Category Archives: business economics

Scott Galloway on the four

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I watched the video. My sense is that now I don’t have to read the book. (And I don’t feel bad about that. For consultants, books are loss leaders.) I recommend the video to all of you (and, yes, some of you recommended it to me before, but I didn’t get around to it until a few days ago).

But I would be wary about getting overly awed by market capitalization numbers. For example, Galloway says that after Amazon announced that it was purchasing Whole Foods, Amazon’s market cap went up by more than the cost of the acquisition, and to Galloway this says that the acquisition was “paid for.” But having a higher stock price does not give Amazon more capital to deploy. It makes it cheaper to float new stock, but unless and until they do that, I do not think you can say that they acquired Whole Foods for nothing.

There is a disconnect between Amazon’s share value and its near-term profit prospects. It will be interesting to see how this plays out. To me, it looks like a consensual-hallucination Ponzi scheme. Galloway thinks otherwise. In any case, Amazon certainly refutes the notion that having to answer to shareholders necessarily creates “short termism.”

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The O’Reilly Cycle

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One of the ideas in Tim O’Reilly’s new book is about a cycle in technology. I describe it this way.

Phase 1: a new hardware platform opens up (personal computers in the late 1970s; the Web in the mid-1990’s’; smart phones in this century) Lots of entrepreneurs try to play with it, figure out what to do with it.

Phase 2: competition to become a dominant infrastructure player within the platform: operating systems in personal computers (came down to Windows vs. Mac); the Web portal (came down to Google vs. AOL vs. Yahoo); capturing user attention in mobile phones (still up for grabs, I think, but with Facebook and Twitter as prominent examples today). In this phase, being more “open” is a competitive advantage. Having a bigger ecosystem of other people adding value to your platform is the winner. For example, Google won because it did the best job of incorporating the entire Web into its ecosystem. Amazon has opened its platform to just about any seller.

Phase 3: cannibalization. The winner in phase 2 decides that its revenue has maxed out in just being an agnostic open platform, so it starts to take over profitable niches within the ecosystem. Microsoft creates Excel. Google captures ad revenue from content providers. In some sense, the winner in phase 3 backs away from the “open” strategy and instead tilts the playing field to favor its own offerings in the most profitable areas. But cannibalizing your ecosystem helps to drive ambitious entrepreneurs to move on to the next hardware platform, where they can have more opportunity.

There is a widespread perception that Apple, Facebook, Google, and Amazon are moving to the cannibalization phase. For example, Amazon is creating some of its own brands. Along these lines, commenter Handle and Tyler Cowen recommend this piece by Andre Staltz. I recommend it, also, and I plan to post on it after I read it again.

Post-election tech guilt

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The un-conference that I attended in San Francisco is over. I found it very stimulating. I am grateful to have been able attend. The format, which was very light on presentations and much heavier on discussions and informal conversation, was congenial to me.

This was my first opportunity to encounter the San Francisco tech scene. Many attendees displayed a combination of high energy and impressive intelligence. I found myself feeling captivated by their spirit and creativity. But this is also a time of collective self-doubt there, like a cloud hanging over.

Some thoughts:

1. One might roughly divide the attendees into capitalists and anti-capitalists. The capitalists are entrepreneurs and VC’s. The anti-capitalists are tech journalists, leaders of non-profits working in the tech field, or leftist heterodox economists. Of course, this is over-generalizing. For example, some in the non-profit sector fell into what I am calling the capitalist camp. But bear with me.

2. The anti-capitalists want the capitalists to feel badly about: (a) the wealth and power of Google, Facebook, Apple, and Amazon; (b) the election of Donald Trump. The capitalists seemed ready to feel guilty about (b) but were not ready to join an assault on (a).

3. Some of the capitalists wanted to want to deal with their disappointment about the election by trying to connect with disaffected Americans in the heartland. They spoke with pride of taking Silicon Valley entrepreneurs to meet with people in the Midwest. They discussed ideas like having Stanford set up satellite campuses there or promoting economic development there.

4. The anti-capitalists were the ones who wanted to re-write the economic rules. Possibilities included breaking up the tech giants or nationalizing them or organizing the tech work force to make demands on them. The idea of government regulation did not come up so much, but perhaps that is because the anti-capitalists cannot picture themselves having infuence with Mr. Trump and a Republican Congress. I found the self-assured certainty of the anti-capitalists frightening. At one small breakout session that included a lot of what I am calling the anti-capitalist thinking, I introduced the expression “fantasy despot.” That term comes from Kenneth Minogue, but when I search for fantasy despot syndrome, I mostly come up with my own previous writing. I tried to explain that the desire to control the tech companies could be seen as a desire to take on the role of a despot. I doubt that I expressed this clearly, and the discussion passed over what I had to say. But my sense of the group dynamics reinforced my thinking. I had visions of a leader emerging reminiscent of Lenin.

