Winner-Takes-Most: the Two Worlds of Increasing Returns
TheFamily Papers #017
By Nicolas Colin (Co-Founder & Partner) | TheFamily
Last week, Verizon was struck by the largest workers’ strike in the US private sector since 2011. Thirty-six thousand workers walked out after contract negotiations broke down a few weeks ago. The main claim was that the company should cease the outsourcing of business to non-unionized contractors—an issue that, by the way, was addressed last year in a decision rendered by the National Labor Relations Board. But Verizon’s union employees also pointed out the fact that the company didn’t invest much in its broadband business, forcing its customers to suffer from a lower quality than that which should normally be available in an advanced economy.
That stand is, in some ways, surprising. A company is a legal fiction embodying a contract between many different parties, who mostly have conflicting interests: shareholders, executives, employees, customers, providers. Conflicting interests are especially present between employees and customers: after all, the more you pay your employees, the higher the price for the customers; conversely, the more you lower that price, the harder it is for employees to make ends meet.
The balance of power between a company’s many stakeholders mostly depends on the competitive pressure on markets for goods and services. On certain markets, such as the food and grocery market, competition is so intense that it brings the prices down at the expense of employees, hence the infamous “Wal-Mart Effect”. On other markets, such as real estate or telecommunications, barriers to entry prevent newcomers from exerting competitive pressure on the incumbents; as a result, companies can focus on maximizing the producer’s surplus and supposedly paying their employees more.
At least, that is the theory. In practice, as proved by the Verizon case, this doesn’t happen anymore because the producer’s surplus, once obtained at the expense of customers, has to be shared between many other stakeholders: employees, executives, and shareholders. And in that context employees don’t have the upper hand anymore.
The reason the producer’s surplus doesn’t imply higher wages anymore is because of a radical shift that happened in the economy as a whole. Until the 1970s, employees were the stronger part in that in-house bargain between a firm’s stakeholders. As Paul Graham noted in January,
Along with giant national corporations, we got giant national labor unions. And in the mid 20th century the corporations cut deals with the unions where they paid over market price for labor. Partly because the unions were monopolies. Partly because, as components of oligopolies themselves, the corporations knew they could safely pass the cost on to their customers, because their competitors would have to as well. And partly because in mid-century most of the giant companies were still focused on finding new ways to milk economies of scale. Just as startups rightly pay AWS a premium over the cost of running their own servers so they can focus on growth, many of the big national corporations were willing to pay a premium for labor.
From the 1980s on, another group took the upper hand: shareholders. There were at least two reasons for this. The first is that the contracts that were negotiated by workers’ unions often proved unsustainable over the long term. In the car industry, they even led car manufacturers to the brink of closing down, notably because the employers had to bear too heavy a weight in financing health insurance—an insurance that wasn’t paid for by the US government, contrary to what exists in other developed countries.
The second reason is the competitive pressure that had been mounted on financial markets. As the financial playground got bigger, depth and liquidity increased exponentially on financial markets, making room for larger pools of capital, bigger bets, higher volatility, and more sophisticated financial products. This, in turn, led to the emergence of giant financial powerhouses who turned on corporations and forced them to increase their returns on invested capital.
The increased competition between firms to raise capital from ever bigger investors on financial markets gave the upper hand to shareholders at the expense of employees (with executives as the main arbiter). As a result, many listed corporations became stock-tickers. Corporate CEOs discovered a new obsession: maximizing shareholder value. There were many adverse consequences: less innovation, more inequality, and eventually a faltering competitiveness.
Now the balance of power has once again changed. As frequently laid out in our Papers, the digital economy marks the rise of the users as the most powerful constituency in corporate politics. This is partly due to the power that has been consolidated by individuals thanks to technology: with economic development, they are more educated; they are also better equipped with powerful devices; above all, they’re connected to each other, and can act as a multitude instead of on their own. When connected users choose one company over another, that multitude instantaneously becomes a strong stakeholder that proves very hard to deal with.
The victory of customers over shareholders is visible in companies such as Amazon. As written in a previous issue dedicated to Amazon’s business model, “the only ways to keep on growing on a consumer market are to create an exceptional customer experience, to use superior growth as a barrier to entry, and to live on low margins.” High quality, low prices: this all sounds like a very good deal for customers, at the expense of all other constituencies. In addition, the aggressive communication by Jeff Bezos on financial markets is precisely designed to consolidate his alliance with Amazon’s customers:
Bezos’s authority over Amazon’s shareholders is a crucial contribution to his forming Amazon’s impressive alliance with its customers. When an Amazon customer hears that the company doesn’t turn a profit and that it makes its shareholders run screaming, it inspires customer trust: that means Amazon isn’t taking money out of their hides and that customers are really guaranteed to have the best deals if they choose Amazon.
