There Is a Free Lunch After All

The most fertile ideas sometimes originate from the most unlikely quarters. For example, Karl Marx had far more insight into the nature of capitalism and entrepreneurship than any of its protagonists. Marx came to the central insight that the machine system - industrialism, capitalism, call it what you like - constantly and continually made goods better and cheaper. "Modern industry," he wrote, "never looks upon the existing form of process as final. The technical basis of that industry is therefore revolutionary, while all earlier modes of production were essentially conservative." Capitalism was therefore genuinely progressive, enlarging personal and social wealth. For the first time in history, wealth could explode rather than just be shuffled around - provided, Marx wrongly added, we moved to a communist society.

This week's gem comes from an article by Evgeny Morozov in the UK's left-leaning Guardian newspaper. He notes that "expensive is everything that Uber is not... Uber's game plan is simple: it wants to drive rates so low as to increase demand - by luring some customers who would otherwise have used their own car or public transport." But he warns that "Wall Street and Silicon Valley won't subsidize transport for ever."

Now, this needs some, um, what Marxists call "deconstruction." The argument is not wholly right, but the central insight is - that uber-modern capitalism subsidizes customers in the short-term in order to create huge markets which can operate at lower costs than before. When this process is complete, the entrepreneurs can increase prices and make a decent living - and everyone is happy. Except, of course, readers of the Guardian.

How the New Economic System Subsidizes Customers

Venture capital, and especially its US West Coast version, subsidizes customers in two ways. One is by providing a product or service that is so outstandingly simple and good that everyone who can afford it wants to use it. This is the Apple way, with all its devices. It is also the Uber way - the key to Uber's appeal is not that it is so cheap, but that it is a joy to use. It is what venture capitalist Greg Lockwood and I, in our forthcoming book Simplify, call "proposition-simplifying."

The other way venture capital subsidizes customers is much more direct: by providing a product or service at a greatly reduced price, while initially - and often for quite a long time - taking little or no profit for the company providing it. Lockwood and I call this "price-simplifying." This is the route taken by Henry Ford in providing the Model T car, by McDonald's in providing half-price burgers and fries, by IKEA in providing half-price stylish furniture, by the budget airlines, and by Amazon.

The proof that the providers are subsidizing users is in the profit margins. In the early years, these are always modest, and often negative. Amazon operated on essentially zero margins for a decade. Venture capitalists are not altruistic. But they are playing a long game that benefits everyone.

Where the Free Lunch Comes In

If all the venture capitalists were doing was foregoing a pot of jam today for a whole warehouse of it in ten years' time, this would not be very interesting. But as our Guardian essayist has correctly spotted, something more is going on.

What is interesting is the exploitation of scale and monopoly power creates something genuinely better for customers, investors, and society - something that could not exist without massive investment and the willingness to forgo profits for a long time.

Take Uber. A necessary part of its success is having a very high market share in each local market where it operates. As Greg Lockwood argues, for Uber to succeed in the long term, it has to shut out its local rivals. Imagine pick-up times in a city which has five companies like Uber, each operating 200 cars. Now imagine the same city where one operator has 600 cars, and the other four have 100 each. In the latter case, the largest operator will have far shorter pick-up times than its rivals. It will be able to attract the best drivers, because they will be able to work more. Being bigger creates a better service - one able to operate at lower cost, and also with better delivery.

But here is the rub - a better and cheaper service also enlarges the market. Uber has increased the size of the taxi market in San Francisco by about ten times. So there is virtue in monopoly, and in global scale. By subsidizing customers today, you can provide a great service tomorrow which is lower cost and also much better. But to do so you have to grow extremely fast, and have lots of cash to cover the working capital and short-term losses.

Amazon is similar. Amazon has lowered inflation and cost of living by making life very hard for a large majority of retailers. You can call this predatory entrepreneurship if you like, but the main beneficiaries are not the Amazon shareholders - though they have done extremely nicely, thank you. The mass of ordinary consumers are the main gainers.

This is a genuinely free lunch which would not exist but for the global scale and extreme ambition of the new kind of entrepreneurs and their venture backers.

Conclusion

Subsidizing customers makes perfect sense if it enables a company to create such huge scale - by multiplying the size of a market and consolidating it so as to take most market share - that it is possible to provide exceptional value for money, either through price reduction, or through product enhancement. Exceptional value for money always enlarges markets exponentially. Shareholders benefit, but in aggregate the main benefit is felt by customers and society.

ACTION IMPLICATIONS

1. As an entrepreneur or investor, do not waste your time on businesses that cannot create global scale by multiplying value for money, market share, and market size

2. As a voter, regulator, or (God forbid) legislator, do not obstruct the new wave of entrepreneurship. It is real force for good. As Bob Dylan sang, "please get out the way, if you can't lend a hand, for the times, they are a-changing."