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Digital
Kapital In the first three issues, we've examined Amazon.com and Yahoo! as two types of prototypical Web businesses. They both enjoy high market capitalization, and as we'll see in this issue, they spend money in increasingly similar patterns, focusing tremendous resources on marketing. Yet Amazon has never made money while Yahoo! stunned Wall Street this week with earnings that double expectations. In this issue, I'll identify exactly what Yahoo! has tapped and explain why it is the mother lode of the digital economy. Two veins of hyperbole characterize the past 15 years of business strategy: the incorporation of the computer and networks into every aspect of business; and the waves of down-, re- and right-sizing that swept millions from their old jobs. At the same time companies have insisted they must let people go, they have lamented the apparent failure by computers to add to human productivity. It is particularly interesting that now, at a time of full employment, the computer is finally delivering on the promise to increase output per employee. The rush of productivity we expected in the late 1980s was delayed by companies' lack of patience and an unwillingness to put tools into people's hands so that they had a chance to be more productive, before making layoffs. Most companies have balanced their computer investments with savings in human resources. Of course, a lot of restructuring has been necessary. Adding computers and networks to the workplace changed the dynamics of work. However, the subtraction of human intelligence from the corporation left less for the computer to magnify, reducing the benefits that could be expected. Moreover, the promises made by computer manufacturers and software developers have been grossly exaggerated - only in the past two years, since the introduction of the Internet into most organizations, has the computer been a tool that truly magnifies human input. Prior to the network, the computer was a tool for reducing human work to an archival composite of programmer and end-user intelligence. Depending upon what operating system, application software and corporate network protocol the end-user relied on, their work was effectively fenced by extremely inconvenient limits in its portability. The Internet has broken down many of these barriers, but we still have a long way to go. The computer actually froze the value in hundreds of thousands of hard disks, instead of freeing it to flow, in the ways described by Karl Marx: "The process of exchange is… accomplished through the following changes of form: Commodity - Money - Commodity." In the proprietary system-dominated computer market place, each information commodity came with extremely high barriers to convenient conversion from one state to another. For example, the equation for transferring a spreadsheet of data describing the performance of a stock portfolio from a Lotus/Novell environment to an Excel/Windows system looked something like this: "Commodity (Portfolio, assembled in an analyst's Lotus Spreadsheet on a Novell network) + archival costs + translation cost + connectivity + time = Commodity cost x n, where n > 1." The value of "n" varies, based on the system you examine. Everything that passed through a proprietary computer system acquired a substantial transaction cost. Is there any other way to explain, for example, the $5 cost for downloading an article from LEXIS/NEXIS in 1992? The same article today is substantially cheaper, because the Internet has lowered the barriers to access to information in the LEXIS/NEXIS database; the service still carries the economic residue of the old information system, in higher translation and archival costs than open sources. In an environment defined by an open standard for data exchange, the HyperText Markup Language, the cost of moving data from one system to another was lowered. The addition of low-priced Internet connectivity brought the barriers down even further. But, more importantly, the traffic in information increased dramatically. The option to explore many more sources of data appeared, increasing the chance that, with sufficient diligence, one could find the information actually needed to increase certainty about a particular conclusion. Claude Shannon's information theory describes the basic mechanism of the phenomenon, stating that the value of a message can be quantified by the degree of uncertainty it eliminates for the recipient. That's progress, but it hasn't been enough for the computer industry, the computer press and business press. Now, they all claim, we are in the midst of a revolution. Just what kind of revolution might be going on? There is, without any doubt, a lot more wealth being created by Internet startups today than most other early-stage industries (a notable exception is the Internet's contemporary, the bio-tech industry, which springs from some of the same improvements in computing, communications and instrumentation that produced the Internet). What's really underway is a rebellion against the way business has been done, not a complete overturning of the standards and strategies that our parents and grandparents would recognize. The rebel, after all, is one who refuses to participate in that which is against her values, morals, mores, who lives in an ongoing process of cross-examination of their assumptions and environment. The product of a rebellion is an environment that has been weeded of old, useless ideas, but which exists on the same foundation as the world did before the rebel appeared. Too, rebellion is a local phenomenon. It may sweep from place to place serially, but it does not wipe away the past like a revolution. There is no revolution. The effects of computerization and network efficiencies are merely an extension of a 220 year old process of industrialization, which may be described as hyper-industrialization or "informatization" in its new form. Human processes are being reduced to algorithms, and the result is that those processes can be reproduced more easily, freeing more of the human intelligence applied to the process for creation of value or innovation. As a result, the production of value has increased substantially over the past decade. It has done so predictably - anyone familiar with the progress of society and economies since the dawn of the industrial revolution is not surprised that the pace economic growth is accelerating. Growth has been accelerating cumulatively since the development of the steam engine by Thomas Newcomen in 1711, which was improved by Watt in 1775 to provide for centralized industrial power without excessive heat. According to the late Japanese economist Yasusuke Murakami, "if one makes a statistical analysis of the industries and firms that play leading roles in industrialization, it is hard to identify examples of increasing cost…. In particular, changes over time in the per unit real cost of industrial manufactured goods are usually decreases." The product of this ongoing improvement in process is declining cost that, in turn, produces "ever-increasing returns" for well-managed companies. Why do we know several companies worth more than $250 billion today? Because they sit atop a history of economic development and industrial consolidation that allowed the owners of those companies to aggregate that much value. Someday, probably in the next 20 years, there will be a half-trillion dollar company, and then a trillion-dollar company. Wealth is managed into these harbors and used to cultivate more wealth. There's nothing new about ever-increasing returns.