But why are tech companies so submissively reliant on their customers, since, like Verizon, they’re also so dominant on their market and seem protected by unbreakable barriers to entry?
Digital markets, after all, are governed by the rule of increasing returns. And with increasing returns, large scale is synonymous with acceleration instead of implying exhaustion. Because of this rare characteristic, digital markets are governed by the rule of winner-takes-most: when several competitors fight to conquer one market, at some point one will come out on top, distancing themselves from the others and ultimately, like in railroads or telecommunications, winning most of their market.
Therein lies the main source of confusion. Because they look like they generate the same increasing returns, we presume that tech companies will all act like Verizon: they’ll cease to invest and will become predators of their customers. But this is a key misunderstanding of what is at stake here.
Digital market concentration doesn’t prevent competition — quite the contrary. The tendency of tech companies to reach a position of natural monopoly is tempered by the ever-growing competitive pressure. Startups never stop entering the market, as the cost of founding them is low, entrepreneurs have nothing to lose, and venture capital is rising as an asset class. Large tech companies are in a continuous effort to diversify, if only to sustain their own increasing returns and to consolidate their dominant position on their original market. Even direct competitors can take the initiative at any moment, as technology makes it possible to propagate new processes and new features within a large organization without much friction. On digital markets, the cards can be quickly reshuffled.
Customers also impose an ever-increasing pressure, forcing tech companies to serve them well. In traditional network industries such as railroads or telecommunications, increasing returns derive from a tangible infrastructure: the more post offices, railroad miles or telephone exchanges the company owns, the easier it is to attract and retain new customers. But in the digital economy, increasing returns depend less on tangible infrastructures than on the trust a company inspires in its demanding customers. Here is the dividing line: corporations don’t own those customers like they would own a telecommunications network.
As a result, tech companies can’t try to hide, like other corporations did in the past, behind tangible infrastructures or regulatory barriers. They must innovate on a continuous basis, constantly improve their value proposal, and keep on meeting the particular needs of every customer.
In addition, what really changes the game is that continuous innovation has finally become sustainable. In the Fordist economy, every corporation that had reached a large scale of operations was confronted with painful choices: between mass production and personalization; between faster growth and higher margins; between efficiency and innovation. Conversely, thanks to many specific features, including the regular and systematic monitoring of users’ activity and increasing returns, tech companies can skip those choices: they can keep on growing and reach a larger scale while improving the quality of their product, making the user experience exceptional, sustaining radical innovation and even, in some cases, increasing their margin.
Hence the digital economy provides us with an unprecedented combination: there’s the race to the larger scale, but there also is the fragility of dominant positions. Far from living off their rent, large tech companies are forced to double down on taking risks as long as the frontier of innovation is pushed ever further and further. To put it differently, strategy (which is about embracing constraints) now merges with innovation (which is about breaking those same constraints).
This is all consistent with Philippe Aghion’s work on growth and competition. As Philippe demonstrated in various papers, competition doesn’t impede innovation: it even increases the innovation efforts of firms that are the closest to the frontier. In the digital economy, because we’re in the presence of increasing returns, competition puts extra pressure on firms and some among them seize that pressure as an opportunity to innovate even more, thus sustaining higher increasing returns and eventually consolidating their dominant position on the market.
Conversely, when rent-seeking tends to dominate, as President Obama says it does in the US cable industry, economists such as Jason Furman (Obama’s economist-in-chief) have proved that it impedes growth. In turn, as pointed out by Edmund Phelps, it even increases inequalities.
This all leads to yet another framework, designed to better understand what a tech company is and what it isn’t. A tech company is not simply a company that uses technology. Nor is it just a business model that generates increasing returns. After all, Verizon also generates these returns. But Verizon lives off its rent, while dominant tech companies such as Facebook, Uber, Netflix, or Amazon remain constantly on the edge.
In fact, we’re now able to define tech companies more precisely and underline the extent to which they’re different from traditional companies—even from those which like Verizon operate networked infrastructure. A tech company matches three criteria:
- Its business model is marked by increasing returns, sustained thanks to economies of scale, network effects, machine learning and the participation of its users in creating value.
- It provides its users with an exceptional experience, as it’s the only way to inspire trust and to retain those users that are so critical for sustaining increasing returns.
- It collects user-generated data on a regular and systematic basis — which enables it to constantly improve the experience and, again, to sustain increasing returns (notably through machine learning).
