The New Matchmaking

A reader suggests, probably correctly, that this story belongs under Four Forces Watch.

The company has come up with a secret algorithm that invites select users to access the app based primarily on LinkedIn résumés and friend networks. Ambition, Bradford says, is the biggest trait The League looks for within its community.

It is a dating application with a very limited, exclusive clientele.

I remember when some discos/nightclubs used a similar sort of business model.

Uncertainty and the Sources of Profit

From The Economic Way of Thinking, eleventh edition, by Paul Heyne and others, p. 195:

Profit arises from uncertainty. In the absence of uncertainty, any differences between expected revenue and expected total cost would be competed away and profits would become zero.

That sounds to me like too strong a generalization. Some remarks.

1. It shows the influence of Frank Knight. But would Knight have bought such a strong statement?

2. Economists, including the authors, point out that profits as reported by business include opportunity cost, particularly the opportunity cost of capital. Economic profit is less.

3. Elsewhere, the authors want to insist, reasonably enough, that taxes are paid by individuals, even when those taxes are called corporate income taxes. I would think that consistency would require insisting that profits accrue to individuals, even when they are called corporate profits. But if all profits accrue to individuals, then I do not see how we can separate economic rent from opportunity cost. Maybe Bill Gates made a lot of money from Microsoft because he happens to have a very high opportunity cost. OK, that sounds absurd, but still, he has a higher opportunity cost than someone with less drive and ability starting a software business.

4. Talking about the profits earned by shareholders is tricky. In the portfolio theory of modern finance, there should be no excess return from taking diversifiable risk. Unless I know something that everyone else doesn’t, I will earn on average a lower return by buying shares in a particular stock than by buying shares in the market portfolio. (I think this point tends to cut against point 3 above.)

5. How do patents fit into the story? Firms obtain patents in order to protect profits. Are patents simply government-chartered monopolies, leading to artificial rents? Or are patents a return on investment in research and development? In the latter case, perhaps one would say that if the outcome of research and development were certain, then profits from those activities would become zero.

6. It seems to me that there are other sources of market power that are defensible. I am not talking about defensible in a moral sense, but defensible in the sense that they will not be competed away. For example, there is reputation. If my insurance company has a reputation for being sound, then potential competitors will find it difficult to persuade my customers to switch. Another example is network effects. Wal-Mart has a lot of customers because it has cheap prices. Because it has a lot of customers, it is in a strong bargaining position with suppliers, so it can keep its prices cheap. But if a lot of companies try to create network effects, and some succeed and some fail, is this another case of profit emerging out of uncertainty?

Going back to the quoted paragraph, I think that it is either false or uninteresting. If we do not stretch our definition of uncertainty, then it is false. Alternatively, suppose that we make it true by arguing that profit from investment in intellectual property, reputation, network effects, and so on is only due to the uncertainty involved in such investment. A forced tautology of that sort is not interesting.

Hayek and Business Management

Chris Dillow writes,

If extensive knowledge is possible, then bosses might be able to manage big companies well. If not, then centrally planned companies will be inefficient. Sure, perhaps competition will eventually weed out egregious incompetence, but market forces might not grind so finely as to eliminate all inefficiency

Pointer from Mark Thoma.

I cannot emphasize enough how much I agree with this. Because I spent 15 years in business, I got an opportunity to see large organizations close up. I saw that in a large business, the top management cannot keep track of more than about three major initiatives at a time. I saw that compensation systems have to be frequently overhauled, because employees learn to game any system that stays in place for more than a couple of years. I saw the “suits vs. geeks” divide, as specialists in information technology or financial modeling had difficulty communicating with executives who had only general knowledge.

The notion of large, efficient organization is an oxymoron. If you think that large corporations have overwhelming advantages, then you have explained why IBM still dominates the computer industry, while Microsoft and Apple never really got amounted to much of anything. I like to say that if you are afraid of large corporations then you have never worked for one.

Of course, large corporations do exist. That is because as clumsy as they are, they can still be less clumsy than the alternative, which is to break a corporation into a network of contractually related divisions. Nobel Laureate Oliver Williamson tried to address the issue of when to expect a market and when to expect a hierarchy. His answers do not really speak to me, but I do not claim to have better ones.

I do think that government often tilts the scale in favor of large organizations. The high fixed cost of regulatory compliance is one factor. Government has been a key customer in industries like aerospace, information technology, and finance, and the fixed costs of selling to government are very high, because of all of the hoops that you have to jump through.

One Peter Thiel Theme: Nonconformity

Tyler Cowen links to his conversation with Peter Thiel. I listened to the YouTube version.

