Information and markets, 3

An anecdote.

A few years ago a private equity firm asked me to help them look at some lead-gen companies. One of the target companies had a network of many thousands of small lead buyers and were known to produce high-quality leads. They had worked years to build this reputation. They got good prices for their leads. But high quality leads are expensive to generate--and there aren't as many of them out there--and building and maintaining a large distribution network is also expensive so while they had historically made OK margins, they weren't blowing the doors off and their growth was steady but slow.

Then the founders started thinking about selling. They hired an investment banker a few months before the PE firm started looking at them. In that time, revenue had started to grow faster and margins had started increasing. The lead-gen company credited improved technology.

The PE buyer was enthusiastic. They asked me what I thought. I called a couple of people who were in the same lead sector. This is what I heard: "they're stuffing the channel, everybody knows that." Maybe everybody in the lead-gen business, but obviously no one in the PE business.

The company had decided that, to boost their valuation, they were going to generate lower-quality leads, and more of them. Since their customers generally bought a few dozen leads at most, they did not in the few months after the change notice when the average conversion went from about 5%-10% to something much lower*. This allowed the lead generator to raise revenue and margins. I warned the PE company that the buyers of these leads would not be fooled for much longer, that this way of doing business would come back to bite them**. And that is what eventually happened; the lead-gen company lost half its customers over the next six months, as the customers became aware that they were paying for high-quality leads and getting low-quality leads.

Any smart buyer knows that uncertainty exists: quality changes over time, for many reasons. The natural response to this is a concentration of buying. Larger buyers have more information, so will notice and respond to changes in quality much more quickly. Any market where quality information is not available will favor large buyers over small, causing the exit of small buyers. This will then cause the marketplace itself to suffer: a large buyer does not need an external marketplace, sellers will come to them. Without a competitive marketplace, the sellers suffer, both from lack of pricing power and lack of information about what is working for the buyers (reflected in varying price levels.) This then causes inefficiencies in production, leading to higher production costs.

This decline in overall efficiency of the ecosystem affects the sellers first, but also eventually affects the buyers. The process, though, can not be avoided by the buyers, even if they are aware of it: they are stuck in a prisoner's dilemma. The only solution is to have more open and robust quality information available.

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* Junior year I took a semester abroad. My alma mater did not believe that any other university, anywhere in the world, could possibly educate me nearly as well as they. As such, they would not allow me to include any class I took anywhere else on my transcript. The most they would do was allow me to take a test and place out of classes I took abroad. Because of this dynamic, I spent my time in London doing anthropological studies of the pub culture. When I got back I did pass the required tests and so placed out of statistics and a year of German. I now find that I can neither speak German nor do statistics unless I have had several pints of bitter. I was going to tell you how many leads a lead buyer would have to buy before they would have a good idea that quality levels have changed, but I wrote this post Sunday morning and I couldn't get my hands on a sufficient supply of ale.

** Oddly, they did not believe me. This turned out badly for them.

Information and markets, 2

Those most familiar with the cattle trade agree that there often exist wide differences between the actual selling price of cattle in the market and the previous estimate by the feeders sending them forward as to the prices they should bring. The small feeder, who seldom follows his cattle to market, has a poor chance to learn market conditions and requirements, but the regular shipper has an excellent opportunity to do so. Feeders must rely largely upon the market reports for their knowledge of the condition of the cattle trade... Inability on the part of the feeder to interpret correctly market quotations places him at a decided disadvantage either in selling his cattle to a shipper or in shipping to the open market.--Market classes and grades of cattle with suggestions for interpreting market quotations, Herbert Mumford. (1902)

Beef isn't assigned to quality grades--like prime, choice and select--to help buyers know what to buy. It's assigned quality grades so producers know what to produce. Mumford's groundbreaking work led, eventually, to the voluntary grading of beef and other commodities by the USDA.

Raising cattle that has a higher proportion of well-marbled, tender, Prime muscles is more expensive than raising one full of chewy, touch Select muscles. So even more than needing to know at what price they can sell cattle, cattlemen need to know at what price they can sell different quality cattle, so they can figure out whether it makes business sense to spend the money to raise high-quality beef.

Markets not only consume information, they generate information: primarily information about demand at different price levels. Price information, of course, is what drives efficient allocation of resources*. So, lack of public information about quality causes both

• Problems for the buyer when the seller knows quality but the buyer doesn't, and
• Problems for the seller, when the buyer knows quality but the buyer seller doesn't**.

