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  • AT&T, Time Warner, and the Need for Neutrality

    The first thing to understand about the decision by a federal judge to approve AT&T’s acquisition of Time Warner, over the objection of the U.S. Department of Justice, is that it is very much in-line with the status quo: this is a vertical merger, and both the Department of Justice and the courts have defaulted towards approving such mergers for decades.1

    Second, that there is an explosion of merger activity in and between the television production and distribution space is hardly a surprise: the Multichannel Video Programming Distributor (MVPD) business — that is, television distributed by cable, broadband, or satellite — has been shrinking for years now, and in a world where the addressable market is decreasing, the only avenues for growth are winning share from competitors, acquiring competitors, or vertically integrating.

    Third, that last paragraph overstates the industry’s travails, at least in terms of television distribution, because most TV distributors are also internet service providers (ISPs), which means they are getting paid by consumers using the services disrupting MVPDs, including Netflix, Google, Facebook, and the Internet generally.

    What was both unsurprising and yet odd about this case was the degree to which it was fought over point number two, with minimal acknowledgement of point number three. That is, it seems clear to me that AT&T made this acquisition with an eye on point number three, yet the government’s case was predicated on point number two; to that end, the government, in my eyes, rightly lost given the case they made. Whether they should have lost a better case is another question entirely.

    Why AT&T Bought Time Warner

    What is the point of a merger, instead of a contract? This is a question that always looms large in any acquisition, particularly one of this size: AT&T is paying $85 billion for Time Warner, and that’s an awfully steep price to simply hang out with movie stars.

    The standard explanation for most mergers is “synergies”, the idea that there are significant cost savings from combining the operations of two companies; the reason this explanation is popular is because saving money is not an issue for antitrust, while the corresponding possibility — charging higher prices by achieving a stronger market position through consolidation — is. Such an explanation, though, is usually applied in the case of a horizontal merger, not a vertical one like AT&T and Time Warner.

    To that end, AT&T was remarkably honest in its press release announcing the merger back in 2016:2

    “With great content, you can build truly differentiated video services, whether it’s traditional TV, OTT or mobile. Our TV, mobile and broadband distribution and direct customer relationships provide unique insights from which we can offer addressable advertising and better tailor content,” [AT&T CEO Randall] Stephenson said. “It’s an integrated approach and we believe it’s the model that wins over time…

    AT&T expects the deal to be accretive in the first year after close on both an adjusted EPS and free cash flow per share basis…Additionally, AT&T expects the deal to improve its dividend coverage and enhance its revenue and earnings growth profile.

    Start with the second point: as I noted at the time, it’s not very sexy, but it matters to AT&T, a 34-year member of the Dividend Aristocrats, that is, a company in the S&P 500 that raised its dividend for 25 years straight or more. It’s a core part of AT&T’s valuation, but the company’s free cash flow has been struggling to keep up with its rising dividends. Time Warner will help significantly in this regard, as did the previous acquisition of DirecTV.

    It is the first point, though, that is pertinent to this analysis: how exactly might Time Warner allow AT&T to “build truly differentiated video services”?

    The Government’s Case

    While the AT&T press release noted that those “truly differentiated video services” could be delivered via traditional TV, OTT, or mobile, the government’s case was entirely concerned with traditional TV. The original complaint stated:

    Were this merger allowed to proceed, the newly combined firm likely would — just as AT&T/DirecTV has already predicted — use its control of Time Warner’s popular programming as a weapon to harm competition. AT&T/DirecTV would hinder its rivals by forcing them to pay hundreds of millions of dollars more per year for Time Warner’s networks, and it would use its increased power to slow the industry’s transition to new and exciting video distribution models that provide greater choice for consumers. The proposed merger would result in fewer innovative offerings and higher bills for American families.

    The idea is that AT&T could leverage its ownership of DirecTV to demand higher prices for Turner networks from other MVPDs, because if the MVPDs refused to pay customers would be driven to switch to DirectTV. The problem is that, as was easily calculable, this makes no economic sense: the amount of money AT&T would lose by blacking out Turner would almost certainly outweigh whatever gains it might accrue. The judge agreed, and that was that.

    AT&T’s Real Goals

    Remember, though, that AT&T did not limit its options to traditional TV: what is far more compelling are the possibilities Time Warner content presents for OTT and mobile. The question is not what AT&T can do to increase the revenue potential of Time Warner content (which was the government’s focus), but rather what Time Warner content can do to increase the potential of AT&T’s services, particularly mobile.

    Forgive the long excerpt, but I covered this angle at length in a Daily Update when the deal was announced:

    AT&T’s core wireless business is competing in a saturated market with few growth prospects. Apple’s gift to the wireless industry of customers demanding high-priced data plans has largely run its course, with AT&T perhaps the biggest winner: the company acquired significant market share even as it increased its average revenue per user for nearly a decade, primarily thanks to the iPhone. Now, though, most everyone has a smartphone and, more pertinently, a data plan…

    The implication of a saturated market is that growth is increasingly zero sum, which presents both a problem and an opportunity for AT&T. The problem is primarily T-Mobile: fueled by the massive break-up fee paid by AT&T for the aforementioned failed acquisition, T-Mobile has embarked on an all-out assault against the incumbent wireless carriers, and AT&T has felt the pain the most, recording a negative net change in postpaid wireless customers for eight straight quarters. Unable or unwilling to compete with T-Mobile on price, AT&T needs a differentiator, ideally one that will not only forestall losses but actually lead to gains.

    At first glance this doesn’t explain the Time Warner acquisition either: per my point above these are two very different companies with two very different strategic views of content. A distributor in a zero-sum competition for subscribers (like AT&T) has a vertical business model: ideally there should be services and content that are exclusive to the distributor, thus securing customers. Time Warner, though, is a content company, which means it has a horizontal business model: content is made once and then monetized across the broadest set of potential customers possible, taking advantage of content’s zero marginal cost. The assumption of this sort of horizontal business model underlay Time Warner’s valuation; to suddenly make Time Warner’s content exclusive to AT&T would be massively value destructive (this is a reality often missed by suggestions that Apple, for example, should acquire content companies to differentiate its hardware).

    AT&T, however, may have found a loophole: zero rating. Zero rating is often conflated with net neutrality, but unlike the latter, zero rating does not entail the discriminatory treatment of data; it just means that some data is free (sure, this is a violation of the idea of net neutrality, but this is why I was critical of the narrow focus on discriminatory treatment of data by net neutrality advocates). AT&T is already using zero rating to push DirecTV:

    This is almost certainly the plan for Time Warner content as well: sure, it will continue to be available on all distributors, but if you subscribe to AT&T you can watch as much as you want for free; moreover, this offering is one that is strengthened by secular trends towards cord-cutting and mobile-only video consumption. If those trends continue on their current path AT&T will not only strengthen the moat of its wireless service against T-Mobile but maybe even start to steal share.

    That this point never came up in the government’s case, and, by extension, the judge’s ruling, is truly astounding.

    That noted, it is very fair to wonder why exactly the Department of Justice sued to block this acquisition: President Trump was very outspoken in his opposition to this deal and even more outspoken in his antipathy towards Time Warner-owned CNN. At the same time, Makan Delrahim, the Assistant Attorney General for Antitrust who led the case, didn’t see a problem with the merger before his appointment. That the government’s complaint rested on both the most obvious angle and, from AT&T’s perspective, the least important, suggests a paucity of rigor in the prosecution of this case; it is very reasonable to wonder if the order to oppose the merger came from the top, and that the easiest case was the obvious out.

    The Neutrality Solution

    Thus we are in the unfortunate scenario where a bad case by the government has led to, at best, a merger that was never examined for its truly anti-competitive elements, and at worst, bad law that will open the door for similar tie-ups. To be sure, it is not at all clear that the government would have won had they focused on zero rating: there is an obvious consumer benefit to the concept — that is why T-Mobile leveraged it to such great effect! — and the burden would have been on the government to show that the harm was greater.

    The bigger issue, though, is the degree to which laws surrounding such issues are woefully out-of-date. Last fall I argued that Title II was the wrong framework to enforce net neutrality, even though net neutrality is a concept I absolutely support; I came to that position in part because zero rating was barely covered by the FCC’s action.3

    What is clearly needed is new legislation, not an attempt to misapply ancient regulation in a way that is trivially reversible. Moreover, AT&T has a point that online services like Google and Facebook are legitimate competitors, particularly for ad dollars; said regulation should address the entire sector. To that end I would focus on three key principles:

    • First, ISPs should not purposely slow or block data on a discriminatory basis. I am not necessarily opposed to the concept of “fast lanes”, as I believe that offers significant potential for innovative services, although I recognize the arguments against them; it should be non-negotiable, though, that ISPs cannot purposely disfavor certain types of content.
    • Second, and similarly, dominant internet platforms should not be allowed to block any legal content from their services. At the same time, services should have discretion in monetization and algorithms; that anyone should be able to put content on YouTube, for example, does not mean that one has a right to have Google monetize it on their behalf, or surface it to people not looking for it.
    • Third, ISPs should not be allowed to zero-rate their own content, and platforms should not be allowed to prioritize their own content in their algorithms. Granted, this may be a bit extreme; at a minimum there should be strict rules and transparency around transfer pricing and a guarantee that the same rates are allowed to competitive services and content.

    The reality of the Internet, as noted by Aggregation Theory, is increased centralization; meanwhile, the impact on the Internet on traditional media is an inexorable drive towards consolidation. Our current laws and antitrust jurisprudence are woefully unprepared to deal with this reality, and a new law guaranteeing neutrality is the best solution.

    1. Whether or not the presumption that vertical mergers are not anti-competitive is a worthwhile, albeit separate, discussion ↩

    2. To be fair, the company also mentioned synergies, but it was hardly the point of the press release. ↩

    3. The FCC said it would take it case-by-case, and did argue in the waning days of the Obama administration that zero rating one’s own services as AT&T is clearly trying to do was a violation, but that was never tested in court and was quickly rolled back ↩

  • The Scooter Economy

    As I understand it, the proper way to open an article about electric scooters is to first state one’s priors, explain the circumstances of how one came to try scooters, and then deliver a verdict. Unfortunately, that means mine is a bit boring: while most employing this format wanted to hate them,1 I was pretty sure scooters would be awesome — and they were!2

    For me the circumstances were a trip to San Francisco; I purposely stayed at a hotel relatively far from where most of my meetings were, giving me no choice but to rely on some combination of scooters, e-bikes, and ride-sharing services. The scooters were a clear winner: fast, fun, and convenient — as long as you could find one near you. The city needs five times as many.

    So, naturally, San Francisco banned them, at least temporarily: companies will be able to apply for their share of a pool of a mere 1,250 permits; that number may double in six months, but for now the scooter-riding experience will probably be more of a novelty, not something you can rely on. In fact, by the end of my trip, if I were actually in a rush, I knew to use a ride-sharing service.

    It’s no surprise that ride-sharing services have higher liquidity: San Francisco is a car-friendly town. The city has a population of 884,363 humans and 496,843 vehicles, mostly in the city’s 275,000 on-street parking spaces. Granted, most of the Uber and Lyft drivers come from outside the city, but there is no congestion tax to deter them.

    The result is an urban area stuck on a bizarre local maxima: most households have cars, but rarely use them, particularly in the city, because traffic is bad and parking is — relative to the number of cars — sparse; the alternative is ride-sharing, which incurs the same traffic costs but at least doesn’t require parking. And yet, San Francisco, for now anyways, will only allow about 60 parking spaces-worth of scooters onto the streets.

    Everything as a Service

    This is hardly the forum to discuss the oft-head-scratching politics of tech’s de facto capital city, and I can certainly see the downside of scooters, particularly the haphazard way with which they are being deployed; in an environment built for cars scooters get in the way.

    It’s worth considering, though, just how much sense dockless scooters make: the concept is one of the purest manifestations of what I referred to in 2016 as Everything as a Service:

    What happens, though, if we apply the services business model to hardware? Consider an airplane: I fly thousands of miles a year, but while Stratechery is doing well, I certainly don’t own my own plane! Rather, I fly on an airplane that is owned by an airline that is paid for in part through some percentage of my ticket cost. I am, effectively, “renting” a seat on that airplane, and once that flight is gone I own nothing other than new GPS coordinates on my phone.

    Now the process of buying an airplane ticket, identifying who I am, etc. is far more cumbersome than simply hopping in my car — there are significant transaction costs — but given that I can’t afford an airplane it’s worth putting up with when I have to travel long distances. What happens, though, when those transaction costs are removed? Well, then you get Uber or its competitors: simply touch a button and a car that would have otherwise been unused will pick you up and take you where you want to go, for a price that is a tiny fraction of what the car cost to buy in the first place. The same model applies to hotels — instead of buying a house in every city you visit, simply rent a room — and Airbnb has taken the concept to a new level by leveraging unused space.

    The enabling factor for both Uber and Airbnb applying a services business model to physical goods is your smartphone and the Internet: it enables distribution and transactions costs to be zero, making it infinitely more convenient to simply rent the physical goods you need instead of acquiring them outright.

    What is striking about dockless scooters — at least when one is parked outside your door! — is that they make ride-sharing services feel like half-measures: why even wait five minutes, when you can just scan-and-go? Steve Jobs described computers as bicycles of the mind; now that computers are smartphones and connected to the Internet they can conjure up the physical equivalent as well!

