Goodbye Gatekeepers

I’d be remiss in not stating the obvious: Harvey Weinstein is a despicable human being, who did evil things. It’s worth noting, though, the structure of Hollywood that made it possible for him to do so much evil with such frequency for so long.

The Structure of Hollywood

                           

There has always been a large “supply” of movie actors, directors, script writers, etc.; Los Angeles is famous for being a city of transplants, particularly young men and women eager to make a go of it in show business, certain their breakthrough opportunity is the next audition, the next script, the next movie pitch.

The supply of movies, though, is limited. These two charts from Stephen Follows tell the story. First, the number of feature films:

Then, the number of studio versus non-studio films:

Back in 1980, shortly after the creation of Weinstein’s Miramax production company, there were just over 100 movies release in US cinemas a year; in 2016, there were 736, but for “wide Studio releases” — Weinstein’s territory — there were only 93. Suppose there are five meaningful acting jobs per movie: that means there are only about 500 meaningful acting jobs a year. And Weinstein not only decided who filled many of those 500 roles, he had an outsized ability to affect who filled the rest by making or breaking reputations.

Weinstein was a gatekeeper, presented with virtually unlimited supply while controlling limited distribution: those that wished to reach consumers had to accede to his demands, no matter how criminally perverse they may have been. Lauren O’Connor, an employee at the Weinstein Company, summed up the power differential that resulted in an internal memo uncovered by the New York Times:

I am a 28 year old woman trying to make a living and a career. Harvey Weinstein is a 64 year old, world famous man and this is his company. The balance of power is me: 0, Harvey Weinstein: 10.

What made Hollywood’s structure particularly nefarious was the fact that selecting actors is such a subjective process. Movies are art — what appeals to one person may not appeal to another — making people like Weinstein cultural curators. If he were to not select an actor, or purposely damaged their reputation through his extensive contacts with the press, they wouldn’t have a chance in Hollywood. After all, there were many others to choose from, and no other routes to making movies.

All the News That’s Fit to Print

Jim Rutenberg, the New York Times’ media columnist, highlighted Weinstein’s press contacts in a follow-up piece entitled Harvey Weinstein’s Media Enablers:

The real story didn’t surface until now because too many people in the intertwined news and entertainment industries had too much to gain from Mr. Weinstein for too long. Across a run of more than 30 years, he had the power to mint stars, to launch careers, to feed the ever-famished content beast. And he did so with quality films that won statuettes and made a whole lot of money for a whole lot of people.

Sharon Waxman, a former reporter for the New York Times, said on The Wrap that the New York Times itself belonged on that list:

I simply gagged when I read Jim Rutenberg’s sanctimonious piece on Saturday about the “media enablers” who kept this story from the public for decades…That’s right, Jim. No one — including The New York Times. In 2004, I was still a fairly new reporter at The New York Times when I got the green light to look into oft-repeated allegations of sexual misconduct by Weinstein…The story I reported never ran.

After intense pressure from Weinstein, which included having Matt Damon and Russell Crowe call me directly to vouch for Lombardo and unknown discussions well above my head at the Times, the story was gutted. I was told at the time that Weinstein had visited the newsroom in person to make his displeasure known. I knew he was a major advertiser in the Times, and that he was a powerful person overall.

Weinstein’s alleged pressuring of the New York Times — and his ability to influence the media generally — rested on the fact that the media is also a gatekeeper. The New York Times still brags as such in its print edition:

“All the News That’s Fit to Print” is rather clear about how the New York Times’ views itself: the arbiter — that is gatekeeper — of what news ought to be consumed by the public. In truth, though, by 2004 that gatekeeper role was already breaking down; perhaps the most famous example involved another set of allegations of sexual misconduct, when in 1998 the Drudge Report reported the news that Newsweek wouldn’t:

The gate could not hold.

The Structure of Newspapers

After Waxman’s post, New York Times’ editor-in-chief Dean Baquet argued that “it is unimaginable” that her story was killed due to pressure from Weinstein; in fact, though, an examination of the structure of the newspaper business suggests it is quite imaginable.

In 2004, the New York Times had $3.3 billion in revenue, up 2.4% year-over-year. That increase, though, belied deeper problems: circulation had dropped a percentage point year-over-year; revenue growth came from a 6% increase in adverting rates. Advertising was the New York Times’ primary revenue source, accounting for 66% of total revenue, and given that in 2003 the average Hollywood movie spent an average of $34.8 million in advertising, some portion of that undoubtedly came from Weinstein specifically.

The reason that circulation decline suggested a problem is that the ability of the New York Times and other newspapers to command advertising depended on being a gatekeeper: advertisers didn’t take out newspaper ads because they loved newspapers, they took out newspaper ads because it was an effective way to reach potential customers:

“Gatekeeper” is another way to say “integrator”, and as I have explained previously, the key to the newspaper business model was controlling distribution and integrating editorial content and ads. In 2004, though, that integration was the verge of falling apart; the Internet meant advertisers would reach customers directly. It had already happened with Craigslist and classifieds, and first ad networks and then social networks would do the same to display ads, causing newspaper advertising revenue to plummet to levels not seen since the 1950s:

2004 came after that first Craigslist-inspired decline, and it’s all too easy to imagine Weinstein’s threats having their intended effect.

Journalism Worth Paying For

The ultimate credit for the New York Times story goes first and foremost to the women willing to go on the record, and then to Jodi Kantor and Megan Twohey, the reporters who investigated and wrote it. If Waxman’s allegations are true, though, then it’s worth pointing out that the New York Times is in a very different place than it was in 2004.

Last year the New York Times had $1.6 billion in revenue, a 53% decrease from 2004. Critically, though, the source of that revenue had flipped on its head: advertising accounted for only 37% of revenue, while circulation was 57%, up from 54% in 2015, and only 27% in 2004; by all account circulation is up significantly more in 2017.

That image is from the company’s 2020 strategy report, which declared that the editorial product should align with the company’s focus on subscriptions; Baquet told Recode that it was his job “to do as many ‘Amazons’ as possible”, referring to the paper’s investigative report on Amazon’s working conditions. Certainly this Weinstein piece fits: whatever expenses the New York Times spent reporting this story will be more than made up in the burnishing of the company’s reputation for journalism that is worth paying for.

Admittedly, “Journalism worth paying for” doesn’t have the same ring as “All the News That’s Fit to Print”, but it is a far better descriptor of the New York Times’ new business model:

In a world where the default news source is the Facebook News Feed, the New York Times is breaking out of the inevitable modularization and commodification entailed in supplying the “news” to the feed. That, in turn, requires building a direct relationship with customers: they are the ones in charge, not the gatekeepers of old — even they must now go direct.

YouTube and the Movies

In the aftermath of the New York Times report (and another from The New Yorker), various stories have alluded to the fact that Weinstein has less power than he used to. I can’t say I know enough about the particulars of Hollywood to know whether that it true in a relative sense, but there’s no question movies are less important than ever before. Indeed, the industry looks a lot like newspapers in 2004; revenue is increasing due to higher prices, even as the number of movie-goers steadily declines (graph from The Numbers):

Meanwhile, more and more cachet — and star power — is flowing to serialized television, particularly distributors like Netflix and HBO that go directly to customers. And don’t forget YouTube: video is a zero sum activity — time spent watching one source of video is time not spent watching another — and YouTube showed over a billion hours of video worldwide every day in 2016.

YouTube represents something else that is just as important: the complete lack of gatekeepers. Google CEO Sundar Pichai said on an earnings’ call earlier this year that “Every single day, over 1,000 creators reached the milestone of having 1,000 channel subscribers.” That is an astounding number in its own right; what is even more remarkable is that while Hollywood has only ~3,500 acting slots a year (including all movies, not just major studios), YouTube creates 100 times as many “stars” over the same time period.

