EconByte

Issue 4/2019

The cost of change

I often write about the flaws of Facebook, Google and other Silicon Valley “unicorns” (companies with one billion+ valuations), but I don’t talk enough about the economic realities of their persistence. Economists are fond of the phrase “there is no such thing as a free lunch”, and it’s as true for the tech unicorns as it is elsewhere. It’s easy to point out flaws and potential improvements from the outside, but the fact is those alternatives come with their own costs.

The nirvana fallacy

Coined by Harold Demsetz in 1969, the nirvana fallacy describes a situation where some ideal solution is pitted against the flawed status quo, often with the full costs of that ideal omitted. As Demsetz put it:

“The view that now pervades much public policy economics implicitly presents the relevant choice as between an ideal norm and an existing ‘imperfect’ institutional arrangement. This nirvana approach differs considerably from a comparative institution approach in which the relevant choice is between alternative real institutional arrangements. In practice, those who adopt the nirvana viewpoint seek to discover discrepancies between the ideal and the real and if discrepancies are found, they deduce that the real is inefficient.”

In my opinion, Facebook is an example of an imperfect institutional arrangement. But that doesn’t mean it’s inefficient, given how imperfect the alternatives are. Have you ever tried GNU social, Diaspora*, Friendica or Pump.io? I have, and let me tell you that for the average punter they are not even close to becoming Facebook equivalents. I love that they exist, but they fill a geeky niche that is entirely different to Facebook’s one-size-fits-all model.

The same can be said for regulating Facebook. Proponents point out all of the flaws in the existing arrangement, but compare it to an ideal state where internet companies are perfectly regulated to a point where they safeguard their users’ data while simultaneously sell it. It’s just not possible, even if we ignore all of the flaws in the political process such as lobbying, rent-seeking and regulatory capture.

The reason Facebook persists is because its users like it more than the alternative options available to them right now.

Switching costs

People hate switching, because it costs them the most important resource of all: time. Even if there were a Facebook alternative that ticks all of the boxes, people would be reluctant to expend time and effort researching it, convincing their friends to join, and so on. Switching costs apply to everything, from social networks to car insurance. For example, Energy Consumers Australia undertakes a monthly survey, with one of the questions being: “Which of the following have you ever done?”.

People don't like to switch

It turns out that Australians don’t switch energy providers very often, with 43.9% of the surveyed population having never switched their gas or electricity providers. As a result, CHOICE estimates that Australian energy consumers are paying about $400 too much every year, with Australian households as a whole paying about an additional $1.2 billion every year. Competition is great, but unless the alternative is significantly better or the switching costs are sufficiently low, people will stick with their existing service providers.

That makes the case of the Silicon Valley unicorns all the more interesting. How much do you pay for Google searches? Your Facebook profile? Scrolling your Twitter feed? Reading a review on Yelp? Sending a Snap? For most people, the answer is $0.

All of the companies I mentioned above derive their revenues from advertising, and by now it’s common knowledge that they take your data and monetise it. But even knowing that, less than 5% of Facebook users care enough to bother changing their privacy settings, and the average user would want more than $1,000 to deactivate their account for a year.

Switching costs are very real and they make it difficult for an individual to change providers, especially when they currently pay nothing (in dollar terms).

Google spent $560 million on its social network, Google Plus, yet ultimately failed because the switching costs were too great (its product wasn’t good enough to offset them). While a competitor with a different, non-advertising business model might have a better chance if it can offer users value greater than the switching costs, that ideal alternative doesn’t yet exist.

Blockchain, meet reality

Perhaps the most recent example of the cost of change is that of cryptocurrencies and the blockchain technology that underpins them, which was hailed as a revolution that would not only replace existing, fiat currencies, but would change banking as we know it. No longer would people need to rely on centralised bastions of trust; instead, a decentralised, trustless ledger would allow transactions to be processed for a fraction of the cost.

But as the fog of euphoria parted, it became clear that the technology was not even close to achieving its lofty goals. A number of papers are starting to emerge that highlight the costs involved in using a blockchain ledger. As Arnold Kling wrote recently:

“…you cannot just look at the costs imposed by centralized record-keepers and say ‘all those costs just go away with blockchain.’ Other costs are introduced.”

It’s important to bear the nirvana fallacy and the cost of change in mind whenever the next latest and greatest technology is discovered. Today’s institutional arrangements exist for a reason and to successfully disrupt them a competitor will need to first overcome the hefty switching costs, a task easier said than done. As a recent Twitter thread highlighted:

  • Uber launched by going to black car companies and paying drivers to be available on Uber during certain hours, ensuring that riders would be able to find a ride.

  • Relationship Hero, a relationship coaching marketplace, scaled to dozens of customers with just one coach–its cofounder! But the website listed 10 fake coaches, to give users the sense that it was a more active platform with diverse coaches who fit their particular situation.

  • The founders of Home Depot used to stock empty boxes on the shelves to make the stores look like they were full of merchandise.

  • According to Reddit cofounder Steve Huffman, the first Redditors populated the site’s content with tons of fake accounts.

I don’t know how the advertising model currently in favour with Silicon Valley will eventually be disrupted. Microtransactions via blockchain showed promise - and developments in the sector continue to show promise - but it has its own costs that many people are too willing to ignore. Until the cost of change is sufficiently lowered the advertising model will remain at the top, warts and all.

If you enjoyed this issue, feel free to share it.

The cost of change was compiled by Dr Justin Pyvis. Feel free to send feedback, suggestions for future issues, ideas, insults, or pretty much anything that crosses your mind to his Keybase chat.