Power laws for fun and profit
Five years ago, the Internet sector was in the middle of a momentous slide in market capitalization. Priceline went from nearly $500 a share to single digits in three quarters. CDnow fell from $23 to $3.40 in about 9 months ending in March 2000. Corvis, Music Maker, Dr. Koop - 2000 was a meltdown the likes of which few recreational investors had ever seen or imagined. Science was invoked to explain this new world of Internet business.
Bernardo Huberman, then at Xerox PARC, and others found that the proportion of Web sites that got the bulk of the traffic fell far from the 80/20 rule of thumb: as of December 1, 1997, the top 1% of the Web site population accounted for over 55% of all traffic. This kind of distribution was not new, as it turned out. A Harvard linguist with the splendid name of George Zipf counted words, and found that a tiny percentage of English words account for a disproportionate share of usage. A Zipf distribution, plotted on a log-log scale, is a straight line from upper left to lower right. In linear scale, it plunges from the top left and then goes flat for the characteristic long tail of the distribution: twosies and then onesies occupy most of the x-axis.
Given such "scientific" logic, investors began to argue that the Internet was a new kind of market, with high barriers to entry that made incumbents' positions extremely secure. Michael Mauboussin, then at CS First Boston and now at Legg Mason, wrote a paper in late 1999 called "Absolute Power." In it he asserted that "power laws . . . strongly support the view that on-line markets are winner-take-all." Since that time, Google has challenged Yahoo, Weblogs have markedly deteriorated online news sites' traffic, and the distinction between online markets and plain old markets is getting harder to maintain. Is the Zipf distribution somehow changing? Were power laws wrongly applied or somehow misunderstood?
Chris Anderson, editor of Wired, has a different reading of the graph and focuses instead on the long tail. In an article last fall that's being turned into a book, Anderson explains how a variety of Web businesses have prospered by successfully addressing the very large number of niches in any given market. Jeff Bezos, for instance, estimates that 30% of the books Amazon sells aren't in physical retailers. Unlike Excite, which couldn't make money on the mostly unique queries that came into the site, Google uses adwords to sell almost anything to the very few people who search for something related to it. As of March, every iTunes song in inventory (that's over 1 million) had been purchased at least once. Netflix carries far more inventory than a neighborhood retailer, and can thus satisfy any film nut's most esoteric request.
At the same time, producers of distinctive small-market goods (like Weblogs, garage demo CDs, and self-published books) can through a variety of mechanisms reach a paying public. These mechanisms include word of mouth, search-driven technologies, and public performance tie-ins; digital distribution can also change a market's economics. Thus the news is good for both makers and users, buyers and sellers; in fact, libertarian commentator Virginia Postrel has written for the last several years on the virtues of the choice and variety we currently enjoy.
There's currently a "long tail" fixation in Silicon Valley. Venture capitalists report seeing a requisite power law slide in nearly any pitch deck. CEO Eric Schmidt showed a long tail slide at the Google shareholder meeting. Joe Krause, formerly of Excite and now at Jotspot, tries to argue for a long tail in software development upon which his product of course capitalizes. The term has made USA Today and The Economist. In some ways this feels like the bubble again, for better and for worse.
At one level, the Internet industry seems to need intense bursts of buzzword mania: you no longer hear anyone talking about push, incubators, portals, exchanges, or online communities even though each of these was a projected multi-billion dollar market. The visual appeal of a Zipf distribution may also confer Anderson's long tail with a quasi-scientism that simple terms like "blog," "handheld," or "broadband" lack. Netflix, Amazon, and Google lacked power law graphs, I'm pretty certain, in their startup documents and have managed to thrive regardless. Anderson's own evidence illustrates what a long way it is from explanation to prediction: showing how some firms can profitably address niches doesn't prove that a startup will similarly prosper in an adjacent market. To his credit, he focuses primarily on entertainment, where digitization is most prevalent.
The recourse to supposed mathematical precision to buttress something as unscientific as a business plan is not new. Sociologists investigating networks of people have been overshadowed by physicists who bring higher math horsepower to the same sets of problems, yet it's still difficult to understand Friendster's revenue model. Complex adaptive systems research was very hot in the 90s, following in the course of the now barely visible "artificial intelligence." The problem extends beyond calculus to spreadsheets: much of what passes for quantitative market research is barely legitimate data. To be reduced to a single semi-reliable number, a simple 5-point questionnaire response should have the answers vary in regular intervals, yet words rarely behave this way. Is "most of the time" 8 times out of ten or 95 times out of 100? Who remembers to count before someone asks? Purchase intent rarely translates to purchase. Yet executives make decisions every day based on customer satisfaction scores, opinion surveys, and focus groups, all of which reduce noisy variation to apparently clinical precision.
Make no mistake: Chris Anderson has identified something important and widespread when he groups superficially dissimilar businesses to spot their shared reliance on the medium's powerful capability for matching big, sparse populations to things they want and will pay for. Returning to our opening question with regard to what's changed since 2000, the necessary preconditions of successful long tail models include large populations and strong search, a relatively new capability. What will disrupt today's incumbents by 2010? New kinds of batteries? Flexible displays? Enforced shutdown of the peer-to-peer networks, possibly by a massive worm/virus of unknown origin?
It's also important to see the both/and: just because quirky tastes can constitute a profitable audience in new ways does not preclude hits like the Da Vinci Code, let's say, from being major news. And power laws still apply to traffic (and presumably revenue): Google and Amazon profitably handle massive volumes of site visits whereas Real's download service, about which Anderson rhapsodizes, still loses money. At the end of the day, no algorithm in the world can negate the most powerful "law" of business, that of cash flow.
--Dr. John M. Jordan
John Jordan is a member of the Guidewire Group Sounding Board.
Posted by John Jordan at May 27, 2005 07:26 AM
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