Strongly Emergent

What comes from combining humans, computers, and narrative

Externalities Are Relevant

The online economy is deeply weird and breaks many rules that guide the functioning of the physical economy. However, there’s one concept that’s highly relevant to the online economy that I need to talk about: externality. We like to think that in any transaction, people are getting what they pay for - but that’s not always true. There are people who aren’t part of the transaction, but who are affected by it anyhow: those people are the recipients of an externality. A positive externality comes when you essentially get something for free that is the result of others’ transactions, and a negative externality is visited upon you when others get to fob off some of the costs of their transaction on you. Externalities are “external” because the people actually involved in the transaction haven’t captured all of the costs and benefits of the transaction; they happen all the time because there are some things it’s impossible to keep internal to a transaction.

Here’s an example: a major public transit agency near me, Caltrain, is about to cut service. Caltrain’s funding, in large part, comes from sources beyond its control. A little less than half comes from ticket sales - and the rest from local municipal governments. The local governments collect no taxes dedicated to and aren’t bound to pay for Caltrain: in years like this one, where tax revenues are shrinking, they can simply decrease their funding. That’s what’s happening now. That’s a transaction between them and Caltrain. I’m just a Caltrain rider, I’m not a party to the transaction - but it’s going to affect me anyhow. The service cuts that Caltrain has to make have major negative effects on riders who aren’t part of the transaction between Caltrain and local governments: they are the subjects of a negative externality. Similarly, if the service cuts go through, traffic on highways between San Francisco and San Jose will get significantly worse. Train service created a positive externality that benefited drivers - anyone who was taking the train was not driving, and congestion decreased. There’s also a positive externality that has to do with air quality: the train is a more efficient way of transporting large numbers of people than requiring each of them to drive their own car.

The reason that externalities are relevant to the tech field is this: most startups entirely rely on them. Free Software, whatever its intentions, creates enormous positive externalities. It’s almost impossible to name a tech company that doesn’t depend on some piece of free software. Further, most tech companies in turn create significant externalities because of their advertising-driven revenue models. I dislike advertising-driven revenue models - but like everything else, they’re a trade-off. An advertising-driven revenue model - for example, Facebook’s - means that all benefits to users are externalities on one level. Of course you are still in a transaction with Facebook - but most of that transaction is invisible to the average user. We users give Facebook data - the data that makes their vaunted social graph valuable and lets them produce creepy marketing videos. That tiny transaction, times hundreds of millions of users, gets refined into a product that Facebook can actually make money from. Any other startup with the same revenue model is doing the same thing: they’re purposefully creating positive externalities, because without those, they can’t do the transactions (with advertisers) that they actually make money from.

This is a highly interesting business model, and has created many interesting things. I personally think that in evolutionary terms it’s a loser: advertising as practiced in the modern world is a hostile, toxic, invasive species, and letting it into your ecosystem is a bad idea. But what I want to talk about now is a company that doesn’t share that revenue model, and about how it handles externalities. It’s time to talk, yet again, about Apple.

Part of the reason that Apple’s prices are what they are is that you are paying for things that you normally get for free as an externality. When you buy Apple products, you are forgoing a price that’s artificially low. I like to think of it this way: you are paying something closer to the ‘true’ price of the product. The price in dollars to the users of Google products like web search, Gmail, and Google Reader, is low or nil because Google relies on selling user data to others for its revenue. You get nice things for ‘free’ because the actual price you’re paying is invisible. Apple products, on the other hand, usually don’t do that - you will pay dollars, and you will get your product or service from them, and that’s that. I think of it as paying for peace of mind. Free services usually involve a third party, an advertiser, who has an enormous, overwhelming, powerful incentive to attack my peace of mind. That is what the modern business of advertising is: it is attacking people’s mental health.

Apple is in the tech news again because of externalities: they have allowed iOS apps to use a subscription-based revenue model, and the changes that they’re making are pissing off all kinds of people. As another economics-oriented blog post put it, “if you own the infrastructure, you get to charge rent.” What interests me, though, is that Apple has chosen to create a positive externality for user experience here - and they have deliberately done it, risked money to do it, risked business partnerships to do it. That’s interesting - and, I think, good. When the people who use your product are the people you make money from, you wind up focusing on keeping them happy. If you make money otherwise, you risk turning into Adobe (Microsoft also has bouts of this): making mediocre products at exorbitant prices and squealing when someone exposes the flaws of your product line.

Whimsically, I think that Apple also creates a huge externality for the tech journalism corps. They are the largest company that actually takes risks, and so they help ensure that there’s always something interesting to write about.