The first case is relatively straightforward: as per Gresham's Law, bad commodities drive out good. The second case is more subtle. Because the buyers know what a quality product is worth to them but the sellers don't, buyers will tend to price goods at the lowest possible price level that ensures they will keep being produced.

In the lead-gen world, I heard over and over from lead generators that it took at least a year before a newcomer could make money. Not because they couldn't generate quality leads at a decent cost, but because it took a year to realize just how much the companies buying their leads were screwing them on price.

In the display ad world, the buyers have access to all the information they need to judge quality--context, customer, behavior, etc. But the sellers, the publishers, have let themselves be isolated from the information they would need to link quality and price on any inventory they sell through markets***. It shouldn't be surprising that the prices they get are rock bottom.

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* I'm sure you've read about it, but if you haven't actually read it, do: Hayek's The Use of Knowledge in Society. It's a good read, and short. It's also explains the key concept in how our economy works.
** If neither knows the quality of the good being sold, a robust market is still possible. The stock market, for instance.
*** Including the ad nets, the ad exchanges and the ad optimizers, all of whom run a type of market.

Information and markets, 1

There are many markets in which buyers use some market statistic to judge the quality of prospective purchases. In this case there is incentive for sellers to market poor quality merchandise, since the returns for good quality accrue mainly to the entire group whose statistic is affected rather than to the individual seller. As a result there tends to be a reduction in the average quality of goods and also in the size of the market.

--The Market for Lemons: Quality Uncertainty and the Market Mechanism, George Akerloff. (1970)

Markets that don't have a good way to judge the quality of the goods being sold have a problem. As Akerloff noted, if buyers can not differentiate quality, they will pay for a statistically likely quality level. This will then drive away the higher quality goods (thus lowering the statistically likely quality level!) Buyers then adjust their price down, and this downward cycle continues until only the shoddiest goods are left.

One long-standing problem in the lead-gen industry (and, in a different way, in the display ad industry) is the inability to grade quality. There are high-quality leads and low-quality leads (quality here meaning likelihood to convert into a sale.) It's cheap to generate low-quality leads (think reg path or, if you've been around a few years, free ipod.) It's expensive to generate high-quality leads.

Problem is, once a lead is generated, it's pretty hard to tell if it's high quality or low quality. You can cross check address, telephone number and email, but you can't see from the face of the lead the key unknown: intentionality. Does the lead actually intend to buy the good or service they entered their information for. Anybody who's been the person calling the lead can tell you how often they hear "I'm not interested in a new car, I just wanted the free _____." This is a poor quality lead, despite all of the information being correct.

Imagine a lead market where the leads have a random quality from 1 to 100. Leads with quality 1 are worth $1. Leads with quality $100 are worth $100. What would you pay for a lead? Statistically it would make sense to pay about $50. On average, you would be getting your money's worth. But when the price level is $50, the people who are selling the leads with quality greater than 50 all leave the market (and, probably, start generating lower quality, lower cost leads.) The average quality now sinks to 25, so the price also goes to $25. Repeat until the quality reaches the lowest increment. This is Akerloff's point, and what I've seen actually happen in lead marketplaces.

Now, ask yourself, why is the inventory trading through the ad exchanges the worst inventory above remnant? Buying and selling through an ad exchange beats direct buying and selling in every single way that doesn't involve expense account meals. Yet both direct sales and ad network/rep sales have higher CPMs than the ad exchanges, because buyers believe the higher quality impressions are sold that way. Is there an information problem here?

CPMs rising?

So, this has been bothering me for a couple of months. I figure it may well be a figment of the data, or I am abusing the data. But I don't know, so I'll put it up... comments welcome.

This is a graph of Implied Average Online Display Ad CPM, 2006 through Q2 2009 (left axis, thick blue line.) Implied Average CPM is ad spend divided by impressions.


The right axis and thin black line are impressions in millions, as per Thursday's post. This seems to show that as display ad impressions fell in 2008, ad spend did not fall as fast. For this to happen, CPM must have increased. This is both not what has happened, anecdotally, and is hard to believe in this era of expanded access to non-premium inventory. But I hate to think I believe the data when it confirms my preconceptions and then disbelieve it when it doesn't.

Are average display CPMs really nearing $7?

Anyone know what's going on here?

Sources: Ad spend--TNS. Impressions--Nielsen Online. Both purport to be display only.

Ad impressions by month

More data. Nielsen Online's ad impressions per month, via Clickz.com (paid CPM display ads only*.)

First, the raw data.

Broken out by category, sorted by change from August 08 to today: largest decline on top (software), largest increase on bottom (telecommunications.)

