Yes, if we accept your ifs, we conclude that the new business is net negative. This really happens and some new businesses really are net negative (although I think negligible compared to negative externalities). But why think your assumptions are normal? Why think that the fixed cost of the business is larger than the time savings of the closer customers? Why expect no price competition, no price sensitivity?
There is a standard analysis of competition. If you reject it, it would be good to address it, rather than ignoring it. The standard analysis is that competition reduces prices. The first order effect of reducing prices is a transfer from producer surplus to consumer surplus, taken as morally neutral. But the lower price induces more sales, creating increased surplus. The expectation is that the first order neutral effect swamps the second order positive effect, which swamps the fixed costs.
The producer surplus is a rent. It induces rent-seeking. The second company to enter the market is mainly driven by rent-seeking. But by lowering the price they probably produce much more aggregate surplus than they capture. The more competitive the market, the lower the rents and the less new entrants are driven by rent-seeking. Late entrants are driven by the belief that they are more efficient.
The producer surplus is a rent. It induces rent-seeking. One form of that rent-seeking is new entrants, but another form is parasites within the organization, which seem much worse to me. Competition applies discipline which discourages these parasites. If the producers are innovative, you might think that they will make better use of the surplus than the consumers. If you do not expect parasites, maybe it would be better for innovators to capture more wealth. Maybe this was true a century ago, but it seems to me very far from true today. So I think the dispersal of wealth by transferring from producer surplus to consumer wealth is morally good by discouraging parasites within larger firms.
1The use of the word "extractive" in this post confused me a lot.
Looking at the example with Tom and Fred - nicer location or not, Tom is repairing cars. That's the value he's providing to customers, and it's enough to account for all the money he's making. And customers are better off too. The only one losing out is Fred.
All right. The question becomes, as a society should we be sad about the losses of companies that get outcompeted? Say Fred has a software company, making some expensive software to do a task. Then Tom, a hobbyist, releases a small piece of open source software that does the same task just as well. He doesn't make any profit from it, but everyone switches to using his software for free. Fred's company goes out of business, the investment is lost and so on. Was Tom's action "extractive"? Should we be sad?
That's the value he's providing to customers, and it's enough to account for all the money he's making
I've replaced a sentence; maybe it will make things a bit clearer:
Now, Tom has certainly provided his customers a bit of value, because it is nicer to be closer to the city center. But the marginal value he's provided to Whoville isn't nearly enough to account for the value of the business he now owns.
To be even more explicit: imagine Tom is not even working at the car repair shop; he's just assigning a manager to operate it for him. Now he's reduced the total wealth of whoville in order to transfer wealth from Fred to him, at no benefit to consumers. The Before and After pictures of the town or its finances are virtually the same as if Tom had found a legal loophole for draining Fred's bank account, without all of the hullabaloo of starting a business!
Say Fred has a software company, making some expensive software to do a task. Then Tom, a hobbyist, releases a small piece of open source software that does the same task just as well. He doesn't make any profit from it, but everyone switches to using his software for free. Fred's company goes out of business, the investment is lost and so on. Was Tom's action "extractive"? Should we be sad?
In this scenario, the overall productivity of society has gone up, because people are no longer paying Fred rents for use of equivalent software. That makes it a lot different than what I view as the default case of capitalist entrepreneurship.
Here's the thing though. What Tom is doing (if we forget distractions like paying salary to employees, paying rent for location etc) is entering the market with a slightly better service, and outcompeting the incumbent. Let's say we ban this activity! Now nobody's allowed to enter a market with a slightly better service and outcompete the incumbent. Enact this ban, and wait a few years. To me it's obvious that society will be much poorer as a result. You'll get rid of the small improvements that add up to large improvements.
And so it seems likely to me that one individual act - Tom starting a car repair shop in a slightly nicer location - will also turn out to increase the total wealth of society, all things considered. Statistically at least.
Let's say we ban this activity!
I'm not saying we ban this activity! I'm just pointing out inefficiencies in our present society. I actually don't know what the solution to this is.
It feels like the problem is that we only have two extreme outcomes: either Tom is not allowed to create his business, or Fred goes out of business.
While the situation looks like Fred created a lot of value, and then Tom improved it a little, so a fair outcome would be that Fred gets paid more and Tom gets paid less but nonzero... and this seems like the only outcome that definitely won't happen.
(Another part that feels unfair is that Fred took a greater risk by exploring a new option, but Tom already knew that Fred's business was profitable.)
I'm also not saying let's ban it. It's a thought experiment. The intended conclusion (though maybe my comment was too cryptic) was that if banning X in general (where X = "entering the market with a slightly better service") is obviously wealth-reducing, then that means allowing X is wealth-increasing, so a random individual instance of X is probably wealth-increasing as well.
