Information and Markets, Pork Chop Edition

In The Omnivore's Dilemma by Michael Pollan, a thought-provoking book, I came across this.

The fact that the nutritional quality of a given food (and of that food's food) can vary not just in degree but in kind throws a big wrench into an industrial food chain, the very premise of which is that beef is beef and salmon salmon. It also throws a new light on the whole question of cost, for if quality matters so much more than quantity, then the price of a food may bear little relation to the value of the nutrients in it ... As long as one egg looks pretty much like another, all the chickens like chicken, and beef beef, the substitution of quantity for quality will go unnoticed by most consumers...

Sounds like Akerloff's information asymmetry to me.

I have in the past conflated this type of information asymmetry, where lack of knowledge of quality drives high-quality items out of the market, with Gresham's Law, where a government requirement to accept unequal things as equal (such as silver and gold coinage) drives the more valuable out of the market. My bad. In both cases the bad drives out the good, but for different reasons.

Pollan's book, in addition to the above Lemon problem, also cites what I think is an example of Gresham's Law: the USDA definition of the word "Organic" conflates many farming practices but none entirely, allowing the least-common-denominator to appropriate the word in the marketplace. Perhaps this sort of informational hollowing-out is inevitable in marketplaces because of information friction. But what happens when information friction comes way down?

It's interesting to think about the different possible trade-offs:

[M]any consumers don't aim for such purity — particularly if they know that the meat is being raised ethically and in an environmentally sound manner. Many hog farmers raising animals according to various “natural” standards have found that customers come back once they learn about the practices each farm employs, even if they are not certified organic.

The 12-year-old Niman Ranch uses a network of small farms certified by the Animal Welfare Institute. They may feed hogs nonorganic corn, but otherwise meet USDA organic standards, said Paul Willis, a founder and director of pork for Niman Ranch, and the extra expense isn't worth the “piece of paper” that would certify his farming practices.

He compared his Iowa farm — a 20-acre pasture on 900 acres and 2,000 hogs — to an industrial farm down the road that has 6,000 pigs inside a building of no more than a couple acres. He composts pig manure on his fields, unlike his neighbor, who pumps thousands of gallons of liquid waste underground, where it can leach into the Iowa River.

His customers know his standards, and buy even [though] he doesn't have the “organic” label. “I guess,” Willis said, “it comes right down to how much of a purist you want to be.”

Niman Farms has invested in a brand name to communicate its practices to its customers. But the cost of building a brand is more than the cost of being organic, so many farms decide to be certified Organic instead. This is the marketing tradeoff: build a brand or commoditize.

The alternative, letting the customers bear the expense of finding a product that matches their particular needs, is too high: the vast majority of customers in most markets have such a large overlap of requirements that search costs are more efficiently borne by the seller.

But online, the search cost is the expense of tweaking the buying algorithm. This argues that, unlike many traditional markets, online markets should supply more information that can be used to determine quality and less commoditization.

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Other posts in this series:
Information and Markets, 1
Information and Markets, 2
Information and Markets, 3

Hitting the tropopause

Some of us old-timers are feeling a bit uneasy. My friend Seth is having flashbacks and reliving Q1 2000. I long ago overcame my own PTSD, embracing my dot com bubble grief after being repeatedly compelled to recall the events in excruciating detail by various lawyers and accountants (ah, the joy of working for a big company.) But I have my own reasons for unease, perhaps no less from the gut than Seth's, but disguised as usual in analytical trappings.

Years ago I was having drinks with a Wall Street friend when the bar TV announced that the Fed had lowered interest rates. The talking heads excitedly averred that this was a good thing. My friend scoffed: "They don't lower rates to make things better, they lower them because they think things are going to get worse. What does the Fed know that this buffoon doesn't?"

Every action is a reaction, a compensation for something else. Google and Apple are acquiring companies left and right. The linked article attributes this to competition between them, but what does this mean? Why are they competing with each other in the first place? No one (aside from the free-thinking Henry Blodget) seems to be correctly attributing this.

When companies anticipate growth in their core business flattening, they start to move outside of their competencies. When there are huge opportunities, companies go deep, become expert at what they do, and need to partner with others to provide complete solutions to customers. When they start to see opportunity becoming limited, they go broad and try to lock up adjacent markets*.

