The most important concept for understanding how the economy really works (after supply and demand) is winner-take-all. Unfortunately, this has been left out of basic economics textbooks. For example, the term “winner-take-all” does not appear anywhere in N. Gregory Mankiw’s textbook, The Principles of Economics. Nor are similar concepts such as “tournament theory” or “rent-seeking.” Buried on page 302, he does note that economies of scale can give rise to natural monopolies. The implication is that this is a minor factor in economics.
In most industries, a competitive market in which no one buyer or seller becomes dominant is an unstable system. It’s sort of like trying to drop a pencil on the floor in hopes that it will land pointing upright. This never happens; the pencil always falls down, and always in some random direction. While people are aware that if the pencil points to 47 degrees after being dropped, there’s nothing special about 47 degrees; if the pencil were dropped again it would point in some other random direction. Unfortunately, when it comes to economic competitions, people have a natural tendency to attract significance to the winner. If someone makes billions of dollars in his market, it must mean something. He must have created more value or done something better than everyone else. What people don’t get is that, if a market is a natural winner-take-all market, then some participant has to win, regardless of whether or not that participant has done anything to deserve winning. It’s like spinning a roulette wheel. The ball has to land somewhere, but whatever number it lands on is no more deserving of any other number, it’s just sheer luck. Because one participant has to win a winner-take-all competition, the lightest edge can tip the contest in a participant’s favor. That factor might be that the participant has a slightly better product, but it’s just as likely if not more likely to be better marketing, better salesmen, the willingness to behave unethically, better at schmoozing those who can supply the business with capital and better at knowing the right people, or just sheer luck.
One may say that in winner-take-all markets, there are economies of scale favoring bigger companies. These economies of scale could be production economies of scale, but more often they are what I call marketing economies of scale.
Take Coca-Cola. It doesn’t take a huge amount of startup capital to start making and selling soda, and you can probably make it for approximately the same price as Coca-Cola can. But no one will buy your soda. What does Coca-Cola have that you don’t have? Coca-Cola has the distribution channels locked up and has brand recognition. Coca-Cola is an example of a business with marketing economies of scale, and I would also say that Coca-Cola possesses a great deal of marketing capital (which doesn’t show up on the company’s balance sheet). People perhaps more often call this “goodwill,” after the accounting term for the amount paid for a company which exceeds its book value. But they are not really the same thing. “Goodwill” could simply mean that the book value was not the same as the true economic value of the assets, or it could mean that the buyer overpaid.
In industries where marketing capital is important, the result tends to be oligopolies rather than monopolies. A lot of industries are like this. There are four big accounting firms. It’s my opinion that a smaller firm actually performs superior work for the same price and that professional services firms have diseconomies of scale from a quality of work perspective, but because the big firms have the most prestige, they get all of the business. Arthur Andersen, the company that audited and enabled Enron, was once one of the most prestigious professional service firms despite the fact that, in hindsight, they sucked really bad and were unethical.
Software is an industry with true production economies of scale. Additional units of software can be sold for zero marginal cost, and it costs just as much money to develop a program that’s used by one customer as it is to develop a program that’s used by a hundred million customers.
Microsoft dominates software, but it’s hard to see what value that Microsoft actually created. The company only exists because IBM made a really dumb decision to give Microsoft ownership of the operating system instead of developing it in-house or with consultants who signed contracts giving all intellectual property to IBM. This is not a mistake that any big company will ever make again, I guarantee you that.
Nearly everything Microsoft sells has been copied or purchased from other business entities. The idea for Windows was copied from Apple and Xerox. Excel was copied from Lotus which was copied from Visicalc. Microsoft is able to dominate all application software because they dominate the operating system, and Microsoft dominates the operating system because Microsoft was first, and Microsoft was first because IBM was stupid and because Bill Gates’ mother knew some top executives at IBM. If anything, Microsoft has actually destroyed value by using its dominant marketing position to make its own software the standards, even though a lot of their software sucked in comparison to their competitors. I call this value creation suppression.
Winner-take-all is a type of value transference. The winners of winner-take-all competition always earn more money than the value they created.
In comments, some have insisted that it’s necessary for such vast rewards to exist because otherwise people won’t take “risks” and there won’t be any technological progress or innovation.
There is absolutely no scientific evidence to support the above theory. Everything we know about human behavior shows that there’s an optimism bias, and that people overestimate their chances of winning difficult-to-win competitions. If people truly understood the odds, no one would ever buy lottery tickets. Behavioral theory tells us that too many people are trying to win winner-take-all competitions rather than the other way around.
Most real invention takes at big companies and is done by salaried employees who don’t retain any of the profits from their labor. There would be no basis for Microsoft, Dell, Apple, Google or Facebook existing were it not for the fact that there are thousands of engineers toiling anonymously at companies like Intel and Motorola making Moore’s Law a reality.