And the example in your post looks to me like a quite typical instance of X. It's not unusually bad. Most instances of X will look like stealing customers, putting incumbents out of business and so on. I'm saying it's all right, the benefit over time is bigger than that.
Here's the thing though. What Tom is doing (if we forget distractions like paying salary to employees, paying rent for location etc) is entering the market with a slightly better service, and outcompeting the incumbent. Let's say we ban this activity! Now nobody's allowed to enter a market with a slightly better service and outcompete the incumbent. Enact this ban, and wait a few years.
I think you just invented patents from first principles.
For that matter, why is Fred passing up the chance to improve his business? If he's on the ball, he should be doing that to forestall a Tom coming in. You snooze, you lose, Econ 101 for agenty people.
As a customer, I broadly prefer competition, because it allows me to capture more of the total gains from trade.
Right now, for example, the small handful of RAM manufacturers have pricing power, and Nvidia has pricing power. It's a terrible time to build a game machine.
But yes, I agree that sometimes capital investment can be stupid. At one point around 2000, the Boston area had a grossly insufficient number of hotels, driving hotel prices through the roof. Then, various projects started construction on at least 10 hotels (or so I was told). This was more capacity than was probably needed at the time, though I didn't stay around long enough to see if prices crashed.
The historic alternative to these kinds of inefficiencies was called "central planning." It failed catastrophically, leading to famine, death, and (even in the best case) adults who had never eaten a banana, like a teacher of mine who grew up in East Germany. Central planning requires the planners to possess truly implausible amounts of information, it provides the planners with little incentive to do a good job, and it removes customer "exit rights" if customers hate doing business with one local shop. Instead, we allow people to do distributed planning, and to occasionally lose their shirts by building an extra sushi restaurant with a stupid business plan.
The only one losing out is Fred.
The article mentions fixed costs of building Tom's business. Like if Fred's business costs $1m to start and creates $100k/year surplus value, it gets paid off in ten years, which seems like a good return on investment. If Tom's building costs $1m to make and only creates an extra $10k/year surplus value (growing the market a little but mostly taking Fred's business), it gets paid off in 100 years, which seems like a bad return on investment.
I guess some things involved in the fixed costs are
- Tom's space isn't used for some other purpose
- Time and materials spent building Tom's shop are lost
How much should we expect the market to be like "well, if Tom's business is a net negative socially, then I'll be able to find some other use for that location and time and materials, which will leave society-at-large better off"? I don't know.
Like if Fred's business costs $1m to start and creates $100k/year surplus value, it gets paid off in ten years
Oh, not quite. "Costs $1m to start" sounds like it's talking about the cost to Fred. Some of that will be e.g. wages paid to construction workers. For this accounting to work, we need to talk about the costs to society versus the value to society. (The costs to society being similar to those from Tom's shop - space, time and materials.)
The use of the word "extractive" in this post confused me a lot.
Changed "extractive" to "rent-seeking".
tl;dr
- Basic market competition effect: Ambiguous (higher customer rents; lower producer rents by other firms), see Econ 101 and Econ 102 as detailed below.
- Bullshittiness of markets: Totally!
- But these are two rather separate effects and should be more cleanly separated for fruitful analysis
- All in all: But despite all, hard to quantify the net effect of an 'average' successful business; I find your title insufficiently substantiated.
Explanation:
Econ 101 model of Monopolistic Competition describes exactly the basic market effect you're going at.
While Econ 101 is though in its most basic form a bit stupid and blind on the more interesting questions you address, when you start from that model and look at effects of market entry, you see that two first-order effects challenge your a priori of there automatically being a reduction of net welfare:
- Yes Tom bites into Fred's profit, i.e. negative externality on others' producer rent. But he also could not attract any single customer w/o increasing consumer welfare (alias consumer rent). Which of the two dominate is absolutely unclear and will depend on subtle market parameters.
- Together the competitors drive down each others' prices, as Richard_Kennaway points out. This increases net rents in the market.
This may be called Econ 102. You find a ton written about it under keyword "business-stealing effect". Conclusion: In some cases free entry has, on the margin at the equilibrium, positive net welfare effects, in some negative.
I'm actually sympathetic that many firms are mostly gaining because of sneakiness that is remote to actual increase of value for customers and society, but it seems to me your post is mixing up (i) fundamental effect that you analyze not in the depth required (the above mentioned additional fundamental basic competition effects) and - in some of your examples later - (ii) the more tricky marketing/sneakiness advantages some profiteer from. These should be separated more clearly for a fruitful discussion of the topic. To be clear what I mean with the latter: Acc. to my experience, a large share of firms mainly tinkers around how to beat competition not in terms of creating better products but in terms of how to better sell it etc., or how to cut costs in gray-zone areas or at least in ways that are not mostly value-adding but instead leading to other negative externalities, so all w/o it necessarily going in the direction of yielding higher value for customer and/or society. And thus also: huge share of bullshit jobs; plus if some jobs aren't full bullshit jobs, they still have a high share of bullshit components (although I guess we should be careful to distinguish within-company bullshittiness and indeed outwardgoing bullshit created, of which only the latter goes in the direction of your argument).