The End of Gatekeepers

It is easy to see the downsides of the destruction of gatekeepers; in 2016, before the election, I explained how the collapse of media gatekeepers meant the collapse of political gatekeepers. From The Voters Decide:

There is no one dominant force when it comes to the dispersal of political information, and that includes the parties described in the previous section. Remember, in a Facebook world, information suppliers are modularized and commoditized as most people get their news from their feed. This has two implications:

  • All news sources are competing on an equal footing; those controlled or bought by a party are not inherently privileged
  • The likelihood any particular message will “break out” is based not on who is propagating said message but on how many users are receptive to hearing it. The power has shifted from the supply side to the demand side

This is a big problem for the parties as described in The Party Decides. Remember, in Noel and company’s description party actors care more about their policy preferences than they do voter preferences, but in an aggregated world it is voters aka users who decide which issues get traction and which don’t. And, by extension, the most successful politicians in an aggregated world are not those who serve the party but rather those who tell voters what they most want to hear.

I can imagine there are many that long for the days when the media — and by extension the parties — could effectively determine presidential nominees. The Weinstein case, though, is a reminder of just how rotten gatekeepers can be. Their very structure is ripe for abuse by those in power, and suppression of those wishing to break through; consumers, meanwhile, are taken for granted.

For my part, I’m thankful such structures are increasingly untenable: perhaps the New York Times didn’t spike that 2004 story because of pressure from Weinstein, but there’s no doubt that for decades “All the News That’s Fit to Print” was shamefully deficient in reporting about news and groups that weren’t on the radar of New York newspaper editors. And, selfishly, I wouldn’t have the career I do without the absence of gatekeepers: anyone can set up a website and send an email and instantly compete with the New York Times and everyone else for attention and subscription dollars.

Most importantly, though, the end of gatekeepers is inevitable: the Internet provides abundance, not scarcity, and power flows from discovery, not distribution.1 We can regret the change or relish it, but we cannot halt it: best to get on with making it work for far more people than gatekeepers ever helped — or harassed.

  1. And fortunately, to date, those that own distribution — the aggregators — have tried to be neutral; that’s a good thing []

Google’s Search for the Sweet Spot

This was my favorite slide from yesterday’s Google hardware event:

Oh, sorry, wrong picture. Here you go:

For Google, a cloud on the slide is not necessary: it is the very essence of the company. Hardware, well, perhaps a little over-compensation is in order.

Apple’s Sweet Spot

Steve Jobs’, in his last keynote, framed that slide as a new direction for Apple after the company’s brilliant digital hub strategy, introduced ten years prior:

In fact, though, Apple was building Digital Hub 2.0, with the iPhone at the center:

Sure, iCloud kept files in sync (usually), but the iPhone was the juggernaut it was because it hit the perfect sweet spot of company, market, and value chain:

Company: Apple from the very beginning has been premised on the idea of integrating hardware and software, and the iPhone was the ultimate expression of that premise.

Market: The smartphone market was the best market technology has ever seen: not only did everyone need a phone, but in developed countries carriers subsidized top-end models because they drove higher average revenue per subscriber. Moreover, because a phone was something you took with you everywhere, there was far more value placed on non-technical attributes like fit-and-finish and brand.

Value Chain: Apple’s integration delivered sustainable differentiation in the smartphone value chain, forcing every other element, from suppliers to network providers to app makers to modularize themselves around Apple’s integration.

The result was the most successful product ever.

Google Search’s Sweet Spot

Given that Google is the second most valuable company in the world (after Apple), it is quite clear the company has found a sweet spot of its own. Indeed, Google Search ticks the same boxes as the iPhone:

Company: Google is built around the idea that superior technology is all that matters; that was certainly the case with search, which brilliantly leveraged the connectivity inherent to the web to make itself better; unlike its competitors, the bigger the web became, the better Google itself became.

Market: The truth is that the best technology does not always win; what made Google search the dominant force that it was and remains was the openness of the web. The less friction there was in the traversal of information the more that sheer technological prowess matters.

Value Chain: Google is the king of aggregators because, when information shifted from scarcity to abundance, discovery became the point of leverage, and Google was better at discovery than anyone. That allowed the company to integrate end users and discovery, making search the single best place to advertise for all kinds of industries.

Building truly transformative products requires all three: a company that is the best at serving a market at the point in the value chain where integration can drive sustainable profits.

Google’s Differentiator

Last year, after the company’s first ‘Made By Google’ event, I framed the company’s hardware efforts in the context of the search business model. Specifically:

A business, though, is about more than technology, and Google has two significant shortcomings when it comes to assistants in particular. First, as I explained after this year’s Google I/O, the company has a go-to-market gap: assistants are only useful if they are available, which in the case of hundreds of millions of iOS users means downloading and using a separate app (or building the sort of experience that, like Facebook, users will willingly spend extensive amounts of time in).

Secondly, though, Google has a business-model problem: the “I’m Feeling Lucky Button” guaranteed that the search in question would not make Google any money. After all, if a user doesn’t have to choose from search results, said user also doesn’t have the opportunity to click an ad, thus choosing the winner of the competition Google created between its advertisers for user attention. Google Assistant has the exact same problem: where do the ads go?

It seemed at the time that Google planned to use the Google Assistant as a differentiator to drive Pixel sales; a few months later, the company either backed down or admitted to what was the better course of action: making Assistant a part of Android. It remains unclear whether the pursuit of alternatives by Android OEM’s was the cause or result of Assistant’s temporary Pixel-exclusivity.

What seems truer than ever, though, is this:

Google has adopted Alan Kay’s maxim that “People who are really serious about software should make their own hardware.” To that end the company introduced multiple hardware devices, including a new phone, the previously-announced Google Home device, new Chromecasts, and a new VR headset. Needless to say, all make it far easier to use Google services than any 3rd-party OEM does, much less Apple’s iPhone.

Yesterday the company doubled down: there were two new Google Home devices, including a competitor for Amazon’s Echo Dot and Apple’s HomePod, an updated Pixel phone, a new laptop with Google Assistant built-in (including into the optional stylus), headphones, and even a standalone camera.

What was most striking, though, was Google CEO Sundar Pichai’s opening:

We’re excited by the shift from a mobile-first to an AI-first world. It is not just about applying machine learning in our products, but it’s radically re-thinking how computing should work…We’re really excited by this shift, and that’s why we’re here today. We’ve been working on software and hardware together because that’s the best way to drive the shifts in computing forward. But we think we’re in the unique moment in time where we think we can bring the unique combination of AI, and software, and hardware to bring the different perspective to solving problems for users. We’re very confident about our approach here because we’re at the forefront of driving the shifts to AI.

Note that last line: Google’s confidence comes from the Company perspective: artificial intelligence, at least its machine learning manifestation, fits perfectly in Google’s wheelhouse of acting on massive amounts of data. Simply being good at something, though, is not enough: you need the market and value chain fit as well.

Indeed, this is why startups often beat incumbents: incumbents have resource advantages, but everything about their company is focused on a solved problem — the one that propelled them from startup to incumbent in the first place. Startups, on the other hand, have the luxury of conforming every aspect of their company around the problem to be solved, perfectly serving the market and capturing the point of integration/differentiation in the value chain.

Google’s Committment

So how does Google fare? Start with value chains: I actually found the breadth of Google products to be impressive, both proof that my suspicions about hardware being the best way to monetize Google software was correct, and evidence of a real commitment on Google’s part to realizing that opportunity. The idea is straight from Apple’s playbook: monetize software by selling integrated hardware at a healthy margin (products competing directly with Amazon excepted).

The breadth is also necessary: for Assistant to reach its potential it is necessary that it be available everywhere, and everywhere happens to hit on both Apple and Amazon’s achilles heel — Apple, the devotion to the phone as the center of everything, and Amazon’s lack of a phone platform of its own.

The question, though, is the market, and this is where I appreciate Pichai’s perhaps inadvertent honesty: Google is excited about AI because Google is good at AI; the success of AI as a differentiator, though, depends on whether or not there is a market for it. That remain to be seen.

That said, perhaps the most surprising news from yesterday came from an interview Pichai did with The Verge’s Dieter Bohn:

As ambitious as Google is with its own hardware, it’s still a tiny drop in the bucket compared to the company’s online business. Pichai won’t say when we can expect to see hardware sales become a big, broken-out part of its financial calls, outside of saying it’ll definitely happen in the next five years.

That’s no small thing: I have hammered the company repeatedly for its failure to break out different business units, particularly YouTube, so a pledge to disclose hardware sales is significant. It also hints at a deeper commitment: specifically, I wouldn’t be surprised if Google announced dedicated retail stores sooner rather than later. AI may be the future, and Google may be the best at it, but sometimes markets need to be made, not simply seized.

