Why Open Doesn't Conflict With Money… But Often Appears To

Economics

from the it's-all-about-the-size-of-the-pies dept

Venture capitalist Fred Wilson has a typically insightful post discussing the question of whether or not being “open” conflicts with making money, building off a post by Mathew Ingram about his love/hate relationship with Twitter in which he notes:

Lastly, I hate that Twitter’s metamorphosis seems to reinforce the idea that being an open network — one that allows the easy distribution of content across different platforms, the way that blogging and email networks do –isn’t possible, or at least can’t become a worthwhile business.

Fred is a well known believer in “open” projects and has quite literally put an awful lot of money into a variety of startups that espouse a very open philosophy. So it’s not surprising that he disagrees that it’s not possible to make money and be open. But his view is nuanced:

I do not think open conflicts with making money and further I think there are ways to make more money by being open rather than closed, but it takes imagination and a well designed relationship between your product/service and the rest of the Internet.

I also think it is better to open up slowly, cautiously, and carefully rather than start out wide open and then close up every time an existential threat appears on the horizon.

He points to Etsy as an example of a company that has become more open over time, and to Twitter as one that started out very open and has had to close up over time (Fred is an early investor in both companies). At the end of his post, Fred tosses in an aside to the “O’Reilly Doctrine” referring to one of Tim O’Reilly’s (many) great maxims:

Create more value than you capture

I’ve actually been thinking about this quite a bit lately, and I think that when you recognize how growing markets tend to work, and the way openness can influence markets, that the O’Reilly Doctrine explains — in a backdoor way — why it appears that open platforms are antithetical to making money, when the truth is often quite the opposite. I’ve been trying to explain this (unsuccessfully) for years, but hopefully I can express it more clearly here.

Economic growth comes from the sharing of ideas (once you get past growth through scarce resource discovery). This is the key realization of a number of economists over the past few decades, most notably, Paul Romer. As we’ve noted in the past, knowlege is a universal resource that does not diminish and can expand — unlike scarce resources that are limited. Knowledge and information only expand, and in doing so they often make all of those other scarce resources more valuable. Knowledge and information makes things more efficient and makes things better, thereby increasing economic value and expanding the overall pie. Or, as Romer has said:

Economic growth occurs whenever people take resources and rearrange them in ways that are more valuable. A useful metaphor for production in an economy comes from the kitchen. To create valuable final products, we mix inexpensive ingredients together according to a recipe. The cooking one can do is limited by the supply of ingredients, and most cooking in the economy produces undesirable side effects. If economic growth could be achieved only by doing more and more of the same kind of cooking, we would eventually run out of raw materials and suffer from unacceptable levels of pollution and nuisance. Human history teaches us, however, that economic growth springs from better recipes, not just from more cooking. New recipes generally produce fewer unpleasant side effects and generate more economic value per unit of raw material.

Every generation has perceived the limits to growth that finite resources and undesirable side effects would pose if no new recipes or ideas were discovered. And every generation has underestimated the potential for finding new recipes and ideas. We consistently fail to grasp how many ideas remain to be discovered. The difficulty is the same one we have with compounding. Possibilities do not add up. They multiply.

Possibilities do not add up. They multiply. But take that a step further. One of the ways to increase this kind of growth and to increase this kind of knowledge sharing is to be open and to allow everyone (or larger groups of people) to contribute. And that requires openness. But there’s a related caveat to that. When you’re open like that and allowing others to contribute, you’re also “leaking” some of the benefits as well — often a very large amount. In economic terms, these are often referred to as positive externalities or spillovers. Basically things that one party does that benefit others widely. I think both terms are slightly misleading in that when most people think about externalities or spillovers, they assume a small bit off the top.

But when it comes to knowledge and information in open systems, it’s not that way at all. The vast majority of the benefit is actually going back to the public, because you don’t have the walls and the gates to contain it and capture all that value directly. But that doesn’t mean there isn’t a tremendous amount of value that can be captured by those responsible for creating the open systems. It’s just that on a percentage basis, it seems much less. They create these massive and expansive fields of value out of nothing, and only capture a small piece of it — leaving the rest of those benefits to be enjoyed by the public. But these fields are so big that the businesses themselves can be huge and can make a ton of money (think: Google, Twitter, Craigslist, Kickstarter, etc…).

Yet, in the old, closed way of doing business, the mentality is very much about how much of the value did you capture. They’re not concerned about expanding the overall market and just keeping a small part. They’re focused on capturing a larger and larger piece of the existing market. It’s why, for example, with the entertainment industry, we see them so focused on taking bigger and bigger licensing deals, and making it so businesses like Netflix and Pandora and Hulu have trouble building long term viable businesses — because the old gatekeepers look at them and say they’re benefiting too much from the value we created — and we need to take our “fair share.” The open systems look at the absolute amount of money they’re making, and say “wow, by creating so much more value, and just taking our sliver of the proceeds, we’re doing great!”

It’s a completely different view of the world.

But, from the outside looking in, if you view the two using the same “metrics” as the old, closed systems, the new “open” ones don’t appear to make as much money. But it’s not that they can’t or don’t make a lot of money. They do. It’s just that they make less as a percentage of the value they create. And while it’s the absolute number that really matters, it seems that our brains are sometimes hardwired to focus on the relative value capture.

Open systems can and do make lots and lots of money. As Fred notes, it requires a lot more thought and planning in terms of figuring out where and how (and often it requires a much closer relationship between products/services and users). But often, looking at the wider market, it feels like those businesses must be leaving more money on the table because they capture a relatively smaller portion of those markets, even if the dollar amounts may be bigger in real terms.

In the simplest of traditional terms: it’s better to capture a small slice of a massive pie then a large slice of a small (and shrinking) pie. And being open is how you grow the pie — not incrementally or linearly, but exponentially.

Filed Under: business models, economics, externalities, innovation, open, spillovers