The general path of a new industry is (1) a profusion of new companies, each commercializing some aspect of a quickly-growing technological domain, and then (2) the consolidation of these technologies under a few roofs. This consolidation is not necessarily acquisition; technologies do not always need to be acquired, sometimes they are just replicated. The signal aspect of this consolidation is not an acquisition binge, but a move from cooperation to closed.

Thus Google shows its insecurity. As does Apple. And Twitter and Facebook.

Blodget, linked above, explains how Google has started to exhaust its opportunity in search. It makes sense for them to move into other markets (display, mobile, social, office apps) to compensate. This is an easy case to make**.

Apple, though, is the darling of Wall Street. Everything they do has been gold. They conquered music and mobile in short order. Now they're trying to move into TV/print with the iPad and advertising with the iAd. There's a case to be made that, with the knowledge gained with iTunes and the associated music sales, TV/print is within Apple's ambit. But advertising is a stretch. Failure here is not only a possibility, but likely***. Apple doesn't know advertising****.

Why would Apple take this gamble? Because they are scrambling for avenues of growth. That they don't see future growth in their core businesses is what troubles me, contra Seth. And that they think there may be growth to be found in someone else's business is not really all that comforting. Google thought it could get growth from Wave or Buzz. You don't know anything important about businesses you're not in.

That this panicky scramble for growth should hit Google and Apple is natural, given their size and their domination of the the markets in their respective primary growth engines. But Twitter is doing the same thing. So, it seems, is Facebook. Their actions say that they think the time for growth through innovation is past, the time for controlling as much of their market's profitable opportunities has come.

So, this is my unease. Have we reached that point already in the growth cycle? I don't think we need to wait for this decade's AOL to buy this decade's Time/Warner to ask "what gives?", if you were around ten years ago, you're probably asking it already.

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* Allyn Young, in his 1928 speech "Increasing Returns and Economic Progress", said

Much has been said about industrial integration as a concomitant or a natural result of an increasing industrial output... But the opposed process, industrial differentiation, has been and remains the type of change characteristically associated with the growth of production.

Or, as David Warsh interprets Young in his Knowledge and the Wealth of Nations:

Such integration seemed to be a function of maturity. A young and growing industry dis-integrates; that is, artisans leave established firms and go into business for themselves, supplying several competing firms with components. There are spin-offs, breakaways, start-ups.

I think this is right even though it is, qua Young, a bit of a non-sequitur*****.

** Although, IMHO, they are moving too quickly to limit their display platform, shutting out before critical mass is reached companies that would cooperate to build it to critical mass.

*** Just as it was in music and mobile, of course. Hindsight being what it is, these things may now seem inevitable, but they certainly weren't. Just because something pays out doesn't mean it wasn't a gamble.

**** The New York Times quotes Steve Jobs as saying, re their complete lack of knowledge of the agency side of advertising: "TBWA [has] been instrumental in helping [us] navigate an unfamiliar business." To anyone in the ad business, this is an extremely suspect statement. The TBWA folk are some of the very best in the world at making ads, but they are not advertising business strategists. There are a lot of people who could give extremely good advice on entering the ad business, but the guys who live and breathe making the ads aren't on the list. It's a completely different conceptual level.

***** To be expected because, since Warsh doesn't write footnotes, we have reason to doubt his seriousness. Serious people write footnotes. Like this one.

A picture worth significantly less than 1000 words

As an aside to yesterday's post, here's the mental model I am using for the industry this week.

Who Invests in Quantitative Marketing Companies?

About a month ago Jay Yarow wrote about the financing of The Trade Desk. One of the commenters insisted that only Redpoint, Union Square, Highland, Sequoia or First Round Capital were expert enough to invest in online marketing firms. I think this is wrong-headed (and not just because I was one of the investors listed in Jay's article.) But, my opinion aside, what's the truth?

To find out, I made a list of some 150 display-ad companies by flipping through AdExchanger.com*, adding a few companies that exited early and then discarding agencies, ad networks, ad ops and rich media companies**. Of these, only those that had VC investors listed in the Crunchbase database are in the final results***. There were 90 of these.

I also split the list into five general categories: buy-side (19 companies), sell-side (20), marketplace (8), targeting (30), and measurement/verification (13). Each company was put into only one sector, unrealistic as that is.