Trustworthy Networking

Fifteen years on, this paragraph from a Bill Gates’ memo is a bit cringe-inducing:

The events of last year — from September’s terrorist attacks to a number of malicious and highly publicized computer viruses — reminded every one of us how important it is to ensure the integrity and security of our critical infrastructure, whether it’s the airlines or computer systems.

Equivocating computer viruses with the worst terrorist attack in U.S. history may be a bit over-the-top, but for Microsoft, anyways, 2001 was a period of real crisis: the company’s software was hit by seven different worms,1 all following on the heels of the previous year’s massively damaging ILOVEYOU worm. More and more consumers were scared to even use their computers.

That was the context for perhaps the second-most famous Gates’ memo — Trustworthy Computing — from which the above excerpt was taken. This was the core takeaway:

There are many changes Microsoft needs to make as a company to ensure and keep our customers’ trust at every level – from the way we develop software, to our support efforts, to our operational and business practices. As software has become ever more complex, interdependent and interconnected, our reputation as a company has in turn become more vulnerable. Flaws in a single Microsoft product, service or policy not only affect the quality of our platform and services overall, but also our customers’ view of us as a company…

In the past, we’ve made our software and services more compelling for users by adding new features and functionality, and by making our platform richly extensible. We’ve done a terrific job at that, but all those great features won’t matter unless customers trust our software. So now, when we face a choice between adding features and resolving security issues, we need to choose security. Our products should emphasize security right out of the box, and we must constantly refine and improve that security as threats evolve.

‘Trustworthy Computing’ was in many respects the inevitable counterpart to Gates’ most-famous memo: 1995’s The Internet Tidal Wave:

In this memo I want to make clear that our focus on the Internet is crucial to every part of our business. The Internet is the most important single development to come along since the IBM PC was introduced in 1981. It is even more important than the arrival of the graphical user interface (GUI).

Obviously Gates was right, but the memo went further: it is packed with ideas about how Microsoft can “superset the Web” in order to “make it clear that Windows machines are the best choice for the Internet”; to that end Gates wrote, “I want every product plan to try and go overboard on Internet features.” And, when Microsoft did exactly that, the result was a set of products with massive security holes, resulting in a crisis. The faster you move towards the future, the more unintended consequences — security debt, if you will — there inevitably will be.

The analogy to Facebook is straightforward: operating with the motto of “Move Fast and Break Things” the company has spent the last decade going overboard, as it were, on connecting everyone and everything. And then, to handle the deluge of information that resulted, the company helpfully presents an algorithmically curated News Feed that shows exactly what it thinks its users will enjoy seeing the most (engagement being a necessary proxy for enjoyment). It is truly a marvel: individual customization at global scale.

There have, though, been side effects.

Russian Ads

I wrote about Russian political ads on Facebook two weeks ago, explaining how the ads were bought through Facebook’s self-serve ad model; this allows the company’s five million advertisers — given that number, by definition the vast majority are small and medium-sized businesses — to run ads without having to interact with another human.

This, I argued, was a good thing, and I absolutely stand by it. From that article:

The biggest beneficiaries of zero transaction costs on the super-aggregators are not traditional advertisers, whether that be companies like CPG conglomerates or presidential campaigns. Both have the resources to advertise anywhere and everywhere, and indeed, often find that the fine-tooth targeting on super-aggregators isn’t worth the effort required. The folks that do benefit, though, are those that wouldn’t have a voice otherwise: startups and niche offerings, both in terms of business and politics. Google and Facebook have opened the field to far more entrants, and while that means there are more folks with bad intentions, there are also a whole lot more folks with ideas that were shut out by the significant transaction costs inherent in pre-Internet platforms.

That line, “folks with bad intentions”, should sound familiar: that is exactly what led to Microsoft’s crisis in 2001. Instead of building for local networks that were protected by the fact that access was non-scalable (i.e. physical access was required), Microsoft products were now on the Internet where they could be attacked from anywhere by anyone. And, when you have to defend against anyone, the likelihood of facing “folks with bad intentions” becomes a certainty. So it is with Facebook self-serve ads.

What is just as important to note, though, is that a scalable solution is also required. In the case of Microsoft, it obviously wasn’t viable to simply rip out Internet connectivity from its products; it is similarly foolhardy to suggest that Facebook abandon all of the benefits of the self-serve model by, for example, reviewing every ad.

To reiterate the point, this is impossible. To use the Russian ad numbers as a proxy, consider the math:

  • The $100,000 spent by 470 inauthentic account identified by Facebook was good for 3,000 ads, which means each ad cost an average of $30.
  • As a quick but essential aside, this exercise is going to be a very rough approximation, because the price paid for an ad varies hugely depending on how finely targeted it is, and how competitive said targeting opportunities are. In the case of these ads, Facebook revealed yesterday that for 50% of the ads less than $3 was spent, and for 99% of the ads less than $1,000 was spent (and 25% weren’t even shown because they failed to win the auction for the audience they targeted). However, given that Facebook only reveals the percentage change in its average price per ad, not the actual amount, $30 is the best we can do.
  • Last quarter Facebook had $9.2 billion in ad revenue, which was an increase of 47% over the year prior. Using that $30/ad number, that means last quarter there were approximately 276 million unique ads on Facebook (each of which could be shown multiple times, of course).

Again, the actual number could be different than this by a huge margin — it is very likely that this Russian ad buy is not at all representative — but that margin could go in either direction. The important takeaway is that looking at every ad means effectively killing self-serve, which not only kills Facebook’s revenue model, but, far more importantly, removes a truly accessible and disruptive advertising channel for small and medium businesses, particularly those uniquely enabled by the Internet.

Fixing Facebook Ads

What makes far more sense is for Facebook to find a point of leverage; for Microsoft, this was relatively easy — harden the operating system, which the company did with XP Service Pack 2. Facebook’s challenge is harder, but the point of leverage seems clear: advertisers themselves, not advertisements; after all, 5 million all-time is a much more manageable number than 276 million a quarter. To that end, the company also announced yesterday a change in how it handled U.S. political advertisers:

Increasing requirements for authenticity. We’re updating our policies to require more thorough documentation from advertisers who want to run US federal election-related ads. Potential advertisers will have to confirm the business or organization they represent before they can buy ads. As Mark said, we won’t catch everyone immediately, but we can make it harder to try to interfere.

This is the right point of leverage, but this policy change is inadequate. The only advertisers affected here are those that explicitly declare they are running ads for US federal elections; what about state elections, or other countries, or, pertinent to this case, bad actors?

Facebook should increase requirements for authenticity from all advertisers, at least those that spend significant amounts of money or place a large number of ads. I do believe it is important to make it easy for small companies to come online as advertisers, so perhaps documentation could be required for a $1,000+ ad buy, or a cumulative $5,0000, or after 10 ads (these are just guesses; Facebook should have a much clearer idea what levels will increase the hassle for bad actors yet make the platform accessible to small businesses). This will make it more difficult for bad actors in elections of all kinds, or those pushing scummy advertising generally.

Secondly, the most scalable counterweight to bad ads is massively increased transparency. Facebook took steps in this regard as well; from the same post:

Making advertising more transparent. We believe that when you see an ad, you should know who ran it and what other ads they’re running — which is why we show you the Page name for any ads that run in your feed. To provide even greater transparency for people and accountability for advertisers, we’re now building new tools that will allow you to see the other ads a Page is running as well — including ads that aren’t targeted to you directly. We hope that this will establish a new standard for our industry in ad transparency. We try to catch content that shouldn’t be on Facebook before it’s even posted — but because this is not always possible, we also take action when people report ads that violate our policies. We’re grateful to our community for this support, and hope that more transparency will mean more people can report inappropriate ads.

This will eliminate so-called Dark Ads which could only be seen by those targeted; again, though, Facebook didn’t go far enough. These ads can still only be seen by going to the actual pages, which are impossible to know about unless you are shown an ad; the company should have a central, searchable, repository of all those hundreds of millions of ads. Again, it is worth pointing out that this will hurt some small businesses (larger competitors can easily pick up on their marketing strategies), but the tradeoff when it comes to oversight of not just political ads but ads of all types is worth it.

