Thoughts on Two-Sided Markets

Lynne Kiesling writes,

the distribution wires firm can, and should, operate as a platform and think about platform strategies as the utility business model evolves. An electric distribution platform facilitates exchange in two-sided electricity and energy service markets, charging a fee for doing so. In the near term, much of that facilitation takes the form of distribution, of the transportation and delivery. As distributed resources proliferate, the platform firm must rethink how it creates value, and reaps revenues, by facilitating beneficial exchange in two-sided markets.

Until now, I have not thought much about this whole two-sided market concept. I am struggling to see what it buys you. Earlier in her post, she quotes from a Harvard Business Review article.

In the traditional value chain, value moves from left to right: To the left of the company is cost; to the right is revenue. In two-sided networks, cost and revenue are both to the left and the right, because the platform has a distinct group of users on each side. The platform incurs costs in serving both groups and can collect revenue from each, although one side is often subsidized

If I’m understanding this correctly, then a brothel is a traditional value chain, but a singles bar is a platform. In terms of that metaphor, Kiesling is suggesting that electric utilities could change from operating like brothels to operating like singles bars.

Some problems I am having:

1. I am not sure what, if anything, makes brothels the natural business model in one industry and singles bars the natural business model in another.

2. Suppose that a singles bar has to pay women in order to get them to show up. By my reading of the HBR excerpt, then it becomes a traditional value chain. Metaphorically, it becomes a brothel, although I assume that it can avoid legal difficulty as long as the beds are off premises.

3. To me, cable TV looks like a brothel, not a singles bar. And to me, electricity looks like cable TV.

4. Metaphorically speaking, taxi companies and hotels operate brothels. Uber and airbnb operate singles bars. What Uber and airbnb are tapping into is supply-capacity that taxi companies and hotels were not using, either because they didn’t think of it or because it didn’t fit their business model. Is there spare electricity-generating capacity that utilities could be tapping into? If so, do they have the know-how and flexibility to tap into it?

Textbooks, Venture Capital, and Pharmaceuticals

Timothy Taylor writes,

It is by no means obvious that a lower-cost book (yes, like my own) works less well for students than a higher-cost book from a big publisher. Some would put that point more strongly.

Yes, I know that professors do not care much, if at all, about the prices of the textbooks they select for their students, but that is not the only reason that prices are so high.

Another factor is that the industry is similar to venture capital and pharmaceuticals. The organizations that fund projects in these areas incur heavy expenses on failures. A lot of textbook projects fail. The author may not even finish the book. Or it will flop in the market.

For a VC firm to stay in business when most of the companies that it funds wind up failures, it has to earn spectacular returns on its successes. For a pharmaceutical firm to stay in business when a lot of its research fails to yield a marketable compound, it has to charge a lot for those drugs that do make it. And for textbook publishers to stay in business when many of their projects flop, they have to charge a high price for the books that do sell.

Advances in technology have made it easier to produce a textbook at low cost. However, by the same token, it has probably increased the probability that any given textbook will fail to get a toehold in the market. So the overall economics of the business still requires publishers to absorb a lot of failed-project costs.

Industrialization, Bureaucracy, and the Nation-State

Robin Hanson quotes from a subscription-only New Scientist article by Deborah MacKenzie.

hierarchical control structures ballooned, with more layers of middle management. Such bureaucracy was what really brought people together in nation-sized units, argues Maleševic. But not by design: it emerged out of the behaviour of complex hierarchical systems. As people do more kinds of activities, says Bar-Yam, the control structure of their society inevitably becomes denser.

In a sense, I began thinking about this fifteen years ago.

Consider two evolutionary processes that could lead to a winner at a particular business.

a) natural selection. Many small firms enter the market and make decisions, and one of them has the skill and luck to make the fewest mistakes, becoming the dominant firm.

b) bureaucratic filtering. A single firm with a large bureaucracy faces many of the same choice points, and it uses its resource-intensive planning processes to sort out the decisions. These processes minimize mistakes, enabling the firm to reach the same point that would be reached in the natural selection process.