    Indeed, the only thing that could make the experience better — for riders and for everyone else — would be dedicated lanes, like, for example, the 900 miles worth of parking spaces in San Francisco. To be sure, the city isn’t going to make the conversion overnight, or, given the degree to which San Francisco is in thrall to homeowners, probably ever, but that is particularly a shame in 2018: venture capitalists are willing to fund the entire thing, and I’m not entirely sure why.

    Missing Moats

    Late last month came word that Sequoia Capital was leading a $150 million funding round for Bird, one of the electric scooter companies, valuing the company at $1 billion; a week later came reports that GV was leading a $250 million investment in rival Lime.

    One of the interesting tidbits in Axios’s reporting on the latter was that each Lime scooter is used on average between 8 and 12 times a day; plugging that number into this very useful analysis of scooter-sharing unit costs suggests that the economics of both startups are very strong (certainly the size of the investments — and the quality of the investors — suggests the same).

    The key word in that sentence, though, is “both”: what, precisely, might make Bird and Lime, or any of their competitors, unique? Or, to put it in business parlance, where is the moat? This is where the comparison to ride-sharing services is particularly instructive; I explained back in 2014 why there was more of a moat to be had in ride-sharing than most people thought:

    • There is a two-sided network between drivers and riders
    • As one service gains share, its increased utility of drivers will restrict liquidity on the other service, favoring the larger player
    • Riders will, all things being equal, use one service habitually

    This leads to winner-take-all dynamics in a particular geographic area; then, when it comes times to launch in new areas, travelers and brand will give the larger service a head start.

    To be sure, these interactions are complicated, and not everything is equal (see, for example, the huge amounts of share Lyft took last year thanks to Uber’s self-inflicted crises). It is that complication, though, and the fact it is exponentially more difficult to build a two-sided network (instead of, say, plopping a bunch of scooters on the street), that creates the conditions for a moat: the entire point of a moat is that it is hard to build.

    Uber’s Self-Driving Mistake

    This is why I have long maintained that the second-biggest mistake3 former Uber CEO Travis Kalanick made was the company’s head-first plunge into self-driving cars. On a surface level, the logic is obvious: Uber’s biggest cost is the driver, which means getting rid of them is an easy route to profitability — or, should someone else deploy self-driving cars first, then Uber could be undercut in price.

    The mistake in Kalanick’s thinking is two-fold:

    • First, up-and-until the point that self-driving cars are widely available — that is, not simply invented, but built-and-deployed at scale — Uber’s drivers are its biggest competitive advantage. Kalanick’s public statements on the matter hardly evinced understanding on this point.
    • Second, bringing self-driving cars to market would entail huge amounts of capital investment. For one, this means it would be unlikely that Google, a company that rushes to reassure investors when it loses tens of basis points in margin, would do so by itself, and for another, whatever companies did make such an investment would be highly incentivized to maximize utilization of said investment as soon as possible. That means plugging into the dominant transportation-as-a-service network, which means partnering with Uber.

    My contention is that Uber would have been best-served concentrating all of its resources on its driver-centric model, even as it built relationships with everyone in the self-driving space, positioning itself to be the best route to customers for whoever wins the self-driving technology battle.

    Uber’s Second Chance

    Interestingly, scooters and their closely-related cousin, e-bikes, may give Uber a second chance to get this right. Absent two-sided network effects, the potential moats for, well, self-riding scooters and e-bikes are relatively weak: proprietary technology is likely to provide short-lived advantages at best, and Bird and Lime have plenty of access to capital. Both are experimenting with “charging-sharing”, wherein they pay people to charge the scooters in their homes, but both augment that with their own contractors to both charge vehicles and move them to areas with high demand.

    What remains under-appreciated is habit: your typical tech first-adopter may have no problem checking multiple apps to catch a quick ride, but I suspect most riders would prefer to use the same app they already have on their phone. To that end, there is certainly a strong impetus for Bird and Lime to spread to new cities, simply to get that first-app-installed advantage, but this is where Uber has the biggest advantage of all: the millions of people who already have the Uber app.

    To that end, I thought Uber’s acquisition of Jump Bikes was a good idea, and scooters should be next (an acquisition of Bird or Lime may already be too pricey, but Jump has a strong technical team that should be able to get an Uber-equivalent out the door soon). The Uber app already handles multiple kinds of rides; it is a small step to handling multiple kinds of transportation — a smaller step than installing yet another app.

    More Tech Surplus

    More generally, in a world where everything is a service, companies may have to adapt to shallower moats than they may like. If you squint, what I am recommending for Uber looks a bit like a traditional consumer packaged goods (CPG) strategy: control distribution (shelf-space | screen-space) with a few dominant products (e.g. TIDE | UberX) that provide leverage for new offerings (e.g. Swiffer | Jump Bikes). The model isn’t nearly as strong, but there may be other potential lock-ins, particularly in terms of exclusive contracts with cities and universities.

    Still, that is hardly the sort of dominance that accrues to digital-only aggregators like Facebook or Google, or even Netflix; the physical world is much harder to monopolize. That everything will be available as a service means a massive increase in efficiency for society broadly — more products will be available to more people for lower overall costs — even as the difficulty in digging moats means most of that efficiency becomes consumer surplus. And, as long as venture capitalists are willing to foot the bill, cities like San Francisco should take advantage.

    I wrote a follow-up to this article in this Daily Update.

    1. That article is perhaps more revealing than the author appreciated ↩

    2. Note: this article is going to focus on San Francisco for simplicity’s sake, although the broader points have nothing to do with San Francisco specifically; I am aware that the transportation situation is different in different cities — I do live in a different country, after all, in a city with fantastic public transportation and a plethora of personal transportation options. ↩

    3. The first was not buying Lyft ↩

  • The Cost of Developers

    Yesterday saw three developer-related announcements, two from Apple, and one from Microsoft. The former came as part of Apple’s annual Worldwide Developers Conference keynote:

    • The iOS App Store, which turns 10 next month, serves 500 million weekly visitors, and as of later this week will have earned developers over $100 billion.
    • Sometime next year developers will be able to write apps for the Mac using iOS user interface frameworks (known as UIKit).

    Microsoft, meanwhile, for the second time in three years, outshone Apple’s keynote with a massive acquisition. From the company’s press release:

    Microsoft Corp. on Monday announced it has reached an agreement to acquire GitHub, the world’s leading software development platform where more than 28 million developers learn, share and collaborate to create the future. Together, the two companies will empower developers to achieve more at every stage of the development lifecycle, accelerate enterprise use of GitHub, and bring Microsoft’s developer tools and services to new audiences.

    “Microsoft is a developer-first company, and by joining forces with GitHub we strengthen our commitment to developer freedom, openness and innovation,” said Satya Nadella, CEO, Microsoft. “We recognize the community responsibility we take on with this agreement and will do our best work to empower every developer to build, innovate and solve the world’s most pressing challenges.”

    Under the terms of the agreement, Microsoft will acquire GitHub for $7.5 billion in Microsoft stock.

    Developers can be quite expensive indeed!

    Platform-Developer Symbiosis

    Over the last few weeks, particularly in The Bill Gates Line, I have been exploring the differences between aggregators and platforms; while aggregators generally harvest already produced content or goods, developers leverage the platform to create something entirely new.

    Platforms facilitate while aggregators intermediate

    This results in a symbiosis between developers and platforms: from a technical perspective, platforms provide the fundamental building blocks (i.e. application program interfaces, or APIs) necessary for developers to build new experiences, and from a marketing perspective, those new experiences give customers a reason to buy the platform in the first place, or to upgrade.

    The degree to which applications drive adoption of the underlying platform can, of course, vary; unsurprisingly the monetization potential of the platform relative to developers varies in a correlated way. Traditional Windows, for example, provided very little end user functionality; what made it so valuable were all of the applications built on top of its open platform.

    Windows was an open platform

    Here “open” means two things: first, the Windows API was available to anyone to build on, and two, developers built relationships directly with end users, including payment. This led to many huge software companies and, in 2003, to the creation of a platform on top of Windows: Valve’s Steam.

    What Valve realized is that playing a game is only one part of the overall customer experience; the experience of discovering and buying the game matters as well, as does the installation and upgrade process. Moreover, these customer pain points were developer pain points as well; the original impetus to develop Steam, for example, was the difficulty in getting players to upgrade en masse, something that was essential for games in which players competed online. And, while Valve is a private company and has never announced Steam’s revenue numbers, reports suggest the platform generates billions of dollars a year.

    Even that, though, pales in comparison to the iOS App Store: Apple took Steam’s app store idea and integrated it with the platform, such that iOS users and developers had no choice but to use Apple’s owned-and-operated distribution channel, with all of the various limitations and costs — 30%, to be precise — that that entailed.

    The iPhone platform with an intermediation layer

    Apple was able to accomplish this first and foremost because the underlying products — the iPhone and iPad — inspired demand in their own right, independent of applications. Apple had the users that developers needed to make money.

    Second, the App Store, like Steam before it, really was a better experience that drove more downloads and purchases by end users. This meant that developing for iOS wasn’t simply attractive because of the number of users, but also because those users were willing to buy more than they would have on another platform.

    Third — and this applies to Steam as well — the App Store dramatically lowered the barriers to entry for developers; this led to more apps, which attracted more users, which led to more apps, both locking in apps as a competitive advantage and also ensuring that no one app had outsized power (leaving Apple free to restrict Steam-like competitors by fiat).

    Apple’s Platform Announcements

    This frames the two Apple announcements I noted above. Start with the news of $100 billion for iOS developers: that means that Apple has collected around $40 billion, and at a very high margin to boot.

    Moreover, the vast majority of Apple’s announcements were, if anything, about competing with those developers: the first new app announced, Measure, should immediately wipe out the only obviously useful Augmented Reality apps in the store. Apple also announced a new Podcasts app for Watch, update News, Stocks, and Voice Memo apps, and the only third party demos were about how one of the largest software companies there is — Adobe — would be supporting Apple’s preferred 3D-image format. And why not! The implication of owning all of those high-value users is that, on iOS anyways, developers are cheap.

    The Mac, though, is a different story: the platform is far smaller than the iPhone; that there remain a number of high quality independent software vendors supporting the Mac is a testament to how valuable it is for developers to be able to build direct relationships with customers that can span years and multiple transactions. Still, there seems little question that the number of Mac apps is, if not trending in the wrong direction, certainly not growing in any meaningful way; there simply aren’t enough users to entice developers.

    That means Apple’s approach has to be very different from iOS: instead of dictating terms to developers, Apple announced that it is in the middle of a multi-year project to make it easier to port iOS apps to the Mac. This is, in a fashion, Apple paying for Mac apps; no, the money isn’t going to developers, but Apple is voluntarily taking on a much greater portion of the porting workload. Developers are much more expensive when you don’t have nearly as many users.

    The Cost of GitHub

    Still, whatever it is costing Apple to build this porting framework, it surely is a lot less than $7.5 billion, the price Microsoft is paying for GitHub. Then again, at first glance, it may not be clear what the point of comparison is.

    Go back to Windows: Microsoft had to do very little to convince developers to build on the platform. Indeed, even at the height of Microsoft’s antitrust troubles, developers continued to favor the platform by an overwhelming margin, for an obvious reason: that was where all the users were. In other words, for Windows, developers were cheap.

    That is no longer the case today: Windows remains an important platform in the enterprise and for gaming (although Steam, much to Microsoft’s chagrin, takes a good amount of the platform profit there), but the company has no platform presence in mobile, and is in second place in the cloud. Moreover, that second place is largely predicated on shepherding existing corporate customers to cloud computing; it is not clear why any new company — or developer — would choose Microsoft.

    This is the context for thinking about the acquisition of GitHub: lacking a platform with sufficient users to attract developers, Microsoft has to “acquire” developers directly through superior tooling and now, with GitHub, a superior cloud offering with a meaningful amount of network effects. The problem is that acquiring developers in this way, without the leverage of users, is extraordinarily expensive; it is very hard to imagine GitHub ever generating the sort of revenue that justifies this purchase price.

    Again, though, GitHub revenue is not the point; Microsoft has plenty of revenue. What it also has is a potentially fatal weakness: no platform with user-based leverage. Instead Microsoft is betting that a future of open-source, cloud-based applications that exist independent of platforms will be a large-and-increasing share of the future, and that there is room in that future for a company to win by offering a superior user experience for developers directly, not simply exerting leverage on them.

    This, by the way, is precisely why Microsoft is the best possible acquirer for GitHub, a company that, having raised $350 million in venture capital, was possibly not going to make it as an independent entity. Any company with a platform with a meaningful amount of users would find it very hard to resist the temptation to use GitHub as leverage; on the other side of the spectrum, purely enterprise-focused companies like IBM or Oracle would be tempted to wring every possible bit of profit out of the company.

    What Microsoft wants is much fuzzier: it wants to be developers’ friend, in large part because it has no other option. In the long run, particularly as Windows continues to fade, the company will be ever more invested in a world with no gatekeepers, where developer tools and clouds win by being better on the merits, not by being able to leverage users.

    That, though, is exactly why Microsoft had to pay so much: buying in directly is a whole lot more expensive than using leverage, which can produce equivalent — or better! — returns for much less investment.