What Facebook has to realize is that while both of these proposals are likely to hurt the bottom line — the first will increase friction in advertisers coming on board (or ramping up spend), while the second will have a commodification effect on ads — this scandal is, to use Gates’ words, “not only affect[ing] the quality of our platform and services overall, but also [their] customers’ view of [them] as a company.” This matters because Facebook’s biggest risk is government regulation, and that is ultimately a political question, where the opinion of the body politic matters greatly.

Filter Bubbles

All that said, its worth stepping back for a moment and putting this scandal in context. I gently mocked Gates for equivocating computer viruses to terrorist attacks, but the suggestion that $100,000 in Facebook ads — of which only 46% ran before the election — swung the presidential results is just as questionable. Frankly, if spending $100,000 on Facebook had that level of return, the company would be worth many multiples of the $492 billion it is today! It is concerning and frustrating to me as a citizen to see so many spend far more time prosecuting these ads at the expense of a broader reflection on the state of the country.

That includes Facebook, by the way. I actually tend to agree with Zuckerberg’s post-election comment — which he since apologized for — that it was “crazy” to think that ‘Fake News’ influenced the election; my view is that Fake News is symptom of a far more serious problem: filter bubbles.

To that end, the Zuckerberg statement that truly concerned me was on the company’s Q2 2016 earnings call; this was a few months after the brouhaha over alleged bias in the Trending Topics module, and Zuckerberg was asked about the filter bubble problem:

So we have studied the effect that you’re talking about, and published the results of our research that show that Facebook is actually, and social media in general, are the most diverse forms of media that are out there. And basically what — the way to think about this is that, even if a lot of your friends come from the same kind of background or have the same political or religious beliefs, if you know a couple of hundred people, there’s a good chance that even maybe a small percent, maybe 5% or 10% or 15% of them will have different viewpoints, which means that their perspectives are now going to be shown in your News Feed.

And if you compare that to traditional media where people will typically pick a newspaper or a TV station that they want to watch and just get 100% of the view from that, people are actually getting exposed to much more different kinds of content through social media than they would have otherwise or have been in the past. So it’s a good sounding theory, and I can get why people repeat it, but it’s not true. So I think that that’s something that if folks read the research that we put out there, then they’ll see that.

Actually, this is…questionable news (I can’t quite bring myself to use the obvious term). The Facebook-commissioned study Zuckerberg referenced had massive problems, including a non-representative sample, a non-reviewable proprietary data set (thus making the study non-reviewable), and beyond that, the study’s results actually did support the idea of filter bubbles.2

It’s rather a meta problem: I suspect Zuckerberg’s own bubble makes him inclined to dismiss the possibility of filter bubbles, while the bubble Facebook’s most strident critics live in means they too are focusing on the wrong thing. Certainly this is a conversation where everyone has more to lose; those scapegoating Facebook probably don’t want to think about their own responsibility, such that it may be, for an election result they disagree with, and the stakes are even higher for Facebook: giving people what they want to see is far more important to the company’s business model than $100,000 in illegal ads, unintended consequences or not.

  1. The Anna Kournikova, Sadmind, Sircam, Code Red, Code Red II, Nimda, and Klez worms, respectively []
  2. Further references here, here, here, and here []

Defining Aggregators

(Note: this is not a typical Stratechery article; there is no over-arching narrative or reference to current news. Rather, the primary goal is to provide a future point of reference)

Aggregation Theory describes how platforms (i.e. aggregators) come to dominate the industries in which they compete in a systematic and predictable way. Aggregation Theory should serve as a guidebook for aspiring platform companies, a warning for industries predicated on controlling distribution, and a primer for regulators addressing the inevitable antitrust concerns that are the endgame of Aggregation Theory.

Aggregation Theory was first coined in this eponymously-titled 2015 article. That article followed on the heels of a series of posts about Airbnb, Netflix, and web publishing that, I realized, fit together into a broader framework that was applicable to a range of Internet-enabled companies. Over the ensuing two years I have significantly fleshed out the ideas in that original article, yet subsequent articles necessarily link to an article that marked the beginning of Aggregation Theory, not the current state.

That noted, the original article is very much worth reading, particularly its description of how value has shifted away from companies that control the distribution of scarce resources to those that control demand for abundant ones; the purpose of this article is to catalog exactly what the latter look like.

The Characteristics of Aggregators

Aggregators have all three of the following characteristics; the absence of any one of them can result in a very successful business (in the case of Apple, arguably the most successful business in history), but it means said company is not an aggregator.

Direct Relationship with Users

This point is straight-forward, yet the linchpin on which everything else rests: aggregators have a direct relationship with users. This may be a payment-based relationship, an account-based one, or simply one based on regular usage (think Google and non-logged in users).

Zero Marginal Costs For Serving Users

Companies traditionally have had to incur (up to) three types of marginal costs when it comes to serving users/customers directly.

  • The cost of goods sold (COGS), that is, the cost of producing an item or providing a service
  • Distribution costs, that is the cost of getting an item to the customer (usually via retail) or facilitating the provision of a service (usually via real estate)
  • Transaction costs, that is the cost of executing a transaction for a good or service, providing customer service, etc.

Aggregators incur none of these costs:

  • The goods “sold” by an aggregator are digital and thus have zero marginal costs (they may, of course, have significant fixed costs)1
  • These digital goods are delivered via the Internet, which results in zero distribution costs2
  • Transactions are handled automatically through automatic account management, credit cards payments, etc.3

This characteristic means that businesses like Apple hardware and Amazon’s traditional retail operations are not aggregators; both bear significant costs in serving the marginal customer (and, in the case of Amazon in particular, have achieved such scale that the service’s relative cost of distribution is actually a moat).

Demand-driven Multi-sided Networks with Decreasing Acquisition Costs

Because aggregators deal with digital goods, there is an abundance of supply; that means users reap value through discovery and curation, and most aggregators get started by delivering superior discovery.

Then, once an aggregator has gained some number of end users, suppliers will come onto the aggregator’s platform on the aggregator’s terms, effectively commoditizing and modularizing themselves. Those additional suppliers then make the aggregator more attractive to more users, which in turn draws more suppliers, in a virtuous cycle.

This means that for aggregators, customer acquisition costs decrease over time; marginal customers are attracted to the platform by virtue of the increasing number of suppliers. This further means that aggregators enjoy winner-take-all effects: since the value of an aggregator to end users is continually increasing it is exceedingly difficult for competitors to take away users or win new ones.

This is in contrast to non-platform companies that face increasing customer acquisition costs as their user base grows. That is because initial customers are often a perfect product-market fit; however, as that fit decreases, the surplus value from the product decreases as well and quickly turns negative. Generally speaking, any business that creates its customer value in-house is not an aggregator because eventually its customer acquisition costs will limit its growth potential.

One additional note: the aforementioned Apple and Amazon do have businesses that qualify as aggregators, at least to a degree: for Apple, it is the App Store (as well as the Google Play Store). Apple owns the user relationship, incurs zero marginal costs in serving that user, and has a network of App Developers continually improving supply in response to demand. Amazon, meanwhile, has Amazon Merchant Services, which is a two-sided network where Amazon owns the end user and passes all marginal costs to merchants (i.e. suppliers).

Classifying Aggregators

Aggregation is fundamentally about owning the user relationship and being able to scale that relationship; that said, there are different levels of aggregation based on the aggregator’s relationship to suppliers:

Level 1 Aggregators: Supply Acquisition

Level 1 Aggregators acquire their supply; their market power springs from their relationship with users, but is primarily manifested through superior buying power. That means these aggregators take longer to build and are more precarious in the short-term.

The best example of a Level 1 Aggregator is Netflix. Netflix owns the user relationship and bears no marginal costs in terms of COGS, distribution costs,4 or transaction costs.5 Moreover, Netflix does not create shows, but it does acquire them (increasingly exclusively to Netflix); the more content Netflix acquires, the more its value grows to potential users. And, the more users Netflix gains, the more it can spend on acquiring content in a virtuous cycle.

