Thursday, 14 October 2010

So you want to become an internet squillionaire...

The first thing to do is to learn some economics. Alternatively you might be naturally endowed with all the right sort of intuitive skills to help you make the correct commercial decisions.

Have a look at this review of the new Facebook movie that documents (to greater or lesser historical accuracy) Mark Zuckerberg's development of the ubiquitous social networking site. How did this not only become so successful, but also something of such commercial value? Here is a clue in the movie, if it is indeed true:

He resisted bombarding users with advertising, believing it best to let the service reach its natural market size without offending them. This is accurately portrayed in the movie; his early business partner Eduardo Saverin insists the company has to immediately "monetize" and Zuckerberg refuses. He still believes that growth is more important than short-term monetization.

A nice exposition of two important concepts; "switching costs" and "network externalities". Take the second first. The phrase network externalities refers to positive indirect effects that accrue to third parties. Elsewhere I have blogged on the more talked about negative externalities, but here is a case of positive ones.

A Facebook with two users provides very little "utility" or value for either of its users. If two more people join then instantly the value to the existing users increases. Why? Because of the additional connections, contributions etc. that those additional people bring. Let's say that the users find the larger Facebook network with twice as many contributors twice as interesting/useful/fun and that feeling is shared by the other users. The size of the network has doubled (from 2 to 4 users) but the value of the network has increased from 2 x 1 = 2 to 4 x 2 = 8; a multiple of 4!! That is network externalities at work; a network gains its value from the number of connections.

Zuckerberg was perfectly correct to resist those urging an early commercialisation of his network, realising (supposedly) that its value would grow exponentially relative to its size. The return to being patient was potentially - and subsequently proven to be - enormous.

What about the other concept - "switching costs". Not only did Zuckerberg appear to realise the need to wait and let the implications of network externalities run their profitable course, but he was reputed to have been concerned about "offending his users". Again, wise to the economics of his website. What is implicitly recognised here is that regardless of how much value the users of Facebook (customers) personally derived from being a member of the network, the only amount that he as owner of Facebook could extract from these same users was the cost any user would bear from leaving - that is each user's "switching costs". And when Facebook was smaller, before the Network externalities had really kicked in and there were other similarly sized and even larger networks around, the switching costs of Facebook users was probably very small. Any actual or perceived cost imposed on Facebook users at that time - for example a user fee or even annoying advertising, could have led to mass desertion of Facebook users to one of the other popular networking sites of the time. Imagine how easy it is to jump ship from a Facebook with 10,000 members, compared to jumping from one with 500,000,000 members. For one thing, there is no alternative...

But Zuckerberg held his nerve and allowed Facebook to grow to the point that it was big enough that:
  1. The exponential growth via network externalities made Facebook very valuable to it users and
  2. That same size and associated network effect increased the switching costs of users to something meaningful; users would now be willing to tolerate some advertising or funnel some money into their use of Facebook.
These are two simple concepts that have been exploit knowlingly or otherwise by Internet winners (Microsoft, Google, Facebook etc.) and not understood by a myriad of losers.

Just a final note. Again something that the astute reader should have picked up. These two concepts together mean that network type industries or businesses will tend to be "winner take all", or natural monopolies. It is no accident that technological, informational or network industries are more commonly dominated by a small number of large participants compared with production or cost driven industries like manufacturing.

For the astute and most likely wealthy readers, there is a lesson for investing here also. Don't try and pick winners in this space. Simply try and cover the field so that you will have some money on the eventual winner.

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