So, what jumps out?

1. Number of Investors

There are a lot of different investors. I counted 200 institutional investors in the 90 companies.

2. Number of Investments

Most investors have one investment in the sector.

There are 154 investors with one investment, 27 with two, 12 with three and seven with more than three.

The top seven:

1. First Round Capital, with 11
2. Accel Partners, 9
3. Union Square Ventures, 6
4. IA Ventures, 5
5. DFJ, 5
6. SVB Financial/Silicon Valley Bank, 5
   
7. Redpoint, 5
   

The firms with three investments: IVP, Rose Tech, Mohr Davidow, Menlo Ventures, DAG Ventures, Founder Collective, Venrock, Shasta Ventures, Mayfield Fund, The Founder's Fund, Battery Ventures, Coriolis and Maples Investments.

3. Most Diversified

Many of these firms have invested in more than one of the five broad sectors.

Here's a table of the most diversified.

	Buy	Sell	Target	Market	Measure
Accel Partners	✔	✔	✔	✔	✔
First Round Capital	✔	✔	✔		✔
Union Square Ventures	✔	✔	✔		✔
Draper Fisher Jurvetson		✔		✔	✔
Redpoint Ventures	✔		✔	✔
DAG Ventures		✔	✔		✔
Institutional Venture Partners		✔	✔		✔
Mayfield Fund	✔	✔	✔
Menlo Ventures	✔	✔	✔
Mohr Davidow Ventures	✔		✔		✔
SVB Financial Group	✔	✔		✔
Coriolis	✔		✔		✔

4. The Truth?

What makes an investor a desirable investor in a sector? Time spent on the board of similar companies certainly counts, as does number of non-competing investments in the sector and adjacent sectors.

Under these criteria, USV, First Round, IA Ventures, DFJ, Redpoint, and Accel all stand out.

But another criterion is deal flow, the number of deals an investor looks at even if they don't invest. This sort of activity gives them a good view of the market, and a great network of potential partners. The deal flow criterion is harder to measure. My sense, from talking to entrepreneurs in New York, is that the investors who have talked to the most entrepreneurs in the sector are First Round, IA Ventures, Founder's Collective, NYC Seed, Genacast, WGI/Point, Coriolis, True Ventures, USV, Greycroft, and Spark.

I've worked with or co-invested with most of these investors. I respect their opinions and, if an entrepreneur tells me that one of them is interested, it influences me. But I don't always think they're right. Sometimes one of them likes a company I don't and sometimes I like a company they don't. None of them are always right and none of them make any investment a sure thing.

Given all the uncertainty about which companies will be successful and which won't, the predictive quality of who the investors are is too small to notice. Picking out five or six and dismissing all the others is silly. If you're an entrepreneur, talk to as many as you can and find the one that is best for you, no matter where they work.

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* I had a conversation with Greg Hills a few months ago where I asked the metaphysical question of who is quantitative marketing and who is not and he averred that the community is essentially self-defined by who are mentioned in, contribute to or comment on AdExchanger. I think this is as good a screen as any.
** Some of these should logically be included in 'quantitative marketing', but figuring which would take more time than I'd be willing to spend. If anyone wants to volunteer a list, feel free. Or, if anyone wants my hacked-together python scripts so they can do it themselves, let me know.
*** Crunchbase data is a bit funky. I amended it where I knew off the bat it was wrong, but didn't dig into every investment or investor. I am sure the data in this post is incomplete.

How to completely disappear in 45 minutes or less (at least from marketers)

Just been reading the FTC complaint against... well, against everyone I know, it seems: the exchanges, the DSPs, the data targeters, the ad agencies, the analytics companies, the whole quantitative marketing shebang. It was pretty straightforward, quoting everyone's marketing material, making the industry seem much, much larger than it actually is*.

Ed Zimmerman has a much better response than I could write, so I'm not going to critique the thing, but one paragraph really jumps out at me.

The value of user data harnessed by these platforms and services is generating higher returns for marketers. Publishers, ad agencies, and marketers are all trying to capitalize on the data of each consumer--thereby causing that consumer a financial loss. None of the so-called consumer benefits of real-time targeting--the "faster loading times" for an ad and whether they provide a "better user experience make up for this financial loss. The availability of so-called free content is an insufficient return to a consumer for their loss of privacy, including their autonomy.