Change in four largest categories, and total, since February 06 (Feb 06=100.)

And percentage of impressions by sector. This one's a bit psychedelic.



* Per Nielsen: "Nielsen Online, AdRelevance service uses a proprietary methodology for estimating online advertising expenditures and only takes into account image-based technologies and advertising sold per CPM. Above data does not reflect house advertising activity, strategic partnerships between publishers and advertisers, or text units, paid search, sponsorships, email, units contained within applications (e.g., messengers and pre-rolls) or performance based advertising. "

Better than Panglossian

Andrew Goodman did not like my post Eliminate Advertising. He says "in an attention economy, can you logically even conceive of no advertising? Not even remotely." He doesn't say why not.


But, to be fair, I also don't believe there will be a time when there is no advertising. In fact, I fear quite the opposite. I fear there will be plenty of advertising, and none of it useful.

An investor in my last company--who, whatever else you might say about him, was quite smart--told me once that the company would be successful in direct proportion to the value it created for the consumer. We thought about this a lot as we built the business, and that was no easy thing, because we were in the lead gen space.

And this is the problem: our incentives were not to create more value for the consumer. The consumer wasn't our customer, the advertiser was. This is the problem for all advertisers.

I think advertising is bad. I also think it's good. I guess, in the end, I think it's the worst possible system, aside from all the rest. Pre-internet, how else could companies let customers know what products were available to them in a reasonably efficient way? Producing a message and distributing it was a scale effort; it was only effective en masse. So the cost of delivering the message had to be borne by the advertiser.

This, though, meant that the consumer had to determine if a given ad could be taken at face value. The elaborate game played between legitimate advertisers, trying to signal quality, and the others, who aped the legitimate advertisers' messages in order to ride on their coat-tails, led ads further and further from actual information-delivering devices*.

This Summer I read The Economics of Attention by Richard Lanham. Lanham argues that in an attention economy what matters is rhetoric: style wins out over substance. He argues it quite convincingly. He spooked me, saying that there is no way to have an open attention economy without rhetoric gaining the upper hand.

In this world the best way to decide which product to buy is to listen to two competing producers argue with each other. Like opposing lawyers in court presenting their case to you, the jury. Or like two politicians putting up TV commercials during election season. Neither of these is an efficient way to come to a rational decision, of course, but what way would be better? Lanham views this result as not only inevitable, but the natural order of things. The scientific mindset, that there is some underlying truth, is to him an anti-Hayekian attempt at top-down control, perpetrated throughout our Western culture, from Plato through Feynman. Against this he says: there is no truth, there is only opinion; let each have their say and you decide who you think is more persuasive.

Call me scientific, but I think that some products are objectively better fits with certain people than others. But I am also a Hayekian, and I don't believe that it's right to tell people what products are right for them. I do believe that we can build tools to help people find products better. Goodman and I can agree on this.

Too many people take advertising as it is for granted, though, rather than seeing today's environment as a bit of a historical anomaly. Look at the chart of ad spend per capita above** (this is in real dollars, btw.) The hockey-stick here, starting in the 1950's, was driven by the emergence of mass media; the increase in access to consumers***.

Now we are witnessing, at the same time, both the apotheosis and the destruction of mass media. The apotheosis--reaching every consumer whenever the advertiser wants--has been realized more fully than ever before. And the destruction: the consumer no longer needs to rely on getting their product information from three TV channels, a monthly and two weekly magazines, and a daily newspaper--they can get all the information they want at their own instigation. Both courtesy of the internet and its concomitant radical reduction in the cost of communicating at personal scale.

Apotheosis: the sophistic element of advertising will expand enormously; I think it already has started to. Destruction: the consumer will get the facts on products in places other than ads; I think they already have started to.

As a result, the slow shift of advertising away from think towards feel will become complete. Within a generation, I predict that any ad that tells the truth will be conveying an emotion and that any ad citing a fact will be a con.

If this is so, then what good will it do us as an industry to target better, to buy more efficiently, to have better-converting landing pages? Yes, we need those things and can sell those things short and even medium-term. But, as an investor and some-day-again-entrepreneur, I also want to think longer-term and bigger. Longer-term, companies and consumers will still find each other through a chaotic sea of information, but it won't be what we think of today as advertising. It will be through allowing consumers other ways of determining the truth, and using other, more grass-roots, means to convey context.

I hoped someone smarter than me would read the blog post and say "I know how to do that" and then go do it. That's why I wrote it. I still hope that. There is work to be done and better ways of doing what advertising does poorly now. Goodman calls me a utopian. I'll accept that.

