Points of control = Rents

Innovation was once the sole rent source in the computer industry, but things have changed.

I watched Tim O’Reilly and John Battelle’s “Points of Control” webcast on Wednesday (archived video will be available here soon). I thought it was great and I dug the map. But as I listened, I kept seeing the “Points of Control” notion through a slightly different frame: economic rents.

Web 2.0 Summit 2010Economists use the term “rent” to mean “a return in excess of the resource owner’s opportunity cost.” That basically means the amount you pay people in excess of what you really have to to get them to do something. In a way, the history of computing has been a history of the evolution of rent-taking within the industry. The fact that we are now talking about “Points of Control” is at least partially because the sources of rent aren’t what they used to be, and in our guts that seems bad.

At the very beginning, innovation was the only source of rent in our industry. In a perfectly functioning Schumpeterian system, that’s where all rents would come from. But rents from innovation are ephemeral and they are quickly eroded by competition. People and companies get paid enough to keep doing the cool things we want them to do, but they have to keep innovating if they want to own a yacht suitable as a platform for mooning.

Microsoft was early in figuring out that innovation in an open ecosystem could create a network effect, and network effects were very effective barriers to exit. Microsoft’s ability to extract rent has been amazing. Innovation was the catalyst, but the rents grew on the back of that network effect to be way out of proportion to the effect of innovation alone. (This weighs heavily on my mind as I contemplate shelling out $279 for Office for Mac so I can effectively share docs with my work colleagues).

A decade or so later, the Internet created new ways to build network effects, and rents at scale. (e.g. eBay).

Now just to be clear, it doesn’t mean that we didn’t (or don’t) get lots of value out of these things. It just means that economically, we didn’t have to pay Meg Whitman enough to fund the most expensive campaign for governor to get her (or someone like her) to do what she did. She would have done it for less.

Open source is a really interesting twist in the midst of all this. Software businesses with profit margins greater than the current Treasury yield hate open source because it mostly eliminates rents. Forkability is a rent vaccine, so open source “products” tend to be sold or serviced at just about their producer’s opportunity cost. In the case of community based software, it is by definition at opportunity cost, but that cost is as likely to be paid in reputation as in dollars — making this a conversation on sociology and psychology rather than economics.

In any case, open source software is a leverage-less wasteland from the point of view of anyone that has an MBA. Or, it’s a wonderfully rich source of innovation for the people that never liked having rent forcibly extracted. You can see this by comparing the relative market caps of Red Hat and Microsoft as a multiple of revenues when they were at similar stages of growth (number of processors they are running on or similar measures). Microsoft probably had a one- to two-order of magnitude advantage on this measure at any point along their growth curves. Or, as someone from Red Hat once told me, “we love making billion-dollar businesses into hundred-million-dollar businesses.”

Obviously digital distribution has also damaged the traditional channel model of the music, film, and photography markets. The impact of this is that the tail-end of the curve can probably shift business models and still make the same money (by touring, selling FLAC files, whatever). But the head — where the record companies are — will struggle to extract rents like they used to. As they realize this, they do what rent holders who are losing always do: dispense patronage from their existing franchise and try to influence the law to make their rents more permanent.

Apple has historically lived on rents derived from superior design, which is a very hard thing to do consistently. So they’ve earned their rents so far. Recently, they’ve gotten even smarter. The App Store is an MBA’s dream because it combines network effects with classic distribution channel control and slotting fees. It also has strong barriers to exit. Interestingly, Foxconn (and its employees) mostly continue to work at opportunity cost levels of renumeration. Rents stay with the leverage and are not evenly distributed through the supply chain.

Apple also finds itself in the odd position of Karmic enforcer. The software developers that once helped destroy content owners’ iron-clad grip on distribution now find themselves selling their creations for 30 70 percent of $.99. Karma is a bitch.

Google extracts amazing rents through a combination of innovation and network effects, although they have really struggled to duplicate their core search / AdSense monopoly. Innovation is keeping Google ahead of Schumpeter for now, but hasn’t yet created a second vortex of network effect monopoly. So Bing is an important threat if its share continues to grow. Emerging and effective competition in the area where you are extracting rents will have a non-linear impact on your bottom line. If all goes well (in a Schumpeterian sense), both Bing and Google’s search franchises will be rent free in an economic sense. Good for people buying ads, bad for people that hope Google will keep taking the cash thrown off to innovate in other areas (like creating an Office rent-neutralizing alternative in the cloud). It’s like watching a pair of Ultra Kaiju trying to choke each other out over Tokyo.

Twitter is the odd case of the network effect without the rent. I like it even more for that.

Both Apple and Google are innovating (obviously) so their network effect and distribution channel rents are at least initiated by innovation. However, we should be observant to those signals that they may be following in Microsoft’s, or the record labels’ footprints, and attempting to make ephemeral innovation rents more permanent through lobbying, aggressive (and abusive) patent strategies, or other approaches that help them avoid Schumpeterian logic. After all, no one hated the Robber Barons when they were laying track and industrializing America. They were heralded. It wasn’t until later, when they distributed rents as patronage to buy politicians (and policies) to lock in the rent streams from those maturing investments, that they became the subjects of political cartoonists.

Mobile telecom providers are my favorite because they are just so obvious. Spectrum auctions are the modern equivalent of the East Indies Trading Company. It’s a royal monopoly charter with a direct lineage from the original form. This is where the word “rent” comes from.

We give these charters because we think the physics can’t be dealt with without ceding monopolies. Too bad, because they are really bad for innovation. The culture of monopoly becomes part of their DNA. Now as computing goes mobile, that same DNA has found a viral vector and is splicing itself into software and computing companies. Obviously Apple, with its historical predilections, is a more accepting host for the splice, but don’t think Google and others won’t be immune to rents. The government auctions spectrum to control it, but what they also get is a patronage network of massive proportions.

Facebook is a hard one to describe in the standard terminology. Innovation, yes. Network effect on distribution, absolutely. But also there is this weird bit about knowing more about us than we ourselves know in a conscious way. It’s a network effect, but the first to be based on our most personal social network. Maybe this will come to be called “Faustian rent.”

Another way of thinking about it is this: for every technology company whose stock we are proud to tell our friends we own, there are significant economic rents being extracted on the other side — otherwise the money would be equally well invested in treasury bonds. No one brags to their friends about that.

The question is, what is the source of the rents? A company that lives by “deliver more value than you extract” is probably living on innovation rents, at least at the catalyzation point. Then it moves faster than the competition to stay out of the chute of Schumpeter’s creative destruction chipper. However, many companies are finding other less palatable sources of rent, or are moving toward them just as fast as their newly minted lobbying crew in DC can make it happen.

As this industry matures, it will either look, economically at least, like a DuPont Styrene plant or it will look like most of Microsoft (the non-Xbox part). A company whose sources of rent have largely tipped from innovation to those based on barriers to exit (lock in), policy (lobby against open source), and patronage (let’s bring the entire USAF IT staff to Redmond for a conference and feed them ice cream at every break!). The thing is, those of us that love doing this kind of work love it for the innovation. I hope we aren’t getting comfortable with the idea of doing it so that we can build our own Burg Pfalzgrafenstein in software.

From the perspective of buyers, we don’t notice rents so much when they are based on innovation. It’s early in Apple’s transition and the faces of the fangregation are still glowing as they come up Peter Bohlin’s 5th Ave. spiral glass staircase. They just spent twice what the device would cost if it was a commodity, but they are grinning as they fondle those little white backpack bags.

On the other hand, rents of the less palatable lock-in variety taste like cod liver oil. And there are some early signs that even for Apple, shiny isn’t always adequate salve for that feeling of being taken. Microsoft is the company we love to hate, but Apple may well become the one we hate to love as it relies less on the shiny and more on the locks to keep us paying.

On a related note, last night my Dad said to me: “I can’t stand Microsoft and avoid it as much as I can. I’ve switched to Ubuntu because I got tired of paying Bill Gates a tax so he could run a charity.” I thought that was funny.

Associated image on home page courtesy Apple.

Editor’s note, 11/1/10: Developers receive 70 percent of revenue from App Store sales, not 30 percent. This was corrected in paragraph No. 11.

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  • ignacio

    Probably one of the best and most dense posts I’ve read recently. Thanks a ton!!!!

  • Matt

    Absolutely fantastic article! While rents can be concerning from a consumer standpoint though, I think most of your examples still deliver enough consumer surplus that they’re not too much of a concern (at least not today).

    The ones that really worry me are the ones that have turned to rent seeking in the political arena, such as mobile providers, as you mention. These are the companies that have more or less abandoned all rent creating opportunities that create a consumer surplus as well (even networking and patronage effects can be beneficial to the consumer at some level). Lobbying efforts are mostly just dead weight loss, not only for the consumer, but for the economy as a whole.

  • http://gumption.typepad.com Joe McCarthy

    This is fabulous integration of the politics, psychology and sociology underlying the push for permanent rents (prents?).

    Your arguments – and references to monopoly charters – align well with other insightful commentary by Doug Rushkoff about the perils of corporatism – extraction, exploitation and externatlities – in his book Life, Inc.

    I’m also reminded of some new insights I gleaned in rereading and review of George Orwell’s classic, 1984. I hope you won’t mind if insert a rather longish excerpt from my review that I believe is relevant to the ideas you articulate in this post about rents and permanence:

    The book offers many insights into — and raises many questions about — human nature, sexuality, truth and reality, and I could write at great[er] length about many of these topics. However, for this post, I’m going to focus on Orwell’s ideas about hierarchies, wealth and power, and how these ideas are playing out today.

    Many of these ideas are expressed in a book that is banned in Oceania — often referred to as the book, or “The Theory and Practice of Oligarchical Collectivism”, allegedly written by Emanuel Goldstein, the allegedly traitorous archenemy of Big Brother.

    Throughout recorded time, and probably since the end of the Neolithic Age, there have been three kinds of people in the world, the High, the Middle and the Low. … The aim of the High is to remain where they are. The aim of the Middle is to change places with the High. The aim of the Low, when they have an aim — for it is an abiding characteristic of the Low that they are too much crushed by drudgery to be more than intermittently conscious of anything outside their daily lives — is to abolish all distinctions in which all men shall be equal.

    Over time, the High become inefficient, insecure, or otherwise ineffective (e.g., being too “liberal or cowardly” or unwilling to use adequate force) at governing, the Middle seize the opportunity and enlist the aid of the Low to rise up against the High, on the premise of liberty and justice for all, after which elements from the Middle become the new High, and the Low are relegated to their former status, and the cycle starts up again. Or at least, it had been a cycle before the rise of The Party (and its contemporaries in Eurasia and Eastasia):

    The new movements … had the conscious aim of perpetuating unfreedom and inequality … the purpose of all of them was to arrest development and freeze history at a chosen moment. The familiar pendulum swing was to happen once more, and then stop … the High would be able to maintain their position permanently.

  • Ml
  • http://www.digitalsamfunn.org Francis D'Silva

    A fantastic post Jim!! You have triggered a whole bunch of related thoughts that I think will be useful for a research project on “Service Innovation” that I hope to work on. Some
    thoughts as bullet points:

  • software vendors are the telcos of today — specially in a future of clouds. They make an upfront investment in the infrastructure and then charge “rents” over the amortization period of that infrastructure included future investment
    costs, margins and future charity works (your dad is a wise man!). Or some such financing model.
  • The rents are possible because of the network effect that you describe so well; its like the first person who had a phone. It was useless until she could call someone else — who also had a phone. Your observation about Facebook is very interesting.
  • Microsoft watcher MIT’s Michael Cusumano talks a lot about Microsoft’s platform play —
    I see them more as an ecosystem; actually a parasitic host that a HUGE industry has been been built on. I recall reading somewhere that 95% of Microsoft’s revenue came through partners. Everything from system integrators to,
    independent (sic) software vendors to training vendors. Apple beat them to
    their own game in the consumer space.
  • the nature of value networks has been studied by some — in fact an interesting
    theory around ways how enterprises are configured for value creation is
    documented in this 1998-paper by Charles Stabell and Øystein Fjelstad

    CONFIGURING VALUE FOR COMPETITIVE ADVANTAGE: ON CHAINS, SHOPS, AND NETWORKS
  • finally, your dad’s comment is spot on! very well put. In a discussion of socialism vs capitalism — argued against the
    backdrop of the internet economy. Should coprorates extract “taxes” or should governments do so; or could both
    work together so that governments can serve as platforms that encourage private enterprise.

  • http://www.kieranlevis.com Kieran Levis

    It’s important to distinguish between Schumpeter’s idea of temporary monopolies and long-lasting strategic assets like network effects and brands, which are the main sources of economic rents.

    Innovators who create entirely new markets enjoy a temporary monopoly mostly because they have developed organisational capabilities that no competitor yet possesses. Sooner or later however, others learn to match them and may have strategic assets too. Apple created the market for the personal computer in 1977, but when IBM launched its PC in 1981 it had, not just comparable capabilities, but a powerful brand and strong customer relationships and quickly dominated the business market for PCs.

    It was Microsoft who came to dominate the PC market, not through stunning innovation, but because its operating system became the standard, and network effects did indeed play a big part in this. It then leveraged this monopoly to dislodge the leaders in applications software, Lotus and WordPerfect, once it had matched their capabilities. Network effects helped it to achieve 90% of the markets for spreadsheets and word-processing within a few years. Those twin monopolies have more or less lasted till today and account for the bulk of its profits still.

    Google has acquired almost as dominant a position in search-based advertising, but its early lead was entirely due to its innovations in search. These gave it the biggest consumer audience and the one that was most attractive to advertisers. It enjoys a kind of network effects, because of the symmetry between its user audience and its advertisers, a particularly virtuous circle. But unlike Microsoft and eBay, none of its customers are locked-in.

    For more on this see: http://www.kieranlevis.com/the-network-effect/

  • Anon

    Developers receive 70% of app store sales, not 30.

  • http://www.johnlusk.net John Lusk

    Wow. Fantastic post…and one that I couldn’t actually just glance over during my daily coffee routine. Your lobbying comment is particularly acute and a bit scary. I can’t imagine what happens if one of the primary tactics of extracting rents from consumers rears its head in lobbying efforts.

  • http://www.earthsharing.org.au K2

    Monopoly rights are the curse of creative capitalism. Beautifully summed up here in the technological sphere but the pursuit of the free lunch runs unabated in the privatisation of our DNA, the copyright locks of classics like Woody Guthrie’s ‘This Land is Your Land’ which leads into the mother of all monopolies – land.
    How many mid 20 somethings are stuck at home not just because of the licensing costs that Adobe et al expunge, but that the price of land imposes upon our freedoms to live where we want to?
    Check the Renegade Economists podcast for more on this scourge of the times

  • Andrew

    Thanks for the insightful article – good work! – but when you say “opportunity cost levels of renumeration”, don’t you mean “remuneration” (that is, to “remoney”, not “renumber”)?

  • Alan

    Whilst I appreciate the economic term “rent” signifies an overpaying of the supplier’s opportunity cost – I wonder how many of the examples actually exceed the cost of replicating the functionality. E.g. the author objects to the cost of Office but wants it so he can “effectively share documents” – is the cost of retyping/re-editing the numerous docs less than 280 USD? Is the cost of coding (and even perhaps reselling) some sort of interpreter less than this? If so, then why isn’t the world full of folk doing just that? I might propose it is because in-house or open-source software actually often shifts the real costs from the rent-seeking corporation onto the user (in both time, effort and support).
    Is it really rent-seeking if the end product value is close to the market value of the effort to duplicate the functionality? Can one consider the “network effects” a function in this case?

    I am not an economist (obviously given the naivete of the above) – but it would seem that you have to allow some sort of rent-seeking to make the entire enterprise worth the candle. If all you could get back following the efforts of innovation etc was opportunity cost plus a small margin, would it really foster innovation (or even replication)? Isn’t this potential massive payoff why coders are leaving Google (post-IPO) for Facebook?

  • Jim Stogdill

    Andrew, thanks for the correction. I wish I could say that I just switched the order of the “m” and the “n”, but it turns out I actually had the meaning reversed in my head. Weird the things we can still learn at an advanced age. Anyway, with that admission in mind, it might be best to read the rest of the post with more than the usual skepticism.

    Alan, you ask a good question and I think the answer is provided by Matt above. The fact is that we do still get plenty of what the economists would call consumer surplus so we keep buying the products. In fact, I bought an iPhone 4 the day I wrote this post.

    Kieran makes a great point to distinguish between temporary monopoly and rents derived from strategic assets (like network effects). I wish I had used that language. I wish I knew to use that language.

    Just to respond to some of the comments here and elsewhere that allude to the, for lack of a better term, moral position of rent taking… I’m not taking a moral position vis a vis rent taking in the case where our system is mostly a well functioning Schumpeterian capitalist system. I’m a capitalist and think when it works it works well at a lot of things. However, the fact that O’Reilly is doing a summit themed “points of control” is because they are picking up the signals that there is growing angst, that feeling in the gut, that something is amiss.

    So, my real point is for us to be more attuned to the places where rents seem to be departing from Kieran’s framework of temporary monopolies and strategic advantage and are shifting to those based in the political netherlands of patronage. A distribution channel based on vinyl is a strategic advantage, continuously expanding copyright is not. Same goes for a bad patent system, spectrum auctions, DMCA, etc. Scratch any of them and you’ll find patronage flowing from the rent back to the law or policy makers.

    This will be even more true more often with the recent Supreme Court Citizens United case.

  • Alan

    Aha, I see your bigger point now. It’s not so much the innovator’s dilemma but rather the risk of an “innovator”-political enshrinement of an elevated cost. Either via barrier-to-entry induction (oligopoly spectrum licensing) or other legislative/political means.
    I think this idea is much closer to what non-economists think of as “rent-seeking”, rather than leveraging of brand power / market share for a premium price.

  • John Page

    Looking forward to the book.

  • http://drcoddwasright.blogspot.com/ Robert Young

    The simplest, and most accurate IMHO, way to figure out the rent is involved is to pose to the “owner” of such an enterprise a direct question: if the income you’re earning from this enterprise is insufficient to your needs, then all you need do is sell to the highest bidder, and from thence go to work earning wages (if you actually have any useful skills) like everybody else. They shut up at that point, because, of course, they have no such valuable skills.

  • http://www.eastok.org Alex Slobodnik

    Insightful, would also recommend the classic take on the same subject of oss economics by Joel Spolsky:

    http://bit.ly/bEWO0W

  • http://drcoddwasright.blogspot.com/ Robert Young

    @Kieran Levis:

    but when IBM launched its PC in 1981 it had, not just comparable capabilities, but a powerful brand and strong customer relationships and quickly dominated the business market for PCs.

    It was Microsoft who came to dominate the PC market, not through stunning innovation, but because its operating system became the standard, and network effects did indeed play a big part in this.

    Woefully inaccurate.

    First: IBM estimated a yearly sale of 2,500 units, since this was to be a Personal Computer, that is a device to be programmed by the user for the user’s problems; much like the engineering workstation that was to be. IBM and MS had no idea how the PC would actually be used, and specifically hadn’t designed it for the use to which it was eventually put. They built a computing device, but the public used it as an appliance to run canned programs. That transition *was not* initiated or managed by either IBM or MS. They just lucked out.

    Second: It was not innovation or network effects or strong customer relations which made the IBM/PC and MS dominant. It was not *any* decision by either company. It was pure, unadulterated LUCK, a factor which more often leads to dominance, but rarely acknowledged. The decision which made both IBM (temporarily) and MS (much longer) was made by one Mitch Kapor, who ran a small software house in Cambridge, MA called Lotus. At the time of its release (and for a few years after), the buyer of an IBM/PC could choose the O/S: CPM/86, UCSD-P, PC/DOS; IBM didn’t care which. Kapor was busy “cloning” an innovative piece of software, VisiCalc (some said ripping off), for the PC, and had to decide which OS to write on. 1-2-3 (as in, “But it’s as easy as 1, 2, 3″) had to be an assembler program for performance, and writing it three times was not an option. The likely reason PD/DOS was chosen was the same reason games worked so well on it: it wasn’t really an operating system at all, merely a Control Program, which allowed user/application programs to fiddle the hardware. (This is also why viruses found it so hospitable.) So, 1-2-3 was written to PC/DOS. The popularity of 1-2-3 made the machine and the OS popular, nothing else.

    At the time, MS had a spreadsheet program, MultiPlan. It was dreadful. Innovation, even of an existing application type, was never a MS trait.

    History is written by the winners. For now, there are people who were sentient in 1981 who know what happened.