Level 1 aggregators typically operate in industries where supply is highly differentiated, and are susceptible to competitors with deeper pockets or orthogonal business models.

Level 2 Aggregators: Supply Transaction Costs

Level 2 Aggregators do not own their supply; however, they do incur transaction costs in bringing suppliers onto their platform. That limits the growth rate of Level 2 aggregators absent the incursion of significant supplier acquisition costs.

Uber is a Level 2 Aggregator (and Airbnb in some jurisdictions due to local regulations). Uber owns the user relationship and bears no marginal costs in terms of COGS, distribution costs, or transaction costs. Moreover, Uber does not own cars; those are supplied by drivers who sign up for the platform directly. At that point, though Uber needs to undertake steps like background checks, vehicle verification, etc. that incur transaction costs both in terms of money as well as time. This limits supply growth which ultimately limits demand growth.

Level 2 aggregators typically operate in industries with significant regulatory concerns that apply to the quality and safety of suppliers.

Level 3 Aggregators: Zero Supply Costs

Level 3 Aggregators do not own their supply and incur no supplier acquisition costs (either in terms of attracting suppliers or on-boarding them).

Google is the prototypical Level 3 Aggregator: suppliers (that is, websites) are not only accessible by Google by default, but in fact actively make themselves more easily searchable and discoverable (indeed, there is an entire industry — search engine optimization (SEO) — that is predicated on suppliers paying to get themselves onto Google more effectively).

Social networks are also Level 3 Aggregators: initial supply is provided by users (who are both users and suppliers); over time, as more and more attention is given to the social networks, professional content creators add their content to the social network for free.

Level 3 aggregators are predicated on massive numbers of users, which means they are usually advertising-based (which means they are free to users). An interesting exception is the aforementioned App Stores: in this case the limited market size (relatively speaking) is made up by the significantly increased revenue-per-customer available to app developers with suitable business models (primarily consumable in-app purchases).

The Super-Aggregators

Super-Aggregators operate multi-sided markets with at least three sides — users, suppliers, and advertisers — and have zero marginal costs on all of them. The only two examples are Facebook and Google, which in addition to attracting users and suppliers for free, also have self-serve advertising models that generate revenue without corresponding variable costs (other social networks like Twitter and Snapchat rely to a much greater degree on sales-force driven ad sales).

For more about Super-Aggregators see this article.

Regulating Aggregators

Given the winner-take-all nature of Aggregators, there is, at least in theory, a clear relationship between Antitrust and Aggregation. However, traditional jurisprudence is limited by three factors:

  • The key characteristic of Aggregators is that they own the user relationship. Critically, the user chooses this relationship because the aggregator offers a superior service. This makes it difficult to make antitrust arguments based on consumer welfare (the standard for U.S. jurisprudence for the last 35 years).
  • The nature of digital markets is such that aggregators may be inevitable; traditional regulatory relief, like breaking companies up or limiting their addressable markets will likely result in a new aggregator simply taking their place.
  • Aggregators make it dramatically simpler and cheaper for suppliers to reach customers (which is why suppliers work so hard to be on their platform). This increases the types of new businesses that can be created by virtue of the aggregators existing (YouTube creators, Amazon merchants, small publications, etc.); regulators should take care to preserve these new opportunities (and even protect them).

These are guidelines for regulation; determining specifics is an ongoing project for Stratechery, as are the definitions in this article.

  1. And yes, in the very long run, all fixed costs are marginal costs; that said, while the amount of capital costs for aggregators is massive, their userbase is so large that even over the long run the fixed costs per user are infinitesimal, particularly relative to revenue generated []
  2. In terms of the marginal customer; in aggregate there are of course significant bandwidth costs, but see the previous footnote []
  3. Credit card fees are a significant transaction cost that do limit some types of businesses, but will generally be ignored in this analysis []
  4. Obviously bandwidth in the aggregate is a particularly large cost of Netflix []
  5. In all cases, credit card fees excepted []

Books and Blogs

A book, at least a successful one, has a great business model: spend a lot of time and effort writing, editing, and revising it up front, and then make money selling as many identical copies as you can. The more you sell the more you profit, because the work has already been done. Of course if you are successful, the pressure is immense to write another; the payoff, though, is usually greater as well: it is much easier to sell to customers you have already sold to before than it is to find customers for the very first time.

There is, though, at least from my perspective, a downside to this model: a book, by necessity, is a finished object; that is why it can be printed and distributed at scale. The problem is that one’s thoughts may not be final; indeed, the more vital the subject, the more likely a book, with its many-month production process, is to be obsolete the moment it enters its final state of permanence.

When I started Stratechery four years ago, with my 384 Twitter followers and little else, the thought of writing a book never crossed my mind; not only did I not have a contract, I didn’t even have a topic beyond the business and strategy of technology, a niche I thought was both under-served and that I had the inklings of a point of view on.

Since then it has been an incredible journey, especially intellectually: instead of writing with a final goal in mind — a manuscript that can be printed at scale — Stratechery has become in many respects a journal of my own attempts to understand technology specifically and the way in which it is changing every aspect of society broadly. And, it turns, out, the business model is even better: instead of taking on the risk of writing a book with the hope of one-time payment from customers at the end, Stratechery subscribers fund that intellectual exploration directly and on an ongoing basis; all they ask is that I send them my journals of said exploration every day in email form.

To put it another way, at least in my experience, the lowly blog has fully disrupted the mighty book: the former was long thought to be an inferior alternative, or at best, a complementary piece for an author looking to drum up an audience; slowly but surely, though, the tools have gotten better, everything from social media for marketing to Stripe for payments to WordPress for publishing to tools like Memberful for subscriber management. It became increasingly apparent, to me anyways, that while books remained a fantastic medium for stories, both fiction and non, blogs were not only good enough, they were actually better for ideas closely tied to a world changing far more quickly than any book-related editorial process can keep up with.

To be sure, I had discovered in 2015 what might have been a worthy book topic: Aggregation Theory. That, though, makes my point: the biggest problem I have with Aggregation Theory is that that old article I keep linking to is incomplete. My thinking on what Aggregation Theory is, what its implications are, and how that should affect strategy both inside and outside of technology and, particularly over the last year, potential regulation, has evolved considerably.

To that end, it is with relief I write the following article: Defining Aggregators. I’ll be honest: it’s more for me than for you; my thinking has evolved, and clarified, and I want to link to something that represents my point of view in 2017, not just 2015. That I can do so by merely hitting ‘Publish’ is a great thing: these ideas are very much alive, and I don’t really see the point of trees that are dead, literally or virtually.

Note: This article is meant as an introduction to Defining Aggregators; it is posted as a separate article as I plan to link to that article many times in the future

The Super-Aggregators and the Russians

In August 2011, just a day or two into my career at Microsoft, I sat in on a monthly review meeting for Hotmail (now known as Outlook.com); the product manager running the meeting was going through the various geographies and their relevant metrics — new users, churn, revenue, etc. — and it was, well, pretty boring. It was only later that I realized just how astounding “boring” was; a small group of people in a conference room going over numbers that represented hundreds of millions of people and dollars in revenue, and most of us cared far more about what was on the menu for lunch.

I’ve reflected on that meeting often over the years, particularly when it comes to Facebook and controversies like censoring too much, censoring too little, or “fake news”, and I was reminded of it again with this tweet:

Mark Warner, the senior Senator from Virginia, is referring to a Russian company, thought to be linked to the Kremlin’s propaganda efforts, having bought $100,000 worth of political ads on Facebook, some number of which directly mentioned 2016 presidential candidates Donald Trump and Hillary Clinton. Facebook has released limited details about the ads, likely due to its 2012 consent decree with the FTC, which bars the company from unilaterally making private information public, as well as the problematic precedent of releasing information without a clear order compelling said release. To that end, it was reported over the weekend that special counsel Robert Mueller received a much more comprehensive set of data from Facebook after obtaining a search warrant.

Even with all that context, though, I found Senator Warner’s tweet puzzling: how else would the propaganda group have paid? Facebook’s self-service ad portal lets you buy ads in 55 different currencies, including the Russian Ruble:1

That, though, brought me back to that Hotmail meeting: that I, and probably many more in the tech industry, find the idea of Facebook selling ads in rubles to strangers to be utterly unremarkable, even as thousands find it equally outrageous and damning, is a reminder of just how unprecedented and misunderstood aggregators like Facebook continue to be, and what a challenge it will be to regulate them.