5. I could not help but think that the dynamics of the conference would have been completely different had the the election swung the other way. If Ms. Clinton were in office, I think that the anti-capitalists would have been much less central. The anti-capitalists were given some pushback, but I think that with a different election result they would have been met with something close to dismissal.

6. As it is, I still would not bet on the anti-capitalists getting very far. But if they do, it could be as a consequence of the chance result of the election. And I, for one (and at this conference I did feel like the only one) do not buy the narrative that fake news and social media ads accounted for the election outcome. Perhaps the SF tech crowd over-estimates the extent that the world revolves around them. Or perhaps I am making the opposite mistake.

7. If the anti-capitalists do get some traction, my guess is that it will come from influencing the tech work force. I could see the social justice causes eating away at the entrepreneurial drive and eroding the elan of the tech bros. I can imagine this having a devastating effect on the famous Silicon Valley ecosystem. I estimate the probability of this as low. It depends on the extent to which tech grads coming out of college these days are susceptible to the leftist politics on campuses, and I have no basis for gauging that. Have a nice day.

8. For all of my concern with the anti-capitalists, I do take the view that the Internet did not turn out the way that many of us hoped for twenty years ago. See my previous posts Thoughts on Internet Censorship and Did the suits win the Internet?. For a deeper discussion, see Professor Fred Turner’s 15-minute video (he has a book on the topic as well). There was a breakout session on this topic, and it was enjoyable, but we spent a lot of time discussing the incorrect assumptions that we made twenty years ago and much less time coming up with possible explanations for how things turned out as they did.

9. I am rooting for the Internet giants to be disrupted, but by market forces, not by self-appointed activist reformers. Even if the market fails to disrupt the giants, I would rather live with them than see the anti-capitalists in charge.

The next tech giant

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Benedict Evans writes,

There probably won’t be a technology that has 10x greater scale than smartphones, as mobile was 10x bigger than PCs and PCs were bigger than mainframes, simply because 5bn people will have smartphones and that’s all the (adult) people.

Pointer from James Pethokoukis.

But there will be at least 10x the number of Internet-connected devices as there are people. That suggests that the next tech giant will be some platform related to the Internet of Things. Somebody who makes it easy for lots of people to create useful, secure apps in that world.

More sentences lifted from the comments

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1. On disciplined software development:

There’s a trap here. The trap is that is the “visible disciplined rules” are how the business actually works, AND that the business CAN work with visible disciplined rules in its market.

…So perhaps Freddie Mac was badly managed. But it may also be that any entity in that market *HAD* to be “badly managed” to stay in the business. In other words, if you didn’t make ad-hoc weird deals with originators, they’d go to a competitor, or to congress.

Exactly. There was tension between the customer-facing divisions of the business, who wanted to be flexible and creative, and the information technology division, which wanted to work with clearly-articulated business rules. The IT people saw the business people as constantly breaking their data model, and the business people saw the IT people as trying to drive the business “from the back seat.”

In recent years, there has been talk of having Freddie and Fannie, or some combination, operating as a “securitization platform.” I figure that this would limit their flexibility and perhaps even put an end to innovation in their business processes–which would not necessarily be a bad thing.

2. On the limits to firm size:

Aren’t many of these questions answered in Sraffa (1926) and Allen and Lueck (1998)?

Piero Sraffa pointed out that in classical economics there was both a law of diminishing returns and a law of increasing returns. The law of diminishing returns applied to land, as exemplified by Ricardo’s theory of rent. The law of increasing returns applied to specialization and trade, as exemplified by Adam Smith saying that the larger the extent of trade, the greater scope for specialization.

Concerning economies of scale at the firm level, Sraffa wrote

Everyday experience shows that a very large number of undertakings-and the majority of those which produce manufactured consumers’ goods-work under conditions of individual diminishing costs. Almost any producer of such goods, if he could rely upon the market in which he sells his products being prepared to take any quantity of them from him at the current price, without any trouble on his part except that of producing them, would extend his business enormously. .. Business men, who regard themselves as being subject to competitive conditions, would consider absurd the assertion that the limit to their production is to be found in the internal conditions of production in their firm, which do not permit of the production of a greater quantity without an increase in cost. The chief obstacle against which they have to contend when they want gradually to increase their production does not lie in the cost of production which, indeed, generally favours them in that direction-but in the difficulty of selling the larger quantity of goods without reducing the price, or without having to face increased marketing expenses.

This describes monopolistic competition before there was such a term in the literature.