The first sentence is interesting because I doubt it is, in general, true, or will ever be. If RTB and its ilk make the whole system more efficient, it is not the marketer that will garner the efficiency. Economics tell us that the main beneficiary will ultimately be the consumer.

The rest of the paragraph is a bit murky and illogical until the last sentence: targeting is corrosive of privacy and autonomy. Long-time readers will know that I don't disagree with this sentiment.

But I've become a bit cynical about consumer privacy. Having been involved in a failed bid to create a product that would safeguard consumer data while allowing marketers to compensate the consumer to use the data, I don't believe that consumers really care enough about their privacy to actually do anything about it. Even the most ardent complainers about the intrusiveness of advertising won't spend more than a few minutes of their time protecting their privacy. This says to me that their privacy is worth nothing to them (but complaining about it is worth something, I think.)

If you really care enough to spend a few minutes, you can do something about it:

• Opt-out of behavioral targeting (NAI)
• Opt-out of telemarketing (Do not call)
• Opt-out of direct mail and other direct marketing (DMA)
• Opt out of the credit bureaus mailings (Experian, Equifax, Innovis, Transunion)
• Opt out at the big data collectors (Axciom, Intelius and Choicepoint)

This will protect your privacy from pretty much everyone except your government. If you want your department of motor vehicles to stop selling your information (yes, they do) you'll have to write them a letter and put it in the mail.

* It also highlighted the importance of AdExchanger.com, who was cited as a source of industry info in at least half the footnotes.

The End to End Principle in Ad Exchange Design (The Thin Exchange, 2)

Where should decisions about which ad runs where be made? Ajay Sravanapudi, in his recent article on AdExchanger says

a DSP is really just a feature on an exchange... A DSP simply uses [RTB API] of an exchange to buy media and run campaigns more effectively. The exchange has an ad server that can deliver campaign pacing, frequency capping, targeting, etc. All that is missing is some intelligence to “auto-magically” buy media on behalf of the campaign... Dozens of ad networks have done this for years on things like YieldManager on the RightMedia Exchange (RMX). If we can simply layer this “auto-magical” intelligence on the exchange then there is no need to pay for a DSP.

I disagree. There's a sort of businessman's view here, where an intuition about power leads to an answer at odds with systemic efficiency.

Exchange 1.0 did not sell real-time. So the exchanges had to have rules in-system. Like the NASDAQ (and other limit order book markets), the exchange hosted the rules about who wanted to buy and who wanted to sell at any given price on any of the thousands of things traded there.

But RTB ad exchanges don't have thousands of things being traded, they have an almost unlimited number of things. Each ad impression--the placement, the context, the viewer--is different than every other. There is no commodity, so there can be no order book.

With an order book, the commodities had to be limited: i.e. "if the ad presented is on the front page of CNN.com, and the person viewing the ad is a male 18-34 years old, then bid $5.00 per thousand." That doesn't work when the ad presented is a photo of a red flower on Photobucket presented to a non-logged in 33 year old male in Northern New Jersey at 12:13am on a Sunday and who searched for gardening tools at an online retailer yesterday but didn't buy anything and whose circle of acquaintances includes several people who bought sunglasses this week." What ad you put in front of this person and at what price is a difficult problem, not one that can be reduced to simple rules.

The only way to move away from rule-driven trading is to use algorithms. On the buy side, developing the right algorithm requires a ton of experience, a ton of data from live campaigns (and the insight into how well each individual impression worked), a huge amount of experimentation, mathematical savvy, and a dose of genius. On the sell-side the algorithms are even more complicated to develop. The algorithms are where the intelligence is.

Where should these algorithms be run? Here's an analogy. Let's say you wanted your computer to run the algorithms. Where do you think they should be coded? In the operating system? Of course not. In the application layer? Almost certainly not. Obviously, you'd code them as routines to be run by a more general application, like Excel. The lower down the stack, the more generic the functionality should be. This is called the End to End Principle:

Using performance to justify placing functions in a low-level subsystem must be done carefully. Sometimes, by examining the problem thoroughly, the same or better performance enhancement can be achieved at the high level. Performing a function at a low level may be more efficient, if the function can be performed with a minimum perturbation of the machinery already included in the low-level subsystem, but just the opposite situation can occur – that is, performing the function at the lower level may cost more – for two reasons. First, since the lower level subsystem is common to many applications, those applications that do not need the function will pay for it anyway. Second, the low-level subsystem may not have as much information as the higher levels, so it cannot do the job as efficiently.