The Cellular Network Company

Senator Warner, it should be noted, is considered one of the most technologically literate people in the entire Senate — and the richest. Warner originally made his fortune by facilitating the sale of cellular phone licenses; he then co-founded Columbia Capital, a venture capital firm which specialized in cellular businesses: the firm’s early investments included Nextel, BroadSoft, and MetroPCS.

A cellular network company is certainly a new kind of business that is similar to today’s tech giants in many respects:

  • At a fundamental level, cellular network companies are about the movement of information — voice and text, in Warner’s era — not physical goods. Moreover, because this information is digital, there are no marginal distribution costs in its transfer. This is the same characteristic of companies like Google and Facebook.
  • A cellular network company has massive fixed costs and minimal marginal costs; one more minute of talk time costs practically nothing to provide, unless the network is saturated, at which point significant capital investment is necessary. Today’s internet services are similar: marginal usage is effectively free, although significant capital investments in data centers are necessary (as well as significant ongoing bandwidth costs, which are effectively zero to serve any one individual but huge in aggregate).
  • A cellular network company is, quite obviously, a network. That means the value of the service increases as the number of customers increases. This produces a powerful virtuous cycle in which new customers increase the value of the network such that it becomes attractive to new marginal customers, further increasing the value of the network for the next set of marginal customers; this “network effect” is the most common driver of the sort of “scalable advantage in customer acquisition costs” that I discussed in the case of Uber, and is a hallmark of Facebook in particular (but also Google and all of the aggregators).
  • Cellular network companies have direct relationships with their customers.

These four characteristics may seem familiar: they are all parts of Aggregation Theory, and I’ve written about each of those components in the two years since I first wrote about the theory.2 There is one more piece, though, that I have only mentioned in passing: zero transaction costs. This is the piece that apparently sets Facebook beyond Senator Warner’s understanding,3 and it is perhaps the key reason why Facebook and other aggregators are unlike any other company we have seen before; oh, and it explains this Russian ad buy.

Transaction Costs

Go back to the generic cellular network company I discussed above, and think about what is entailed in adding a new customer (and leaving aside the marketing expenditure to make them aware of and desirous of the service in the first place):

  • Talk with the customer on the phone or in person
  • Collect identifying details and run a credit check
  • Provision a SIM card and/or a phone
  • Receive payment
  • Manage contract renewals and cancellations and other customer service

While some of these activities could be automated, the reality is that the cost of customer management had a linear curve: more customers meant more costs. Moreover, these costs accumulated, limiting the natural size of any company; at some point the complexity of managing some finite number of customers across some finite number of geographic areas cost more than the marginal profit of adding one more customer, and that limited how big a company could grow (which, to be clear, could be very large indeed!).

What makes aggregators unique, though, is that thanks to the Internet they have zero transaction costs: for Google, or Airbnb, or Uber, or Netflix, or Amazon, or the online travel agents, adding one more customer is as simple as adding one more row in a database. Everything else is automated, from sign-up to billing to the delivery of the service in question. This is why all of these companies are global, often from day one, and, as I explained in Beyond Disruption, why they start at the high end of a market and work their way down.

Note that aggregators can deal with the physical world and still have zero transaction costs, at least on the consumer side: Airbnb deals with rooms, but bears no transaction costs when it comes to signing up new customers; Amazon and Uber are similar with regards to e-commerce and transportation, respectively. Netflix doesn’t deal in physical goods (beyond its old DVD business), although it does bear significant transaction costs when it comes to sourcing content (in addition to actually paying for the content), but when it comes to customers there are no marginal costs at all.

Facebook and Google, though are a special case: they are (and yes, I know this is the least imaginative term ever) super-aggregators.

Super-Aggregators

What makes Facebook and Google unique is that not only do they have zero transaction costs when it comes to serving end users, they also have zero transaction costs when it comes to both suppliers and advertisers.

Start with supply: not only is the vast majority of online content accessible to Google’s search engine (unsurprisingly, the biggest exception is Facebook), but in fact that content wants to be discovered by Google. Nearly every site on the web has a sitemap that is intended not for humans but for web crawlers, Google’s in particularly, and there is an entire industry dedicated to search engine optimization (SEO). Netflix is on the opposite side of the spectrum here (unlike YouTube, it should be noted): the company has to actively source content and pay for it. Uber and Airbnb and Amazon are in the middle: theoretically there is an open platform for suppliers but there are costs involved in bringing them online.

Facebook takes this to another level: its users are its most important content providers, and they do it for free. Professional content providers aren’t far behind, not only linking to all of their content but increasingly putting said content on Facebook directly (to the extent Facebook is paying for content it is to juice this cycle of self-interested content production on Facebook).

That said, there are a few more companies that have a similar content model: Twitter, Snapchat, LinkedIn, Yelp, etc. All run on user-generated content augmented by professional content placing links or original material on their services. However, there is still one more thing that separates Facebook and Google from the rest: advertisers.

Super-aggregators not only have zero transaction costs when it comes to users and content, but also when it comes to making money. This is at the very core of why Google and Facebook are so much more powerful than any of the other purely information-centric networks. The vast majority of advertisers on both networks never deal with a human (and if they do, it’s in customer support functionality, not sales and account management): they simply use the self-serve ad products like the one pictured above (or a more comprehensive tool built on the companies’ self-serve API).

This is the level that the other social networks have not reached: Twitter grew revenue, but primarily through its sales team, which meant that costs increased inline with revenue; the company never gained the leverage that comes from having a self-serve ad platform (specifically, the self-serve platform costs are fixed but the revenue is marginal).

Snap is following in Twitter’s footsteps: to date the vast majority of the company’s revenue has come from its sales team; the company has a perfunctory API for self-serve ads, but most of the volume springs from the aforementioned deals made by its sales team. Similar stories can be told about LinkedIn, Yelp, and other advertising-based businesses.

This, then, is a super-aggregator: zero transaction costs not just in terms of user acquisition, but also supply acquisition, and most importantly, revenue acquisition, and Google and Facebook are the ultimate examples.

Facebook and the Russians

This is why I was confused that Senator Warner made a big deal out of the fact Facebook was paid in Russian Rubles: the entire premise of the company’s revenue model is that anyone can run an ad without having to talk to another human, and obviously a key component of such a model is supporting multiple currencies.

Again, though, this is the first such model in economic history: it seems I am the one who was blinded by my having experienced the meaning of scale. In that Hotmail meeting everyone and everything was reduced to a number on a spreadsheet: the United States, Japan, Brazil, Russia, all were simply another row. So I naturally assume it is in the case of Facebook ads: that some advertisers buy in dollars, some in Yen, some in Real, others in Rubles is unremarkable to me, and, I suspect, many of the folks working at these companies.

And yet, it is not at all unrealistic that this be very remarkable to everyone else, even someone with the technical and business background of Senator Warner. It would immediately be eyebrow-raising should any of the companies he managed or was invested in suddenly started transacting in Russian Rubles! For a super-aggregator, though, it is not only unremarkable, it is the system working as designed.

This applies to the content of those ads, too: last week, when ProPublica reported that Facebook enabled anti-Semitic targeting, I told a friend that a similar story would come out about Google within a week; it only took one day. When you makes something frictionless — which is another way of describing zero transaction costs — it becomes easier to do everything, both good and evil.

Regulating the Super-Aggregators

This should probably be another article — indeed, it’s an article I’ve been working towards for a long time now — but this appreciation of what Super-Aggreagators are, and how it is a Russian propaganda outfit could buy Facebook ads that likely broke the law, gives insight into a number of principles that should guide people like Senator Warner as they consider potential regulation:

  • Don’t Force the Super-Aggregators to Make Editorial Decisions: It has been distressing to see how quickly some folks have resorted to insisting that Google and Facebook start having a point-of-view on content on their platforms. The problem is not that they might be effective, but rather that it is inevitable that they will be. I wrote in Manifestos and Monopolies:

    My deep-rooted suspicion of Zuckerberg’s manifesto has nothing to do with Facebook or Zuckerberg; I suspect that we agree on more political goals than not. Rather, my discomfort arises from my strong belief that centralized power is both inefficient and dangerous: no one person, or company, can figure out optimal solutions for everyone on their own, and history is riddled with examples of central planners ostensibly acting with the best of intentions — at least in their own minds — resulting in the most horrific of consequences; those consequences sometimes take the form of overt costs, both economic and humanitarian, and sometimes those costs are foregone opportunities and innovations. Usually it’s both.

