The economics of priceless transactions

Taken together, you have a simple alternative to trading: the price of anything that affirms shared values is infinite, the price of anything else is zero or negative when the alternative is to debase or reverse a value.

Saint-saint transactions are not uncomputable though. You can order priceless values from greatest to smallest. You can do some simple, low-precision math with the infinities of pricelessness. Lives are priceless, but it is only acceptable for a mother to give her life to save  a young child, not the other way around. Often, one infinity is devalued in proportion to how corrupted it seems relative to another infinity of the same kind. So the adult life has been more corrupted by base trader considerations of adult circumstances. Therefore it must be sacrificed for the child’s life.

In general, the innocent are more priceless than the corrupt, the pure more priceless than the impure, the lofty more priceless than the base, the natural more priceless than the artificial. Some examples are harder to analyze. Soldiers giving their lives for their country are often viewed as superior, purer people giving their lives to protect inferior, more corrupt people.

To resolve this paradox, we agree to pretend that soldiers fight directly for the proclaimed values of a nation, rather than the lived values of its actual people. This is why soldiers’ families in movies are always archetypal, sometimes even cartoonish, models of perfect virtue. They are never the messed-up rolling train-wrecks that are the families of most real people. In theory, we are supposed to honor the lives of the fallen by striving harder to be worthy of their sacrifice. That of course means living more truly by the values they died for.
 

Excerpt from a fascinating post on the economics of priceless transactions. As the author notes, the rise of the internet has put a spotlight on the economics of free, but what of the opposite end of the spectrum?

Three things come to mind. One is that I recall my mother never split any bills when going out to meals with friends and family. Someone always picked up the tab only after a theatrical fight between Asian adults for the check when it landed on the table after a meal, almost a ceremony of sorts. It resembled some notion of what the author terms a saint-saint transaction with a price attached but treated as an afterthought. More important than the equitable division of the tab was affirming the friendship. Since the continuation of the relationship likely meant more meals in the future, the favor would be returned at the next meal in a the next stroke of a lifelong financial volley.

I picked up on this tradition, and after college, once I had enough income to start eating out on a more regular basis, I tried to carry it on when eating out with others. This worked well with some folks who shared that tradition, but I found the vast majority of Americans were more accustomed to splitting the check. This often led to a semi-awkward impedance mismatch after meals.

The second thing that comes to mind is that our online selves are often closer to idealized constructions of our identity than to our actual selves. This, to me, leads to the exhausting cycle of outrage on Twitter and other social networks. In 140 characters, we must express absolute outrage at every moral transgression from any public figures. After all, we live in an age where our online self, our construction of it, often reaches more people than our real selves. This makes our virtual identity critical, and after all, the cost of moral indignation online comes with little cost. Online, we are all saints.

Third is the internal struggle many NFL fans are caught up in right now. On the one hand, football fans love the sport, the cultural touchstone that is the secular religion of NFL Sunday. It is nearly impossible to dispute, however, the gladiatorial destruction the sport wreaks on its participants' bodies and minds. And, thanks to the elevator security footage of Ray Rice knocking his wife out cold with a vicious left hook, all the multitude of domestic violence cases over the years involving NFL players suddenly took on a tangible nature that's not as easy for fans of the sport to ignore.

What makes fans uncomfortable is that even if they elevate their love of the sport to an intangible and priceless stature, perhaps as some touchstone of American spirit, or some cultural bond between generations, they know that in a comparison of priceless values, the health and lives of players and the safety of their spouses and children must rank higher. It's not sacrifice if you aren't letting go of something you genuinely love.

I also loved this bit from the post:

When traders, rather than saints, control the narrative, the narrative logic is baser-than-thou. This is the logic of status-leveling humor rather than the logic of status-preserving solemnity. To understand why, consider the classic joke about prostitution:

Man: will you sleep with me for $1 million?
Woman: Okay
Man: will you sleep with me for $5?
Woman: WHAT! What kind of woman do you take me for?
Man: we’ve already established what kind of woman you are. Now we’re just haggling over the price.

In this joke, the initial offer of $1 million is actually fake-out code for “priceless.” The joke relies on treating it as an actual negotiable number later, instead of sticking to the fiction that it is a symbolic infinity. The trader here has an ulterior motive: exposing the hypocrisy of the woman’s position, thereby up-ending the presumed status relationship at the start.

The reason jokes like this work is that priceless actually is a number less than infinity in many practical situations. For something to be priceless, it is only necessary for it to be priced at a point where it can be compared with something else that is priceless.

