The use of the word “extractive” in this post confused me a lot.
Looking at the example with Tom and Fred—nicer location or not, Tom is repairing cars. That’s the value he’s providing to customers, and it’s enough to account for all the money he’s making. And customers are better off too. The only one losing out is Fred.
All right. The question becomes, as a society should we be sad about the losses of companies that get outcompeted? Say Fred has a software company, making some expensive software to do a task. Then Tom, a hobbyist, releases a small piece of open source software that does the same task just as well. He doesn’t make any profit from it, but everyone switches to using his software for free. Fred’s company goes out of business, the investment is lost and so on. Was Tom’s action “extractive”? Should we be sad?
That’s the value he’s providing to customers, and it’s enough to account for all the money he’s making
I’ve replaced a sentence; maybe it will make things a bit clearer:
Now, Tom has certainly provided his customers a bit of value, because it is nicer to be closer to the city center. But the marginal value he’s provided to Whoville isn’t nearly enough to account for the value of the business he now owns.
To be even more explicit: imagine Tom is not even working at the car repair shop; he’s just assigning a manager to operate it for him. Now he’s reduced the total wealth of whoville in order to transfer wealth from Fred to him, at no benefit to consumers. The Before and After pictures of the town or its finances are virtually the same as if Tom had found a legal loophole for draining Fred’s bank account, without all of the hullabaloo of starting a business!
Say Fred has a software company, making some expensive software to do a task. Then Tom, a hobbyist, releases a small piece of open source software that does the same task just as well. He doesn’t make any profit from it, but everyone switches to using his software for free. Fred’s company goes out of business, the investment is lost and so on. Was Tom’s action “extractive”? Should we be sad?
In this scenario, the overall productivity of society has gone up, because people are no longer paying Fred rents for use of equivalent software. That makes it a lot different than what I view as the default case of capitalist entrepreneurship.
Here’s the thing though. What Tom is doing (if we forget distractions like paying salary to employees, paying rent for location etc) is entering the market with a slightly better service, and outcompeting the incumbent. Let’s say we ban this activity! Now nobody’s allowed to enter a market with a slightly better service and outcompete the incumbent. Enact this ban, and wait a few years. To me it’s obvious that society will be much poorer as a result. You’ll get rid of the small improvements that add up to large improvements.
And so it seems likely to me that one individual act—Tom starting a car repair shop in a slightly nicer location—will also turn out to increase the total wealth of society, all things considered. Statistically at least.
It feels like the problem is that we only have two extreme outcomes: either Tom is not allowed to create his business, or Fred goes out of business.
While the situation looks like Fred created a lot of value, and then Tom improved it a little, so a fair outcome would be that Fred gets paid more and Tom gets paid less but nonzero… and this seems like the only outcome that definitely won’t happen.
(Another part that feels unfair is that Fred took a greater risk by exploring a new option, but Tom already knew that Fred’s business was profitable.)
I’m also not saying let’s ban it. It’s a thought experiment. The intended conclusion (though maybe my comment was too cryptic) was that if banning X in general (where X = “entering the market with a slightly better service”) is obviously wealth-reducing, then that means allowing X is wealth-increasing, so a random individual instance of X is probably wealth-increasing as well.
And the example in your post looks to me like a quite typical instance of X. It’s not unusually bad. Most instances of X will look like stealing customers, putting incumbents out of business and so on. I’m saying it’s all right, the benefit over time is bigger than that.
Here’s the thing though. What Tom is doing (if we forget distractions like paying salary to employees, paying rent for location etc) is entering the market with a slightly better service, and outcompeting the incumbent. Let’s say we ban this activity! Now nobody’s allowed to enter a market with a slightly better service and outcompete the incumbent. Enact this ban, and wait a few years.
I think you just invented patents from first principles.
For that matter, why is Fred passing up the chance to improve his business? If he’s on the ball, he should be doing that to forestall a Tom coming in. You snooze, you lose, Econ 101 for agenty people.
As a customer, I broadly prefer competition, because it allows me to capture more of the total gains from trade.
Right now, for example, the small handful of RAM manufacturers have pricing power, and Nvidia has pricing power. It’s a terrible time to build a game machine.
But yes, I agree that sometimes capital investment can be stupid. At one point around 2000, the Boston area had a grossly insufficient number of hotels, driving hotel prices through the roof. Then, various projects started construction on at least 10 hotels (or so I was told). This was more capacity than was probably needed at the time, though I didn’t stay around long enough to see if prices crashed.
The historic alternative to these kinds of inefficiencies was called “central planning.” It failed catastrophically, leading to famine, death, and (even in the best case) adults who had never eaten a banana, like a teacher of mine who grew up in East Germany. Central planning requires the planners to possess truly implausible amounts of information, it provides the planners with little incentive to do a good job, and it removes customer “exit rights” if customers hate doing business with one local shop. Instead, we allow people to do distributed planning, and to occasionally lose their shirts by building an extra sushi restaurant with a stupid business plan.
The article mentions fixed costs of building Tom’s business. Like if Fred’s business costs $1m to start and creates $100k/year surplus value, it gets paid off in ten years, which seems like a good return on investment. If Tom’s building costs $1m to make and only creates an extra $10k/year surplus value (growing the market a little but mostly taking Fred’s business), it gets paid off in 100 years, which seems like a bad return on investment.
I guess some things involved in the fixed costs are
Tom’s space isn’t used for some other purpose
Time and materials spent building Tom’s shop are lost
How much should we expect the market to be like “well, if Tom’s business is a net negative socially, then I’ll be able to find some other use for that location and time and materials, which will leave society-at-large better off”? I don’t know.