My guess is that process (a) will increase in importance in the future, and that process (b) will be less productive. The challenge with defending this guess is the fact that large companies with bureaucratic management are so successful at present.

That particular essay did not deal with the issue of nation-states. But it is consistent with the idea that industrialization and the nation-state would evolve at the same time, because bureaucracy was more important and effective in an industrial economy than in a pre-industrial or post-industrial economy.

Joshua Gans on Apple Pay

He writes,

This is why I think the resolution for the identification challenge is more significant. Last year, with the iPhone 5s, Apple finally got fingerprint recognition right. Last week I actually had to use a iPhone 5c for a few days without Touch ID and I couldn’t believe how much I had learned to rely on it. It really does work and you really do use it and it really is less hassle than a pin or even swiping to unlock the phone. But the security issues were not paramount but a fortunate side product.

Now they are paramount and what is more Touch ID solves the identification problem. It is really hard for criminals to spoof it or steal your identity using it. They would literally have to hold a gun to your head or take a hostage and, frankly, at that point, they are better off just robbing merchants directly.

U.S. credit cards are quite insecure. Biometric ID would seem to me to be a big improvement. Financial intermediaries will still have to put in back-up security measures, so that somebody who figures out how to copy your fingerprint is not able to make unlimited purchases. But I see phone-based payment technology as leapfrogging the current European model of more-secure credit cards.

Incidentally, I want an i-Watch, as long as it can use Google Maps as input. It would make bicycle navigation easier, but not with the crummy default maps app. Since the product won’t be available for a few months, and it since it won’t be biking weather for a few months after that, there is time to see how it develops.

I Wish I Knew More About This

From Technology Review.

Heimerl’s innovation comes in a gray box roughly the size of a microwave oven. It has solar panels on the outside to power cellular equipment inside, along with the software for management functions like billing and analytics. Secure the box somewhere and link it via satellite to a voice-over-IP network, and you’re ready to open shop as a mobile service provider. Heimerl’s nascent company, Endaga, sells it for $10,000

…Just one hitch: it’s illegal. Regional mobile providers hold licenses to the necessary airwaves. Indonesian officials were willing to look the other way, but in general, regulation is a significant hurdle for Heimerl’s vision of universal access. To resolve that issue, he has helped develop a “white space” workaround that occupies unused radio frequencies until another network needs them.

The Endaga company web site does not tell me much.

Health Care Innovation

I review the book by Jonathan Bush and Stephen Baker. An excerpt:

Bush argues that for most medical services, flagship research hospitals are high-cost providers. He believes that in a rational marketplace, the leading hospitals would have to specialize in particular areas of expertise. A hospital with unique skills at treating a certain type of cancer might attract patients from all over the United States with that cancer. However, it would not treat local patients for ailments that are more common and more easily treated. Instead, those cases would be handled by smaller community hospitals or clinics.

Why I would be inclined to replace the FCC and the FDA

Francis Fukuyama writes,

Institutions are created to meet the demands of specific circumstances, but then circumstances change and institutions fail to adapt. One reason is cognitive: people develop mental models of how the world works and tend to stick to them, even in the face of contradictory evidence. Another reason is group interest: institutions create favored classes of insiders who develop a stake in the status quo and resist pressures to reform.

Pointer from Tyler Cowen.

The same holds true in business. Business organizations develop group-think biases and constituencies that resist change. However, if this gets to the point where the organization becomes dysfunctional, the market weeds out the organization. Government agencies lack such a weeding-out mechanism.

Overall, I found Fukuyama’s views did not correspond well with mine. I am concerned with the fundamental knowledge gaps that plague government policymakers. I think that the difference between market competition and government monopoly is significant. I also think that there are diseconomies of scale and scope in government.

Is the Aging of Firms Good News?

Amidst all the discussion of the trend toward fewer young firms in the economy, this question occurred to me.

I think of entrepreneurship as a trial-and-error learning process. If we had perfect knowledge in the economy, we would not need new firms. Is it possible that information about business prospects is getting better, so that we do not need as many new firms?