In the prostitution example, an offer of $1 million is (if you’ll pardon the joke) big enough to be considered fuck-you money. This has a very specific valuation in the priceless economy: it is the price of liberty for the rest of your life. The woman is willing to do for $1 million what she is not willing to do for $5. Not because she has a rational pricing model in mind, but because at $1 million, she is wrestling with a high-minded internal values conflict (liberty versus purity). At $5, she’s thinking about paying for a sandwich. The joke works because it disrupts the original fiction that purity ought to be the more priceless value of the two. Indecent Proposal works as a tragedy for the opposite reason: the original fiction is ambiguous and the ending affirms values in the “right” order (watch the movie to understand why and at what cost).

This is why earnest discussions in the startup world about what your “number” might be, are deluded. Liberty means different things to different people. For some, it is a dollar and a mindset shift away. Others remain trapped even with hundreds of millions of dollars.
 

And, for those of you who come here just for technology related stories, an excerpt that veers closer:

Marketing represents a net return on investment if the irrationality it induces, via movement of the transaction into saintly regimes, increases margins sufficiently. You could measure the irrationality of a market (or equivalently, the hierarchical rationality of a reputation economy) by the amount spent on marketing, particularly in a saintly mode. A marketing-dominates-sales company is one that has carved out a defensible position: a regime behind a fixed boundary where a favorable values economy of pricelessness prevails.

This is what positioning means: drawing a boundary around a set of values that your customers will accept, that put you on top in most transactions.

As Exhibit A, I give you Apple during the reign of Steve Jobs at the top of the Apple reputation economy. That Apple at the time was primarily a reputation economy, and only secondarily a computing hardware market, is clear from the fact that there is a clear hierarchy in its market, with users at the bottom, genius-bar reps one level up, and an invisible secret church in the background with Jobs at the top. Now that he’s gone, the fate of the company depends on the ability of Tim Cook to play St. Peter well.

How Apple deploys its cash

It's often said that Apple is sitting on too large a horde of cash, that if it can't come up with ways to deploy that cash that exceed its own internal rates of return or other such hurdles (to use finance speak), it should return that cash to shareholders.

On Quora, an anonymous account posted an interesting take on why Apple accumulates so much cash and how it deploys that as a strategic weapon.

When new component technologies (touchscreens, chips, LED displays) first come out, they are very expensive to produce, and building a factory that can produce them in mass quantities is even more expensive.  Oftentimes, the upfront capital expenditure can be so huge and the margins are small enough (and shrink over time as the component is rapidly commoditized) that the companies who would build these factories cannot raise sufficient investment capital to cover the costs.

What Apple does is use its cash hoard to pay for the construction cost (or a significant fraction of it) of the factory in exchange for exclusive rights to the output production of the factory for a set period of time (maybe 6 - 36 months), and then for a discounted rate afterwards.  This yields two advantages:

  1. Apple has access to new component technology months or years before its rivals.  This allows it to release groundbreaking products that are actually impossible to duplicate.  Remember how for up to a year or so after the introduction of the iPhone, none of the would-be iPhone clones could even get a capacitive touchscreen to work as well as the iPhone's?  It wasn't just the software - Apple simply has access to new components earlier, before anyone else in the world can gain access to it in mass quantities to make a consumer device.  One extraordinary example of this is the aluminum machining technology used to make Apple's laptops - this remains a trade secret that Apple continues to have exclusive access to and allows them to make laptops with (for now) unsurpassed strength and lightness.
  2. Eventually its competitors catch up in component production technology, but by then Apple has their arrangement in place whereby it can source those parts at a lower cost due to the discounted rate they have negotiated with the (now) most-experienced and skilled provider of those parts - who has probably also brought his production costs down too.  This discount is also potentially subsidized by its competitors buying those same parts from that provider - the part is now commoditized so the factory is allowed to produce them for all buyers, but Apple gets special pricing.

For me this recalls sushi restaurants. When I first graduated college and finally had enough money to eat sushi regularly, I'd sit at the bar at a sushi restaurant and watch the sushi chef cutting the fish and wonder what was so difficult about what they were doing. After watching a few of them, I felt like I could climb over the counter and assemble a reasonably good piece of sushi myself.

After watching Jiro Dreams of Sushi, I realized that watching a chef prepare a piece of sushi was just the tip of the iceberg, that much of what set one sushi restaurant apart from another was the supply chain, the relationships with the right buyers and suppliers and fishmongers that helped secure the best ingredients.