As for Allen and Lueck, a description of their work says

They posit that if there are gains to be captured from specialization, then partnership or corporate farm organizational arrangements could be more efficient than farms in which ownership and control is combined– if partners could monitor and enforce farmer effort at lower cost. But because most agriculture production is heavily influenced by nature, it becomes too costly to differentiate production deficiencies from lack of farmer effort or from effects of nature.

Well, I did not claim that my thoughts were original.

Sentences lifted from the comments

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1. A commenter writes,

At the core of the problem is the reality that government and culture are both making American life a bit more complex and demanding an experience each year. We aren’t using expanded knowledge and technology to make our lives easier, but to have more and to do more.

If you can keep up, this is good. If you can’t, this breaks you down. The size of the group that can keep up gets just a bit smaller each year.

It should be possible for people to live a simple, dignified life if they want to, and government should facilitate that. But instead, we slowly ratchet up the complexity of every aspect of a normal life. The answers aren’t with strategies to help everyone live faster. It’s to allow some to live slower, the way they want to.

2. A different commenter writes,

As the firm grows, each employee’s self-interest is slightly more separated from the owner-entrepreneur. As the firm gets larger, the joint production of all employees is increasingly divergent from what the market requests. Instead, some of the employees’ joint production is used to create longer coffee breaks, more internet shopping, and more personal story-telling. Eventually this firm is no longer competitive in the market, because too much cost and effort is channeled into non-profitable activities.

…Therefore the employees’ individual pursuits of self-interest are constrained by the discipline of competing in the marketplace, and that’s why firms don’t continue to grow boundlessly.

Government bureaucracies are not constrained by the discipline of the market. They therefore grow largely to serve the needs of their employees.

The Schumpeterian lag

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Michael Mandel writes (WSJ),

But does e-commerce destroy more jobs than it creates? So far the answer seems to be no. From the third quarter of 2015 to the third quarter of 2017, brick-and-mortar retail full-time-equivalent jobs fell by roughly 123,000, or about 1%, according to my think tank’s analysis of the latest Labor Department data.

Over the same two-year stretch, the e-commerce industry has added some 178,000 jobs in fulfillment centers and electronic shopping firms. In addition, express delivery companies and other local couriers boosted their full-time-equivalent workers by another 58,000.

If you take this on its face, then the retail industry as a whole is getting much less efficient. There has been a net increase in labor required to deliver goods from manufacturers to consumers.

I think what is happening is what might be called Schumpeterian lag. Schumpeter suggested that in the process of creative destruction, optimism over new methods combined with a reluctance to let go of old methods to create a boom. But eventually some firms realize that they are wrong, as they suffer losses. Then you get the bust. I expect that is the way it will play out in the case of retail.

What is the limit on firm size?

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Miles Kimball wrote,

Given the replication argument, there is no scale of operation that is beyond efficient scale. There may be ample reason to make different plants or divisions quasi-independent so they do not interfere with one another’s operations. But that is not an argument against scale per se. There may even be reason to set up incentives so that different divisions are almost like separate firms, headed by someone in an entrepreneurlike position. But that still is not, properly speaking, an example of diseconomies of scale.

Read the whole post.

So what are we to make of this?

1. For the economy as a whole, the law of diminishing returns applies. You cannot grow all the world’s wheat in a single flower pot.

2. But the size of any one farm is not limited to a single flower pot. Any one farm can keep adding land (until it gets to be large relative to the earth’s arable land).

3. Kimball sees the assumption of diminishing returns at the firm level as a staple of standard pedagogy. But it is more than that. Dropping that assumption takes you away from the perfectly competitive equilibrium, as Kimball spells out in his important follow-up.

4. What about the notion that the entrepreneur’s time or skill is a fixed factor? This appears to be a way to show that firm size must be limited. But it also is like question-begging or hand-waving. If you start with a traditional production function, with output a function of the two factors of homogeneous labor and homogeneous capital, then you have a hard time rationalizing diseconomies of scale until the firm gets to be really big relative to the whole market. So you tack on a fixed factor, and call it “entrepreneur’s time.” But the original production function assumed away the entrepreneur to begin with, and you never did spell out the entrepreneur’s role in that context.

5. Kimball’s approach in the second post consists of postulating a demand curve and zero profits and solving for firm size. That also strikes me as hand-waving, with math. Call it math-waving.

6. Think of a real-world example of monopolistic competition. I like to use ethnic restaurants in Wheaton, Maryland, near where I live. What stops a single owner from taking over multiple restaurants under the auspices of one firm? What stops an owner from then expanding to other locations far away, where the local demand curve is not a limiting factor?

