Intangible investment behaves differently
gatesnotes.com
gatesnotes.com
Er, no. I guess even smart people like Gates get simple economics wrong sometimes. It's understandable, though, I've always felt the P/Q axes should be switched, since people always speak about the price as the independent variable.
He's conflating the idea of pricing along the line with the demand line itself. Yes, at higher prices, less quantity is demanded and vice versa. Similarly, if you can sell the thing for a higher price, more people will be interested in and able to sell it, so the quantity available will increase, and vice versa.
However, "supply" and "demand" refer to the whole lines themselves, not points along the lines. Changing supply and demand means the lines shift. If "demand for a product goes up", the demand line shifts to the right, the equilibrium quantity increases, but so does the price, the opposite of what he's saying.
His misconception then leads to an even larger error in understanding with the next part:
The second assumption this chart makes is that the total cost of production increases as supply increases.
This is false. What it says is that with if the price you can get for a good is high there will be more suppliers. The canonical example is oil: when it sells for $20/barrel, only Saudi Arabia and places with it easily accessible will be able to profitably drill for it, and so the quantity supplied will be low. But at $120/barrel, you can now use fracking, deep water drilling, and other much more expensive processes, and so the quantity supplied will be higher.
Supply and demand is not about any individual producer producing more, and so it's not particularly useful in analyzing the behavior of a single firm. It's about the aggregate effect of multiple different parties, each with their own respective infrastructures and costs, profitably contributing to the supply (or not) at different price points.
2) In my experience, the supply+demand curve is one of the most misunderstood concepts in economics, and it took me a long time in college until I found an economics professor who could explain it properly. A lot of really intelligent people I know don't understand it (even though they think they do), and in my experience most business people don't actually understand it (that's fine, they don't usually need to), but I am fairly shocked to see Gates misunderstand it... unless this article is written by an intern or something, which I find more likely.
https://en.wikipedia.org/wiki/Supply_and_demand
It does a good job of getting into and linking to its nuances, although it's not exactly a tutorial or anything.
I think that's a poorly phrased segway.
What he actually seems to be talking about later is that marginal cost flattens after some number of units, but then continues at a fairly constant level (representative of material inputs).
Contrasting this with software and intangible production, where the marginal cost continues to decrease for much larger scales, before hitting a much lower floor (compute + disk + amortized development + maintenance).
And how the proportion of our economy governed by that different marginal cost vs volume curve has continued to grow. And that this has underappreciated implications on how we design economic law.
As he notes, Capitalism Without Capital is an exploration of this idea that he read and enjoyed.
On the side note, crypto currency is the new new intengible assets that is hard to internalize. Ironically, Gates has wrote them off as not worth calling them assets because they aren’t store of a value.
The user manuals were absolutely necessary for complex software. Most users had only a single low resolution monitor back then so online documentation had poor UX.
There's a shrink-wrapped cardboard package that contains Windows 98. It's the size of a cereal box, and at least as colorful.
Today, I'd be intensely annoyed if I had to wait for and pay for a large box to ship - I'd much prefer an instant download, but the box was much more tangible than an email with a download link and license key.
Was this not the reason software was distributed in CDs? I can understand MSFT/Apple using that packaging for customer experience.
The problem was that you couldn't convince consumers to pay for software downloaded over a modem. (The infrastructure wasn't in place anyway - nobody was going to send their credit card number unencrypted to a random BBS sysop, and encryption was outlawed as a munition.) Many software firms in fact had huge problems with piracy over modem, and would build copy-protection into their software so you needed the original physical disk to run the software.
The idea that you could pay for a license key that unlocks software you download over the Internet only happened in the early 2000s, driven by combination of remaining restrictions on encryption being dropped, easy-to-integrate payment solutions for webpages coming to market, and widespread broadband adoption meaning that most consumers could easily download a big file.
You didn't have this for business software, but you did need something to keep the disks in. I think the largest such thing I saw was 100+ floppy disks; here's Raymond Chen on floppy installs of Windows: https://blogs.msdn.microsoft.com/oldnewthing/20050819-10/?p=...
