Smart, but a little too much Kool-Aid

Ben Thompson is the author of Stratechery, a popular newsletter that “provides analysis of the strategy and business side of technology and media.” Thompson, who has an MBA, is a former tech industry worker who has spent time at various tech firms, including Apple and Microsoft. He is a smart and thoughtful guy who has interesting and insightful things to say about tech strategy, which is an endlessly interesting topic. I appreciate his work and admire his effort to set up his own shop and do his own thing.

[IMPORTANT: Part 2 of this ANSWERS MANY QUESTIONS you may have, and it is here, and Thompson responds to this post here]

However, Thompson has more recently begun to pronounce and analyze in the field of tech antitrust, and here he is on less solid ground. I appreciate that deep industry expertise is important in his area, especially, say, when designing remedies that make sense. Nonetheless, I’d say Thompson’s readers are at risk of being misled if they rely too much on what he has to say about tech antitrust. For, as we shall see, his analysis relies too much on an idiosyncratic “digital markets are fundamentally different” thesis that really doesn’t hold up too well. Stated simply, I’d say he’s inducing his readers to drink too much of his “aggregation theory” Kool-Aid, as opposed to encouraging them to think more broadly or read more deeply to understand a slightly messier reality than he presents.

Take Thompson’s recent analysis of the United States v. Google case. According to Thompson, the Google case needs be understood primarily through what he calls aggregation theory, which is something of a specialized version of what economists call a two-sided markets theory. His theory asserts that 1) the quality of the user experience, rather than control over distribution, is what determines the winners in digital markets; and 2) a lead based on quality is self-reenforcing, because either more suppliers are attracted or the winner, with more customers, gets more feedback on what makes for a better product. (For those with a background in economics, Thompson’s aggregation theory resembles a mixture of a two-sided market theory with some positive feedback loop stuff thrown in.) Thompson says that “aggregators” (or more technically, “level-3 aggregators” which are platform in economic if not technological parlance) are in this manner different than traditional monopolists, for they “win by building ever better products for consumers.”

Viewed more carefully, aggregation theory is — at least in part — a model of what idealized competition might look like online, in some markets. Competition driven by quality reflects what antitrust and net neutrality advocates want competition to look like — that is, the better product wins, instead of whoever owns the pipes (or the channels). But that doesn’t mean it is what competition actually does look like, even on the internet. And this jump from the normative to the descriptive is the major pitfall of Thompson’s analysis.

The problem is that his aggregation theory isn’t aspirational. Instead, it is presented as a description of how the internet has “fundamentally changed the plane of competition” in a world where “on the internet everything is just zero marginal bits.” It also takes as its assumptions: “Zero distribution costs. Zero marginal costs. Zero transactions.” In that, in some ways, it is like the older economic models from the 1960s, except that they were at least billed as models, not depictions of reality.

There is truth to the idea that in many online markets over the past 20 years, the most popular platforms attract more suppliers, which attracts more consumers, and so on, acting as the platform or intermediary between the two “sides” of the market. (Some, like David Evans, call this a matchmaking model.) Providing a great user experience, attracting suppliers, and improving the product through feedback certainly describes an important way an online company can generate an advantage for itself.

But none of this means a company can’t, or doesn’t, gain advantage for itself in many other ways, too, and that some of which may actually matter as much and maybe more. Nor is it inconsistent with the story of a company that gets its start with a great user experience and attracts users and suppliers, but then, over time, turns to other, old-school techniques to fortify its market position. Indeed, that is roughly what Google is accused of, and there is good reason to think most of the platforms rely on similar, old-fashioned sources of advantage as well.

If that’s true, then aggregation theory is no longer a dominant theory of competition on the internet — “a completely new way to understand business in the Internet age” — but merely another source of competitive advantage in some contexts. The advantage may also, as Jonathan Knee, my co-teacher at the Columbia Business School points out, vary greatly as between platforms. And aggregation theory’s assumptions (or assertions) of “zero distribution costs, marginal costs, and transaction costs” damage the model in any real-world situation where none of those are true. An alternative model—like, say a straightforward platform or matchmaking model—doesn’t depend on such assumptions and therefore is probably more useful, though it may require more background reading to understand.

Here’s my send-up of aggregation theory: Imagine this is the 1920s and we were speaking of the invention of brand advertising, and someone says, “whichever brand has the most people attracting it will create a buzz that further favors the winner. Hence, traditional metrics of competition are out the window.”

I think we’d all agree that brand matters, and indeed the invention of powerful brands did change competition. But it might be a little too easy to think competition actually has changed forever. And we can see Thompson falling into the novelty trap by asserting things like “the internet has made transaction costs zero” — a sentence that would make any serious economist howl with laughter.

Here is the danger: If you think competition is all about brands and buzz (in the 1890s) or Thompson’s aggregation theory (right now), you might end up overlooking all of the other strategies and factors that could also lead to a lasting advantage. Consider Amazon. Thompson says that “the internet has made distribution (of digital goods) free.” But, as implied, that hasn’t made the distribution of physical goods free. And that is why a company like Amazon can, and has, gained a major advantage by building up a large physical infrastructure (warehouses), not unlike a steel producer in the 20th century, and strongly relying on a loyalty program (Prime). So, it turns out Amazon’s competitive advantage isn’t all about the fact that “on the internet everything is just zero marginal bits.”