7. When you do this thought experiment, you realize that firm size is not determined by the tangible variables that are central to neoclassical economics. Instead, you have to turn to principal-agent problems and whatever else might help deal with the “boundary of the firm” problem that has been articulated but not necessarily solved in a satisfactory way by Coase, Williamson, and Alchian and Demsetz.

8. Why are farms in two different states separate businesses? I would say that it is because it is costly for the Iowa farmer to observe the Kansas farmer’s effort, giving rise to a principal-agent problem. This may turn out to be a testable hypothesis. It predicts that as the cost of monitoring goes down (because of cheaper surveillance technology), we will see mergers take place that would have been unthinkable until recently.

9. This year, Amazon bought Whole Foods. Where does it stop? Where are the diseconomies (of scope, if not of scale)? Suppose that in order not to incur management costs, Amazon leaves Whole Foods executives in place and adopts a hands-off approach. Then from the point of view of somebody who owned shares in both firms, the merger only changed the form of ownership. You used to own a sort of mutual fund, and it was your choice how to weight the shares of Amazon and the shares of Whole Foods in that fund. Now you own shares in a conglomerate, with the weight fixed–you can no longer simultaneously reduce your holdings of Whole Foods while increasing your holdings of Amazon.

10. From the foregoing, it would appear that shareholders always lose in a merger, because they lose the option to alter the weights of their holdings. In fact, mergers have other effects, but they involve those intangible “boundaries of the firm” phenomena.

11. Suppose that a major element in a corporate merger is ego. The CEO of the company being acquired gives up status but gains wealth for the firm’s shareholders. The CEO of the acquiring firm does the opposite. The ego hypothesis predicts that immediately after the merger the acquiring firm will not give the post of CEO to someone from the acquired firm. It also predicts that the merger will be positive for the shareholders of the acquired firm but not for those of the acquiring firm. I haven’t kept up with the literature, but it used to be that those predictions held up.

12. In conclusion, the attempt to rationalize diminishing returns at the level of a firm in neoclassical economics opens up a can of worms, and Kimball’s math-waving with the demand curve does not close it.

More thoughts on disciplined software development

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Tom Killalea wrote,

Robert C. Martin described the single responsibility principle: “Gather together those things that change for the same reason. Separate those things that change for different reasons.” Clear separation of concerns, minimal coupling across domains of concern, and the potential for a higher rate of change lead to increased business agility and engineering velocity.

This is another characteristic of the disciplined approach to software development that Tim O’Reilly describes at Amazon. I didn’t include it in my previous post. Thanks to a reader for the pointer.

Thanks also to a commenter, who sends a link to a memo.

There are without question pros and cons to the SOA approach, and some of the cons are pretty long. But overall it’s the right thing because SOA-driven design enables Platforms.

SOA stands for “service-oriented architecture.”

O’Reilly explains SOA, as does Zack Kanter.

each piece of Amazon is being built with a service-oriented architecture, and Amazon is using that architecture to successively turn every single piece of the company into a separate platform — and thus opening each piece to outside competition.

Thanks yet again to another commenter for the link.

I reiterate my view that a firm’s software development can only be as disciplined as its business units. I have a hard time picturing Freddie Mac in the late 1980s and early 1990s (when I was there) having a culture to do SOA, even if you gave the IT department all of 2017-vintage technology to work with. The dependencies across business units were extremely tight, with decisions made by the people negotiating terms with loan originators having downstream effects on folks servicing defaulted loans years later as they tried to determine what recourse Freddie had, if any, back to the originator in order to compensate for losses. In practice, this was handled in an informal, ad hoc manner. To get to the point where you could have executed SOA, you would have needed business units to understand and buy into a much more explicitly documented business process. That is what I cannot picture happening.

Recently, some economists have been struck by the high degree of inequality across firms. I can imagine that one source of inequality would be in the ability of management teams to take advantage of highly disciplined processes for software development. The skill and culture of the management team might be more important, and more unequal across firms, than was the case a few decades ago.

Social media and the art of thinking unreasonably

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Here comes my rant against political uses of social media, notably Twitter and Facebook.

Politics on social media is not reflective. It is not deliberative. It is not long-term thinking. It is short-term, reactive, tribal, and emotional.

Social media facilitates the formation of mobs. Contra Howard Rheingold, mobs are not smart. When it comes to politics, mobs are epitomized by Charlottesville.

Politics on social media is cyber-bullying. Progressives started it, and they have been relentless and ruthless practitioners of it. But in recent years their opponents have discovered it, culminating in the election of the cyber-bully-in-chief.

I wish somebody could figure out how to walk it back. Social media is not the whole problem when it comes to political polarization and anger, but the way it works today, it sure as heck is not the solution.