As someone with software and hardware at Ford in Dearborn and at many of their suppliers, this is not true. Ford knows that the costs decrease over time, and demands part of this cut from their suppliers. The contract includes a decreasing price over time or over quantity, because ostensibly you're increasing efficiency and writing off initial engineering costs.
I imagine that Microsft does the same with their hardware division, and agree with the sibling comments that Gates probably did not write all of this.
Even with the supply curve, real-world commercial software virtually always has unit costs. It generally takes marketing and/or sales to acquire new customers, ongoing server and storage costs, customer support... and ongoing bugfixes and improvements merely to remain competitive and not fall behind in the market.
When Microsoft calculates the profitability of Word, their costs aren't "virtually free" or anywhere even close to that.
It sounds like your point is that the entire business world understands software in 2018. I don't think that's entirely true, but I'll accept that it's pretty close. However, I don't think Gates is talking about the business world.
Then I realized it was written by Bill effing Gates. And that made me feel sad.
Firstly, because Bill is smarter than this. His lack of awareness of just how pressing this phenomenon is, indicates that he's either had his head in the sand, or the intellectual circles he swims in hasn't been ringing the alarm bells about this. (See my essay on the Changing Nature of Scarcity: https://medium.com/@pwang/the-changing-nature-of-scarcity-fc...)
Secondly, because of the irony. Bill Gates made his fortune having created a business around selling software. It would be good for him to review John Perry Barlow's "Selling Wine Without Bottles": https://www.eff.org/pages/selling-wine-without-bottles-econo...
As the world's first and most successful wine bottler, billg might find this perspective illuminating.
From personal experience, this covers: any kind of software-driven hardware, health care, tax, CAD, POS, finance, transportation, & retail.
They're changing. But I'd estimate most Top 500 companies are at 0-25% open source migration of core business processes.
1. While the cost to produce N+1 and N+1000 version of the software is same in terms of producing the code, if you have a piece of software that functions more like a specialized tool, training user N+1 and N+1000 can be radically different and therefore more time consuming and costly.
2. Sunk cost of development: IP has a lot of value. If you work in producing custom solutions a lot of these solutions have components (code) that work across customer needs. Development may fail on one project, but helps in another. Overtime you have the components to sell a COTS
3. Goods actually aren't intangible, value is. Electricity costs money and it takes the infrastructure to support a small city to run a large-scale server farm. What's missing in the economic model are the costs we don't always factor in or more importantly that are publicly subsidized. Look at the breaks companies get at MSoft, Google, etc on utilities and land.
What hopefully will happen over time is that these rent seeking entities are squeezed out of the market over time, otherwise we are entering an area of corporate feudalism. This can be prevented as long as the assets needed for production are easily and cheaply available, which is the case thanks to the Free Software Movement.
JetBrains has the best of both worlds with a fallback license to let you keep using an old version, or a subscription to get continued updates.
Games are becoming increasingly long lived pieces of software as well. With bugfixing and updates continuing for years. The industry is struggling to find novel ways to make money in that environment, which is why you get things like loot crates. I would prefer an honest subscription over that.
What I see is a devaluing of software as a product. I should be able to spend a couple of hundred hours on a package for a framework and sell it, but there is always someone offering a free version and then using weird and sometimes shady ways to make money. I wish it were more common to just sell code for money, instead of people pretending they are altruistic and then selling your data, selling your eyeballs or locking you into their ecosystem. Subscriptions are at least an open and honest transaction.
This is quite similar to "free" (as in beer, let us not go down that tedious path). Say it only provides thousands of dollars of value and it's still pretty similar.
I don't think any economic theory is that naive.
It's actually the cost of production divided by the number of sales, where the cost of production can be many millions of dollars worth of development and testing and the size of the addressable market can in some cases be very few.
"It" refers to "intangible investment" here--
1. It’s a sunk cost. If your investment doesn’t pan out, you don’t have physical assets like machinery that you can sell off to recoup some of your money.
2. It tends to create spillovers that can be taken advantage of by rival companies. Uber’s biggest strength is its network of drivers, but it’s not uncommon to meet an Uber driver who also picks up rides for Lyft.
3. It’s more scalable than a physical asset. After the initial expense of the first unit, products can be replicated ad infinitum for next to nothing.