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Continuing with Murakami's analysis, he says the decreasing cost of products is "natural because industrialization is a continuous increase in per capita productivity, seen macroeconomically…. The results of most analyses that account for growth have shown that less than half of the economic growth rate can be explained by the growth rate of labor and capital. Without assuming a trend of decreasing cost (or increasing returns), it is impossible to explain the remainder of the growth." That is a stunning statement. Everyone who is full of the power of the digital economy should stop to reread the last paragraph: Only half of the economic growth since the beginning of the industrial revolution can be accounted for by the growth rate of labor and the quality of capital. What is the source of the other half of economic growth? The source is human creativity liberated by improving tools. The product of human intelligence and human skill or craft is magnified by the tools people use. Some eras use tools less effectively (wave analysis of history shows that society passes through generations of inefficient technology use, during phases of assimilation) or the tools themselves are less effective, due to a change in technology that is not fully understood. The overall trend is clearly one of diminishing cost, because the availability of human ingenuity compensates for inefficiency. Half of all economic growth comes straight out of people. Even Adam Smith recognized this prior to the Industrial Revolution: "The division of labour, however, so far as it can be introduced, occasions, in every art, a proportionable increase of the productive powers of labour." In the organization, the improved output is the product of two or three forces, depending on one's perspective. First, there is the simple increase in output by all workers, in any class of workers who embrace a new technology. This improved output may follow a period of actual decline in productivity, during which the workforce is learning to use the tools, but if the tools are truly useful they will inevitably provide improved productivity. Second, the improvement in tools is a compounding phenomenon. One improvement may drive the development of many new next-generation tools, which frees even more human creativity. Finally, management is evolving to adapt to the increasing efficiency of the worker. You may not agree, being of the Dilbert persuasion, but I've seen too many good managers who have converted improvements in process into profit - output must be managed into the channel and after-market support in order to become profitable. This last is particularly important to our topic, because the choices management make about how to alter a business in response to a changing economics of cost can be critical to the success of the company. It is probably a bad idea to fire people in exchange for computers, since the people who know the processes you wish to automate are the best people to use the new tools. Now, consider that the phenomenon of increasing returns is restricted to non-extractive industries. Alfred Marshall, Principles of Economics, writes: "…in those industries which are not engaged in raising raw produce an increase of labour and capital generally gives a return increased more than in proportion; and further this improved organization tends to diminish or even override any increased resistance which nature may offer to raising increased amounts of raw material…. In most of the more delicate branches of manufacturing, where the cost of raw material counts for little, and in most of the modern transport industries the law of increasing returns acts almost unstopped." Murakami put it more succinctly when he wrote that "in those industries where the human role is important the tendency toward increasing returns is dominant." Listen to Adam Smith, too: "The nature of agriculture, indeed, does not admit of so many subdivisions of labour, nor of so complete a separation of one business from another, as manufactures." And, so, to the question of Yahoo! and Amazon. I contend Yahoo! is an example of a third degree of industrial organization evolving today. It is an industry that extracts high-value information from the data flow erupting on the Internet using the human skills that have produced the phenomenon of increasing returns. It mines "Net-value," delivering certainty to a hungry audience. The raw material of the Net, as I wrote in Vol. 1, No. 2, is the contribution made by each individual who adds to the knowledge base that is the Net. Intelligence is being laid down like sediment in cyberspace, and in some places the data is so rich that it yields fantastic value for those who process it for public use. The majority of the data on the Net today, however, is like a vast wasteland waiting to be mined. If you apply Shannon's information theory, the cost of finding a message that increases certainty usually exceeds the value of that message. Fortunately, the human mind enjoys digging for its knowledge, or else the Net would never have found its place in the lives of 110 million people, according to the latest NUA survey. The relationship of Yahoo! to Amazon is analogous to the difference between a pre-industrial farming business and a manufacturing enterprise. Amazon is still trying to extract value primarily from a distribution business, it merely uses the Web to aggregate contributions from its customers to a