If there is one constant theme, it is Thiel’s support for nonconformity or contrarianism. If you start a business, try to make it so original that it is a monopoly. If you want to start a non-profit, make it for an unpopular cause. Try to value substance over status, meaning you worry about being true to yourself, not about obtaining broad approval and support. The independent truth-seeking scientist is the opposite of the popular truth-bending politician.

Still, he wants contrarians, not misanthropes. Contrarians who can work in teams. I would add, and I imagine he would agree, that contrarians need to be particularly selective about who they team up with.

Subway Externalities

Paul Romer says,

If the only way to support Manhattan densities is with the subway system, then you’ve got to figure out how to finance the subway system. And, you know, part of what we’ve learned is that the value of the subway system will show up to a large extent in the value of the land. So that you can’t just think about sending out, giving out a contract for somebody to build the subway system and try to finance it based on the fare revenue. What you’ve got to do is somehow internalize the increases in the value of the land induced by the kind of access that the subway can provide.

This in a Russ Roberts podcast. Russ has had other interesting guests the last few weeks, also.

Scope and Banking

A reader recommended this post by Jeff Carter.

The days of the one stop shop that Sandy Weil envisioned when he built Citigroup ($C) are gone.

I have always believed that there are diseconomies of scope. Companies with many lines of business are difficult to manage effectively, in my view.

In the case of banking, I thought that the “financial supermarket” fad of the 1980s was silly. Consumers are fine having separate vendors for credit cards, checking accounts, and stock portfolios.

I have to say, though, that it is not just banks that defy my prejudice against multiple business lines. Amazon has branched into all sorts of unexpected businesses, such as renting Web servers. Google is another example of a company that is not strictly bounded in what it businesses it will try.

Some possibilities:

1. I am correct, and whenever you see a company with many lines of business, whether it’s a bank or a tech firm, it represents the CEO’s ego gain and the shareholders’ wealth loss.

2. I am somewhat correct, but the diseconomies of scope are actually quite small. Six lines of business can be managed almost as effectively under one organization as under six totally separate entities.

3. I have it wrong. There actually are tremendous fixed costs to developing a good decision-making structure, and CEO talent is scarce. These super-managers, or management super-cultures, can handle a sixth line of business more effectively than other managers can handle a first.

Capitalist Tentacles

From Fortune,

Founded in 2006, the company has grown to 1,200 employees and operates in 40 countries. With 11 billion page views, 25 million listings, and 8.5 million transactions per month, it is the largest marketplace in India, Poland, and, as of last year, Brazil. Funded by U.S. venture firms including Bessemer Ventures and General Catalyst Partners, OLX sold a majority stake to the African conglomerate Naspers in 2010.

This story made me feel good. I thought I would pass it along.

Technical and Communications Skills

Catherine Weinberger writes,

while math scores, sports, leadership roles, and college education are all associated with higher earnings over the entire 1979-1999 period, the time trend in the earnings premium was strongest among those individuals who participated in sports or leadership activities during high school and had higher levels of cognitive skills. Supporting evidence based on Census and CPS data matched with the Autor, Levy and Murnane (2003) job-task measures provides an independent observation also suggesting that the labor market increasingly favors workers with strong endowments of both cognitive and social skills. These findings, coupled with evidence of growing employment, suggest increasing complementarity between cognitive and social skills among young workers.

Pointer from Tyler Cowen, who sees the findings in an average-is-over context. Indeed, if cognitive skills and social skills are both somewhat scarce and imperfectly correlated, increasing complementarity would lead to greater inequality.

I would always tell my AP Statistics students that they were learning technical communications skills. I would say that communicators without technical skills end up as baristas. Those with technical skills but poor communication skills will end up as Dilbert, working for a boss who appears to be an idiot.

Joshua Gans on Apple Pay and Market Power

He writes,

So last week, in some of these stores you could use Apple Pay. This week in CVS and Rite Aid you can’t. The reason appears to be that a bunch of large retailers got together a couple of years ago to develop their own mobile payments solution — mostly to compete with existing banks and credit card associations. They are still doing that and will only launch their app, CurrentC, next year. In the meantime, they have acted to stop Apple Pay and Google Wallet from getting traction.

When a consortium of big legacy companies tries to take on a tech company in an innovative area, I expect an epic fail.

Matthew Yglesias on Amazon and Market Power

He writes,

What is indisputably true is that Amazon is on track to destroy the businesses of incumbent book publishers. But the many authors and intellectuals who’ve been convinced that their interests — or the interests of literary culture writ large — are identical with those of the publishers are simply mistaken.

Pointer from Jason Collins.

I agree that we should not be rushing to the barricades to defend the traditional publishing business model. Rooting for the book publishers to have strong negotiating leverage with Amazon is equivalent to rooting for the legacy music industry to have strong negotiating leverage with iTunes.