This strikes me as the same way most people underestimate Apple. They see the aesthetics of the final product, the software or hardware design of an iPhone or a MacBook air, and they don't see any sustainable competitive advantage. All of that can be copied, they think.

Leaving aside the fact that in hardware design if you have to copy someone else in technology you're already one generation behind, what people often fail to see (or can't, given Apple's secrecy) is the massive supply chain edifice below the water's surface. Scaling in software may be less of a problem for David than it once was, but in hardware it pays to be Goliath. 

Apple strategy and disruption

The Businessweek interview with Tim Cook is fascinating because it's not often you get to hear the tech titans talking about each other.  CEO's of most tech companies are fairly guarded when speaking to the press, and most won't address the competition head on, but Cook didn't shirk those subjects.

I think if I bought [an Android tablet] and used it, and I thought that was a tablet experience, I’m not sure I would ever buy another tablet. The responsiveness isn’t there. The basic touch is really off. The app experience is a stretched-out smartphone kind of experience. It’s not an optimized experience. However, that said, I have always said that the tablet market was going to surpass the PC market. I was saying that well before it was viewed to be sane to say that. It’s clear that we’re 24 months away from that.

On Android's market share: 

Has Android’s rise in market share surprised you in the time that it’s happened?

I don’t think of Android as one thing. Most people do. I mean, from a consumer point of view, if you look at what Amazon (AMZN) does with Android, forget the name Android for a minute. If you’re coming down from a different planet and you were going to name it, you wouldn’t name it the same thing as what another company does. If you compared that to what Samsung (005930:KS) does, I’m not sure you would name that the same thing either.

I think that the importance of that is overplayed. The truth is that there are more people using iOS 6 than there is any version of Android. And in days from now, iOS 7 will be the most popular mobile operating system. And so what does it really mean at the end of the day to show these share numbers and combine all of these disparate things as if they’re one thing? I’m not so sure it has a great meaning to it at the end of the day.

So your question, does it surprise me? I don’t look at it in the same way as you might. I think the way a consumer looks at this is different. Does a consumer that’s buying a Kindle think about it being an Android? Probably not. And so I think that’s a bit different than where Microsoft (MSFT) and Windows was.

On Android's OS fragmentation:

What’s your take on Android’s many versions? The “fragmentation” issue.

It’s a growing problem.

From a functional level?

Yes. And it’s just not growing in the—it’s not like a baby that becomes an infant. It’s not like that. It’s an exponential. It’s a compounding problem. And think about all these people that they’re leaving behind from a customer point of view. People do hold on. Most people hold on to their phones a couple of years. They enter a contract and honor that contract and then upgrade after that two-year period. So in essence, by the time they buy the phone, many of these operating systems are old. They’re not the latest ones by the time people buy. And so by the time they exit, they’re using an operating system that’s three or four years old. That would be like me right now having in my pocket iOS 3. I can’t imagine it.

It’s not because it was bad. It’s just because the world has changed and there is so much more. And so anyway, I think it is a growing issue. It will show up in developers. It will show up for people that no longer have access to certain apps. It will show up in security issues, because if you’re not moving your customer base to the latest version, then you have to go back and plug holes in all of this old stuff, and people don’t really do that to a great degree. So they are more susceptible to issues.

It just shows up in—I mean, name it. And that issue grows, and because the population is growing, it becomes bigger and bigger and bigger. So we’ll see.

On market share generally:

While these phones represent the high end of the industry, there’s another part of the industry that’s racing toward the bottom. Chinese manufacturers, Indian manufacturers, $100 phones, $150 phones. What do you think about that? What does that mean for Apple?

I think it’s important that we grow, but I don’t measure our success in unit market share. So if there are a lot of $69 tablets sold that you’re just pounding on to get something to work and get some responsiveness, and it’s thick and fat and just a terrible experience, I don’t really weigh that unit of share like I do a different unit of share. I don’t weigh them to be equivalent.

So I think in most markets in consumer electronics, there’s always a large junk part of the market. We’re not in the junk business. We don’t want to make something for that. What we want to do is make a really great product and provide a great experience. And I’m sure we’ll get enough customers that want to buy that. We want to please them.

That other business, it’s not something—we don’t spend our time obsessed of how to make a product for that because that’s just not who we are and what we’re focused on.