  • The Bill Gates Line

    Two of the more famous military sayings are “Generals are always preparing to fight the last war”, and “Never interrupt your enemy while he is making a mistake.” I thought of the latter at the conclusion of last Sunday’s 60 Minutes report on Google:

    Google declined our request for an interview with one of its executives for this story, but in a written response to our questions, the company denied it was a monopoly in search or search advertising, citing many competitors including Amazon and Facebook. It says it does not make changes to its algorithm to disadvantage competitors and that, “our responsibility is to deliver the best results possible to our users, not specific placements for sites within our results. We understand that those sites whose ranking falls will be unhappy and may complain publicly.”

    The 60 Minutes report was not exactly fair-and-balanced; it featured an anti-tech-monopoly crusader1, an anti-tech-monopoly activist, an anti-tech-monopoly regulator, and Yelp CEO Jeremy Stoppelman. And, in what seems highly unlikely to have been a coincidence, Yelp this week filed a new antitrust complaint in the EU against Google. To be sure, just because a report was biased does not mean it was wrong; while I am a bit skeptical of the EU’s antitrust case against Google Shopping, the open case about Android seems pretty clear-cut. Neither, though, is Yelp’s direct concern.

    Yelp’s Case Against Google

    This is from a blog post about the 60 Minutes feature:

    Yelp did participate in the piece because Google is doing the opposite of “delivering the best results possible,” and instead is giving its own content an unlawful advantage. We’ve made a video to explain exactly how Google puts its own interests ahead of consumers in local search, which you can watch here:

    Yelp’s position, at least in this video, appears to be that Google’s answer box is anticompetitive because it only includes reviews and ratings from Google; presumably the situation could be resolved were Google to use sources like Yelp. There are three problems with this argument, though:

    • First, the answer box originally included content scraped from sources like Yelp and other vertical search sites; under pressure from the FTC, driven in part by complaints from Yelp and other vertical search engines, Google agreed to stop doing so in 2013.2
    • Second, in a telling testament to the power of being on top of search results, Google’s ratings and reviews have improved considerably in the two years since that video was posted; this isn’t a static market (to be sure, this is an argument that could be used on both sides).
    • Third — and this is the point of this article — what Yelp seems to want will only serve to make Google stronger.

    No wonder Google declined the request for an interview.

    The Bill Gates Line

    Over the last few weeks I have been exploring what differences there are between platforms and aggregators, and was reminded of this anecdote from Chamath Palihapitiya in an interview with Semil Shah:

    Semil Shah: Do you see any similarities from your time at Facebook with Facebook platform and connect, and how Uber may supercharge their platform?

    Chamath: Neither of them are platforms. They’re both kind of like these comical endeavors that do you as an Nth priority. I was in charge of Facebook Platform. We trumpeted it out like it was some hot shit big deal. And I remember when we raised money from Bill Gates, 3 or 4 months after — like our funding history was $5M, $83 M, $500M, and then $15B. When that 15B happened a few months after Facebook Platform and Gates said something along the lines of, “That’s a crock of shit. This isn’t a platform. A platform is when the economic value of everybody that uses it, exceeds the value of the company that creates it. Then it’s a platform.”

    By this measure Windows was indeed the ultimate platform — the company used to brag about only capturing a minority of the total value of the Windows ecosystem — and the operating system’s clear successors are Amazon Web Services and Microsoft’s own Azure Cloud Services. In all three cases there are strong and durable businesses to be built on top.

    A drawing of Platform Businesses Attract Customers by Third Parties
    From Tech’s Two Philosophies

    Once a platform dips under the Bill Gates Line, though, the long-term potential of a business built on a “platform” starts to decline. Apple’s App Store, for example, has all of the trappings of a platform, but Apple quite clearly captures the vast majority of the overall ecosystem, both because of the profitability of the iPhone and also because of its control of App Store economics; the paucity of strong and durable businesses on the App Store is a natural outgrowth of that.

    The App Store intermediates 3rd parties and users

    Note that Apple’s ability to control the economics of its developers comes from intermediating the relationship of those developers with customers.

    Aggregators, Not Platforms

    Facebook and Google take this intermediation to the extreme, leveraging their ability to drive discovery of the sheer abundance of information on their network and the Internet broadly:

    A drawing of Aggregators Own Customer Relationships and Suppliers Follow
    In the aggregator business model the aggregator owns customers and suppliers follow

    It follows that Facebook and Google’s “platforms” not only don’t meet the Bill Gates Line, they don’t even register on the graph: they are the purest expression of aggregators. From my original formulation:

    The fundamental disruption of the Internet has been to turn this dynamic on its head. First, the Internet has made distribution (of digital goods) free, neutralizing the advantage that pre-Internet distributors leveraged to integrate with suppliers. Secondly, the Internet has made transaction costs zero, making it viable for a distributor to integrate forward with end users/consumers at scale.

    This has fundamentally changed the plane of competition: no longer do distributors compete based upon exclusive supplier relationships, with consumers/users an afterthought. Instead, suppliers can be aggregated at scale leaving consumers/users as a first order priority. By extension, this means that the most important factor determining success is the user experience: the best distributors/aggregators/market-makers win by providing the best experience, which earns them the most consumers/users, which attracts the most suppliers, which enhances the user experience in a virtuous cycle.

    The result is the shift in value predicted by the Conservation of Attractive Profits. Previous incumbents, such as newspapers, book publishers, networks, taxi companies, and hoteliers, all of whom integrated backwards, lose value in favor of aggregators who aggregate modularized suppliers — which they often don’t pay for — to consumers/users with whom they have an exclusive relationship at scale.

    This is ultimately the most important distinction between platforms and aggregators: platforms are powerful because they facilitate a relationship between 3rd-party suppliers and end users; aggregators, on the other hand, intermediate and control it.

    Moreover, at least in the case of Facebook and Google, the point of integration in their respective value chains is the network effect. This is what I was trying to get at last week in The Moat Map with my discussion of the internalization of network effects:

    • Google has had the luxury of operating in an environment — the world wide web — that was by default completely open. That let the best technology win, and that win was augmented by the data that comes from serving an ever-increasing portion of the market. The end result was the integration of end users and the data feedback cycle that made Google search better and better the more it was used.
    • Facebook’s differentiator, meanwhile, is the relationships between friends and family; the company has subsequently integrated that network effect with consumer attention, forcing all of the content providers to jostle for space in the Newsfeed as pure commodities.

    It’s worth noting, by the way, why it was that Facebook could come to be a rival to Google in the first place; specifically, Facebook had exclusive data — those relationships and all of the behavior on Facebook’s site that resulted — that Google couldn’t get to. In other words, Facebook succeeded not by being a part of Google, but by being completely separate.

    Succeeding in a World of Aggregators

    This gets at why I find Yelp’s complaints a bit besides the point: the company seems to be expending an awful lot of energy to regain the right to give Google the content Yelp worked hard to acquire. There is revenue there, of course, just as there is in the production of commodities generally, but without a sustainable cost advantage it’s not the best route to building a strong and durable business.

    Of course that is the bigger problem: I noted above that Google’s library of ratings and reviews has grown substantially over the past few years; users generating content are the ultimate low-cost supplier, and losing that supply to Google is arguably a bigger problem for Yelp than whatever advertising revenue it can wring out from people that would click through on a hypothetical Google Answer Box that used 3rd-party sources. And, it should be noted, that Yelp’s entire business is user-generated reviews: they and similar vertical sites are likely to do a far better job of generating, organizing, and curating such data.

    Still, I can’t help but wonder whether or not Yelp’s problem is not that Google is using its own content in the Answer Box, but rather the Answer Box itself; which of these set of results would be better for Yelp’s business, even in a hypothetical world where Answer Box content comes from Yelp?

    Yelp would get more visitors without the answer box

    Presuming that the answer is the image on the right — driving users to Yelp is both better for the bottom line and better for content generation, which mostly happens on the desktop — and it becomes clear that Yelp’s biggest problem is that the more useful Google is — even if it only ever uses Yelp’s data! — the less viable Yelp’s business becomes. This is exactly what you would expect in an aggregator-dominated value chain: aggregators completely disintermediate suppliers and reduce them to commodities.

    To that end, this is why the best strategies entail business models that avoid Google and Facebook completely: look no further than Amazon, which last month stopped buying Google Shopping ads, something the company can afford to do given that half of shoppers start their product searches on Amazon. To be sure, Amazon is plenty powerful in its own right, but it is a hard-to-ignore example of Google’s favorite argument that “competition is only a click away.”

    Yelp Versus Google

    Still, I have sympathy for Yelp’s position; Stoppelman told 60 Minutes:

    If I were starting out today, I would have no shot of building Yelp. That opportunity has been closed off by Google and their approach…because if you provide great content in one of these categories that is lucrative to Google, and seen as potentially threatening, they will snuff you out.

    Stoppelman is right, but the reason is perhaps less nefarious than it seems; the 60 Minutes report explained why in the voiceover:

    Yelp and countless other sites depend on Google to bring them web traffic — eyeballs for their advertisers.

    Yelp, like many other review sites, has deep roots in SEO — search-engine optimization. Their entire business was long predicated on Google doing their customer acquisition for them. To the company’s credit it has become a well-known brand in its own right, and now gets around 70% of its visits via its mobile app. Those visits are very much in the Amazon model I highlighted above: users are going straight to Yelp and bypassing Google directly.

    That, though, isn’t great for Google! It seems a bit rich that Yelp should be free to leverage its app to avoid Google completely, and yet demand that Google continue to feature Yelp prominently in its search results, particularly on mobile, where the Answer Box has particular utility. I get that Yelp feels like Google has changed the terms of the deal from when Yelp was founded in 2004, but the reality is that the change that truly mattered was mobile.

    What I do find compelling is a new video that Yelp put out yesterday; while it makes many of the same points as the one above, instead of being focused on regulators it is targeting Google itself, arguing that Google isn’t living up to its own standards by not featuring the best results, and not driving traffic back to sites that make the content Google needs (by, for example, not including prominent links to the content filling its answer boxes; Yelp isn’t asking that they go away, just that they drive traffic to 3rd parties). Google may be an aggregator, but it still needs supply, which means it needs a sustainable open web. The company should listen.

    Facebook and Data Portability

    Facebook, unfortunately for its suppliers, faces no such constraints: the content that is truly differentiated is made by Facebook’s users, and it is wholly owned by Facebook. Facebook is even further from the Bill Gates Line than Google is: the latter at least needs commoditized suppliers; the former can take or leave them on a whim, and does.

    That is why I’ve come to realize a popular prescription for Facebook’s dominance, data portability, put forward this week by a coalition of progressive organizations under the umbrella Freedom From Facebook, is so mistaken.3 The problem with data portability is that it goes both ways: if you can take your data out of Facebook to other applications, you can do the same thing in the other direction. The question, then, is which entity is likely to have the greater center of gravity with regards to data: Facebook, with its social network, or practically anything else?

    Facebook at the center of data exchange
    From The Facebook Brand

    Remember the conditions that led to Facebook’s rise in the first place: the company was able to circumvent Google, go directly to users, and build a walled garden of data that the search company couldn’t touch. Partnering or interoperating with companies below the Bill Gates Line, particularly aggregators, is simply an invitation to be intermediated. To demand that governments enforce exactly that would be a mistake that only helps Facebook.4

    The broader takeaway is that distinguishing between platforms and aggregators isn’t simply an academic exercise: it should affect how companies think about their competitive environment vis-à-vis the biggest companies in tech, and, just as importantly, it should weigh heavily on regulators. The Microsoft antitrust battles of the 2000s were in many respects about enforcing interoperability as a way of breaking into the Microsoft platform; today antitrust should be far more concerned about aggregators capturing everything they touch by virtue of their control of end users.

    That’s the thing about the “Generals fight the last war” saying; it’s usually applied to the losing side that made mistake after mistake while the victors leveraged the new world order.

    I wrote a follow-up to this article in this Daily Update.

    1. I’ve discussed why I disagree with Gary Reback’s views on monopoly and innovation in this Daily Update  ↩

    2. With regard to that FTC decision, yes, as the Wall Street Journal reported, some FTC staff members recommended suing Google; what is not true is that the recommendation was unanimous, or that FTC commissioners ultimately deciding to go in another direction was unusual. In fact, other staff groups in other groups recommended against the suit, and the decision of the FTC commissioners was unanimous. Again, that is not to say it was the right decision, but that the popular conception — including what was reported in that 60 Minutes piece — is a bit off ↩

    3. To be fair, I’ve made the same argument previously, but I’ve changed my mind ↩

    4. The group’s demand that Facebook be forced to divest Instagram, WhatsApp, and Messenger makes much more sense in terms of this framework (with the exception of Messenger, which has always been a part of Facebook). I strongly believe that the single best antitrust remedy for aggregators is limiting acquisitions  ↩

  • The Moat Map

    A subtext to last week’s article, Tech’s Two Philosophies, was the idea that there is a difference between Aggregators and Platforms; this was the key section:

    It is no accident that Apple and Microsoft, the two “bicycle of the mind” companies, were founded only a year apart, and for decades had broadly similar business models: sure, Microsoft licensed software, while Apple sold software-differentiated hardware, but both were and are at their core personal computer companies and, by extension, platforms…

    Google and Facebook, on the other hand, are products of the Internet, and the Internet leads not to platforms but to aggregators. While platforms need 3rd parties to make them useful and build their moat through the creation of ecosystems, aggregators attract end users by virtue of their inherent usefulness and, over time, leave suppliers no choice but to follow the aggregators’ dictates if they wish to reach end users.

    The distinction wasn’t entirely satisfying; first and foremost the power of both aggregators and platforms, however defined, ultimately rests on the size and strength of their userbase. Moreover, Google and Facebook have platform-type aspects to their business, and Apple has aggregator characteristics when it comes to its control of the App Store (that Microsoft does not is a symbol of the company’s mobile failure).

    Moreover, what of companies like Amazon, or Netflix? In a follow-up Daily Update I classified the former as a platform and the latter as an aggregator, but clearly both have very different businesses — and supplier relationships — than either Google and Facebook on one side or Apple and Microsoft on the other, even as they both derive their power from owning the customer relationship.

    Make no mistake, that bit about owning the customer relationship remains critical: that is the critical insight of Aggregation Theory. How that ownership of the customer translates into an enduring moat, though, depends on the interaction of two distinct attributes: supplier differentiation and network effects.

    The Supplier Differentiation Spectrum

    Consider the six companies I mentioned above: Facebook, Google, Amazon, Netflix, Apple, and Microsoft.1

    The degree of differentiation of tech company suppliers varies

    These companies exist on a spectrum in terms of supplier differentiation (and, by extension, supplier power):

    • Facebook has commoditized suppliers more than anyone: an article from the New York Times is treated no differently from a BuzzFeed quiz or the latest picture of your niece or an advertisement.
    • Google gives slightly more deference to established content providers, but not much; search results are presented the same regardless of their source (although Google increasingly presents results differently depending on the type of content).
    • Amazon is a little harder to classify — that’s kind of entailed in the name The Everything Store — but generally brands are much less important than they are in a world of limited shelf space, and few people even realize they are buying from the 3rd party merchants that make up over half of Amazon’s sales.
    • Differentiation matters more for Netflix, particularly when it comes to acquiring new users; still, users are transacting with Netflix and, the longer they stick with the streaming service, first opening Netflix and then looking for something to watch, as opposed to the other way around.
    • Apple first and foremost attracts and retains users through its integrated experience, but that experience would quickly be abandoned were there not third party apps.
    • Microsoft traditionally succeeded entirely because of its ecosystem, not just applications but also the entire universe of value-added resellers, systems integrators, etc.

    The extremes make the point: Facebook could lose all of its third party content providers overnight and still be a compelling service; Microsoft without third parties would be, well, we already saw with Windows Phone.

    The Network Effect Spectrum

    Another way to consider this spectrum is in terms of user-related network effects. The idea of a network effect is that an additional user increases the value of a good or service, and indeed all of these companies depend on network effects. However, the type of network effect differs considerably, as well as the extent to which the network effect directly improves a company’s core product (what I am calling an “internalized” versus “externalized” network effect):

    The internalization of network effects varies by tech company

    Again there is a spectrum:

    • For Facebook the network effect that matters is users — a social network’s most important feature is whether your friends and family are using it. This network — given it is the product! — is completely internal to Facebook.
    • Google has network effects of its own, but they are less about users and more about data: more people searching makes for better search results, because of the system Google has built to relentlessly harvest, analyze, and iterate on data. Like Facebook, Google’s network effect is largely internal to Google.
    • Amazon’s network effect is more subtle: there is an aspect where your shopping on Amazon improves my experience through things like rankings, reviews, and data feedback loops. Just as important, though, are two additional effects: first, the more people that shop on Amazon, the more likely suppliers are to come onto Amazon’s platform, increasing price and selection for everyone. In other words, Amazon, particularly as it transitions to being more of a commerce platform and less of a retailer, is a two-sided network. There is one more factor though: Amazon’s incredible service rests on hundreds of billions of dollars in investments; that fixed cost investment has to be born by customers at some point, which means the more customers there are the less any one customer is responsible for those fixed costs (this manifests indirectly through lower prices and better service).
    • Netflix is a hybrid much like Amazon: there are certainly data network effects when it comes to what shows are made, what are cancelled, recommendations, ratings, etc. An essential part of Netflix’s competitive advantage going forward, though, rests on its differentiated ability to invest in new shows; this investment capability is driven by the company’s huge and still-growing user base, which is the biggest way that additional users benefit users already on the service.
    • Apple certainly benefits from a large user base over which to spread the significant fixed costs of its products, but on this end of the spectrum it is the two-sided network of developers and users that is most important. The more users that are on a platform, the more developers there will be, which increases the value of the platform for everyone.
    • Microsoft, befitting the point I made above about the expansiveness of its ecosystem, has the most “externalized” network effect of all: there is very little about Windows, for example, that produces a network effect (Office is another story), but the ecosystem on top of Windows produced one of the greatest network effects ever.

    At this point, you may have noticed that these two spectrums run in roughly the same order: I don’t think that is a coincidence.

    The Moat Map

    Here are these two spectrums laid out on two orthogonal axis:

    The Map Moat represents the relationship between supplier differentiation and network externalization

    This relationship between the differentiation of the supplier base and the degree of externalization of the network effect forms a map of effective moats; to again take these six companies in order:

    • Facebook has completely internalized its network and commoditized its content supplier base, and has no motivation to, for example, share its advertising proceeds. Google similarly has internalized its network effects and commoditized its supplier base; however, given that its supply is from 3rd parties, the company does have more of a motivation to sustain those third parties (this helps explain, for example, why Google’s off-site advertising products have always been far superior to Facebook’s).
    • Netflix and Amazon’s network effects are partially internalized and partially externalized, and similarly, both have differentiated suppliers that remain very much subordinate to the Amazon and Netflix customer relationship.
    • Apple and Microsoft, meanwhile, have the most differentiated suppliers on their platforms, which makes sense given that both depend on largely externalized network effects. “Must-have” apps ultimately accrue to the platform’s benefit.

    It is just as useful to think about what happens when companies find themselves outside of the Moat Map.

    Missing Moats

    Start with Apple and apps: in August 1997, Steve Jobs, having just returned to Apple, took the stage at Macworld Boston and proceeded to humble himself: first, he talked about how much Apple needed Adobe, and then he announced a settlement with Microsoft that entailed Microsoft investing in Apple and developing Office for Mac for at least five years. That was followed by Bill Gates’ grinning visage appearing via satellite over Jobs’ head:

    An image from MacWorld Boston when Microsoft invested in Apple

    I wrote in 2013 that I believe this experience resulted in Apple making poor strategic choices with the iPhone and iPad: the company never again wanted to have its suppliers become too powerful. The way this played out, though, is that Apple for years neglected the business model needs of developers building robust productivity apps that could have meaningfully differentiated iOS devices from Android.

    To be sure, the company has been more than fine: its developer ecosystem is plenty strong enough to allow the company’s product chops to come to the fore. I continue to believe, though, that Apple’s moat could be even deeper had the company considered the above Moat Map: the network effects of a platform like iOS are mostly externalized,2 which means that highly differentiated suppliers are the best means to deepen the moat; unfortunately Apple for too long didn’t allow for suitable business models.

    Some company's and models outside of the Moat Map

    Another example is Uber: on the one hand, Uber’s suppliers are completely commoditized. This might seem like a good thing! The problem, though, is that Uber’s network effects are completely externalized: drivers come on to the platform to serve riders, which in turn makes the network more attractive to riders. This leaves Uber outside the Moat Map. The result is that Uber’s position is very difficult to defend; it is easier to imagine a successful company that has internalized large parts of its network (by owning its own fleet, for example), or done more to differentiate its suppliers. The company may very well succeed thanks to the power from owning the customer relationship, but it will be a slog.

    On the opposite side of the map are phone carriers in a post-iPhone world: carriers have strong network effects, both in terms of service as well as in the allocation of fixed costs. Their profit potential, though, was severely curtailed by the emergence of the iPhone as a highly differentiated supplier. Suddenly, for the first time, customers chose their carrier on the basis of whether or not their preferred phone worked there; today, every carrier has the iPhone, but the process of reaching that point meant the complete destruction of carrier dreams of value-added services, and a lot more competition on capital-intensive factors like coverage and price.

    Direction or Context?

    It’s worth noting that maps can take two forms: some give direction, and others provide context for what has already happened; I’m not entirely sure which best describes the Moat Map. In the case of Apple and apps, for example, I absolutely believe the company could have made different strategic choices had it fully appreciated the interaction between supplier differentiation and network effects.

    On the other hand, one could make a very strong case that the degree of supplier differentiation possible flows from the network effect involved: perhaps it was inevitable that Facebook and Google commoditized suppliers, for example, or that Amazon and Netflix would have to simultaneously pursue differentiated suppliers even as they sought to suppress them. What is always certain, though, is that there is no one perfect strategy: as always, it depends.

    Thanks to James Allworth, my co-host on the Exponent podcast, for helping me conceptualize this framework

    I wrote a follow-up to this article in this Daily Update.

    1. In this article when I refer to “Amazon” I am primarily referring to the e-commerce company; Microsoft the PC company. I will cover AWS and Azure in a follow-up in the Daily Update. ↩

    2. iMessage being an instructive exception ↩

  • Tech’s Two Philosophies

    Even though Apple’s developer conference is still a few weeks away, I think it’s safe to say that the demo of Google Duplex at yesterday’s Google I/O keynote will go down as the most impressive of the tech conference season. If you haven’t seen it, it is a must-watch:

    Once I picked my jaw up off the floor, though, what struck me about Google CEO Sundar Pichai’s presentation was how he opened the segment:

    Our vision for our assistant is to help you get things done.

    And how he closed it:

    A common theme across all this is we are working hard to give users back time. We’ve always been obsessed about that at Google. Search is obsessed about getting users to answers quickly and giving them what they want.

    In Google’s view, computers help you get things done — and save you time — by doing things for you. Duplex was the most impressive example — a computer talking on the phone for you — but the general concept applied to many of Google’s other demonstrations, particularly those predicated on AI: Google Photos will not only sort and tag your photos, but now propose specific edits; Google News will find your news for you, and Maps will find you new restaurants and shops in your neighborhood. And, appropriately enough, the keynote closed with a presentation from Waymo, which will drive you.

    The Google and Facebook Philosophy

    Rewind a week, and there was a specific section in Mark Zuckerberg’s keynote at the Facebook F8 conference that stuck out to me:

    I believe that we need to design technology to help bring people closer together. And I believe that that’s not going to happen on its own. So to do that, part of the solution, just part of it, is that one day more of our technology is going to need to focus on people and our relationships. Now there’s no guarantee that we get this right. This is hard stuff. We will make mistakes and they will have consequences and we will need to fix them. But what I can guarantee is that if we don’t work on this the world isn’t moving in this direction by itself.

    Zuckerberg, as so often seems to be the case with Facebook, comes across as a somewhat more fervent and definitely more creepy version of Google: not only does Facebook want to do things for you, it wants to do things its chief executive explicitly says would not be done otherwise. The Messianic fervor that seems to have overtaken Zuckerberg in the last year, though, simply means that Facebook has adopted a more extreme version of the same philosophy that guides Google: computers doing things for people.

    The Microsoft and Apple Philosophy

    Earlier this week, while delivering Microsoft’s Build conference keynote, CEO Satya Nadella struck a very different tone; after describing how computing was becoming invisible, because it is everywhere, Nadella said:

    That’s the opportunity that we have. It’s in some sense endless, but we also have responsibility. We have the responsibility to ensure that these technologies are empowering everyone, these technologies are creating equitable growth by ensuring that every industry is able to grow and create employment. But we also have a responsibility as a tech industry to build trust in technology.

    In fact Hans Jonas was a philosopher who worked in the 50s, 60s, and he wrote a paper on technology and responsibility…he talks about act so that the effects of your action are compatible with permanence or genuine life. That’s something that we need to reflect on, because he was talking about the power of technology being such that it far outstrips our ability to completely control it, especially its impact even on future generations. And so we need to develop a set of principles that guide the choices we make because the choices we make is what’s going to define the future…

    This opportunity and responsibility is what grounds us in our mission to empower every person and every organization on the planet to achieve more. We’re focused on building technology so that we can empower others to build more technology. We’ve aligned our mission, the products we build, our business model, so that your success is what leads to our success. There’s got to be complete alignment.

    This is technology’s second philosophy, and it is orthogonal to the other: the expectation is not that the computer does your work for you, but rather that the computer enables you to do your work better and more efficiently. And, with this philosophy, comes a different take on responsibility. Pichai, in the opening of Google’s keynote, acknowledged that “we feel a deep sense of responsibility to get this right”, but inherent in that statement is the centrality of Google generally and the direct culpability of its managers. Nadella, on the other hand, insists that responsibility lies with the tech industry collectively, and all of us who seek to leverage it individually.

    The Bicycle of the Mind

    This second philosophy, that computers are an aid to humans, not their replacement, is the older of the two; its greatest proponent — prophet, if you will — was Microsoft’s greatest rival, and his analogy of choice was, coincidentally enough, about transportation as well. Not a car, but a bicycle:

    Steve Jobs was exceptionally fond of this analogy: there are multiple clips of him making the point in mostly the same way; I usually link to this one because by the time this video was recorded1 Jobs had his delivery perfectly honed.

    Interestingly, though, the earliest known clip of Jobs telling this story, from 1980, doesn’t include the famous phrase “Bicycle of the Mind”; it’s worth watching, though, all the same:

    The best analogy I’ve ever heard is Scientific American, I think it was, did a study in the early 70s on the efficiency of locomotion, and what they did was for all different species of things in the planet, birds and cats and dogs and fish and goats and stuff, they measured how much energy does it take for a goat to get from here to there. Kilocalories per kilometer or something, I don’t know what they measured. And they ranked them, they published the list, and the Condor won. The Condor took the least amount of energy to get from here to there. Man was didn’t do so well, came in with a rather unimpressive showing about a third of the way down the list.

    But fortunately someone at Scientific American was insightful enough to test a man with a bicycle, and man with a bicycle won. Twice as good as the Condor, all the way off the list. And what it showed was that man is a toolmaker, has the ability to make a tool to amplify an inherent ability that he has. And that’s exactly what we’re doing here.

    This is precisely what Nadella was driving at: “to empower every person and every organization on the planet to achieve more” is to “amplify an inherent ability” those people and organizations have; the goal is not to do things for them, but to enable them to do things never before possible. And, I would hasten to add, Apple remains very much on the same side of this philosophical divide.

    The Chicken and Egg Question

    There is certainly an argument to be made that these two philosophies arise out of their historical context; it is no accident that Apple and Microsoft, the two “bicycle of the mind” companies, were founded only a year apart, and for decades had broadly similar business models: sure, Microsoft licensed software, while Apple sold software-differentiated hardware, but both were and are at their core personal computer companies and, by extension, platforms.

    In a platform business model 3rd parties attract customers

    Google and Facebook, on the other hand, are products of the Internet, and the Internet leads not to platforms but to aggregators. While platforms need 3rd parties to make them useful and build their moat through the creation of ecosystems, aggregators attract end users by virtue of their inherent usefulness and, over time, leave suppliers no choice but to follow the aggregators’ dictates if they wish to reach end users.

    In the aggregator business model the aggregator owns customers and suppliers follow

    The business model follows from these fundamental differences: a platform provider has no room for ads, because the primary function of a platform is provide a stage for the applications that users actually need to shine. Aggregators, on the other hand, particularly Google and Facebook, deal in information, and ads are simply another type of information.2 Moreover, because the critical point of differentiation for aggregators is the number of users on their platform, advertising is the only possible business model; there is no more important feature when it comes to widespread adoption than being “free.”

    Still, that doesn’t make the two philosophies any less real: Google and Facebook have always been predicated on doing things for the user, just as Microsoft and Apple have been built on enabling users and developers to make things completely unforeseen.

    Tech’s Yin and Yang

    That there are two philosophies does not necessarily mean that one is right and one is wrong: the reality is we need both. Some problems are best solved by human ingenuity, enabled by the likes of Microsoft and Apple; others by collective action. That, though, gets at why Google and Facebook are fundamentally more dangerous: collective action is traditionally the domain of governments, the best form of which is bounded by the popular will. Google and Facebook, on the other hand, are accountable to no one. Both deserve all of the recent scrutiny they have attracted, and arguably deserve more.

    That scrutiny, though, and whatever regulations that result, must keep in mind this philosophical divide: platforms that create new possibilities — and not just Apple and Microsoft! — are the single most important economic force when it comes to countering the oncoming wave of computers doing people’s jobs, and lazily written regulation that targets aggregators but constricts platforms will inevitably do more harm than good.

    The truth is that the Divine Discontent that I wrote about last week is not only an antidote to low-end disruption, but also a reason for optimism: companies like Apple and Amazon can, as I noted, win in the long run by offering a superior user experience, but more importantly, the dividend of discontent is a greenfield of opportunities to build new businesses and new jobs alleviating that discontent. For that we need platforms on which to build those businesses, and yes, we will need artificial intelligence to do things for us so we have the time.

    I wrote a follow-up to this article in this Daily Update.

    1. 1990 I believe, but I’m not certain ↩

    2. As I’ve written in the past, this is why mobile saved Facebook: the company desperately wanted to be a platform but being “just an app” left Facebook no choice but to be self-contained and thus a better ad company ↩

  • Divine Discontent: Disruption’s Antidote

    It is nothing but a number, no different than 999,999,999,999 for all practical purposes, but we humans are not practical creatures: we attach importance to all kinds of silly things, round numbers chief amongst them. To that end, an increasingly popular parlor question in the stocks as entertainment business is which company will be worth $1 trillion first?

    The market caps of the top five companies over time

    There are certainly cases to be made for Google and Microsoft and even Facebook, but most of the attention is focused on Amazon and Apple: the latter for being the closest, and the former for growing the fastest, at least recently:

    The market cap of Apple and Amazon over time

    It is interesting to consider these two companies in conjunction: they couldn’t be more different, but for the one thing that makes them both so valuable.

    Apple Versus Amazon

    I mean it when I say these companies are the complete opposite: Apple sells products it makes; Amazon sells products made by anyone and everyone. Apple brags about focus; Amazon calls itself “The Everything Store.” Apple is a product company that struggles at services; Amazon is a services company that struggles at product. Apple has the highest margins and profits in the world; Amazon brags that other’s margin is their opportunity, and until recently, barely registered any profits at all. And, underlying all of this, Apple is an extreme example of a functional organization, and Amazon an extreme example of a divisional one.

    These points are all, of course, interrelated: Apple’s organizational structure, focus, and release-focused development cycle enable it to create highly differentiated products, even as the exact same structure, focus, and development cycle underly the company’s struggles in iterative services.1 Similarly, Amazon’s highly modular structure, varied businesses, and iterative approach to those businesses enable it to create services with itself as its first, best, customer, and then extend those services to developers and retailers, even as the exact same factors lead to product disasters like the Fire Phone.

    Both, taken together, are a reminder that there is no one right organizational structure, product focus, or development cycle: what matters is that they all fit together, with a business model to match. That is where Apple and Amazon are arguable more alike than not: both are incredibly aligned in all aspects of their business. What makes them truly similar, though, is the end goal of that alignment: the customer experience.

    The iPhone Versus Disruption

    The first time Apple released two different iPhone form factors in the same year was 2013. There the new form factor was the iPhone 5C, but while the industrial design was new, the pricing wasn’t: the 5C slotted into the spot where the discontinued iPhone 5 would traditionally have gone — $100 less than the new flagship iPhone 5S. Analysts and pundits were aghast: how could Apple not produce a truly low-price iPhone? Didn’t they know this guaranteed disruption?

    I argued to the contrary in a piece entitled What Clayton Christensen Got Wrong. After recounting the many predictions by the father of disruption that the iPhone would not be a success, I came up with three specific reasons why Apple seemed immune to disruptive gravity:

    • First, it was folly to presume that consumers were rational, at least to the extent that rationality could be reduced to easily articulable features balanced against price (or appreciating that round numbers aren’t anything special).
    • Second, there are many attributes of a product that can’t be easily measured, but only experienced, and that they loom large when the person using the product is the same as the person buying the product.
    • Third, that modular products, by virtue of their prioritization of standardization and interconnectivity, would inevitably fall short on attributes directly connected to the experience of using the device.

    The key paragraph is here:

    The attribute most valued by consumers, assuming a product is at least in the general vicinity of a need, is ease-of-use. It’s not the only one — again, doing a job-that-needs-done is most important — but all things being equal, consumers prefer a superior user experience. What is interesting about this attribute is that it is impossible to overshoot.

    The term “overshoot” is right out of disruption theory. Christensen writes in his seminal book, The Innovator’s Dilemma:

    The second element of the failure framework, the observation that technologies can progress faster than market demand…means that in their efforts to provide better products than their competitors and earn higher prices and margins, suppliers often “overshoot” their market: They give customers more than they need or ultimately are willing to pay for. And more importantly, it means that disruptive technologies that may underperform today, relative to what users in the market demand, may be fully performance-competitive in that same market tomorrow.

    This was the basis for insisting that the iPhone must have a low-price model: surely Apple would soon run out of new technology to justify the prices it charged for high-end iPhones, and consumers would start buying much cheaper Android phones instead!

    In fact, as I discussed in after January’s earnings results, the company has gone in the other direction: more devices per customer, higher prices per device, and an increased focus on ongoing revenue from those same customers. Yesterday’s results were mostly more of the same: wearables were up a lot (more devices per customer); ASP’s were down from last quarter but still 11% higher than a year ago;2 services revenue, meanwhile, shot through the roof for reasons that are still a bit unclear, but impressive nonetheless.

    Also the same was a very modest increase in the number of iPhone sold: 3% more than a year ago. Apple seems to have mostly saturated the high end, slowly adding switchers even as existing iPhone users hold on to their phones longer; what is not happening, though, is what disruption predicts: Apple isn’t losing customers to low-cost competitors for having “overshot” and overpriced its phones. It seems my thesis was right: a superior experience can never be too good — or perhaps I didn’t go far enough.

    Amazon and Divine Discontent

    Jeff Bezos has been writing an annual letter to shareholders since 1997, and he attaches that original letter to one he pens every year. It included this section entitled Obsess Over Customers:

    From the beginning, our focus has been on offering our customers compelling value. We realized that the Web was, and still is, the World Wide Wait. Therefore, we set out to offer customers something they simply could not get any other way, and began serving them with books. We brought them much more selection than was possible in a physical store (our store would now occupy 6 football fields), and presented it in a useful, easy-to-search, and easy-to-browse format in a store open 365 days a year, 24 hours a day. We maintained a dogged focus on improving the shopping experience, and in 1997 substantially enhanced our store. We now offer customers gift certificates, 1-Click shopping, and vastly more reviews, content, browsing options, and recommendation features. We dramatically lowered prices, further increasing customer value. Word of mouth remains the most powerful customer acquisition tool we have, and we are grateful for the trust our customers have placed in us. Repeat purchases and word of mouth have combined to make Amazon.com the market leader in online bookselling.

    Over the last 20 years Amazon has dramatically changed, but Bezos’ annual focus on consumers has not. This year, after highlighting just how much customers love Amazon (answer: a lot), Bezos wrote:

    One thing I love about customers is that they are divinely discontent. Their expectations are never static — they go up. It’s human nature. We didn’t ascend from our hunter-gatherer days by being satisfied. People have a voracious appetite for a better way, and yesterday’s ‘wow’ quickly becomes today’s ‘ordinary’. I see that cycle of improvement happening at a faster rate than ever before. It may be because customers have such easy access to more information than ever before — in only a few seconds and with a couple taps on their phones, customers can read reviews, compare prices from multiple retailers, see whether something’s in stock, find out how fast it will ship or be available for pick-up, and more. These examples are from retail, but I sense that the same customer empowerment phenomenon is happening broadly across everything we do at Amazon and most other industries as well. You cannot rest on your laurels in this world. Customers won’t have it.

    Critically, when it comes to Internet-based services, this customer focus does not come at the expense of a focus on infrastructure or distribution or suppliers: while those were the means to customers in the analog world, in the online world controlling the customer relationship gives a company power over its suppliers, the capital to build out infrastructure, and control over distribution. Bezos is not so much choosing to prioritize customers insomuch as he has unlocked the key to controlling value chains in an era of aggregation.

    Bezos’s letter, though, reveals another advantage of focusing on customers: it makes it impossible to overshoot. When I wrote that piece five years ago, I was thinking of the opportunity provided by a focus on the user experience as if it were an asymptote: one could get ever closer to the ultimate user experience, but never achieve it:

    The asymptote version of the user experience

    In fact, though, consumer expectations are not static: they are, as Bezos’ memorably states, “divinely discontent”. What is amazing today is table stakes tomorrow, and, perhaps surprisingly, that makes for a tremendous business opportunity: if your company is predicated on delivering the best possible experience for consumers, then your company will never achieve its goal.

    The ever-changing version of the user experience

    In the case of Amazon, that this unattainable and ever-changing objective is embedded in the company’s culture is, in conjunction with the company’s demonstrated ability to spin up new businesses on the profits of established ones, a sort of perpetual motion machine; I’m not sure that Amazon will beat Apple to $1 trillion, but they surely have the best shot at two.

    The Disruption Antidote

    This analysis applies to Facebook and Google, two of the other companies in that chart, more than you might expect. While the two companies’ revenues are based on advertising, the attractiveness to advertisers rests on consumers using both services.3 Both, though, are disadvantaged to an extent because their means of making money operate orthogonally to a great user experience; both are protected by the fact would-be competitors inevitably have the same business model.4

    That is why, for all four companies, the first place to look for weaknesses is not in the supplier base or distribution or even regulation: it is with the end users. That is why it matters that Amazon is the most popular company in the United States, why Apple and Google continue to have two of the most respected brands, and why Facebook is right to be more concerned about the PR effect of its scandals than the regulatory ones. Owning the customer relationship by means of delivering a superior experience is how these companies became dominant, and, when they fall, it will be because consumers deserted them, either because the companies lost control of the user experience (a danger for Facebook and Google), or because a paradigm shift made new experiences matter more (a danger for Google and Apple).

    In the meantime, though, disruption5 has its antidote.

    1. Yes, the company is crushing it with regards to “Services” revenue; that is mostly from the App Store and also iCloud Storage, that is to say, predicated on iPhone dominance. This reference is to things like Siri and Maps ↩

    2. There was a lot of breathless speculation about iPhone X sales cratering, which clearly didn’t happen. That said, iPhone X sales clearly fell off a bit: iPhone ASP was down 9% sequentially, a much larger drop than the 6% drop a year ago. ↩

    3. Microsoft is an enterprise company, a very different beast ↩

    4. For a social network, the number one feature is how many of your friends are on it, which means a “free” service will always have an advantage; for a search engine, there is a weaker, but still significant, network effect that is based on data, which again augurs for a free service with the maximum number of users that entails. ↩

    5. Low-end disruption, to be clear ↩

  • Open, Closed, and Privacy

    Note: This article has nothing to do with open or closed source code

    It was eight years ago next month that Vic Gundotra, then-VP of Engineering at Google, delivered a blistering attack on Apple for not being open:1

    A slide from Google's 2010 I/O keynote criticizing Apple

    On [my] first day I met a man named Mr. Andy Rubin. Now I suspect most of you know who Andy Rubin is. At the time he was responsible for what was then a secret project codenamed Android, and on that first day Andy enthusiastically described to me the team’s mission and purpose. And as he spoke — I’ll level with you — I was skeptical. In fact, I interrupted Andy, and I said, “Andy, I don’t get it. Does the world really need another mobile operating system? Google is about advertising — shouldn’t we be on every phone?”

    To this day I remember Andy’s response, and he made two points. The first point Andy made was that it was critically important to provide a free mobile operating system — an open-source operating system — that would enable innovation at every level of the stack. In other words, OEMs should be free to build all kinds of devices — devices with keyboards, without keyboards, with front-facing cameras, two inches, three inches, four inches — that operators should be able to compete on the strength and coverage of their network — 2G, 3G, 4G, LTE, CDMA — and that in the end, with innovation coming at every layer, it would be the consumer who would be able to benefit by getting the best device on the best network for them.

    I remember Andy’s second point: he argued that if Google did not act, we faced a draconian future, a future where one man, one company, one device, one carrier, would be our only choice. That’s a future we don’t want! So if you believe in openness, if you believe in choice, if you believe in innovation from everyone, then welcome to Android.

    Gundotra repeated the word “open” like a mantra, appealing to the sensibilities of not just people in technology but also its critics, opposed to so-called “walled gardens”; the two primary offenders were deemed to be Apple and Facebook.

    This is what made Google’s low-key announcement of its latest plans for messaging on Android phones — an exclusive with The Verge about what it calls Chat — so striking: the company is introducing an open alternative to products like iMessage and WhatsApp, but only as a last resort, and the effort is being pilloried by critics to boot; Walt Mossberg was representative:

    Of course Google’s critics are not criticizing Chat for being open; they are, like Mossberg, criticizing it for being “insecure” — that is, not end-to-end encrypted like iMessage or WhatsApp. That, though, is the rub: being “secure” and being “open” are incompatible.

    How End-to-End Encryption Works

    A quick primer on how end-to-end encryption works, using iMessage as an example; I’m going to dramatically simplify this explanation, but you can read Apple’s security white paper to get the specifics:

    • When iMessage is turned on, “keys” are generated; these are produced in pairs, one private and one public. These two keys are related: the public key encrypts content such that it can only be decrypted by a private key; to analogize them to a safe, the public key locks the door, and the private key unlocks it.
    • The relationship between these two keys is, well, the key to understanding how encryption works in messaging (and all communications): anyone sending an encrypted message “locks” the content using a public key, which means that the only person that can “unlock” and read the message is whoever has the corresponding private key.
    • To that end, the private key is, as the name implies private: it is kept on the device that generated it (in fact, every device with iMessage generates its own encryption keys). The public key, meanwhile, is public: for anyone to be able to send you an encrypted message means that everyone must be able to find the public key that corresponds to your private key.

    This is the precise spot where “open” breaks down: you can, in fact, send encrypted content over open protocols like email. The problem is that the sender cannot just unilaterally decide to encrypt a message; rather, the receiver has to first generate a public-private key pair, then share the public key with the sender so that the email can be encrypted in a way that only the recipient — thanks to their private key — can read it. This is, needless to say, far beyond the capabilities of most users: not only do they not understand that there needs to be a conversation before the conversation, they don’t even know the language they need to use.

    And yet, over 100 billion messages are sent per day on WhatsApp and iMessage alone, and the reason is because both are closed. To continue with the iMessage explanation, public keys are sent to Apple’s servers to be stored in a directory service; there they (along with the public keys from all of the user’s devices) are associated with the user’s phone number or email address. This is the critical piece to making iMessage encryption easy-to-use: senders need only know the recipients phone number or email address; Apple will silently pass the appropriate public keys to the sender to encrypt the message such that only the recipient can read it.2

    In short, encryption is viable for the public at scale precisely because Apple controls everything: clients on both ends, and the server in the middle. It’s the same story with WhatsApp or any of the other encrypted messaging services: being closed makes end-to-end encryption actually usable at scale.

    And, as I explained on Monday, this option is not available to Google when it comes to Android: OEMs don’t want to deepen their Google dependence, and carriers do not want to undercut their lucrative SMS business (and Google can’t force the issue because of its looming antitrust problems). The only option was the one Gundotra lauded in 2010: an open standard that no one controls, for better or, in the case of the desire for end-to-end encryption, worse.3

    Encryption and Privacy

    The ongoing debate about data and privacy is directly related to the question of encryption in some important ways, as Mossberg’s tweet notes: messaging content is data that users would like to keep private, and encryption accomplishes that.

    Of course it is not the only data generated by messaging: entailed in the ease-of-use that comes from relying on centralized servers for key exchange is the necessary collection by those servers of metadata. Obviously email addresses and/or phone numbers and/or usernames have to be stored (so that they can be associated with public keys), and the very act of connecting two accounts will generate logs of who was communicating with whom and when, and often from where (through IP addresses). Services can and do differentiate based on how long they keep that metadata; Signal,4 for example, promises to flush metadata as soon as possible, whereas WhatsApp — which uses encryption developed by Signal — keeps such data indefinitely.

    That gets at the more important way that the relationship between open/closed and encryption is relevant to data and privacy: just as encryption at scale is only possible with a closed service, so it is with privacy. That is, to the extent we as a society demand privacy, the more we are by implication demanding ever more closed gardens, with ever higher walls. Just as a closed garden makes the user experience challenge of encryption manageable, so does the centralization of data make privacy — of a certain sort — a viable business model.

    The reality of digital services is that the amount of data each of us generates at basically all times is astronomical; your phone always knows where you are, but so does every app you use and every website you visit.

    A map of Stratechery readers
    Stratechery readers

    Google, of course, knows one’s every search, for many people their every email, and thanks to the company’s ad network, control of Chrome and Google analytics, and, of course Android, pretty much everything else one does online. Facebook’s knowledge is slightly less broad but arguably deeper: your friends, your interests — both stated and revealed — and thanks to its ‘Like’ button, your web activity as well.

    To focus on simply Google and Facebook, though, is to miss how much other data collection is going on: ad networks are tracking you on nearly every website you visit, your credit card company is tracking your purchases (and by extension your location), your grocery store is tracking your eating habit, the list goes on and on. Moreover, the further down you go down the data food chain, the more likely it is that data is bought and sold. That, of course, is as open as it gets.

    Data Collection Versus Data Leakage

    Still, the contrast between Google and Facebook is worth considering: Facebook is in hot water thanks to the revelation that some amount of the data it collects was sold to Cambridge Analytica, which bragged it helped elect Donald Trump president. One does wonder how much that allegation drives the outrage about the fact that Facebook shared that data to begin with, but leaving that aside, what is noteworthy is that the outrage stems from the sharing of the data, not its collection. Yes, some are outraged by that collection — but they were outraged before the current scandal, and their objections simply didn’t register with the broader public.

    This view is buttressed by the fact that Google has been largely unscathed by the current controversy; what seems significant is not the fact that the company collects data, but rather that it has been careful to keep that data inside its walled garden. Indeed, that was always the irony with Gundotra’s attack on Apple: Google has always been anything but open when it came to its proprietary technology or its money-making ad apparatus (of which user data plays an important part). Its insistence that Android be open was based not on principle but on sound strategy: challengers always want to commoditize their complements, and for Google, smartphones themselves were complements to Search and ads.

    The implication is quite far-reaching: being open, at least to the extent that openness involved user data of any sort, is increasingly unacceptable; that new companies and user benefits might result from that data no longer matters, a fate that all-too-often befalls the not-yet-created.

    The Entrenchment of Google and Facebook

    This entrenches Facebook and Google in three ways:

    • First, it is even more unlikely that a challenger to either will arise without meaningful access to their proprietary data. This, to be fair, was already quite unlikely: the entire industry learned from Instagram’s piggy-backing on Twitter’s social graph that sharing data with a potential competitor was a bad idea from a business perspective.
    • Second, Google and Facebook will increasingly be the only source of innovations that leverage their data; it will be too politically risky for either to share anything with third parties. That means new features that rely on user data must be built by one of the two giants, or, as is always the case in a centrally-planned system relative to a market, not built at all.
    • Third, Google and Facebook’s advertising advantage, already massive, is going to become overwhelming. Both companies generate the majority of their user data on their own platforms, which is to say their data collection and advertising business are integrated. Most of their competitors for digital advertising, on the other hand, are modular: some companies collect data, and other collect ads; such a model, in a society demanding ever more privacy, will be increasingly untenable.

    There are increasing expectation that this is exactly what will happen with the European Union’s General Data Protection Regulation (GDPR). From the Wall Street Journal:

    Brussels wants its new General Data Protection Regulation, or GDPR, to stop tech giants and their partners from pressuring consumers to relinquish control of their data in exchange for services. The EU would like to set an example for legislation around the world. But some of the restrictions are having an unintended consequence: reinforcing the duopoly of Facebook Inc. and Alphabet Inc.’s Google…

    Digital advertising companies, known as ad tech firms, say Google and Facebook’s strict interpretation of GDPR squeezes their business. The ad tech firms embed their own technology in publishers’ websites and apps, putting them in competition with the tech giants. Unlike the giants, the ad tech firms have no direct relationship with consumers. They say Google’s and Facebook’s response pressures publishers to seek consent on behalf of dozens of ad tech firms that people have never heard of.

    This is hardly a surprise — I predicted this months ago. And, while GDPR advocates have pointed to the lobbying Google and Facebook have done against the law as evidence that it will be effective, that is to completely miss the point: of course neither company wants to incur the costs entailed in such significant regulation, which will absolutely restrict the amount of information they can collect. What is missed is that the increase in digital advertising is a secular trend driven first-and-foremost by eyeballs: more-and-more time is spent on phones, and the ad dollars will inevitably follow. The calculation that matters, then, is not how much Google or Facebook are hurt in isolation, but how much they are hurt relatively to their competitors, and the obvious answer is “a lot less”, which, in the context of that secular increase, means growth.

    Privacy and Regulation

    There is a broader question from GDPR specifically and the idea that the tide is pushing towards walled gardens generally: what should the seemingly inevitable regulation of tech companies look like? It seems increasingly certain that privacy will be a major focus (it obviously already is in the European Union), but to stop there would be a mistake.

    Specifically, if an emphasis on privacy and the non-leakage of data is a priority, it follows that the platforms that already exist will be increasingly entrenched. And, if those platforms will be increasingly entrenched, then the more valuable might regulation be that ensures an equal playing field on top of those platforms. The reality is that an emphasis on privacy will only increase the walls on those gardens; it may be fruitful to rule out the possibility of unfair expansion.

    Note: I wrote a follow-up in the Daily Update that you can read in this footnote:5

    1. The picture is from his presentation ↩

    2. Because private keys are associated with devices, iMessage actually encrypts a single message multiple times, each time using the public key for a different recipient device ↩

    3. To be very clear, it is technically possible to layer encryption onto RCS, but it requires the cooperation of the carriers collectively and the addition of a trusted entity like certificate authorities for https; the entire point, though, is that carriers refuse to do this. ↩

    4. An example of a open-source software that is a closed service ↩

    5. So, I definitely messed up with yesterday’s article in a way none of you noticed; given that on Monday I wrote in-depth about Google’s new Chat initiative, I kind of skirted over the details in yesterday’s article, Open, Closed, and Privacy. Unfortunately, that meant I got a whole bunch of tweets and email from non-subscribers taking me to task for items, well, that I already explained (I didn’t get any from subscribers). The perils of paywalls!

      Probably the two biggest points of pushback were that Google could build an encrypted system if they wanted to (as I explained on Monday, they already tried, and they can’t really exercise Android leverage right now), and that carriers could build a federated key exchange system and/or something akin to the certificate authority framework that undergirds HTTPS. That is all true!

      My point, though — and the reality that Google had to accept, as The Verge feature explained — is that the carriers are not going to do that, full stop. The only way to achieve end-to-end encryption in the real world as it exists today is to build a separate centralized service that sits on top of phones (via apps) and runs over the Internet. To put it another way, Google wasn’t choosing whether to build an encrypted service or an open one; they were choosing whether to build something better than SMS or nothing at all.

      Now, does Google have a business interest in message content being unencrypted? I suppose, and as I noted on Monday, making Allo unencrypted by default was a bad look (although understandable for non-advertising related reasons, specifically the deep integration with Google Assistant). The truth, though, is that Google already knows plenty about everyone, especially those using Android. One could argue that Google didn’t fight hard enough for encryption, but to say the company actively didn’t want encryption isn’t quite right in my opinion.

      Still, the clarification is useful given the comparison I was trying to draw between encryption and privacy: just as one can, in theory, envision a standard that is both open and includes encryption (like HTTPS!), one can also envision a world where users truly own their data in a secure way and carry it from service-to-service. In reality, such systems are far more viable if built into the foundation of the technology (like HTTPS!) as opposed to being retrofitted over the objection of entrenched incumbents.

      Two more points of follow-up:

      • While I didn’t say so explicitly, I think I at least strongly implied on Monday that I would not expect Apple to support Chat. They certainly could — remember, this is basically SMS 2.0, and Apple obviously supports SMS — but it is difficult for me to imagine any scenario where Apple doesn’t hold its ground with the (very legitimate!) excuse that Chat is not encrypted. More importantly, it is even more difficult for me to see any way that carriers could exert leverage on Apple; their lack of leverage is why iMessage exists in the first place.
      • The blockchain is, of course, a theoretical solution, but as I’ve noted previously, the real blockchain upside with regards to this debate is the entire undoing of aggregators through decentralization. To be sure, that is by no means a sure thing, for many of the principles laid out in this article, particularly the trade-off between a user experience that scales and such decentralization. Regardless, any such solution is quite a ways in the future.

      As for the final bit about regulation, stay tuned. It has been top-of-mind for a long time. ↩

  • Zillow, Aggregation, and Integration

    Last Friday something truly remarkable happened: a public company that had grown its valuation from $539 million to nearly $7 billion in seven years announced it was changing its business model. The company was Zillow, and the stock market quickly put a price on how big of a risk the company was taking; from CNBC:

    Zillow shares plunged 9 percent on Friday after the online real estate database company announced it will begin buying and selling homes, a capital-intensive endeavor. With Zillow’s new program, announced on Thursday, home sellers in the test markets of Phoenix and Las Vegas will be able to use Zillow’s platform to compare offers from potential buyers — and Zillow. When Zillow purchases a home, it will aim to quickly flip the home, making updates and repairs and listing it as soon as possible. An agent will represent Zillow in each transaction.

    “We’re entering that market and think we have huge advantages because we have access to the huge audience of sellers and buyers,” Zillow CEO Spencer Rascoff said on CNBC’s “Squawk Alley.” “After testing for a year in a marketplace model, we’re ready to be an investor in our own marketplace.”

    But investors are less enthusiastic. Flipping homes, a model that’s being utilized by start-up Opendoor, is very different than operating an internet marketplace. It carries additional risk associated with buying and selling homes and requires a hefty investment in operations. And it also potentially puts Zillow in direct competition with the realtors on its platform. Zillow sank $5, or 9.3 percent, to $48.77 as of mid-day on Friday, knocking more than $900 million off its stock market value.

    That’s a lot of money to bet on…well, what exactly? What kind of company is Zillow today, and what kind of company does it hope to be in the future?

    Zillow and Aggregation Theory

    Last fall I refined Aggregation Theory by Defining Aggregators. To quickly summarize, I wrote that Aggregators as a whole share three characteristics:

    • A direct relationship with users
    • Zero marginal costs to serve those users
    • Demand-driven multi-sided networks that result in decreasing acquisition costs

    This allows Aggregators to leverage an initial user experience advantage with a relatively small number of users into power over some number of suppliers, which come onto the platform on the Aggregator’s terms, enhancing the user experience and attracting more users, setting off a virtuous cycle of an ever-increasing user base leading to ever-increasing power over suppliers.

    Not all Aggregators are the same, though; they vary based on the cost of supply:

    • Level 1 Aggregators have to acquire their supply and win by leveraging their user base into superior buying power (i.e. Netflix).
    • Level 2 Aggregators do not own their supply but incur significant marginal costs in scaling supply (i.e. Airbnb or Uber).
    • Level 3 Aggregators have zero supply costs (i.e. App Stores or social networks)

    Where, then, does Zillow fit? It certainly has the hallmarks of an Aggregator: users go to Zillow directly to look for homes, Zillow incurs zero marginal costs to serve those users, and the company has created a two-sided market where its suppliers (home sellers) are incentivized to come onto the platform on Zillow’s terms in order to reach Zillow’s end users, thus making the platform more attractive to those end users.

    The question of supply is more complicated; in North America real estate listings are gathered in hundreds of local multiple listing services (MLSs) run by local realtor associations, and access is restricted to brokers in that local region. Redfin got access to those listings by becoming a broker itself, but Zillow, at least at the beginning, relied on brokers uploading listings themselves — which they were willing to do, thanks to the userbase Zillow had already built up thanks in part to its Zestimate house valuation tool.

    This was Aggregation Theory in action: gain users with a new kind of user experience, then leverage that user base to get suppliers to come onto your platform on your terms, further improving the user experience. And, eventually, Zillow was able to parlay that user base into direct access to those MLS services, first via the owners of Realtor.com, and then, when they pulled the agreement, via local MLSs and brokers directly who understood how important it was to stay on Zillow.

    Interestingly, this means that Zillow arguably started out as a Level 3 Aggregator, and then stepped down to a hybrid of Level 1 and Level 2: cutting all of those deals is expensive, and the company does pay for the data, but it’s not exclusive by any means. And this, by extension, gets at why Zillow, despite having so many of the characteristics of an Aggregator, just doesn’t seem nearly as important as companies like Netflix or Airbnb or Facebook: it has accommodated itself to the real estate industry; it hasn’t transformed it.

    The Real Estate Media Company

    The first sentence in Zillow’s S-1 was its mission statement: “Our mission is to build the most trusted and vibrant home-related marketplace to empower consumers with information and tools to make intelligent decisions about homes.” In 2014, though, the company coined a new description for itself: a “real-estate media company.”

    The occasion was the purchase of Trulia: both companies made money selling ads to real estate agents eager to get their listings at the top of the two real estate aggregators that were the top two starting points for real estate searches; by emphasizing they were both media companies Zillow could claim they both had many competitors and weren’t competitive with real estate agents all at the same time.

    It also had the benefit of being true (until last week). The real estate business in North America has long been an expensive quagmire, for reasons I laid out when Zillow bought Trulia:

    • While real estate transactions in the aggregate are very frequent, for individual buyers and sellers they are very rare. Thus there is little incentive to push for a simpler solution.
    • A real estate transaction is usually the largest transaction most buyers and sellers will undertake, which makes them very risk averse and unwilling to try an unconventional service.
    • There is a lot of regulation and paperwork associated with a real estate transaction, where assistance is very valuable. And, as just noted, transactions are rare, which means there is little incentive to learn how to deal with said regulations and paperwork on your own.

    Combine the reticence of consumers to push for change with the local realtor association-controlled MLSs, and a willingness by realtors to punish anyone changing the status quo (by not showing a house, or pointing out flaws that would kill a sale), and the best outcome for Zillow was to be an aggregator but not an integrator: the company was completely removed from the purchase process.

    Integration and Aggregation

    This gets at why Zillow, for all of its success, seems so underwhelming compared to other Aggregators. One of the key theories underpinning Aggregation Theory is Clayton Christensen’s Conservation of Attractive Profits, which I explored in the context of Netflix while developing the theory:

    The Law of Conservation of Attractive Profits1 [was] first explained by Clayton Christensen in his 2003 book The Innovator’s Solution:

    Formally, the law of conservation of attractive profits states that in the value chain there is a requisite juxtaposition of modular and interdependent architectures, and of reciprocal processes of commoditization and de-commoditization, commoditization, that exists in order to optimize the performance of what is not good enough. The law states that when modularity and commoditization cause attractive profits to disappear at one stage in the value chain, the opportunity to earn attractive profits with proprietary products will usually emerge at an adjacent stage.

    That’s a bit of a mouthful, but the example that follows in the book shows how powerful this observation is:

    If you think about it in a hardware context, because historically the microprocessor had not been good enough, then its architecture inside was proprietary and optimized and that meant that the computer’s architecture had to be modular and conformable to allow the microprocessor to be optimized. But in a little hand held device like the RIM BlackBerry, it’s the device itself that’s not good enough, and you therefore cannot have a one-size-fits-all Intel processor inside of a BlackBerry, but instead, the processor itself has to be modular and conformable so that it has on it only the functionality that the BlackBerry needs and none of the functionality that it doesn’t need. So again, one side or the other needs to be modular and conformable to optimize what’s not good enough.

    Did you catch that? That was Christensen, a full four years before the iPhone, explaining why it was that Intel was doomed in mobile even as ARM would become ascendent.2 When the basis of competition changed away from pure processor performance to a low-power system the chip architecture needed to switch from being integrated (Intel) to being modular (ARM), the latter enabling an integrated BlackBerry then, and an integrated iPhone four years later.3

    The PC is a modular system whose integrated parts earn all the profit. Blackberry (and later iPhones) on the other hand was an integrated system that used modular pieces.
    The PC is a modular system whose integrated parts earn all the profit. Blackberry (and later iPhones) on the other hand was an integrated system that used modular pieces. Do note that this is a drastically simplified illustration.

    More broadly, breaking up a formerly integrated system — commoditizing and modularizing it — destroys incumbent value while simultaneously allowing a new entrant to integrate a different part of the value chain and thus capture new value.

    Commoditizing an incumbent's integration allows a new entrant to create new integrations -- and profit -- elsewhere in the value chain.
    Commoditizing an incumbent’s integration allows a new entrant to create new integrations — and profit — elsewhere in the value chain.

    This is exactly what is happening with Airbnb, Uber, and Netflix too.

    This is the original piece of Aggregation Theory that was missing from last year’s Defining Aggregators: it is one thing to sit on top of an existing industry and, well, be a media company/lead generation tool. There have been a whole host of businesses that did exactly that, and while there is plenty of money to be made, without some sort of integration into the value chain of the industry itself they simply aren’t transformative. To put it another way, aggregation doesn’t transform value chains; integration does.

    Why aggregation matters is that it is the means by which new integrations are achieved:

    • Netflix leveraged its position as an aggregator of video content into the integration of the customer relationship and content creation, undoing the integration of linear channels and content creation
    • Airbnb/Uber and other similar services integrate the customer relationship with the driver/homeowner relationship, undoing the integration of cars/property with payment
    • Google and Facebook integrated content discovery with advertising, undoing the integration of editorial and advertising

    More broadly — and this really gets at why Zillow is different — Aggregators that change industries (including Aggregator-like Amazon and Apple that deal with physical goods) integrate the customer relationship with however it is their industry generates revenue; Zillow, on the other hand, was completely divorced from the home selling-and-buying process.

    The Threat to Zillow — and the Opportunity

    Again, not all companies need to be Aggregators, and as I noted at the beginning, Zillow has become a very successful company by getting half-way there. And, to return to that Daily Update about their purchase of Trulia, I didn’t think it was even possible for them to go all the way:

    So then, perhaps this deal isn’t anticompetitive, but rather the key to building a company big enough to finally shake up the homebuying process? That’s Brad Stone’s argument in Bloomberg Businessweek…But remember, Zillow/Trulia are marketing tools; who is paying for that tool? Stone has the answer in the next paragraph:

    The companies, which rely on advertising from real estate agents for the bulk of their revenues, are being careful about how they discuss the future of their combined efforts.

    What Stone characterizes as “careful” I characterize “prudent” and “truthful”, because let’s be honest: Zillow/Trulia are not going to bite the hand that feeds them. Nor should they! It would be irresponsible to their shareholders, employees, and all their other stakeholders. It’s very easy to fantasize about disruption; it’s much more productive to simply follow the money. (This is why Redfin is the more interesting company in this space; they use their own network of real estate agents. It’s also why they are much smaller, despite having had a head start.)

    This is why last week’s news was such a surprise, to me anyways; granted, Zillow had been experimenting with facilitating sales to investors, but to fundamentally change your capital structure, margin profile, and compete with your customers in one fell swoop feels like something else entirely — and Wall Street agreed!

    I can, though, see where Zillow is coming from: no one thinks the North American real estate market is the way it is because that is somehow optimal or good for consumers; the only folks that benefit from the status quo are real estate agents that continue to collect 6% of the purchase price even as their responsibilities, particularly in the case of the buying agent, run in the opposite direction of their incentives. Zillow did well to capture a portion of that 6% for itself through its realtor ad model, but that only meant that Zillow was as dependent on the status quo as the realtors.

    To be sure, Zillow has long been a better bet than Redfin, which has admirably IPO’d with a business that basically adds a tech layer (and thus superior lead generation) to a traditional real estate agency; the reality is that simply adding a tech layer doesn’t change industries — that requires new business models. This, though, is where Opendoor, the startup I wrote about in 2016, is compelling: buying houses with the click-of-a-button solves a major problem for sellers, the most disadvantaged party in the entire value chain under the status quo (and thus the most open to something new). And, by definition, it means the company (and competitors like OfferPad) are involved with the transaction that drives the value chain — the actual buying and selling of homes.

    Make no mistake, the business model is risky, but that is another way of saying the potential return is massive as well: truly becoming a market maker for an industry that does $900 billion worth of transactions every year has massive upside. And, by extension, massive downside for the status quo — which again, includes Zillow. That is one reason to act.

    Even so, that might not have been enough for Zillow to make such a shift: remember, this is a public company accountable to shareholders, and sometimes doubling down is the most prudent course of action. That, though, is why I spent so much time discussing integration: there is a massive amount of upside for Zillow in this move as well.

    Remember, Zillow is in nearly every respect already an Aggregator: it is by far the number one place people go when they want to look for a new house, and at a minimum the starting point for research when they want to sell one. They own the customer relationship! What has always been missing is the integration with the purchase itself — until last week. Zillow is making a play to be a true Aggregator — one that transforms its industry by integrating the customer relationship with the most important transaction in its respective value chain — by becoming directly involved in the buying and selling of houses.

    The Zillow Experiment

    This absolutely could go sidewise: Zillow is already being hammered in the stock market — investors aren’t generally fans of high-margin companies entering low-margin businesses, with huge amounts of volatility risk to boot. Moreover, Zillow is embracing a model that, should it be successful, tears down the status quo: this will not only enrage Zillow’s customers, but also endanger Zillow’s primary revenue stream.

    Here, though, Zillow’s status as an almost-Aggregator looms large: we now have years’ worth of evidence that realtors will do what it takes to ensure their listings appear on Zillow, because Zillow controls end users. It very well may be the case that realtors will find themselves with no choice but to continue giving Zillow the money the company needs to disrupt their industry.

    I will certainly be watching closely: how Zillow fares will result in lessons that may be applicable broadly. Think of Spotify, for example: I was a bit bearish on the company last month because of the power of Spotify’s suppliers; the bull case is that Spotify’s ownership of the customer relationship will allow the company to build out the capability to sidestep the record labels even as the record labels can’t punish Spotify because they need them. That’s exactly what Zillow is testing right now: just how much power comes from being an Aggregator, and how much an industry can be transformed when that power is wielded.

    1. Later renamed the Law of Conservation of Modularity ↩

    2. I have my differences with Christensen, but as I’ve said repeatedly my criticism comes from an attempt to build on his brilliant work, not tear it down ↩

    3. As I’ve noted, the iPhone is in fact modular at the component level; the integration is between the completed phone and the software. Not appreciating that the point of integration (or modularity) can be anywhere in the value chain is, I believe, at the root of a lot of mistaken analysis about the iPhone in particular ↩

  • The Facebook Current

    “I thought something was going to get done,” lamented a friend, in reference to yesterday’s Senate hearing that featured a single witness: Facebook Founder and CEO Mark Zuckerberg. “This was the moment of reckoning, but it just turned out to be a whimper — it’s just for show.”

    The sentiment seemed widespread on tech and media Twitter: there was a lack of specificity in terms of questions about privacy (this allowed Zuckerberg to turn nearly every question about the ownership of data to a discussion about user interface controls that limit where data is shown to other Facebook users), plenty of dodged questions (every time there was a question about the data Facebook generates about users beyond what they themselves enter into the system Zuckerberg needed to “check with his team”), and bad questions that presumed Facebook sells data, letting Zuckerberg run out the clock at least three times by explaining the basics of Facebook’s business model (this is precisely why I have been so outspoken about the problem of perpetrating this falsehood: it lets Facebook off the hook).

    In fact, though, I thought the hearing was quite revelatory — a “show”, if you will. First, the fact that Zuckerberg appeared at all is the most meaningful news; the nature of the American political system is that changes happen extremely gradually, and only then in response to fundamental shifts in underlying political opinion. This can certainly be frustrating if one wants faster change — or a relief if one fears those in power — but that is precisely why Zuckerberg’s appearance was noteworthy: there is a current moving against Facebook, and while it is not realistic to expect that current to already be a wave, it was strong enough to sweep him to Washington D.C. for the week.1

    Secondly — and count this as another indication that that current is stronger than it seems — there was a significant amount of agreement amongst the Senators in yesterday’s hearings that something needed to be done about Facebook. Forget the specifics, for a paragraph, because this is a notable development: while these hearings usually devolve into partisan cliches with the same talking points — Democrats want regulations, and Republicans don’t — yesterday Senators from both sides of the aisle expressed unease with Facebook’s handling of private data; obviously Democrats tried to tie the issue to the last election, but that made the Republicans’ shared concern all-the-more striking.

    Here is where the partisan divide does matter: the most important takeaway from yesterday’s hearing was the emergence of two distinct viewpoints on what the problem with Facebook actually is, and what to do about it. That these two viewpoints are in opposition is precisely why their emergence is so compelling: a current has to be very strong indeed for there to be two clearly articulable sides.

    Viewpoint One: Facebook Needs Regulation

    OK, so maybe one of the viewpoints fit the partisan cliche, but the idea that Facebook might need regulation was a frequent talking point, particularly from Democrats pushing already-proposed legislation. After detailing how, in his view, Facebook violated its 2011 Consent Decree with the FTC, Senator Richard Blumenthal distilled this viewpoint to its essence here:

    Senator Blumenthal: What happened here was willful blindness. It was heedless and reckless and in fact amounted to a violation of the FTC consent decree. Would you agree?

    Mark Zuckerberg: No, Senator. My understanding is not that this was a violation of the consent decree. But as I have said a number of times today, I think we need to take a broader view of our responsibility around privacy than just what is mandated in the current laws.

    SB: Well here is my reservation Mr. Zuckerberg…we’ve seen the apology tours before. You have refused to acknowledge even an ethical obligation to have reported this violation of the FTC consent decree, and we have letters, we’ve had contacts with Facebook employees…that indicates not only a lack of resources but lack of attention to privacy. And so, my reservation about your testimony today is that I don’t see how you can change your business model unless there are specific rules of the road. Your business model is to monetize user information, to maximize profit over privacy, and unless there are specific rules and requirements — enforced by an outside agency — I have no assurance that these kinds of vague commitments are going to produce action.

    This view is clearly gaining traction in certain political circles. For example, here is Matthew Yglesias in Vox:

    Online social networks obviously pose some novel legal and regulatory issues. But broadly speaking, the question of how to ensure that companies discharge their responsibilities is not a brand new one. Companies involved in the provision of health care are responsible — not just morally but legally and financially — to abide by the terms of the Health Insurance Portability and Accountability Act of 1996. That law hasn’t eliminated all privacy violations in the health care space, by any means, but when violations occur, they are punished, and the punishment gives actors in that space real reason to avoid them. Financial institutions, similarly, must comply with the privacy rules set out in the Gramm-Leach-Bliley Act. GLBA compliance has thus become its own somewhat tedious mini industry, with lawyers and specialized GLBA compliance firms you can hire…

    Once upon a time, the US government wisely believed that it would be a bad idea to subject promising young internet startups to the bureaucratic morass involved in things like HIPAA or GLBA compliance. But the young internet startups are all grown up now, and can easily afford to hire vast armies of lawyers and compliance experts who will help them avoid breaches that lead to massive fines. There is no longer a need to treat Facebook like a delicate flower whose agility will vaporize if it is held legally accountable for its actions.

    That means disclosure rules for advertising, it means financial consequences for privacy violations, it means firm antitrust action to restrain further acquisitions and try to uphold some semblance of competition in this marketplace, and it means taking a close look at whether the development of ever more sophisticated ad targeting algorithms is being done in a way that serves the public’s interest in creating a robust media infrastructure.

    What is worth noting was the extent to which Zuckerberg was open to, if not something as specific as Yglesias’ proposal, regulation of some sort. Zuckerberg told Senator Dan Sullivan:

    I’m not the type of person who thinks that all regulation is bad, so I think the Internet is becoming increasingly important in people’s lives, and I think we need to have a full conversation about what is the right regulation, not whether it should be or shouldn’t be.

    This isn’t a surprise: Zuckerberg said in his opening remarks that Facebook was “going through a broader philosophical shift in how we approach our responsibility as a company”, which he meant as an indication that the company would be taking more responsibility, but which could easily be interpreted as the company locking the doors to its closed garden and throwing away the key. In this regulation is actually helpful, a point made by Senator Sullivan in response to Zuckerberg’s statement:

    Senator Sullivan: One of my worries on regulation with a company of your size saying “Hey, we might be interested in being regulated”, but as you know, regulations can also cement the dominant power. So what do I mean by that? You have a lot of lobbyists, I think every lobbyist in town is involved in this hearing in some way or another, a lot of powerful interests. You look at what happened with Dodd-Frank: that was supposed to be aimed at the big banks, the regulations ended up empowering the big banks and keeping the small banks down. Do you think that that’s a risk given your influence that if we regulate, we’re actually going to regulate you into a position of cemented authority, when one of my biggest concerns about what you guys are doing is that the next Facebook, which we all want, the guy in the dorm room, we all want that to be started, that you are becoming so dominant that we’re not able to have that next Facebook? What are your views on that?

    MZ: Senator I agree with the point that when you’re thinking through regulation across all industries you need to be careful that it doesn’t cement in the current companies that are winning…I think part of the challenge with regulation in general is that when you add more rules that companies to follow, that’s something that a larger company like ours inherently just have the resources to go do, and that might just be harder for a company getting started to comply with.

    That Sullivan, a Republican, would be suspicious of regulation is hardly a surprise — that’s the cliche I referenced above. There’s more context to Sullivan’s comments though: he hinted at an alternative to regulation.

    Viewpoint Two: Facebook is Too Big

    Here is Sullivan’s lead-up to Zuckerberg’s embrace of regulation quoted above:

    Your testimony, you have talked about a lot of power, you’ve been involved in elections, I thought your testimony was very interesting, really all over the world, 2 billion users, over 200 million Americans, $40 billion in revenue, I believe you and Google have almost 75% of the digital advertising in the U.S., one of the key issues here is Facebook too powerful? Are you too powerful?…

    When you look at the history of this country, and you look at the history of these kinds of hearings…when companies become big and powerful and accumulate a lot of wealth and power, what typically happens from this body is there’s an instinct to either regulate or break-up. Look at the history of this nation. Do you have any thoughts on those two policy approaches?

    No wonder Zuckerberg was so eager to talk about regulation: it’s not simply that it benefits incumbents, it’s that it is a whole lot more attractive than discussing a potential break-up!

    Note, though, that Sullivan wasn’t alone in pushing this idea that Facebook might be too big (a sentiment that Senator John Kennedy also raised last fall). The most fascinating Republican line of questioning came from Senator Lindsey Graham:

    Senator Graham: Who’s your biggest competitor?

    MZ: We have a lot of competitors.

    SG: Who’s your biggest?

    MZ: Hmm, I think the categories — did you want just one? I’m not I could give one — could I give a bunch?

    SG: Uh-huh.

    MZ: So there are three categories I would focus on. One are the other tech platforms, so Google, Apple, Amazon, Microsoft. We overlap with them in different ways.

    SG: Do they provide the same service you provide?

    MZ: Uhm, in different ways, different parts of it, yes.

    SG: Let me put it this way. If I buy a Ford and it doesn’t work well and I don’t like it, I can buy a Chevy. If I’m upset with Facebook, what’s the equivalent product that I can go and sign up for?

    MZ: Well, the second category that I was going to talk about…

    SG: I’m not talking about categories. What I’m talking about is real competition that you face, because car companies face a lot of competition, that if they make a defective car, it gets out in the world, people stop buying that car and buy another one. Is there an alternative to Facebook in the private sector?

    MZ: Yes Senator. The average American uses eight different apps to communicate with their friends and stay in touch with people, ranging from texting to email…

    SG: That is the same service you provide?

    MZ: Well we provide a number of different services.

    SG: Is Twitter the same as what you do?

    MZ: It overlaps with a portion of what we do.

    SG: You don’t think you have a monopoly?

    MZ: It certainly doesn’t feel like that to me!

    SG: So it doesn’t. So, Instagram, you bought Instagram, why did you buy Instagram?

    MZ: Because they were very talented app developers who were making good use of our platform and understood our values.

    SG: It was a good business decision. My point is that one way to regulate a company is through competition, through government regulation, here’s the question all of us have to answer. What do we tell our constituents given what’s happened here, why we should let you self-regulate? What would you tell people in South Carolina, that given all the things we just discovered here, is a good idea for us to rely upon you to regulate your own business practices?

    Zuckerberg quickly articulated that he would be in favor of regulation, using much the same language he would return to later in his response to Senator Sullivan, but the implication of Graham’s line of questioning was more profound than that: perhaps the real problem is the monopolistic nature of the company, because the normal checks that come from competition were missing.

    This is, I would note, quite consistent with the skepticism about regulation voiced by Senator Sullivan: if the concern is that a bunch of rules limit competition, then a better response, if there must be one, would seek to empower competition by undoing the monopoly entirely.

    The Shifting Debate

    The most likely outcome of Facebook’s current scandal continues to be that nothing will happen, for all of the inherent lethargy in our political system noted above. And, if something does, European-style data regulation seems the more likely outcome, as I noted last month. No wonder Facebook’s stock was up after the hearing!

    It’s worth keeping in mind, though, that because Facebook is so dominant, the question of its governance is ultimately a political question, and to that end the shifts in the terms of debate, if not yet its outcome, have been striking. Zuckerberg is in Washington D.C., everyone says something must be done, and critically, both sides have ideas about what that should be; while this certainly may be mostly a Facebook problem, the rest of the industry should take note.

    1. Zuckerberg will testify again later today, this time in front of the House of Representatives’ Energy and Commerce Committee ↩