30 June 2020 | By DF
It is now conventional wisdom that competition among firms creates value for society. There was a point in the 20th century when this was in doubt—might central planning avoid the wasteful, zero-sum aspects of inter-firm competition?—but we are in 2020 now. From a whole-of-society vantage point, economists have the privilege of overlooking how this value is allocated.
In business, however, the difference between value creation and value capture is huge. For example, I have long known that Lee Kuan Yew considered air-conditioning the greatest invention of the 20th century. But Byrne Hobart of The Diff has given this trivia an interesting twist:
The challenge, sometimes, is not creating a valuable product, but creating a valuable product and capturing the value. Government contractors run into this issue all the time: building a better website for filing unemployment claims would make millions of people better-off, but building a website that’s barely functional but technically meets the spec pays just as well and is a lot easier. Or, to take another example: the economies of Singapore, Dubai, and Atlanta can only function because of air conditioning. The industry has created trillions of dollars in value, but that’s mostly captured by the buyers, not the sellers. Sometimes not even the buyers: when department stores started adding air conditioning, the first department store to do so benefited from incremental customers and sales. But once every store had them, market share returned to normal; it was just a cost of doing business. A benefit to the customers, but not to the owners.
In a sense, this is simply how civilization works. We get to free-ride on the ideas and innovations of the people who came before us. Humanity’s greatest hits are transmitted in the form of intangible information, via textbooks and Sunday school and memes, as well as in the form of tangible artifacts like air-conditioners and plastic bags and iPhones. Cesar Hidalgo poetically calls the latter “crystals of imagination” in Why Information Grows.
And so it goes.
This distinction between value creation and value capture is highly illuminating in tech.
Consumer-facing software companies, like economists, sometimes have the luxury of ignoring the distinction. In the early years of the consumer Internet, the standard playbook is roughly:
This is why, in Facebook’s early days, Mark Zuckerberg’s disinterest in monetizing the social network and keen interest in growing the social network were in fact the optimal strategy. As Antonio García Martínez puts it in Chaos Monkeys:
Before 2013, if you wanted to know how Facebook made money, the answer was very simple: a billion times any number is still a big fucking number. Facebook monetization was laughable compared with Google’s on a purely CPM basis. But usage was ungodly. Up there with heroin, carbohydrates, or a weekly paycheck: that’s how addictive and rewarding Facebook was.
As such, it is entirely credible that when Facebook launched Libra, monetization was not a top priority. Facebook has no lack of billion-user apps through which it could capture the value it helped to create. (Assuming Libra takes off, of course, which is a big if.)
However, transitioning from value creation to value capture is much easier if company owns the customer relationship. For example, after opening up the platform for free-wheeling third-party experimentations, Twitter significantly tightened its APIs for third-party clients in 2012 because it figured out that its preferred choice of value capture is serving ads. To do so, it had to make sure users access Twitter via its own client.
This direct relationship with the consumer also underlies the network effect of many consumer software companies: the value of many software products increases with the number of users (up to a point). Unlike enterprise customers who are wary of lock-in, consumers are usually too scattered to coordinate and switch to a different provider. (This is why Schelling points like this are newsworthy.)
For companies that do not own the customer relationship, however, their ability to capture the value they helped to create is significantly attenuated.
Unlike software companies, hardware companies are forced to be much more conscious of the distinction between value creation and value capture. I came across this Tweet by Jonathan Blow that has stuck with me since: