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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