When you look at all the big tech firms, in fact, they actually all rely on some mixture of tools for lasting comparative advantage. Facebook, obviously, relies on old-fashioned network effects, not unlike AT&T circa 1908. Some of Google’s advantage is also a physical scale advantage — its server infrastructure, for example. The big online media companies gain an advantage through control of intellectual property. And yes, even on the internet, transaction costs matter a lot — especially when they create frictions that make it a pain to switch and thereby induce consumer retention. These are just some strategies among others too numerous to mention. None of these, I should mention, are entirely new to the internet age.

Perhaps it is boring to say that silly old things like scaling physical infrastructure or consumer-retention frictions still convey major competitive advantages. Unfortunately, it may also be true. And in their hearts, the leadership of the major tech firms know this — the “tell” is what they do to protect themselves when aggregation theory suggests they should be invulnerable.

Whether this is core to his theory or not, Thompson also takes a highly anti-empirical approach to switching costs. He endorses the old 1990s idea that “competition is just one click away,” which may have been true in 1999, but that can’t be taken seriously now — if what he means is that the costs of leaving Google or Facebook are close to zero.The real question is whether there are, for the average person, costs to switching from Facebook or Google to use something else. The assertion that those costs are near zero is magical thinking. Indeed, one of Google’s most important strategies over this decade — its tell — has been to increase those switching costs in subtle ways.

How does all this relate to antitrust? Antitrust should be dealing with the reality of anticompetitive behavior in markets, not ideals of how companies work. And it is the difficult job of the law to determine which of these durable advantages just described are part of fair competition (for example, a better user experience) and which are not (for example, buying out dangerous rivals, or exclusionary deals that keep out competitors). Here, the key problem with Thompson’s analysis is that he comes close to assuming this problem away by implying both that his aggregation theory is the real key to understanding online markets and that the winners are there because of aggregation, and not these other advantages and strategies, and that the product is therefore the winner on the merits.

Well, this overstates matters, because Thompson himself, faced with the actual Google case, to his credit, does not fall into his own novelty trap. Instead, in his post, he speculates that what might be at issue is duopoly collusion with Apple; he also suggests that other duopolies may be controlling distribution. (This insight, by itself, makes his post worth reading.)

But there’s a disconnect here. For if Thompson agrees that collusion over distribution is an important part of gaming competition, then the rules of competition haven’t changed so much after all. In fact, all the techniques of trying to control distribution might matter, even as the other Thompson (the one who wrote aggregation theory) suggests that such things no longer matter, and today’s monopolies are fundamentally different than what we’ve seen before.

We may summarize the problem for Thompson this way: Why, exactly, did Google pay Apple billions to gain control over distribution rights? And why, to bring the law into it, hasn’t Google settled the case? If aggregation theory is right — if competition has changed in the digital market and the best user experience wins — then Google doesn’t need to spend that money. In fact, Google should have settled the case immediately and stopped paying Apple. But Google did spend that money and hasn’t settled, and even for Google, billions of dollars isn’t chump change. Something else is, at least probably, going on.

In the end, Thompson and I come to a similar normative conclusion. I think we’d both like Google to fight without its exclusive deals and to prove its greatness without buying its way out of competition. But we get there in very different ways.

Stratechery, I repeat, is well written and smart, and I’ve learned from reading it. It should go without saying that I intend my critiques to be constructive. But it is missing things that matter, in a manner that is underacknowledged. When it comes to understanding what really makes large tech firms dominant and predicting what judges will do, you aren’t getting the full picture. Maybe I’m just suggesting the site should be more modest and, in particular, be careful about treating aggregation theory as if it were almost like a brand that needs be elevated. The danger for readers is a false confidence, for what Thompson too rarely reminds the reader is what we don’t know.

An endnote — not a “conclusion”

This may be too much for some readers, but a last problem with aggregation theory is that its “winner take all” assertion seems to assume away the importance of differentiated user preferences. In other words, it tends to assume that there is one “user experience” that is preferred by everyone, and by depending on feedback, the product can be improved to match that.

I do think that might be true sometimes. But the question is when, and unfortunately Thompson’s theory isn’t flexible that way. For me, the important, really interesting question might be phrased this way: When do consumers care about the user experience—or, perhaps, convenience—more than anything else, even more than their own supposed preferences?

The background is that in many consumer markets, what you see are differentiated preferences (or, even among very similar products, brands used to create differentiations). For example, there isn’t one news platform that is the winner based on the fact that it has the greatest number of suppliers. Instead, you see different platforms that aggregate content for conservatives, for liberals, for the business-inclined, and so on, which we call MSNBC, FOX, CNBC, etc.

When preferences are differentiated, aggregation theory doesn’t work, because improving the product for one set of users will turn off others who want something different. Even attracting the greatest number of suppliers isn’t ideal if people want only one subset. Some platforms may help handle this by algorithmically customizing the product—Facebook’s news feed, for example, is arguably both Fox News and MSNBC for different people—but depending on the platform, this will also run into its own limits.

Perhaps Thompson has addressed this somewhere (and he says he has), but I thought it important to point out. The model seems to me to only works well either when consumers have identical preferences or when they want the greatest number of suppliers for some reason, or maybe when consumer value convenience even over what they’d called their own stated preferences (the so-called tyranny of convenience).

A second endnote. Much of what I say in this piece I want to credit to the experience of co-teaching a class with Jonathan Knee at the Columbia Business school, and from reading his book “The Curse of the Mogul.”