sense of community. It collects book reviews from commercial and individual contributors, it mines its customers' preferences to make suggestions about titles, and it gives authors and publishers a forum for interacting with its customers. The fact that 50 percent of Amazon's sales are made to repeat customers says a lot about the strength of the community. Of course, it also has to support a fantastically expensive cost of doing business - between 45 percent and 55 percent of revenues go straight to the producers of the books it sells. Shipping and warehousing costs eat up more of its margin, so that 80.49 percent of Amazon revenues are consumed by the cost of goods sold. Combine with these costs the additional expense of marketing, which totaled 26.37 percent of revenue in 1997, and Amazon's already into the red before general and administrative costs. With its newly launched television campaign, Amazon's reported to be spending as much as 125 percent of revenue on advertising, which will drive losses upward dramatically. Amazon's productive development costs, including the cost of all editorial and systems for supporting the "community" features of the site, was a mere 8.49 percent of revenues in 1997. Yet, it's this component of the business that provides the Net-value that draws an audience to Amazon vs. other bookstores. As the market develops, the price of books will become the least cogent point of differentiation among book sites, and some level of service or, if you will, intelligence, should emerge. At that point, Amazon must shift its investments to facilitating both the maximum collection of book-related information and screening of the input to create a high-value experience for every user. Likewise, it must invest to extend this intelligence to Amazon affiliates. Yahoo!'s free of the basic, industrial anchor around Amazon's neck - it's cost of goods sold is a mere 16 percent of revenues over the first nine months of 1997. This includes all the acquisition of content and technology for serving community features. Yahoo! is free to spend 65 percent of revenues on marketing, which drives new users into the site. These users, each in their turn, are able to experiment with the service at no cost, finding the way they want to use Yahoo! to discover their certainty, whatever that is. Low opportunity cost for the customer is what the Net is all about. And that cost is minimized by the availability of all the information on the Web. Just an aside: Most of us have probably read the reports that search engines miss "half the Net." This is understandable and expedient, since the purpose of a search or information-navigation site is basically to orient the user, and that requires an editorial decision - that someone excise most of the choices available. Where Yahoo! and Amazon can never meet is on the cost of product development. Yahoo! can treble its spending on content acquisition to build more vertical Yahoo! sites that address narrower audiences, without approaching Amazon's percentage of spending on cost of goods sold. It may do so sporadically, making investments and segmenting only when the need presents itself. Excite, InfoSeek, Lycos and the other "search" sites can do the same - and, because it's a big world, there are plenty of audiences for each. Amazon will be pressed to expand and verticalize, and it will not be able to afford to do so, because it's business today contributes to the general complexity, rather than reduces it. Amazon is just one more catalog among catalogs. A change in strategy will require a massive investment in redaction and personality. It will demand a complete redirection of the world's biggest bookstore, to turn it into the world's greatest source of referrals, niche specialties and guidance. Yahoo! contributes to certainty. Not a whole heck of a lot and in a ridiculously arbitrary fashion, since it is not comprehensive in its coverage of all possible answers, but it does help decrease the cost of extracting knowledge from the Web. It's success proves that, instead of being tapped out, the search market has only begun to deliver value. Since it does add to certainty, it can deliver value to the user, as predicted by Shannon this is economically useful - and Yahoo! does it at a very low cost (remember, 16 percent of revenues for product development). So the company maximizes its opportunity to build brand equity. This decreases its costs by enhancing returns on marketing investments, an outcome predicted by Lanchester, since Yahoo!'s weapons are more powerful and it has more interactions with customers. But here's the rub: Yahoo!'s working with an army that doesn't know it is enlisted in the Yahoo! cause (nor the Excite, InfoSeek or HotBot cause, for that matter, because information can be consumed many times without being depleted of its ability to increase certainty or decrease uncertainty.) The Net is a massive induction muscle developed by humanity to help us more rapidly test our reality. If the legions that fill the Web with pages, reports, art, chat, science, attitude and indulgences should ever realize that they are the unpaid labor shoveling value into the arms of investors in the search companies, it may be necessary to find a new economic model for compensation - so that the 50 percent of previously unaccounted growth can finally find its home. |
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Sites on my mind: Far
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