FWIW Tangential topic: Low marginal costs
A related effect I find annoying is that we rely on competition and markets while more and more goods are quasi-artificially-scarce (low marginal cost goods) but with high fixed costs. Independent private business don't want and cannot sell these goods at efficient low prices. If by pure luck we stumbled into a future with a benevolent AI future, we'll have some directed communistic element complementing the market economy. Sadly, otherwise, we'll probably be stuck with highly inefficiently high prices and, yes, maybe with too many firms doing similar things without gains justifying duplication costs.
Suppose consumers value the marginal minute spent driving at dollars/minute, and Tom's car repair service is minutes closer than Fred's. Then consumers will pay at most an premium to access Tom's service over Fred's.
Should we expect that Tom's business puts Fred's out of business? Only if Fred can't afford to charge or less, where is the price Tom is charging.
Realistically, consumers will have a wide range of costs to driving, and consumers with higher time costs will go to Tom's car repair service, and those with lower time costs will go to Fred's, and everyone (except Fred) will be much happier and nobody out of business. Fred will have to charge lower prices, of course, so he will be upset, but the overall pie will increase and the time and money of the vast majority will be freed to be invested or spent on more productive ends.
You should not be arguing about economics without at least some basic knowledge of economics first. It is not as intuitive as many mistakenly believe.
upvoted, but I do not accept the framing that "value" is somehow aggregated across fred, tom, and the drivers in the town. Value is individual, and it matters (to the evaluators, the actors in any scenario) which of them get what value out of the transactions.
further, it does seem a bit obvious that if the increment of improvement is small (slightly more convenient, but overall the same service at the same cost of provision), the value-add is small. Note that in this example, there are other dimensions that haven't been mentioned, like the throughput of the shop and how long one has to wait for a repair, or any variance in specialization/quality between the shops.
This feels very similar to the observation that leads to the idea of patents - namely, that if spinning up the first instance of a thing and working out the kinks is expensive, but copying is cheap and the invention will predictably be copied as soon as it's shown to be valuable, that removes most of the incentive to build new things.
It's similar but not the same. You can correctly compensate people for innovation and this is still a problem.
Tom's business cannot with any confidence be said to be rent seeking behavior:
- There is value for being closer to customers (as you pointed out)
- Assuming no cartelization, the quantity supplied for car repair and maintenance increases reducing price, society is therefore richer in terms of amount of car repair.
- On the margin Fred may be forced to give more of his surplus to his employees to keep them (potentially enticing a more efficient number of mechanics for optimal allocation of resources that makes society richer as a whole)
- If Fred were to go out of business, the city might be left with a more optimally placed/ran shop and his building and employees are then available for more productive uses.
This scenario breaks down the second you leave ideal spherical cow static city land. In cases where Tom's business is reducing total productivity, it could become productive at a moments notice from any number of hypotheticals: a large new housing development opens, a new common car is found to have lots of issues, Fred dies/a new shift manager is terrible. Tom is providing value simply by being latent capacity for car repair.
In your other examples:
- Venture Capitalist - finding the great startups that need funding weeks sooner is of massive value, to the extent they outcompete others, society is just left with VC that funds good deals sooner and the slow competitors employ fewer resources.
- Sushi Restaurant - Restaurants are very low margin, if 15% of demand moved to their 2% better restaurant each time, eventually the city is just left with 2% better sushi restaurants only, not 2% sushi and empty restaurants.
- Payroll Company - If the product is the same, they are at least providing redundancy of firms for whenever a competitor makes a big mistake. Its not like their competitors will keep the same staff, you end up with a similar amount of employees working in payroll in the end if companies are just as efficient.
You are ignoring the point the hypothetical is attempting to illustrate in order to quibble with practical details of the stories I tell in the post. My point is that new businesses (even productive ones, with few negative externalities) typically make money through siphoning the value of other businesses and also creating value. In some cases the ratio is highly positive (i.e. the companies I list), in most cases it is not.
If you need a more "realistic" example of a business that is almost entirely and clearly predicated on redirecting money from other businesses, see the high frequency trading industry.
You are the one that made the strong claim "Most successful entrepreneurship is unproductive". Are you saying that claim doesn't need to hold up in the practical details? If so, maybe the post should be titled, "Successful Entrepreneurship Can Be Unproductive".
If the hypotheticals in the post are all potentially not actually cases where successful entrepreneurship was unproductive for society, I am highly skeptical of the claim.