    The best solution in my estimation is enforced neutrality; to the extent limitations are put in place they should be enforced by another entity with far more accountability to the people than either of these Super-Aggregators. That probably means the government (with the obvious caveat that authoritarian governments would certainly prefer to use Facebook for their own ends).

  • Focus on Transparency: The personalization afforded by Super-Aggregators means their advertising is simply not comparable to anything that has come before: television commercials, radio jingles, newspaper ads, all are publicly disseminated and thus can be tracked (the one possible exception is direct mail, which, unsurprisingly, has been the home of the foulest sort of political advertising in particular). Digital ads, on the other hand, can be shown to a designated audience without anyone else knowing. It is worth debating whether this level of secrecy should be allowed in general; it seems without question, in my mind, that it should not be allowed for political ads. Of course, that begs the question of what is a political ad, which again points towards regulation (which, per point one, is preferable to the unaccountable Google and Facebook deciding).

  • Remember the Benefits of Zero Transaction Costs: The biggest beneficiaries of zero transaction costs on the super-aggregators are not traditional advertisers, whether that be companies like CPG conglomerates or presidential campaigns. Both have the resources to advertise anywhere and everywhere, and indeed, often find that the fine-tooth targeting on super-aggregators isn’t worth the effort required. The folks that do benefit, though, are those that wouldn’t have a voice otherwise: startups and niche offerings, both in terms of business and politics. Google and Facebook have opened the field to far more entrants, and while that means there are more folks with bad intentions, there are also a whole lot more folks with ideas that were shut out by the significant transaction costs inherent in pre-Internet platforms.

There’s one final consideration that should apply to regulation, broadly: given that Google and Facebook are already well-established with businesses that serve users, suppliers, and advertisers in a virtuous cycle, it is unlikely that regulation of any kind will have meaningful effects on their bottom lines. Indeed, I expect Google and Facebook to be mostly cooperative with whatever regulation comes from these recent revelations.

Rather, the companies that will be hurt are those seeking to knock Google and Facebook off their perch; given that they are not yet super-aggregators, they will not have the feedback loops in place to overcome overly prescriptive regulation such that they can seriously challenge Google and Facebook.

For example, consider the much-touted General Data Protection Regulation (GDPR) set to take effect in the European Union next year. There is lot of excitement about how this regulation will limit Google and Facebook in particular, by, for example, limiting the use of personal data and enforcing data portability (and not just a PDF of your data — services will be required to build API access for easy export).

The reality, though, is that given that Google and Facebook make most of their money on their own sites, they will be hurt far less than competitive ad networks that work across multiple sites; that means that even more digital advertising money — which will continue to grow, regardless of regulation — will flow to Google and Facebook. Similarly, given that the data portability provisions explicitly exclude your social network — exporting your friends requires explicit approval from your friends — it will be that much harder to bootstrap a competitor.

This is the reality of regulation: as much as the largest incumbents may moan and groan, they are, in nearly all cases, the biggest beneficiaries. To be sure, that doesn’t mean regulation isn’t appropriate — it should be far more obvious to everyone that Russians were purchasing election-related ads on Facebook — but rather that it be expressly designed to limit the worst abuses and enable meaningful competitors, even if they accept payment in Russian Rubles.

  1. For what it’s worth, Stratechery has never actually taken out a Facebook ad, or any ad for that matter []
  2. Yes, I’m writing about Aggregation Theory again; I explain why I do so often here []
  3. Presuming his tweet was not as cynical as it very well might have been []

The Lessons and Questions of the iPhone X and the iPhone 8

It’s tempting — and easy — to be cynical about the richest company in the world beginning its annual unveiling of new products with what effectively amounted to a promotional video for a building custom-built at enormous expense for said unveiling, set to the soundtrack of John Lennon singing “All You Need is Love”.1


There’s nothing you can do that can’t be done
Nothing you can sing that can’t be sung
Nothing you can say but you can learn how to play the game
It’s easy

Nothing you can make that can’t be made
No one you can save that can’t be saved
Nothing you can do but you can learn how to be you in time
It’s easy

In fact, the song was perfect; the temptation to be cynical is right there in the first verse, with the observation that by virtue of doing or singing or making you are operating in the bounds of what is merely possible, no more. And yet, the second verse holds forth salvation: find yourself, and find fulfillment. After all, you are the only one that can accomplish that precise task.

After the song finished, with the stage saying nothing more than “Welcome to the Steve Jobs Theater,” a recording of the late Apple founder and two-time CEO made the same point:

There’s lots of ways to be as a person. And some people express their deep appreciation in different ways. But one of the ways that I believe people express their appreciation to the rest of humanity is to make something wonderful and put it out there. And you never meet the people, you never shake their hands, you never hear their story or tell yours, but somehow, in the act of making something with a great deal of care and love, something is transmitted there. And it’s a way of expressing to the rest of our species our deep appreciation. So we need to be true to who we are, and remember what’s really important to us. That’s what is going to keep Apple Apple, if we keep us us.

I don’t know when Jobs said those words, but one of the most compelling examples of what he meant was, by definition, yet to come. My mind immediately went to the days after Jobs passed away in October 2011:

Spontaneously, all over the world, makeshift memorials, usually around Apple Stores, sprang up to honor someone whom, to paraphrase Jobs, they never met, whose hand they never shook, who never heard their story — and frankly, had they met Jobs, they very well might have regretted the experience!

That, though, was Jobs’ point: the stories of his mistreatment of those closest to him, both professional and deeply personal, reveal the man’s weaknesses; I see no need and have no desire to whitewash them. The company he built and the products that engendered such a deep emotional attachment in their owners, though, captured his strengths — and Apple’s customers felt his appreciation. You might call it love.

To return to Lennon’s words, Jobs, particularly in his second stint at Apple, had learned how to be himself: less designer than editor-in-chief, Jobs not only drove those he worked with to create “with great deal of care”, he also set Apple on a path towards being its best self. That, famously, means the integration of hardware and software, but at least in the case of the iPhone, the pertinent integration goes down to the silicon.

To that end, the products Apple unveiled at the new Steve Jobs Theater could not have been more appropriate: a cellular watch significantly smaller than competitors with comparable battery life, a new iPhone 8 improved in virtually every dimension, and, of course, the iPhone X, with nearly every new feature dependent on that integration.2

About That Notch

Apple clearly decided to not minimize the notch, the black cut-out at the top of the iPhone X that houses an array of sensors and cameras. If anything, the company went out of its way to emphasize it, including playing video such that the notch obscured what was being shown (that is actually an optional view; by default video is letter-boxed such that it avoids the notch).

I think the emphasis on the notch served another purpose, though: it is, in its own way, something that only Apple can do.3 First, the operating system needed to be modified to work around the notch. Only Apple has sufficient control of the entire stack that they can pull off such a radical overhaul in software to accommodate the change in hardware. Second, applications will need to be reworked to look their best; thousands of developers are hard at work today doing just that, because the iOS ecosystem is so valuable.

Moving beyond the notch, Apple is also demonstrating its power over users; using an iPhone X is going to be significantly different than any other previous iPhone. Everything has changed, from unlocking the phone to invoking Siri to exiting apps to multi-tasking to Apple Pay. And yet there is little doubt that millions will do just that (and, naturally, insist that the new way is obviously better).

What is and remains so brilliant about the iPhone specifically and Apple’s business broadly is how everything is aligned around Apple being the Apple Jobs envisioned: a company that shows its “appreciation to the rest of humanity [by making] something wonderful and put[ting] it out there.” By making the best products Apple earns loyal customers willing to pay a premium; loyal customers give Apple both freedom to make large scale changes and also a point of leverage against partners like carriers and developers. And then, the resultant profits lets Apple buy the small companies and do the R&D to create the next set of products.

