Friday, August 22, 2008

Analogy #202: Tax vs. Toll

Once there was a king, King Antaro, who wanted to use his power to make a lot of money. What he did was build only one road which went across the entire kingdom. King Antaro then put toll booths all along the road.

King Antaro was excited. He thought to himself, “I have a monopoly on all road traffic across my kingdom. Anyone who wants to get from one side of the kingdom to the other has to use my one road. I can charge whatever I want for people to use this road, since they have no other choice. I’ll be fabulously rich in no time.”

So King Antaro had his toll booths charge extremely high rates for passage on his road. Nobody wanted to pay that much to travel across the kingdom, so they avoided the kingdom altogether. They found alternative routes in neighboring kingdoms and did their business transactions with others.

As a result, not only did King Antaro not get the toll money he expected, the kingdom’s economy suffered from a lack of business. It was leading to the King’s financial ruin.

Suddenly, King Antaro had a new idea. He eliminated the tolls booths and allowed everyone to build any kind of transportation business they wanted in the kingdom. The only condition was that they would pay the king a very small tax from their profits. New transportation businesses flooded into the kingdom. This lead to a growth in the rest of the economy.

The small income tax on all of this growth added up, and in no time King Antar became fabulously wealthy.

One of the long-standing principles of economics has been that monopolies create extraordinary wealth for the one who owns the monopoly. The thinking is that the monopoly allows the owner to charge excessive fees, which “unfairly” exploit everyone else (who have no alternative but to pay the fee). As a result, most governments try to limit monopoly practices by businesses.

The modern equivalent of the monopoly has been the platform wars. Companies try to create technology platforms that become the industry standard—a near monopoly for anyone wanted to do something in that space. Then, like King Antaro, they set up high tolls for anyone who wants to use that standard. Microsoft has made a fortune from owning the operating platform standard for PCs. Sony’s Playstation II made a fortune off the tolls it charged from anyone wanting to create a game which plays on their proprietary gaming standard.

Going back even further in time, Philips made a fortune off of owning the monopoly on the cassette tape standard, and extracted a toll off of every cassette made. It is no wonder that the companies behind Blu-Ray and HD DVD spent so much money trying to make their version the standard for next-generation DVDs.

King Antaro found out, however, that there are limits to this monopoly/toll booth phenomenon. First, if you charge too much, you will limit the usage of the standard. Second, there are always alternatives to your near-monopoly. King Antar eventually realized that if he gave up control and made the market open, he could make more money off fair taxation of the open market than he could off exploitive tolls from the closed market.

As we will see in this blog, the evolving business model seems to be abandoning the old platform wars and moving to something more akin to this taxation model. As you build your strategies into the future, you should keep this in mind as you develop your business model.

The principle here is that monopoly-like business models appear to be drifting away from the exploitation model (extracting tolls on a tightly controlled path) to a taxation model, where you can do anything you want as long as you pay a tax.

The problems with the tightly controlled model are that:

1) Nobody likes to be tightly controlled. They will resist and seek out alternatives (or build a competing system).

2) Controlling the path usually results in restricting the commerce. Less total business will take place because you are not smart enough to dream up all of the potential possibilities.

3) Tight controls tend to restrict innovation and progress (standards must be maintained). As a result, instead of integrating incremental change, you get replaced by an innovative leap by someone else.

4) Tolls tend to be high fixed charges, no matter how successful the toll payer is. This tends to restrict risk and experimentation.

5) Tolls require people to behave in a particular way (tell you which road you have to take). This is not always the best way.

By contrast:

1) If the system is fully open, there is less incentive to avoid it or build an alternative (standard is more likely to thrive for a longer period).

2) As others add innovative applications for your platform, they make the standard ever better, ever stronger (the virtuous cycle). The market for your standard increases in size.

3) Taxes do not demand how someone makes their money…they just take a cut, regardless of what you do. This freedom can result in more money-making ideas…more things to tax.

For an example of this principle, compare how Facebook is trying to use more of a traditional “toll” approach for how people use its site, whereas Apple is using more of a tax approach for its mobile Apps Store. The “tax” for Apple, in this case, comes from retail markup on what Apps others build. I borrow this comparison from Umair Haque, Director of the Havas Media Lab, who is a Harvard Business blogger:

“Apple took something terminally closed - the mobile value chain -and pried it radically open. Facebook - still thinking in yesterday's terms - took something radically open - the www - and is trying to make it a little bit more closed.

“Apple took something radically evil - the mobile industry - and is making it a little bit more good: finally, now that it's usable, there's an incentive for you to get stuff that's actually useful on your phone, instead of just being a zombie whose head is getting ripped off by suits scheming up hidden charges in boardrooms.

“Facebook - still thinking in yesterday's terms - took something radically good - the self-organizing incentive for people to share knowledge with others on the www - and is making it a little bit more evil: exclude people from accessing it, trying to pollute it with ads, subvert it with pseudo-friends, silo it across mini-networks, dilute it to the point where low-quality apps proliferate like weeds.”

In other words, the near-monopolies of the future will not thrive based on control and exploitation. Today’s transparent and consumer-advocacy marketplace will not tolerate it. Instead, tomorrow’s near-monopolies with thrive by being the most consumer-friendly, with the gains coming from sharing in the success of those who choose to opt in.

The irony is that the monopoly-like models of the future will be a net result of avoiding all of the practices which created the near-monopolies of the past. Practices like control, exclusivity, ownership, and dictation of terms are giving way to openness, inclusion (even bringing competition and customers into the process), lack of ownership, and uninhibited free flow of ideas.

Or put another way, we used to think of “monopolies” as one large, single unit of power. Future “monopolies” will be nearly infinite units of independence who gain from working together. The “monopoly” comes from having one large, single unifying force which causes everyone in the value chain to be better off than if they were not in the value chain. And the one managing that force in the chain (and collecting the taxes) is the best off of all.

Umair Haque refers to this fragmentation as “atomization of the value chain.” But I think Umair may be missing the point that even if the value chain is atomized, they system only works if there is still a monopolistic type of force to enable the atoms work together. And no matter how open Apple’s App Store is, Apple still wants to be the sole owner of the store. This is not the end of monopolistic-like activities. It is just a different manifestation…a kinder, gentler force, but a force nevertheless.

Apple’s larger move into retail—Apple Stores, I-tunes and App Store—is no accident. It looks like the retailer may be in the best position to become the tax gatherer. Let everyone else make whatever they want to sell (the more the better), but if you are the best way to buy it (and store it and play it back), then you have the best chance of putting your tax-like markup on most of the transactions. And, by the way, it also makes it easier to sell your own stuff.

In the past, it was concentration of power and exploitation (through tolls) which tended to lead to greatest profitability. In the future, it appears that dispersion of power will lead to the greatest profitability—provided that you manage the enough of the way everyone interacts so that you can “tax” it (get a cut of their success).

In building your future business models, you may want to look for strategies where you can “atomize” a market, yet still control the system enough to extract a “tax.”

EBAY used to try to exert more control over its system, but they are finding that if they open things up and act less like a toll-keeper and more like a taxman, they are better off. Now, some of that conversion was due to bowing to the demands of their partners, rather than a premeditated strategy. Why be like EBAY and wait until forced into it—be proactive.

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