Like if Fred’s business costs $1m to start and creates $100k/year surplus value, it gets paid off in ten years
Oh, not quite. “Costs $1m to start” sounds like it’s talking about the cost to Fred. Some of that will be e.g. wages paid to construction workers. For this accounting to work, we need to talk about the costs to society versus the value to society. (The costs to society being similar to those from Tom’s shop—space, time and materials.)
The use of the word “extractive” in this post confused me a lot.
Looking at the example with Tom and Fred—nicer location or not, Tom is repairing cars. That’s the value he’s providing to customers, and it’s enough to account for all the money he’s making. And customers are better off too. The only one losing out is Fred.
All right. The question becomes, as a society should we be sad about the losses of companies that get outcompeted? Say Fred has a software company, making some expensive software to do a task. Then Tom, a hobbyist, releases a small piece of open source software that does the same task just as well. He doesn’t make any profit from it, but everyone switches to using his software for free. Fred’s company goes out of business, the investment is lost and so on. Was Tom’s action “extractive”? Should we be sad?
I’ve replaced a sentence; maybe it will make things a bit clearer:
To be even more explicit: imagine Tom is not even working at the car repair shop; he’s just assigning a manager to operate it for him. Now he’s reduced the total wealth of whoville in order to transfer wealth from Fred to him, at no benefit to consumers. The Before and After pictures of the town or its finances are virtually the same as if Tom had found a legal loophole for draining Fred’s bank account, without all of the hullabaloo of starting a business!
In this scenario, the overall productivity of society has gone up, because people are no longer paying Fred rents for use of equivalent software. That makes it a lot different than what I view as the default case of capitalist entrepreneurship.
Here’s the thing though. What Tom is doing (if we forget distractions like paying salary to employees, paying rent for location etc) is entering the market with a slightly better service, and outcompeting the incumbent. Let’s say we ban this activity! Now nobody’s allowed to enter a market with a slightly better service and outcompete the incumbent. Enact this ban, and wait a few years. To me it’s obvious that society will be much poorer as a result. You’ll get rid of the small improvements that add up to large improvements.
And so it seems likely to me that one individual act—Tom starting a car repair shop in a slightly nicer location—will also turn out to increase the total wealth of society, all things considered. Statistically at least.
I’m not saying we ban this activity! I’m just pointing out inefficiencies in our present society. I actually don’t know what the solution to this is.
It feels like the problem is that we only have two extreme outcomes: either Tom is not allowed to create his business, or Fred goes out of business.
While the situation looks like Fred created a lot of value, and then Tom improved it a little, so a fair outcome would be that Fred gets paid more and Tom gets paid less but nonzero… and this seems like the only outcome that definitely won’t happen.
(Another part that feels unfair is that Fred took a greater risk by exploring a new option, but Tom already knew that Fred’s business was profitable.)
I’m also not saying let’s ban it. It’s a thought experiment. The intended conclusion (though maybe my comment was too cryptic) was that if banning X in general (where X = “entering the market with a slightly better service”) is obviously wealth-reducing, then that means allowing X is wealth-increasing, so a random individual instance of X is probably wealth-increasing as well.
And the example in your post looks to me like a quite typical instance of X. It’s not unusually bad. Most instances of X will look like stealing customers, putting incumbents out of business and so on. I’m saying it’s all right, the benefit over time is bigger than that.
I think you just invented patents from first principles.
For that matter, why is Fred passing up the chance to improve his business? If he’s on the ball, he should be doing that to forestall a Tom coming in. You snooze, you lose, Econ 101 for agenty people.
As a customer, I broadly prefer competition, because it allows me to capture more of the total gains from trade.
Right now, for example, the small handful of RAM manufacturers have pricing power, and Nvidia has pricing power. It’s a terrible time to build a game machine.
But yes, I agree that sometimes capital investment can be stupid. At one point around 2000, the Boston area had a grossly insufficient number of hotels, driving hotel prices through the roof. Then, various projects started construction on at least 10 hotels (or so I was told). This was more capacity than was probably needed at the time, though I didn’t stay around long enough to see if prices crashed.
The historic alternative to these kinds of inefficiencies was called “central planning.” It failed catastrophically, leading to famine, death, and (even in the best case) adults who had never eaten a banana, like a teacher of mine who grew up in East Germany. Central planning requires the planners to possess truly implausible amounts of information, it provides the planners with little incentive to do a good job, and it removes customer “exit rights” if customers hate doing business with one local shop. Instead, we allow people to do distributed planning, and to occasionally lose their shirts by building an extra sushi restaurant with a stupid business plan.
The article mentions fixed costs of building Tom’s business. Like if Fred’s business costs $1m to start and creates $100k/year surplus value, it gets paid off in ten years, which seems like a good return on investment. If Tom’s building costs $1m to make and only creates an extra $10k/year surplus value (growing the market a little but mostly taking Fred’s business), it gets paid off in 100 years, which seems like a bad return on investment.
I guess some things involved in the fixed costs are
Tom’s space isn’t used for some other purpose
Time and materials spent building Tom’s shop are lost
How much should we expect the market to be like “well, if Tom’s business is a net negative socially, then I’ll be able to find some other use for that location and time and materials, which will leave society-at-large better off”? I don’t know.
Oh, not quite. “Costs $1m to start” sounds like it’s talking about the cost to Fred. Some of that will be e.g. wages paid to construction workers. For this accounting to work, we need to talk about the costs to society versus the value to society. (The costs to society being similar to those from Tom’s shop—space, time and materials.)
Changed “extractive” to “rent-seeking”.