Saturday, June 14, 2003

Time off

OK, I'm off to graduate, get married, visit Hawaii, and move to Boston. Blogging will be light.

Thursday, June 12, 2003

Lessig on iTunes

In this part of a PBS forum, Lessig notes that
Apple's experiment is a hopeful sign, but it will only be effective if independent labels are allowed compete directly with the major labels. When some are able to offer songs at 15 cents a copy to compete with songs offered at 99 cents a copy, then we will have the kind of competition that could explode the Internet as a medium for distribution.
It does not look like that will happen (but who knows).

Tuesday, June 10, 2003

Surowiecki and the FCC

Surowiecki has a typically good article on the recent FCC decision to relax media ownership rules. His point is that while the markets should produce the right incentives for good content, broadcast media collude.

He is quite right, but I would argue that broadcast media collude because they are competing for advertisers, not viewers, and the economics of that market leads to precisely the outcomes Surowiecki objects to. Remember, advertisers want to buy eyeballs from a *national* distribution network, and the type of consumer focused content folks dream of will not appear until there is viable pay-TV (and free, broadcast TV is gone). Given the falling unit cost of programming and the customer's desire for a single, national market, broadcast media will consolidate and collude. Surowiecki's argument that ownership of production and distribution is harming quality is contradicted by the facts: areas where producer/broadcasters (partially) own cable networks have higher penetration than where they don't, suggesting that they can somehow market better to consumers.

Until lots more spectrum is freed up and customers pay directly for their TV, you're not going to get the sort of competition Surowiecki hopes for.

Risk loving VCs

A reader (whose reply email address sadly did not work) wrote in regarding a recent post about VCs. It's a good letter, so I'll reprint most of it
After reading your article "Fixing Venture Capital," I was surprised that you (and the various commentators, some of whom are VCs!) failed to mention the more fundamental reason why VCs prefer riskier investments. It's not about diversification of portfolios, although you are correct that a diverse portfolio incentivizes the VC to make risky investments. The more fundamental reason is that the VC has a direct financial interest to maximize risk, even setting aside portfolio diversity.

Overwhelmingly, and simplifying only slightly, VCs are compensated in two ways. VC firms receive a "Management Fee," a flat annual amount that is supposed to cover their salaries, rent, secretaries, etc. The Management Fee is usally 2% of committed capital (ie capital they can drawdown from investors). The Management Fee is nice, but its not where the action is. VCs also receive a "Carried Interest" in the profits of the fund, a minimum of 20% (top-tier funds can get up to 35%, even in this bad environment). This means that to the extent that the fund is net profitable, the VC will receive 35% of the profit. In other words, because the VC takes a share in the profits, but is not investing his own money, the VC shares in the upside potential but has a limited downside potential; this is a classic case of assymetrical risk-taking encourages the VC to act riskier than he would if he had a straight interest in returns, rather than profits.

Just to make this overwhelmingly clear, lets suppose the VC had an average size fund of $100 million with a 20% carry that had two potential investment targets (each will take the entire $100 million capital). Target 1 has a 50% change of being worth $90M, and 50% chance of being worth $120M, for an expected net value of $105M. Target 2 has a 90% chance of being worth $0M, and a 10% chance of being worth $1,000M, for an expected net value of $100M. Obviously, Target 1 has a larger overall expected net value than Target 2, but now look at the VC's incentives.

With Target 1, the VC can expect his Carried Interest to be worth $4M [50%*20%*($90M-$100M, i.e. 0)+50%*20%*($120M-$100M)]. With Target 2, the VC's Carried Interest is worth $18M [90%*20%*($0M-$100M, i.e. 0)+ 10%*20%*($1,000M-$100M)]. Thus, *even where the net expected value of the riskier investment is lower, the VC is incentivized to make the riskier investment.*

Why is this so? Well, the investors who invest in VC funds are looking for extremely risky asset classes. They don't want VCs to turn their money around and invest it in companies with less risk (after all they can always buy S&P 500s for themselves). What are the implications of all this? I'm in agreement with Naval, VC money is not for every type of business. And thats not necessarily a bad thing, after all entrepreneurs with slower, less riskier business plans can get secured bank financing (which of course has the opposite incentives of overvaluing stability ...).
Essentially, the argument is that the carry ("carried interest") rewards VCs on the upside but does not penalize them on the downside, and so motivates them to be risk loving, not risk neutral. He demonstrates this by showing why a VC would choose an investment with higher variance but lower expected return over one with lower variance but higher expected return. Note that a risk neutral investor would pick highest expected return and ignore variance.

Also note that this structure is very similar to a call option, and we know that volatility (risk) makes options more valuable. An options trader, then, likes risk for its own sake. But a VC investment, even with carry, is not the same as a call option. Clawback provisions mean that the VC has to return the fund investors' money first before they can keep any for themselves. Also, if you want to raise a fund in the future, you better do a good job with the one you have now. These factors help VCs go from risk loving to risk neutral, but I don't know by how much. I don't think that institutional investors want risk just for the hell of it, otherwise they would allocate some of their pension money to Vegas.

You can actually model VC funds by looking at their payoff structure and putting together a portfolio of options that match it, both for the institutional investors and the VCs (so gross returns and net returns). It turns out that the generous carries VCs give themselves makes little difference to what the institutional investors get back, but it also seems that the VCs who actually outperform keep all their outperformance in compensation.

Monday, June 09, 2003

Number portability

The FCC has ruled that cell phone users can take their numbers with them when they change service. Is this a victory for consumers? It is in the sense that the phone company owned the number before and they do now, so the transfer of wealth is now going to go from the phone company to the consumer, not the other way around. But I also anticipate more expensive and draconian upfront service agreements--if phone companies can't lock customers in as much (and they were never much good at this) they're going to try and get more of their money upfront.

Indy labels get screwed

It looks like Apple's promised not to discriminate between the big labels and indy labels with its new iTunes music service. Some people may cheer for fairness, but if I were an Indy label, I'd want my stuff on iTunes to be cheaper so I could beat out the incumbents. "Non-discriminatory" often means "collusive".

Thursday, June 05, 2003

Media's golden age

A nice piece in Reason pointing out that media's "golden age" was also when it was most consolidated. An argument, if you would belive, for deregulation.


My old buddy Mark Hurst sends me a clip from the Economist outlining new "4G" networks. For those who don't have a burning interest in telco infrastructure marketing jargon, "3G" was meant to be about movies on phones (which failed) and "4G" seems to be about...well, the best I can do is long distance 802.11 service.

Sometimes I have been lucky finding a WiFi hotspot and sometimes I haven't, but I don't know how much I'm willing to pay to get that connection in those few instances when I want to but cannot. What I really want is a cell phone with great reception, especially since those new tiny phones have lousy antennas.

Clay Shirky and FCC rule changes

Clay Shirky has a good essay arguing that media can be any two of free, diverse, and equal, but not all three. Worth reading.

Fixing entrepreneurs

Joel has a nice post on why venture capitalists are dumb: they prefer taking risky longshots with big payoffs over sure things with lower payoffs even though entrepreneurs would prefer the latter. Since entrepreneurship is the lifeblood of economic progress, this mismatch in financing is bad.

I have no quarrel with this statement. Certainly during the bubble, lots of new people entered the VC arena and lavishly funded bad deals. Everyone was sure they could get rich quick (it was a bubble after all) and people took risks which, in hindsight, look crazy.

But because VC's are interested in the performance of their portfolio as a whole, they are willing to take greater risks with individual companies because they are diversified in a way individual management teams are not. I wrote about this a while ago. While this may be bad for the entrepreneur, it's good for the VC and probably good for the economy as a whole too. The larger economy is highly diversified so does best when everyone is taking risks because it can (at a macro level) aggregate those risks and therefore reduce them. This is no fun for people taking the risks themselves and failing, but good for the rest of us.

I will also add that those "sure things" that Joel mentions exist more often in the mind of the entrepreneur than in reality. They (the Small Business Bureau, I think) did a survey of 2995 entrepreneurs who recently started new businesses, 46% in retail, 19% in service, and 7% in construction, and asked them what they thought the odds were of their business succeeding vs. any other startup in their category succeeding.

Odds, your business succeeding, any business like yours succeeding
0 0 0
0.1 1 3
0.2 1 6
0.3 1 7
0.4 1 6
0.5 10 30
0.6 4 9
0.7 9 11
0.8 19 12
0.9 20 5
1.0 33 11

Poorer 5%
The same 27%
Better 68%

Forgive my lousy typesetting. But basically everyone thought that they were above average (surprise surprise) and we know at least half of them are wrong for sure. I'm not sure how many new businesses fail within the first two years, maybe 80%, but I'm sure every one of them thought they were a stable, conservative 80% sure shot success. VCs are probably closer to the truth when they assume most of their portfolio companies will fail.

Tuesday, June 03, 2003

OS personality

It turns out I was Debian Linux. (via

When is a monopoly not a monopoly?

Winterspeak reader Joe Gregorio asks:
[Microsoft is now bundling and integrating its browser with its operating system to get people to upgrade. I don't think this will work] This does make me wonder if there is an economics term for this, a monopoly that can't be leveraged. Or is it not a monopoly if it can't be exploited?
Personally I don't like using the term "leveraged" unless you're referring to debt (it's finance jargon, don't worry) or "exploited" because it's too emotionally charged, but I understand Joe's point. I would answer that a monopoly that can't be used is a weak one.

The most useful way to think about a monopoly is to ask yourself how easily the product can be substituted. If you raise the price and everyone buys it anyway, it's probably pretty tough to substitute. If you raise the price and everyone switches to something else, then it's very easy to substitute. Ford Motor Company has a monopoly on Ford cars and they're welcome to it. There are lots of substitutes for Fords, namely cars made by everyone else.

When people say that Microsoft has a monopoly on the desktop PC operating system market, they're referring to Win 95, Win 98, Win 2000, and Win XP. But each of these operating systems are actually pretty good substitutes for each other and Microsoft is struggling to get people to upgrade. License 6.0 was their attempt to push businesses to XP and get folks to rent operating systems, thus solving the problem, and I'm not sure how much success they've had. Integrating browser upgrades seems to be the plan for the consumer market. The point is that Microsoft's biggest source of competition is old versions of Microsoft stuff, and they're doing the best they can to kill that off. While Microsoft may have a monopoly on desktop PC OSes, Windows XP does not.