4. It’s more likely to have valuable synergies with other intangible assets. Haskel and Westlake use the iPod as an example: it combined Apple’s MP3 protocol, miniaturized hard disk design, design skills, and licensing agreements with record labels.
Dunno if they're fallacies so much as oversimplifications. But the oversimplifications aren't really the point; they're just meant to reference the concepts and give a hyper-quick overview if you've never heard of them. The rest of the review remains a valid point if you substitute more realistic economic concepts. This is my pre-emptive reply to the inevitable dozens of posts arguing about the oversimplifications. None of it matters to the point the author wanted to make.
Note I say "valid", not correct. Whether economists are undervaluing intangible assets is a rich and interesting question that I have only vague opinions about personally. I'm just pointing out that the argument itself does not depend on the oversimplified economic concepts used to introduce the point.
No, they're far enough off of correct that I wouldn't even call them oversimplifications. The statement of the problem is wrong:
The second assumption this chart makes is that the total cost of production increases as supply increases.
That's simply not what the curve says at all. The curve isn't about any one producer making more of an item (as the Ford example given), it's about how producers with different costs are able to profitably add to the supply or not, based on the price they can get for the product.
The review might be fine otherwise, but there's no reason to throw supply & demand under the bus to motivate it. In fact, if you frame it correctly (say, technical innovations have enabled more people to more easily write software, thereby shifting the supply curve to the right and lowering prices), you can still meaningfully analyze these situations with those curves.
> The first is still more or less true today: as demand for a product goes up, supply increases, and price goes down.
Classic econ teaches as demand increases, prices go up. The exception is if the supply curve is flat (for instance, 0 marginal cost).
WTF, seriously?
He probably just stuck with repeating what the book said or is just trying to keep it simple.
https://www.imperial.ac.uk/business-school/knowledge/finance...
He’s just using the example from the book and doesn’t feel the need to restate it?
That also means it’s cheaper to develop. Software is so popular since it’s only requires a developer and a PC. The return/investment is a lot higher and faster than traditional hardware development. Cheap and fast is what everyone wants.
Of course investors are now realizing, in the case of self driving cars (or cars themselves with Tesla), that hardware still plays a role, and it’s not cheap and fast with instant riches.
20 years ago, biotech was supposed to be the hot thing after the internet. Instead it has been software services, focusing on service labor. Biotech is not cheap and fast enough.
Also, his statement implies that digital assets have no real-world financial value. In practice, even if the investment fails, the codebase of the company, body of active users, and any user data gathered will have some value.
"The portion of the world's economy that doesn't fit the old model just keeps getting larger." How can it get larger if no one is paying attention?
Or do you think the phrases mean the same thing?
(e.g. it doesn't matter if I have insufficient money or no money at all; life sucks in both of those alternate-universes)
They absolutely don't. I'd you have "not enough money" to meet your current monthly budget that means you can't afford to put anything aside for your vacation next year but can still get by.
If you have "no money", you can eat or pay your rent.
The two phrases have entirely different meanings, and usually with important differences in connotation.
He then says:
That has major implications for everything from tax law to economic policy to which cities thrive and which cities fall behind, but in general, the rules that govern the economy haven’t kept up. This is one of the biggest trends in the global economy that isn’t getting enough attention.
Yes - over time supplies tend to change due to demand, of course, but that's 'long run' stuff ... not in that chart. The author is kind of misinterpreting the chart.
2) It's not 'sunk cost' that's the issue, this is about 'fixed' vs. 'unit' cost. Software is all 'fixed' (i.e. setting up the production line) whereas most material things are mostly about 'unit' costs (i.e. the cost to make an item)
3) Software sales are a tiny fraction of the economy because almost nobody is selling software. People are selling 'services', basically products that 'do stuff using software'.
The 'key ingredient' is usually some type of business or experiential knowledge, not some algorithm.
4) Software development doesn't finish at v1, it's ongoing.
You can sell a big industrial motor or fork lift that might be part of the fixed costs of running a small factory.
