Why I Do Not Believe In (Product) ‘Scale’
Since the industrial revolution, it has been common among ‘industrial’ entrepreneurs to undertake projects that are difficult, focused on the long-term and are aimed at accumulating ‘maximum value’ from future customers.
While these projects were laudable, they also introduced a new phenomenon of companies that are much larger than the most advanced cities in the world. IBM, for example, is larger than the ancient cities of Geneva (Switzerland) and Heidelberg (Germany) combined.
What makes this new phenomenon of multinational conglomerates especially peculiar is the reality that they have organisational structures that are somewhat centralised, but are simultaneously geographically dispersed.
Consumer-Entrepreneur Information Asymmetry
The most daring of all the market attempts that aim to provide value are those targeted at the maximum number of consumers.
This requires the entrepreneur to make heavy investments on machinery, labour, material, networks, distribution and marketing in order to introduce a product at an affordable price to a larger audience.
The salient problem with this approach, is not just that it requires a lot of capital, but it also lends itself to being extremely vulnerable to uncertain events (e.g. material cost changes, labour price changes, labour strikes, government regulation, and competitive substitutes).
The result of this approach is that consumers are held at the mercy of ‘competitive market pricing’ in terms of the quality of the products they are buying. In the consumer’s mind, complex factors such as government ‘price’ regulation, customer price inflation, GDP growth, import/export exchange rates, and the company ‘brand’ are involved in influencing the price of a product.
The other result of this approach is that the entrepreneur is held at the mercy of possible competition and a complex market environment. In the entrepreneur’s mind, complex factors such as production costs, material costs, labour regulation, employment rates, customer affordability, lifestyle and social interests are involved in influencing the choice of the product the prospective customer will buy.
Due to a lot of uncertainty on both sides, the generally adopted approach is ‘advertising’. ‘Ads!’ it is believed, will make it clearer to the consumer which product, from which entrepreneur, should be bought. ‘Ads!’ will establish the much needed ‘demand’ for the entrepreneur which will cover the fluctuating and uncertain production, distribution and marketing costs of a product.
Given that the ‘demand’ has now been ‘guaranteed’ through advertising, the entrepreneur, it is believed, can now turn his focus back to ‘optimising’ the productive and ‘competitive’ elements of a product. What is never taken into account, is the possibility of market collusion on the part of product producers/companies in terms of manipulating market prices and in introducing appearances of scarcity and/or increased demand for a product…
But the real problem with this consumer ‘scalability’ approach is that of analysing the intrinsic value of products. Classical economics’ models assume that competition will drive market prices to an ‘equilibrium’; which would result in a market price not much higher than the production cost. While the concept of ‘intrinsic value’ is generally vague and a hotly debated subject in economics, it is generally accepted that markets drive pricing to some version of it, given enough time.
A key point of this discussion, is to examine whether, at the end of the day, both the entrepreneur and the consumer are benefiting from their participation in the market economy.
The entrepreneur faces the uncertainty of competition and production costs; which the customer faces the uncertainty of product pricing and product quality.
In monetary terms, the entrepreneur has to pay for the cost of production and distribution; and the customer has to pay for a product at a fair ‘market’ price. Unfortunately for the entrepreneur, he has to pay for what he hopes the customer will find to be of value. Unfortunately for the customer, he has to pay for what he believes has been fairly priced.
It is generally assumed that during a customer transaction, it is the retailer who knows more about the product and other important details of the transaction than the customer does (i.e. information asymmetry). But even the entrepreneur behind the product has an information asymmetry problem. The entrepreneur does not know, for example, if the customer is merely buying the product just to see its ingredients in order to learn how to make the same product and re-sell it at a competitive price and with better value within his community. The entrepreneur has to trust the customer; and the customer has to trust the entrepreneur.
Avoiding Scale…
Patent laws were ‘invented’ precisely for such entrepreneurial asymmetries. They were meant to protect the first entrepreneurial producer of a product that may take years to become a profitable business.
The problem of course has now been that the ‘originators’ of ideas, and patents, are almost never its implementors. The incentives for patents are generally skewed towards idea ‘generation’, and remove any incentive for market ‘ready’ implementations as the latter are usually more costly than generating a new ‘patentable’ idea.
The answer, ultimately, to the information asymmetry problem for the entrepreneur, lies in limiting supply.
The technology entrepreneur should not scale.
He would likely do better verifying, validating, fine-tuning and establishing market networks with the end goal of creating demand for a new product. Once the demand has been established, the entrepreneur’s goal should be to satisfy this initial market base with the ‘value’ introduced by the new product. This is why it is generally a good idea for a company to start with a small market; much similar to what Facebook did in starting primarily on college campuses, and Tesla, in starting with a sport cars model, the Roadster.
The problem though, and the blindspot of many technology companies, is that they still ultimately aim for scale. What this results in is a decreasing level of information visibility to both the customer and especially to the entrepreneur. The various failures and related recalls that have now been associated with the Tesla S model and the various Facebook information ‘leak’ media reports are a case in point.
The challenge is that companies that start small with a great vision for the world, tend to become big eventually. But there is little evidence that such companies do achieve their great ‘visions’ in the way they originally postulated. An even bigger problem in these companies is their tendency to lose touch with their customers: precisely because they have become so ‘big’.
The perceived market ‘value’, per customer product, tends to decrease!
Vertical Markets
The general presumption in most companies is that the larger the market and customer base size, the more valuable the company size.
