately, it may prove cheaper for these companies to pay people directly to come to their site rather than pay through Yahoo. Internet companies already exist that have the infrastructure to pay consumers for visiting sites. The day may come when instead of starting a surfing session at an Internet directory, the typical consumer will start by going to a site that answers the question, "Who wants my attention today, what do they want it for, and how much are they willing to pay me to get it?"

4. Distributed processing. The Internet is not an inherently centralized medium. It may turn out that an informal network of "mini-Yahoo's" can do a better job of helping people to navigate the Internet.

5. Innovation. Another company could develop a more ingenious way to help people navigate on the Internet. If they are successful, word would spread quickly, so that marketing costs would not be terribly high.

Yahoo is the leader in its field primarily because of the quality of its product. In my opinion, the advantage that they gained from early entry is that they understand their business better than most would-be competitors. However, this has not put them in a position where they can coast to easy profits. They will continue to have to deal with: the need to invest in research and development; limits on their market power because of competition; and the possibility of sudden obsolescence of their product.

For a Yahoo or an Amazon.com to be worth billions of dollars, when the cost of developing their products is a small fraction of that, suggests that investors believe implicitly that the barriers to entry are in the billions. This is the achilles heel in the McKinsey business plan: the faith in the existence of barriers to entry, a faith that often is out of touch with reality.