The analogy might be with inventories. In the 20th century, a major factor in recessions was that auto and steel manufacturers often were caught with large excess inventories, resulting in layoffs as the companies reduced production to work off the unwanted inventories. Over the last 25 years, computer and communication technology has caused the inventory cycle to be much more subdued.

What if “big data” in the economic and business environment has a similar effect on starting new ventures? Instead of having to spend years to determine whether a new business idea is viable, suppose it takes months, or can be predicted with reasonable accuracy even before it is launched?

In that kind of environment, I think that some of the advantage shifts away from entrepreneurs and toward existing businesses. As Amar Bhide pointed out, ambiguity deters large established businesses but attracts entrepreneurs. We think of rapid technological change as adding ambiguity to the environment, because change creates uncertainty. But if one of the effects of change is to make the business environment easier to read, maybe the ambiguity is lower today than it was 20 years ago.

Put this post in the “ideas I put out there but to which I am not committed” category.

UPDATE: That didn’t take long. from the comments:

I think if this were the case we would expect to see fewer of the types of entrepreneurs that don’t grow/fail quickly, but the types of entrepreneurs who grow rapidly and create a lot of jobs would not be affected (because predictions of success are becoming more accurate). This may have been the case prior to 2000, but we show that since 2000 the top of the growth rate distribution for entrepreneurs has fallen. Entrepreneurs aren’t growing as fast, and/or the high-growth types aren’t entering the market, which I think reduces the plausibility of the “lower ambiguity” theory. See http://updatedpriors.blogspot.com/2014/08/entrepreneurial-decline-mom-n-pop-or.html

Start-ups as Experiments

William R. Kerr, Ramana Nanda, and Matthew Rhodes-Kropf write,

The costs of running experiments play a big role in entrepreneurship. Technological change in the laqst decade has dramatically lowered these costs, particularly in industries that have benefited from the emergence of the Internet

Right. But then why do we see the decline in the rate of start-up formation that I have discussed in other recent posts?

Later, they write,

Large corporations…often find it difficult to terminate experiments that aren’t working out.

Right again. And government is even worse at terminating failed experiments, of course.

I have to say that I found little in this article that wasn’t obvious to me before.

Others on the Aging of U.S. Firms

Ryan Decker, John Haltiwanger, Ron Jarmin, and Javier Miranda write,

the typical young firm (as captured by the median) exhibits little or no growth even conditional on survival…however, among all the young firms, a few do exhibit very high rates of growth which yields a high mean growth rate.

Later,

the annual startup rate declined from an average of 12.0 percent in the late 1980s to an average of 10.6 percent just before the Great Recession, when it plummeted below 8 percent.

Still later,

firms aged five years or less made up about 47 percent of all firms in the late 1980s, but this number declined to 39 percent of all firms before the start of the Great Recession, and has declined further since then.

They point to one factor that I had thought of, which is that large retailers are reducing entrepreneurial activity in the “mom and pop” sector.

They also point to the possibility that startups now must spend more resources assembling a trained work force. That sounds to me like an intriguing notion. It might be the case that older, more experienced firms are better able to take advantage of the Great Factor-Price Equalization. In any event, it is probably hard to find a profitable strategy that involves creating lots of new jobs for unskilled workers in the U.S.

Let me also propose a New Commanding Heights explanation. The economy is shifting inexorably toward a larger share of spending on education and health care. Those are sectors where it is relatively hard to create a successful start-up. Do you compete against the incumbents, which have huge advantages in terms of reputation and government suppport? Or do you try to sell to the incumbents, in which case you have to overcome their bureaucracy?

Sure, there are lots of start-ups in education and health care. But my guess is that if you could come up with a way to measure the amount of effort required to be successful in a start-up, that amount would be higher in education and health care than in sectors, such as manufactured goods, on which the share of spending is declining.

Remember this story?

Health is just so heavily regulated, it’s just a painful business to be in. It’s just not necessarily how I want to spend my time. Even though we do have some health projects, and we’ll be doing that to a certain extent. But I think the regulatory burden in the U.S. is so high that I think it would dissuade a lot of entrepreneurs.

If demand shifts to sectors where entrepreneurship is harder, the rate of entrepreneurship is going to decline.