Saltzer, Reed and Clark in "End to End Arguments in System Design". This paper described an idea that has been central to internet architecture since early days: don't put in the center what can be done at the edges. Similarly, David Isenberg's "Rise of the Stupid Networks" (predicting that the internet would beat out the "smart" telecom nets.)

Okay, I can hear all you adtech gearheads: is the exchange really "low" level? It's probably the most complicated piece of software in the whole ecosystem.

But low-level in this argument really means that the functionality is used by the most end-user applications. It has nothing to do with how close to the hardware the function is (the two are correlated, but that's outside my scope.)

Clearly the exchange has the functionality that is shared by the most end-users. Each agent is different: different approaches, different algorithms, different in ways none of us has yet imagined. Why should we attempt to encode this as-yet-undetermined difference into the exchange? Putting DSP functionality into the exchange simply means that everyone has to pay for it, even if they don't use it. This means that other, better ways to be a DSP do not get developed, because then the customer has to pay twice: once for the DSP's DSP and once for the exchange's DSP.

And this brings me to my real beef with the idea that DSP functionality should be built into the exchange, or that any functionality outside of what is absolutely necessary should be built into the exchange. The internet has been so phenomenally successful because the low levels are bare boned and flexible. HTTP, FTP, POP, SMTP, DNS, IMAP, etc. have all been built on top of TCP because TCP does nothing but transfer data from one place to another. It doesn't have much expectation about what that data is or what it should do. If the internet's designers had made TCP more "intelligent", we probably would have never had the Web or Skype. Building low level functionality that is simple and allows layers to be built on top enables innovation. And heaven knows what we need right now in interactive advertising is some innovation.

I don't think the ad exchanges should layer in "auto-magical intelligence." I don't think they should layer in anything. I think they should start dumping functionality like Carl Fredricksen tossing furniture out of his house. The ad exchange should do three things. It should do them fast, it should do them cheaply and it should do them six-sigma. What the ad exchange should do, and all it should do, is cookie-match, cross and clear. The ad exchange should be thin, and as dumb as possible.

Everybody's an ad exchange (The Thin Exchange, 1)

Everybody's a DSP? Everybody's a marketplace.

There's this confusing moving about in the marketplace. AdECN was a pure exchange, and is now part of a publisher. Right Media, same thing. OpenX was a publisher tool, and is now running an exchange. AdMeld similarly. AppNexus was an exchange and is now a DSP (I think.) Same with Turn (who was first an ad net before raising money to become an exchange.) Glam and FIM are publishers and now have some features of an exchange. Several of the ad agency holding companies are making unlikely noises about building their own tech. And AdEx, well... they're doing pretty much everything.

It was so confusing I made a picture of companies moving about.

A good entrepreneur will change strategies as they learn the lay of the land. But some companies who weren't exchanges are becoming exchanges and some companies who were exchanges are becoming something else so, um, how does the land lay?

Here's what I think:

1. The ad exchanges know that running a marketplace should not command what they are charging, and lie awake at night fearing that their customers might someday come to the same awful conclusion.
   
2. The customers already have.
   

Why did the exchanges add other functionality? Because they know that they won't make much money as an exchange. I don't have much to add to my analysis in the linked post, other than to say that it seems all the exchanges agree with me, if you look at what they do rather than what they say.

Why is everyone becoming an exchange? Because it's just not that hard to add exchange-like functionality and escape the 20% transaction fees being levied by Google et al. An exchange is a low marginal cost, high fixed cost system. Once you've built the system, you just need to amortize the cost over a sufficient volume. That means that anyone with good volume is better off building their own than paying someone else.

If you extend this economic logic into the future, you arrive at an inevitable conclusion. Someday, someone will garner a huge amount of volume by offering exchange services at the lowest possible price, somewhere just north of marginal cost, probably in the 1% to 5% range of transaction fees. Everyone else will find that it is cheaper to use this single exchange than it is to run one themselves. Non-exchanges will stop reinventing the RTB wheel. And exchanges will be glad they moved into other lines of business.