This ‘horizontal’ market model has two problems with it:
- it leads to splintered company goals or drives
- it leads to diminishing ‘value proposition’ returns in each vertical market the company is involved in
The general challenge is usually a combination of the ‘fear’ of picking the wrong horse in terms of product strategy, and of losing revenue in otherwise lucrative markets. In terms of the former: it is clearly risky for one to take a ‘vertical market’ approach. But there are usually benefits (in terms risk hedging) in choosing a specific product strategy as well. The most obvious benefit of this strategy is that it allows a business to pick up lessons about the market, customers, and technologies required to make a product successful much faster than it would otherwise be able to, if it chose the ‘horizontal market’ approach. In terms of the latter: there are definitely ways to increase revenue (albeit in a more dynamic way), that is not entirely dependent on ‘sales’ targets. Richard Cantillon’s ‘method’ (my interpretation thereof!) is that of limiting supply and implementing dynamic pricing (predicated on demand). If one where to do that, and combine that with an elastically increasing value proposition model for a vertical market, there would certainly be a case to be made for an increase (rather than a decrease!) in revenue and profits for a vertical market.
This thesis has some challenging implications. Firstly, most businesses are founded on the presumption that the ‘cost’ of production will ‘break even’ when a particular sales target has been met after a period of time. There is usually a subsequent expectation that the company, its founders and investors will enjoy the ‘profits’ of their labour after such a ‘break even’ point is reached. This proposed thesis then, threatens not only the ‘viability’ of many business ventures, but also their long-term profitability. Secondly, most businesses are expected to outlast their products’ lifecycles.
Very few companies are founded on the expectation that they will immediately fold after a product sales target limit has been reached.
Both of these concerns (i.e. the long-term profitability and long-term ‘existence’) can be addressed by a form of ‘aristocracy’.
The Aristocratic Approach
Aristocracy, by definition, is a rule by the wise. As a political philosophy, however, it primarily referred to a form of political rule that favoured the nobility (i.e. those born of noble birth).
If we were to apply a similar concept to business, it would result in the most successful entrepreneurs being the ‘benevolent leader for life’ in their companies.
I believe the ‘aristocratic’ model in building, running and ‘evaluating’ a company’s success is much superior to the traditional ‘PLM’ approach used in evaluating businesses. The current PLM approach has obvious flaws in that ‘public’/private investors usually develop narrow interests about profit margins and ‘future discounted cash-flows’ that tend to have mostly nothing at all to do with the value or products the company is contributing to society. The aristocratic model allows for a more dynamic ‘company evaluation’ model that assesses a company for what it does, not for who is leading the company, what decisions are being made, and who are the various ‘investors’ or company ‘directors’ in charge! The proposed aristocratic model, will thus allow for a company to be evaluated much more objectively.
My thesis then, has to be re-evaluated in ‘aristocratic’ terms. That is, concerns about ‘long-term profitability’ and ‘long-term existence’ have to evaluated in aristocratic terms.
‘Aristocratically’ speaking, a company needn’t be ‘profitable’ for it to be deemed ‘valuable’ to society. Aristocratically speaking, a company needn’t still be ‘around’ for its contributions to be felt and valued in society. The classic example of this is the various inventions by the likes of Nicola Tesla, the Wright Brothers, Alexander Bell, Howard Hughes and Steve Jobs. They are all long-dead, but to this day, their contributions continue to provide value to millions around the world. Aristocratically speaking, then, it is ‘the man’ behind the product that is more important than what the company or its directors are doing. This, is the ultimate rule by the ‘wise in business’.
Unfortunately though, most of these aforementioned names did not necessarily create ‘product value’ that can be singled out and measured. They certainly assisted (and even founded) companies, but those companies only remained a shell of what they were with those men around. Sadly, they cannot be said to have created anything of monetary value to the extent that we would be able to ‘acquire’ those things from a securities exchange or a local supermarket. We can certainly speak of their ‘influence’, but not of measurable monetary value.
Vertical Market Value
A business then, that focuses on ‘vertical markets’ is likely to be led by a ‘visionary aristocrat’ (who may very well also be involved in other ventures/vertical-markets, e.g. Elon Musk).
In order for this ‘aristocrat’ to be able to capture the ‘market value’ of his innovations, he would need to continually increase and promote the value proposition of his innovation.
If the aristocrat limits the supply (to the market) of his innovation, he’s likely to be able capture most of the initial value of his innovations. If he also dynamically prices his innovations in the market, he’ll likely capture the growing value of his innovations. The key is in: limiting the total supply, limiting initial sales, and increasing the price as the demand increases over time.
The evaluation of the ‘success’ of such an entrepreneur will thus not be based on how many ‘patents’ he filed, or how many product-units / customers he sold to, or how big the company he founded became. The evaluation will instead be entirely based on the price of the last sale of the product he ‘invented’.
‘Consumer Scale’
I believe consumer ‘scale’ is still possible using this aristocratic business model.
The main method of achieving scale, will now be to allow consumers to ‘pay-per-use’.
What most companies and most ‘inventors’ do, is to focus on the wrong objective of decreasing production costs in lieu of focusing on product and (vertical) market value. The reasoning behind such a terrible objective is usually to allow ‘greater market access’ (e.g. Henry Ford in the automotive industry). But such an objective usually has side effects: the product quality tends to decrease; the company becomes increasingly measured in ‘PLM’ terms in lieu of long-term productivity and the market/social value of its products; even worse, the company increasingly takes ‘short-cuts’ in quality, production, sales, and distribution in order to ‘reduce’ prices, increase sales and improve profits! The modern (product) scaling model is particularly worrying in that it often has other terrible side effects on society (promoting ‘consumerism’), the environment (promoting pollution), and in politics (‘too big too fail’ businesses!).
The pay-per-use model is much superior to the scaling model. It allows for the wider public to have access to the latest technologies without necessarily having to pay the high-cost of owning an entire product. Serendipitously, the pay-per-use model would also result in the wider public having access to the best and the most premium technology products; in lieu of the current model of being provided the ‘low cost’ alternatives (e.g. the airline industry)!