More on FCC's decision

The LA Times has two OK pieces on the FCC's decision to relax media ownership rules (which I commented on yesterday). You can read them here and here but need to register. The two best lines are:
Monday's vote by the Federal Communications Commission to loosen the rules governing media ownership were, at root, about one thing: "trying to strengthen the foundations of free, over-the-air television," in the words of FCC Chairman Michael K. Powell.
"Take away the government protections, and the free TV system would die a natural death," said Thomas guarantees, a former chief economist for the FCC and now a senior fellow at the Manhattan Institute for Policy Research. "We should do something productive with the spectrum."
When you read "the market for free, over-the-air television" you should think "a national market for eyeballs that can be sold to advertisers" because that's how the free broadcast business works. The restrictions on cross-media ownership and consolidation were explicitly crafted to maintain a collusive oligopoly in national broadcasters. I find that it's often the same people who loudly complain about the poor quality of TV that fight hardest to protect the advertiser model which guarantees that quantity of eyeballs trumps quality of programming and produces the "vast wasteland" that they now decry. If you want quality TV you're going to have to be a customer to be served, not an eyeball to be sold.

And lastly, may I observe that TV is a lousy medium for debate because you can't rebut anything or ask questions. I belive that people who want to maintain "diversity" on the airwaves are really more interested in getting a subsidized soapbox to preach to the masses and thereby 1) get converts and 2) indulge their taste for performance art. Anything that unites so many antagonistic special interest groups has to be good for special interest groups, and by extension, bad for the public interest.

Monday, June 02, 2003

What makes media diverse?

In light of the FCC's rather decision to slightly relax media restrictions, it's worth thinking about what makes media "diverse" (since the diversity argument seems to be the biggest objection to this change that's honest). The main candidates for a definition of diversity seems to be 1) number of channels and media outlets, 2) number of different owners. In addition we need to figure out how popularity and quality factor into all of this.

I think that both 1) and 2) are lame definitions. It's clear that the rise of cable, satellite, and the Internet have greatly expanded the number of media options and channels within those options than we had in 1941 and 1975. And though I generally belive that profit-seeking media companies will put customer satisfaction before their own personal indulgences, I also know that management is often only too keen to put their own interests before shareholders. (Mind you, I also belive that non-public companies, such as the BBC and NPR, are more self indulgent than public companies that need to sell audiences to advertisers). Does the obvious increase in 1) counter act the tendency for 2)? How can we tell which way things are going?

The popularity vs. quantity question makes it hard to answer this question. Media companies that are unpopular (in the sense that hardly anyone watches them) argue that their high-quality programming is drowned out in a sea of crass commercialism and so lousy ratings don't tell you anything about whether their stuff is any good. It could just be underappreciated. And by the same token, no one will argue that "Survivor's" high ratings make it in anyway more worthy than a History Channel documentary on WWII. (The History Channel, which I like, is a good example of a for-profit channel dealing in "quality" subject matter successfully). Underwatched "quality" programmers would argue that people don't wise up and switch to their stuff because they're brainwashed by large media outlets.

In some ways this echoes the lament of bloggers that a few A-list folks get all the hits and relegate everyone else to obscurity. Past success drives future success, so even an excellent B-list blog will be unknown forever because it was late to the party.

I think the right thing to consider is how easily can people alter what they watch and how flexible is the system to shocks. So if people suddenly stop liking (or being interested) in a certain channel, how easily can they switch to something else. This elasticity includes switching between different media, and between consuming media to doing other things (like spending time with friends instead of watching TV). It's important to consider switching between different media because newspapers, magazines, the Internet, TV, radio, cable, and satellite are substitutes, and it's important to consider other leisure time activity because public media needs viewers and so cannot afford to alienate large segments of their base by doing things to drive them away.

I don't know if the war in Iraq is a good test case for this, but it certainly represented an event where people dramatically changed what they wanted to see. I'm sure CNN and the other news channels enjoyed dramatic increases in viewership that have now evaporated (and there seems to be evidence that this happened in the blogging world also). I remember reading an article that news sites enjoyed an increase in foreign viewers as people sought media outlets that best reflected their own prejudices. At least a few of these folks are almost certainly now moaning about lack of "diversity". This to me suggests that people change what they view when they aren't happy with what they have now and that the system offers more choice than before. Both of these argue for relaxed ownership rules in the more substitutable world of US TV ownership.

One last point: People who argue that the FCC is ignoring the "public good" in relaxing media ownership rules seems to belive that lower cost and higher quality cannot be a part of it, perhaps because if it's good it must also be unpleasant (certainly this fits the "diversity is good" criteria given how deeply people loathe encountering an opinion they don't agree with.) Until the FCC finally lets spectrum be fully traded, it needs to try and make sure it's being used at least slightly efficiently, and in this age of the Internet, cable, and satellite, I would argue this means relaxing ownership restrictions and enjoying the lower marginal costs that brings.