It absolutely is an equilibrium in normal economics: https://en.wikipedia.org/wiki/History_of_microeconomics
"demand for a product goes up, supply increases, and price goes down"
Assumption 2 from article:
"The second assumption this chart makes is that the total cost of production increases as supply increases. Imagine Ford releasing a new model of car. The first car costs a bit more to create, because you have to spend money designing and testing it. But each vehicle after that requires a certain amount of materials and labor. The tenth car you build costs the same to make as the 1000th car"'
In assumption 1 - he's not describing how equilibrium works at all. Equilibrium is the price the market will clear at given a supply and demand curve. If 'demand goes up' - given a fixed supply demand curve ... 'price goes up'. So what the author must be referring to is some kind of market response, i.e. if demand is increasing for something, more suppliers will come along and build it, create more competition, and drive prices down. This has little to do with the Supply/Demand curve.
I don't even know what assumption 2 is about, I get what he is saying but it has nothing to do with supply and demand curves.
Anyhow - even if there is logic in his statements, neither assumption is drawn from the Supply and Demand curve he is showing.
With assumption 2, he's saying that in software (and many other businesses now), supply curves do not necessarily slope upwards. For software, producing 100,000 units takes exactly as much money as producing 1,000 units, and can be offered at the same cost.
The author (who is Bill Gates, BTW, and can be assumed to know a thing about microeconomics) only alludes to this and doesn't say it outright, but there are a number of knock-on consequences to flat supply curves that explain much of the counterintuitive properties of the tech industry but aren't well-explained by classical economics. For example, the "lottery economy" aspect (where there is one company that ends up dominating a market and the size of that company is dictated only by the size of the market) comes from zero marginal costs: once a software firm has built a solution that satisfies a market, there is nothing stopping it from expanding to serve the whole market far faster than any competitor can enter. The existence of the VC industry follows from this, because when success is binary and can't be interfered with once discovered, it makes sense to spread capital across a number of bets, hoping for a hit, rather than rationally analyze how much additional return invested capital will give in an existing business.
Google & Facebook's dominance also stems from this zero-cost-of-production property. When your cost of production to provide the good or service is zero, then the only thing blocking your continued expansion is finding & convincing potential customers. With CAC forming an increasing percentage of your total marginal costs, any services that lower it or make it scale better can realize huge profits.
I'm not sure what you mean, this is 100% covered in general economic theory with barriers to entry.
> Google & Facebook's dominance also stems from this zero-cost-of-production property. When your cost of production to provide the good or service is zero
But it's actually not 0 or even close to it. There are still economies of scale at play, if Facebook were to lose millions of users their costs would grow per user, which is what a marginal cost curve represents. Just because the curve is different doesn't mean it doesn't exist.
I'm pretty disappointed with Gate's post, because every academic economist I know is mocking it...since it's not well represented or thought out. It ignores so many principles and theories in economics for the sake of being "ground breaking." Even though most of the theories are hundreds of years old and still apply completely.
"as demand for a product goes up, supply increases, and price goes down"
No, when demand goes up, the price will go up as well unless supply increases by the same amount. The price will only go down when supply increases and demand doesn't keep up with it.
"the tools many countries use to measure intangible assets are behind the times, so they’re getting an incomplete picture of the economy. The U.S. didn’t include software in GDP calculations until 1999. Even today, GDP doesn’t count investment in things like market research, branding, and training—intangible assets that companies are spending huge amounts of money on."
First of all let's skip the part about what the US did until 1999 because we're living in 2018 at the moment. And then the fact that market research, branding etc. is not included in GDP calculation has little to do with the digital age. There has always been market research and branding, not just now. One might argue that it should be included but that is really a separate topic.
"It took time for the investment world to embrace companies built on intangible assets. In the early days of Microsoft, I felt like I was explaining something completely foreign to people. Our business plan involved a different way of looking at assets than investors were used to. They couldn’t imagine what returns we would generate over the long term."
No doubt things were like that in the 80's. But just take a look at the most valuable Dow Jones funds now and it's clear that intangible assets are valuated well nowadays.
https://smile.amazon.com/Capitalism-without-Capital-Intangib...
I suspect he gave this book review assignment to an intern that majored in something besides CS, business or Econ.