The most common questions about Apple: why don't they come out with a lower price iPhone for non-subsidized markets? Why do they leave a price umbrella in phones and tablets? Is Android's growing market share concerning? Cook took them all head on and seems, at least to me, very candid. The next time someone poses these questions again they can just reference this interview.

The Cook interview pairs nicely with the Ben Thompson post What Clayton Christensen Got Wrong. Christensen is the intellectual of the moment in technology the past several years with his theories of disruption from his classic text The Innovator's Dilemma. Disruption has proven to have great explanatory power in many sectors of the technology industry. But Christensen has been wrong, repeatedly, about Apple's susceptibility to disruption. Many a time he has predicted Apple will be bitten at the heels, and time after time they've been fine.

Thompson believes he knows why. 

In the case of low-end disruption, the rational buyer considers the superior integrated offering and the inferior (but still good) modular offering, decides the latter is “good enough,” and buys it because it is cheaper. The buyer knows the integrated offering is better, but the buyer is unwilling to pay a premium for features the buyer does not need.

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EVERY ATTRIBUTE THAT MATTERS CAN NOT BE DOCUMENTED AND MEASURED

The attribute most valued by consumers, assuming a product is at least in the general vicinity of a need, is ease-of-use. It’s not the only one – again, doing a job-that-needs-done is most important – but all things being equal, consumers prefer a superior user experience.

What is interesting about this attribute is that it is impossible to overshoot.

Given how often the tech industry rushes to apply Christensen's theories of disruption (as in most walks of life, disruption is the hammer through which the tech industry sees an infinity of naials), Thompson's article is a must read. 

The sound of iOS 7

I've been running iOS 7 on my iPhone for about a month now, largely for testing our iOS 7 compatible version of Flipboard, and just at noticeable as the visual and spatial navigation changes are the updated sounds and ringtones. It's like the iPhone got a new voice. 

Alan Hanson at The Awl reviews the top 5 new ringtones of iOS 7.  On Constellation:

It is twilight. You are living inside of a prism beam. You are slowly falling through a prism beam without worry and with a satiated stomach. All of your childhood pets are running toward you in slow motion and they are hungry for your love. Your favorite blanket is playing your favorite instrument on a bed of newly fallen autumn leaves. Insects do not exist and yet, the ecosystem remains beautifully balanced. Your boss who respects you very much enters your line of vision and unrolls a long scroll. She reads from the scroll. She reads all of your favorite words, slowly, then disintegrates and is carried off by a warm wind. You have never had a parking ticket. Your dentist is in awe of your brushing habits.

If you think that sounds overblown, go listen to Constellation . I've never switched from the default ringtone before iOS 7 came along, but now the default ringtone has even changed. RIP Marimba, you were the reigning rooster's crow of a digital generation.

I never browsed the list of ringtones in my iPhone in much detail before, but the Awl article raised my curiosity. Many of the new options, and there are many, strike me as more New Agey in nature. Uplift could be the start of an Enya song.  Many of the are more melodic and tune-like than alert-based in nature. For once, I may opt for one of the former.

The price game

When Ron Johnson took over as CEO of J. C. Penney, one of his most sweeping changes was to move away from the constant sales and coupons to a more straightforward pricing model. Not surprising considering he came from Apple where they hold one sale a year, on Black Friday, and not even a great one at that.

But J. C. Penney is not Apple, and the price game each is playing is different.

Mr. Johnson explained a similar logic when he moved the chain toward simplified pricing. In January 2012, while introducing his new plan to investors, the press and vendors, Mr. Johnson said that in the previous year, the company held 590 sales events; almost three-quarters of the stuff it sold was marked down 50 percent or more.

But here’s the thing: customers weren’t actually paying less. The chain just kept raising the prices that customers saw on the racks, and then discounted those prices during promotions. Why keep playing a game that is expensive and troublesome for the seller and a mirage for the consumer?

J. C. Penney was not the first retailer to be astonished by the brilliance of this realization. In 2006, Macy’s had a similar idea after acquiring the coupon-happy May department stores. It decided to “retrain” those customers, as its chief financial officer put it at the time, by drastically cutting coupons. By 2007, it had abandoned that strategy. Its chief executive acknowledged that pulling back on coupons was Macy’s biggest mistake in its acquisition.

Even Walmart, which actually does pull off the trick of “everyday low prices” in its domestic stores, is finding it hard to convert consumers to a single-price model in countries like Brazil and China, where retailers give deep discounts on a few main products, then mark up the rest, said Mark Wiltamuth, an analyst at Morgan Stanley.