Notice how consistent it is with the definition of entrepreneurship provided by Babak Nivi: “For entrepreneurs, there is no tradeoff between quality [exceptional experience] and scale [increasing returns]. The job is to do both [by collecting user-generated data] — not one or the other. If it can’t be done, you innovate [use those data].”
Notice also that the importance of data collection for improving the user experience is probably one of the biggest problems with the move toward the future of data gathering. People have essentially come to believe that companies gather data so that they can sell it to marketers or otherwise use it for nefarious purposes—this is because we’re so used to predatory companies such as Verizon. There’s very little sense among the general public that their own lives/services utilized will be improved through collection of user-generated data.
Finally, it’s interesting to think about how there are non-tech companies that fit only one or two out of the three criteria.
Exceptional experience only = local stores. Many, many small businesses provide an exceptional customer experience, without monitoring user activity or benefiting from increasing returns—typically a local shop where customers are served with great care.
Exceptional experience + data collection = luxury chain stores. Some businesses provide an exceptional customer experience and collect lots of data because they’re really eager to know their customers, if only to take better care of them. Luxury chain stores and luxury brands typically fall in that category, but they’re not driven by increasing returns.
Data collection only = hypermarkets. A few businesses collect data on a regular and systematic basis, but without bothering to provide an exceptional experience or benefitting from increasing returns. Hypermarkets are a good example: they know so many things and collect such amounts of data, but they don’t know a thing about providing an exceptional experience—and they’re trapped on the Northern Side, without the increasing returns that only Amazon generates.
Data collection + increasing returns = banks & telcos. A few very big businesses check two boxes: regular and systematic monitoring of their user activity and increasing returns. Verizon, as every telco, is a case in point: it knows everything about its customers and enjoys increasing returns thanks to its infrastructure. But that kind of business will never provide an exceptional experience, for one very simple reason: it is so easy, when you own an infrastructure that generates increasing returns, to live off your rent that there’s no point in wondering about your customers’ feelings. This is, I think, the reason why both telcos and banks take so little care of their customers—and why they’re among the most hated corporations in the business world. Indeed they use the data they collect not to serve us better, but to act as predators and live off their rent.
Increasing returns only = postal services. I found an example of a business that enjoys increasing returns, but that doesn’t check the other two boxes: postal services. National postal services don’t know their customers, since in the pre-digital world you couldn’t track customers sending mail to each other. Also, they don’t really provide an exceptional experience—some would say it’s an understatement but believe me, they’re willing to do better and they’re trying hard.
Exceptional experience + increasing returns = ∅. I didn’t find any example of a company that has both an exceptional customer experience and increasing returns without collecting data from its users. I guess to achieve that goal you really need to collect user-generated data and become… a tech company.
I hope this framework is of interest for you. Its purpose is to help big corporations realize that no matter how hard they try, they’re not tech companies. It is also helpful to devise how they, too, can become tech companies: some of them lack one criteria; some of them lack two.
At that point it should also be obvious why every successful startup ultimately becomes a tech company: it starts by collecting user-generated data, then it designs an exceptional experience, and finally it exploits technology to trigger increasing returns. Eventually, it still has to take bold risks because nothing can be taken for granted on digital markets.
In 1996, W. Brian Arthur wrote a seminal article whose original title was “Increasing Returns and the Two Worlds of Business”. As you can guess, it was meant to explain how the presence or absence of increasing returns determined radically different ways of doing business.
I wanted to add another chapter and stress the fact that the world of increasing returns in and of itself is also divided in two:
- on one side, you’ll find the likes of Verizon: companies whose increasing returns are driven by their infrastructure. These don’t have to take care of their customers to succeed: hence the tough regulatory frameworks that have been put in place in every industry where a tangible infrastructure triggers network effects;
- on the other side are the tech companies: these have increasing returns too, but they can’t live off their rent as those returns depend on their users repeatedly using their applications. For that reason, it is crucial to collect data and know their customers intimately; it is also vital to provide them with an exceptional experience.
As I frequently say to union executives, when it comes to becoming a tech company, workers are not the problem; incompetent managers and feeble investors are the ones who make it impossible to invest and prosper in a more digital economy.
So why won’t workers go on strike to denounce the fact that current shareholders and executives are incapable of leading their firm in the digital age? The Verizon strike certainly comes up short on that front, but the intent is correct: forcing Verizon to serve its customers better instead of living off its rent, and ultimately making it into a tech company—where “it’s all about the long term.”
(This is an issue of TheFamily Papers series, which is published in English on a regular basis. It covers various areas such as entrepreneurship, strategy, finance, and policy, and is authored by TheFamily’s partners as well as occasional guest writers. Thanks to Kyle Hall for reviewing drafts.)