This has been the story of the iPhone: for ten years every single model has been a meaningful jump over the previous one, giving Apple a stranglehold on the top of the market. There was no further segmentation needed: the smartphone market was growing around the world, and Apple was taking the premium part. Indeed, the company’s one misstep — 2013’s iPhone 5C — came from a misguided attempt to go downmarket.

The iPhone 5C

“Misstep” is perhaps a bit harsh. What we know about the iPhone 5C is this: in 2013 Apple was under tremendous external pressure, not just in the press but especially on Wall Street4, to produce a lower-cost iPhone. Most analysts were convinced the company had not just saturated the high end but was in imminent danger of being disrupted by cheaper good-enough Android phones5, and speculation was rampant that Apple would release a new iPhone at a significantly lower price point.

Apple went the other way; in one of my favorite Apple keynotes, the company stuck to the high end. The iPhone 5C was cheaper than the 5S, announced on the same day, but only by $100; it was effectively a replacement for the iPhone 5 in terms of Apple’s previous practice of selling previous iPhones at a lower price.

Still, I for one thought it would sell very well; all indications are that Apple agreed, but it quickly became apparent that customers overwhelmingly preferred the iPhone 5S. Apple struggled to keep the latter in stock, having produced far too many 5Cs, and the model was quietly discontinued two years later. I wrote at the time:

The problem with the 5C, though, is that it wasn’t an iPhone. Well, technically it was — it was made by Apple, after all — but particularly in Asia, and especially in China, an iPhone is about more than even the hardware and software that Apple is so proud of integrating. It is the device to own for emerging upper middle class consumers, and what is brilliant about the sell-old-flagship-iPhones strategy is that it allows the cheaper iPhones to punch above their weight: after all, that iPhone 5S you pull out of your pocket and casually place on the table may be brand new today (because you can only afford $450), or you may simply have not yet replaced the iPhone you bought at full price when it came out. Regardless, you have a flagship; the 5C, on the other hand, was from day one not the flagship, and quite obvious about it (one is reminded of Jony Ive calling it “unapologetically plastic”). To buy a 5C was to show you couldn’t afford a better one.

The 5C’s failure, such that it was, showed that the iPhone had three distinct markets:

  • Customers who wanted the best possible phone. They bought the 5S.
  • Customers who wanted the prestige of owning the highest-status phone on the market. Heavily concentrated in China, they bought the gold 5S.
  • Customers who aspire to owning a top-of-the-line iPhone, but couldn’t afford one. They bought the 4S instead of the 5C.

What was missing was the cost-conscious customer; the truth is that if price is the priority an Android phone will always win. By 2013 even the cheapest phones were “good enough”; only people who cared about owning an iPhone would pay more,6 and if they were going to pay more of course they wanted the best, or at least a phone that gave off the prestige of having been the best at some point in time.

More Lessons Learned

A year later Apple (finally) released two iPhones with significantly larger screens: the iPhones 6 and 6 Plus. The response was incredible: iPhone sales jumped a staggering 45% year-over-year. That, though, made the iPhone 6S a much tougher sale. It became clear that Apple had pulled forward some number of upgraders to the iPhone 6, even as other customers held onto their good-enough phones for longer.

The iPhone 7 cemented this view: growth returned inline with models that presumed that the iPhone 6 pulled forward upgrades in an increasingly saturated market; Apple was no longer benefiting from overall smartphone growth, but the company also wasn’t losing customers to Android — if anything, it was gaining them.

The one exception was China. As I noted in Apple’s China Problem, the iPhone was growing all over the world but shrinking in China, and I blamed WeChat:

WeChat works the same on iOS as it does on Android. That, by extension, means that for the day-to-day lives of Chinese there is no penalty to switching away from an iPhone. Unsurprisingly, in stark contrast to the rest of the world, according to a report earlier this year only 50% of iPhone users who bought another phone in 2016 stayed with Apple:

This is still better than the competition, but compared to the 80%+ retention rate Apple enjoys in the rest of the world, it is shockingly low, and the result is that the iPhone has slid down China’s sales rankings: iPhone sales were only 9.6% of the market last year, behind local Chinese brands like Oppo, Huawei and Vivo. All of those companies sold high-end phones of their own; the issue isn’t that Apple was too expensive, it’s that the iPhone 6S and 7 were simply too boring.

There was one more lesson learned from the iPhone 7: for the first time Apple raised prices. Specifically, the iPhone 7 Plus was $769, $20 more than the iPhone 6S Plus at launch; the iPhone 7 pricing was identical to the iPhone 6S ($650). Theoretically this should have curbed demand for the 7 Plus, but the opposite happened: Apple sold more 7 Pluses relative to the 7 than they did 6S Pluses relative to the 6S. To be clear, I don’t think they sold more because of the price change; rather, consumer preferences continued to move towards bigger phones and, at least for an iPhone buyer, price simply isn’t the top priority.

Apple’s New iPhone Strategy

Forgive the long-winded history of the iPhone, but I think it is critical to understand Apple’s thinking when it comes to this year’s announcements; I think all of the lessons I referenced above influenced this lineup:

Start at the top. The iPhone X sells to two of the markets I identified above:

  • Customers who want the best possible phone
  • Customers who want the prestige of owning the highest-status phone on the market

Note that both of these markets are relatively price-insensitive; to that end, $999 (or, more realistically, $1149 for the 256 GB model), isn’t really an obstacle. For the latter market, it’s arguably a positive.

The iPhone 8 (and 8 Plus), meanwhile, serves the slow and steady markets that bought the iPhone 7: previous iPhone owners upgrading and Android switchers. Critically, the iPhone 8 also serves those folks who aspire to an iPhone. No, they can’t afford an iPhone 8, but the iPhone 6S they can afford looks almost exactly the same, and in a few years the iPhone 8 will still be viewed as a once-flagship (the SE, meanwhile, deliberately apes the shape of the once-flagship 5S). Oh, and by the way, Apple is raising the price on the 8 as well: if price isn’t the chief factor, how far can you go?

Apple’s Risk

That said, I think Apple is taking a pretty significant risk with the iPhone 8 in particular: we know the company can succeed by selling the “best” phone, but the one example we have of building a less-than-best phone was underwhelming; to that end, how many iPhone buyers will forgo the 8 to wait for the X?

In some respects this is a good problem to have — customers wanting to give you more money for a more expensive phone — but the fact the iPhone X is not launching until November suggests it is well behind in production, which further suggests supply will be limited for some time to come. It is quite possible that Apple’s fiscal Q12018 results will be depressed by limited supply.

Of course this is a short-term problem; I do expect the iPhone X to be a massive hit in China in particular. Indeed, I wouldn’t be surprised if most of the early iPhone X supply were earmarked for the country. My argument about WeChat’s effect on Apple is that it elevates the importance of fresh hardware designs over iOS when it comes to iPhone sales; iPhone X is as fresh as it gets.


There’s one more verse in Lennon’s song:


Nothing you can know that isn’t known
Nothing you can see that isn’t shown
Nowhere you can be that isn’t where you’re meant to be
It’s easy

I have to disagree: I don’t know if Apple can segment the iPhone market; what has been shown is that they can’t, that the iPhone can only be the best, nothing less.

That is why I find this launch so fascinating, and will be watching the upcoming quarter’s results so closely: Jobs built Apple to be the best, and the company has succeeded by being exactly that. Does that foreclose the possibility of also being really good, and the gains from market segmentation that follow?

  1. Unfortunately, the video of the event no longer includes the opening with The Beatles song; you’ll have to take my word for it []
  2. I will cover all aspects of Apple’s keynote in tomorrow’s Daily Update []
  3. Other phones, like the Essential Phone, do have a much smaller cutout; the operating system isn’t re-worked to the degree the iOS is for the iPhone X, though, nor will developers put in special work []
  4. The stock had fallen to $55.79 in April 2013, nearly half the price of a year earlier []
  5. In a fortuitous coincidence, I started Stratechery in 2013, and I got a lot of early traction by arguing that Apple was fine []
  6. I’m generalizing here; some customers genuinely prefer Android and primarily bought Samsung; Apple dominated the high end though []