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* This, if you think about it, explains a lot about the advertising agency business, including why good creative is so difficult to make.
** Sources:
(1) Real and nominal GDP, GDP deflator, and population: Louis D. Johnston and Samuel H. Williamson, "What Was the U.S. GDP Then?" MeasuringWorth, 2008.
(2) Ad spend, Douglas Galbi based on Coen numbers.
*** This is not to say that consumers got no benefit, just that the increased benefit was not the driver. In other words, I believe that the rise in spending per capita was accompanied by a decrease in advertising efficiency above and beyond diseconomies to scale.

Not yet Enough

I was reading Skidelsky's critique of Keynes' "Economic Possibilities for Our Grandchildren". In Economic Possibilities, written in 1930, Keynes asked

What can we reasonably expect the level of our economic life to be a hundred years hence? What are the economic possibilities for our grandchildren?

He concluded that by the year 2030,

Assuming no important wars and no important increase in population, the economic problem may be solved, or be at least within sight of solution.

Because economic growth makes us wealthier, at some point people would have enough--"the absolute needs...satisfied in the sense that we prefer to devote our further energies to non­-economic purposes"--and would cut back on hours worked.

This seems reasonable (if a bit far from the problems we face today) but Skidelsky notes that, despite significant progress in the developed countries towards what Keynes viewed as enough, we are not working less.

...We are two-thirds of the way towards Keynes’s target. We might therefore have expected hours of work to have fallen by about two-thirds. In fact they have fallen by only one-third – and have stopped falling since the 1980’s.

This makes it highly improbable that we will reach the three-hour working day by 2030. It is also unlikely that growth will stop – unless nature itself calls a halt. People will continue to trade leisure for higher incomes.

Skidelsky says the reason is that

The accumulation of wealth, which should be a means to the “good life,” becomes an end in itself because it destroys many of the things that make life worth living.

Now, I think Skidelsky is a genius, both in his biography of Keynes* and his more recent book on Keynes' renewed influence, Keynes: The Return of the Master. But I think his acceptance of Keynes' definition of enough--about eight times the average income of 1930--is the flaw, not human nature.

It must have seemed to Keynes that incomes eight times higher than the then-current incomes would be an enormous amount. Today the average US household income is about $68,000**. Imagine if the average household income were north of $500k. Everyone would certainly then have enough, wouldn't they?

This is probably how Keynes felt. And it's true that we've become wealthy in terms of what people thought they needed in 1930. In 1934--soon after Keynes wrote Economic Possibilities--food, clothing and shelter consumed 76% of household income, on average. In 2002-2003, these expenses were only 50% of household income***. (And, god knows, we are consuming more food, housing and clothing than we were in 1934, so our well being has increased more than these numbers indicate.) Far more households can now afford the basics they need to survive, and far more households have much more money left over after they buy these basics.

What have we done with all this new wealth, this extra income? Why haven't we, as Keynes expected, cut back our working hours, and thus our incomes? Why haven't we realized that we now have enough? Skidelsky thinks it's because of our paucity of imagination.

But maybe instead it's because once we had food, shelter and clothing, we realized that we needed more. We've moved up the hierarchy of needs, from physiological to safety. Now that we can, on average, afford the physiological needs, we are spending on health and education. In this light, the enormous increase in the costs of these services might be the desirable result of our ability to finally afford them.

Or, at least, start to afford them. Our healthcare debate is now dominated by whether we really can pay for everyone to have basic healthcare. Costs have increased at jaw-dropping rates, and many feel that we've lived beyond our means for too long already. Even with incomes that Keynes would think were more than enough, we find that we don't have nearly enough for what we now think we need.

But this also points to the solution. Just as we grew into being able to afford the basic needs, we need to grow into the ability to afford these new needs. On healthcare, for instance, the question is not How can we keep the cost down? but, instead, What policies can we enact to be able to afford it sooner? The answer to Skidelsky's question--How Much is Enough?--is that what we have now isn't enough: it would be inhuman to have the means to make peoples' lives better and then not do it, to be able to save lives and then not save them. Instead, we need to think about what we can do to increase our rate of economic growth. What can we do to be able to afford quality healthcare for all, not 100 years from now, but within our lifetimes?

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* Although not so much a genius that I read the full three volumes. I read the 1056 page "abridged" version.
** Median is about $50k and, while the median is more telling about how the average person lives, I think using the average is a better measure when talking about societal income.
*** Source: "100 Years of of Consumer Spending", US Department of Labor Report 991, May 2006.