I understand illustrative hypotheticals, but to call most entrepreneurship unproductive by disregarding one the most important functions of entrepreneurship (price discovery) is silly; try having a productive society without efficient prices. The price discovery requires the "creative destruction" of businesses that, at a first glance, appears to be unproductive to happen.
Maybe I am just not understanding a nuance in your post.
This applies to basically any form of competition beyond the amount needed to avoid pricing power.
For example, if you are a job seeker, you can dedicate your time to learning actual skills and looking for employers with unmet needs, or you can rack up your credentials to be candidate #1 instead of #2 in an oversubscribed hiring process.
That doesn't make these activities unproductive in most cases: if customers or employers pick you it's because you are providing some marginal value, but the marginal value might be low compared to the amount you capture
Interesting post. I think there is a large distinction between "vc backable" startups and the rest (sushi restaurants, tire shops). Successful startups ride an exponential technological, regulatory or social trend and create massive amounts of value very quickly, reaching massive markets that would otherwise be underserved. (most also fail). Here's a great essay by Paul Graham https://www.paulgraham.com/growth.html
I disagree with consumers only being "mildly priviledged by competition" because the alternative would be monopoly or oligopoly and arbitrary pricing power by incumbents (there's a reason why antitrust suits happen all the time). Deel v Rippling is an almost comically bad situation, but prices are almost certainly lower and pressure to create a better product far higher than in a counterfactual world where Deel did not exist. As another example, consider Delve, Scytale and the other automated compliance providers following Vanta. Delve costs half as much and certifies SOC 2 twice as fast. Scytale provides other features, like providing in house auditors instead of just referrals. No two companies are exactly alike, and a company usually earns the right to exist by being different in a crucial way (different vertical, different pricing, different features, different secret etc)
I disagree with consumers only being "mildly priviledged by competition" because the alternative would be monopoly or oligopoly and arbitrary pricing power by incumbents
Certainly, what I mean to say is that these particular instances of competitive behavior I've highlighted result in little benefit to consumers, not that competitive pressure is useless. But it is the case that a lot of competition in capitalism that is just entrepreneurs wastefully wrestling shareholder value from each other, and I'm not sure why I haven't heard of this criticism before.
From my notes for the book 0 to 1: "Competition is destructive and not a sign of value".
For your alpha, look for secrets (things you know or are confident in, but no one else is). Create something that is 10x better than any alternative. Don't start the next restaurant. You want to be the next monopoly.
Not the focus of that book, but personally, I would also like to create value, not only capture it. So I'd aim not to start the next Elsevier, Coca-Cola, or Facebook, even though they have great profit margins. There are good and bad monopolies.
When Tom opens his shop, Tom and Fred have each other as competitors, so they both need to up their game to stay competitive. This is non-zero-sum value that competition provides. Without Tom, Fred with his local monopoly can be lazy. Econ 101.
I agree that that's a benefit of capitalism, but it's a point orthogonal to the one I'm making.
Suppose Fred opens up a car repair shop in a city which has none already. He offers to fix the vehicles of Whoville and repair them for money; being the first to offer the service to the town, he has lots of happy customers.
In an abstract sense Fred is making money by creating lots of value (for people that need their cars fixed), and then capturing some fraction of that value. The BATNA of the customers Fred services was previously to drive around with broken cars, or buy new ones. As a result of his efforts, Whoville as a town can literally afford to spend less time building or purchasing cars.
But then let's say Tom sees how well Fred is doing, and opens up an identical car repair business ~1 mile closer to the city center. Suddenly most of Fred's customers, who use a simple distance algorithm to determine which car repair business to frequent, go to Tom.
Now, Tom has certainly provided his customers a bit of value, because it is nicer to be closer to the city center. But the marginal value he's provided to Whoville isn't nearly enough to account for the value of his new business. Mostly, Tom has just engineered a situation where customers that previously patronized a business owned by Fred now patronize his.
In fact, if there were fixed costs involved in building the shop that exceeded the value of the shorter travel distance, society as a whole might literally be net-poorer as a result of Tom's efforts. This is all true in spite of the fact that the business itself has no negative externalities and appears productive to external observers. Tom's business once created is a productive one, but the decision to start a new business was rent-seeking behavior.
Most new businesses tend to be rent-seeking in this sense. That's because it's much easier to make a slightly more enticing offer than your competitors, than it is to innovate so much that you can pay yourself from the surplus. Consider:
In all of the above cases, the businesses aren't extracting money from the consumer, who is either unaffected or mildly privileged by the competition. But they're not creating value either. They're just pulling money from other entrepreneurs & shareholders of already-existing competitors.
Most businesses are like this, but not all. Consider:
The largest technology companies tend to be obviously not rent-seeking in retrospect, partly because their market caps are so high that they literally could not have pulled money any other way.