Software is the extreme end of scalability. One good lesser example is manufacturing vs repair. As mass production took off in the time it took to repair one item a worker could make ten new. Wasting some material on defectives made more sense than repairing them usually unless the cost of failure is extra high, inspections more expensive or a more cautious approach yielded better viable output. It is only when the expense of new is high that repair remains intrinsically viable (if you enjoy repairing things economics don't matter as it is its own reward).
If fixed per unit costs are high extra supply does little good - especially if it is durable. You won't be able to buy $100 for $99.
They discuss it as if price is the independent variable and quantity (demanded or supplied) is the dependent, and yet any 9th grader would be marked down for putting their independent variable on the "y-axis".
It amazes me how something generally accepted as wrong stays that way.
The cylinder-with-a-piston used to teach Boyle's law in secondary-school physics is a familiar example: in the short term pressure is a function of volume; in the longer term volume is a function of (external) pressure.
Given that any Y-X chart is an X-Y chart if rotated 90 degrees and then flipped horizontally, is there any real issue here, other than the axes being the reverse of the standard statistical style?
How so? Econ major here, and I agree the axes should be swapped, but I don't follow your other point.
If I was a company director and the price of the commodity that I produced dropped by a lot, I would work harder to produce more of the commodity to offset the lower profit margins; that way I could earn the same bonus at the end of the year in order to make the payment for the mortgage on my yacht.
Also in the case of cryptocurrencies, it doesn't seem to work the way the graph suggests; when the price goes up, people buy more.
> Why is it that when the price drops, consumers would want to buy more and producers would necessarily want to produce less?
I would phrase it as when the price is lower, there are more consumers who would buy, and fewer producers to sell. To take the demand curve, for example, it doesn't explain one person's behavior at different prices. Rather, think of the curve as a thousand points, each representing a different person and their own maximum price at which they would buy the item. The supply curve is a thousand producers each with the minimum price they'd be willing to operate at.
> If I was a company director and the price of the commodity that I produced dropped by a lot, I would work harder to produce more of the commodity to offset the lower profit margin
Yes, this is already reflected in the supply curve. If your company is able and willing to produce that commodity at a lower price, you're already reflected on the supply curve as one of the points on the line below the current equilibrium price. You have what's called a "producer surplus" if you'd be willing to produce at a lower price than the equilibrium.
Take the supply of uber drivers for example. If the price of rides decreases, you may to some extent see drivers adjusting how much they drive, but the main effect is to remove drivers from the market who have better uses of their time, less efficient cars, etc. Similarly, if the price increases you'll see new uber drivers coming online driving their clunky SUVs or whatever.
Or, in the case of cryptocurrency, the supply follows this as well: at a higher price, less efficient miners or people in locations with higher utility prices will be able to profitably mine, and so the number of people supplying computation will increase.
> Also in the case of cryptocurrencies, it doesn't seem to work the way the graph suggests; when the price goes up, people buy more.
This, too, works with the supply and demand curves, when you understand them properly. The concept at work, here, is that changing supply or demand (i.e. think of the thousands of people that make up each curve shifting their preferences in the aggregate) represents shifts of the curve, not movements along it. Increased demand is the curve shifting up and/or to the right (it's the same thing).
So, when the price goes up, people see it in the news and have FOMO and so "demand increases", meaning the curve shifts to the right. If you look at the graph again, you'll see that means the equilibrium price increases, which is what's happening. That, in turn, drives more breathless speculation and aggregate demand increases again, pushing the curve further to the right, driving up the price some more.
Concept check: the supply curve is not shifting, here. Per my earlier paragraph, the increasing price may mean more miners come online, but that's already what the supply curve means. A shift in the supply curve would be something like a new breakthrough energy technology making everyone's utilities cheaper. That means if everyone's minimum price before was $x, they're now willing to supply computation at $x + 5, shifting the supply curve to the right and (if you check the diagram) driving down the equilibrium price (since the # of bitcoins in circulation will increase faster and the demanded fee by the miner's will be less).
I think it is fine but confusing because it skips over some steps. A longer version might be:
... as demand for a product goes up, the demanded quantity goes up, which causes supply to increase (to meet the higher demanded quantity) which then pulls the price down (due to the increased size of the market and competition).
The net effect of this is decreased price overall due to economies of scale (since the total production volume of the product in the market is now higher).
I was under the impression the Gates Notes were written by him, wrong?