The problem, economists and marketing experts say, is that consumers are conditioned to wait for deals and sales, partly because they do not have a good sense of how much an item should be worth to them and need cues to figure that out.

Just having a generically fair or low price, as Penney did, said Alexander Chernev, a marketing professor at the Kellogg School of Management at Northwestern University, assumes that consumers have some context for how much items should cost. But they don’t.

Price strategy has to be supported throughout the organization. For Apple to have one price for its items means they must enforce that price through all of its distribution partners, and it must also create advertising that reinforces the premium quality of the goods. And of course, the products must be good enough to justify a no discount policy.

One thing is for certain: once you go sale, it's tough to go back (once you go red, it's hard to go black?). Companies that consider a sale or discount strategy should do so carefully. Once customers expect a regular cadence of sales or discounts (e.g. Restoration Hardware's bi-annual bath sales, or Bed Bath and Beyond's ubiquitous 20% off coupons) they orient their entire behavior around that pattern and won't easily be persuaded to buy at full price ever again.

A surprising corporate giant

What company, according to Fortune, is the eighth largest employer in the world, with over 549,000 employees globally?

The answer shocked me: Volkswagen. That's just the tip of the iceberg in terms of fascinating tidbits from this mini profile.

Efficiency experts will tell you that on an employee-per-vehicle basis, Volkswagen looks hopelessly inefficient. Financial analysts will tell you that the company woefully trails its competitors on a revenue-per-employee basis. But VW will tell you that it makes more money than any other automaker – by far.

While VW's stated goal is to become the world's largest car company by 2018, it's already there if you measure it by revenue and profits. Its revenue of $200 billion is greater than every other OEM. Last year's operating profit of $14 billion is the kind of performance you expect from Big Oil companies, not automakers.

Last year's operating profit of $14 billion is the kind of performance you expect from Big Oil companies, not automakers.

How can this be possible? How can VW look so uncompetitive from a productivity standpoint, yet out-earn all of its competitors?

Ah, that's the magic of VW's corporate structure. While business schools teach future MBAs that centralized operations can cut cost by eliminating overlapping work and duplication, VW maintains strongly decentralized operations with lots of overlap. While business schools preach the benefits of outsourcing to cut cost, VW is very vertically integrated.

Anytime a car company buys a component from a supplier, that supplier has to charge a profit. If an automaker can make those components in-house, it gets to keep that profit. VW is building a lot of components in-house.

To dominate you need multiple brands, and VW has more than anyone else.

If an automaker truly wants to dominate the market, it has to accept a certain amount of overlap and duplication. It just goes with the territory. To dominate you need multiple brands, and VW has more than anyone else, which admittedly overlap at the edges. But to VW they are more than just brands.

All of VW's brands (VW, Audi, Seat, Skoda, Bentley, Lamborghini, Ducati, Porsche, Bugatti, MAN, Scania, and VW Commercial) are treated as stand-alone companies. They have their own boards of directors, their own profit & loss statements, and their own annual reports. They even have their own separate design, engineering and manufacturing facilities. Yes, they do share some platforms and powertrains and purchasing, but other than that they're on their own.

Anyone who works in technology will hear an echo in much of this strategy. Volkswagen's model of of running all its brands as independent companies is an example how the biggest tech companies try to push decision-making to the edges, to the teams running a variety of product lines, as a way of trying to remain entrepreneurial, innovative, and nimble. 

The way Volkswagen has vertically integrated is reminiscent of the way Apple has, over time, taken over more and more of the computing value chain, down to opening their own retail stores. Given how Samsung is also vertically integrating and competing head on with Apple in the mobile computing market, it would be surprising if Apple didn't stop sourcing chips from Samsung and take their business elsewhere, to a partner less vertically integrated, like Taiwan Semiconductor.

Volkswagen, by dint of its vertical integration, can capture value wherever it occurs in the value chain, and as the sources of value shift as it often does over the life cycle of technology products, Volkswagen retains its cut. On a related note, look at the last chart on this post at Asymco. Stunningly, Samsung makes more operating income from Android than Google is! In this mobile computing war, Samsung is making money off of both Google and Apple. After Apple, it's difficult to name another company that has profited more from the mobile computing revolution.

Volkswagen is the answer to the subject of this post, but Samsung is nearly as shocking a dark horse of a corporate behemoth.