The argument that there will be another bubble seems pretty strong; but to me, the reasoning around how and why “the bubble cycle has replaced the business cycle” raises a lot of questions. He traces origins to the 1971 decoupling of the dollar from gold and the 1999 repeal of the depression-era Glass-Steagall Act regulating banks and markets. I don’t see a complete story there, but then again, maybe his book goes into more detail.

A backstory that I see being mentioned many other places is the question of how much longer the standard “reflation” methods can be used to recover from burst bubbles while inflating new ones. Interest rates, the dollar, and taxes are all already low, while the federal deficit is high; and the credit / real estate bust has yet to run its course. I suppose that short of moderating the cycles themselves, the lesson is to be disciplined in increasing rates, taxes, and surpluses while a boom is on.

The basic idea is that a fund manager has a good shot at generating outsized returns over a limited time period by selling insurance against a low-probability event. The reason for the high return is the low but significant risk of losing everything.

This would be no problem ordinarily. This is the same reason a treasury note pays less than a corporate bond pays less than credit card debt: the federal government is less likely than a corporation to default, and a corporation is less likely than a single individual.

The problem is in transparency: since the investors don’t know what risks the manager is taking, they can only judge on results over a finite time period. If they were explicitly asked whether they were willing to run a 10% risk of losing everything for an extra 2 points of return, they might make a different decision.

At the root of this problem is compensation. The standard “2 and 20″ structure rewards gains but does not pass through losses, and it reflects a built-in assumption that some kind of reliable algorithm, strategy, or talent lies behind the higher returns. You could argue that the same problem exists with massive CEO stock grants: risky ways of boosting the stock price may pay off for the CEO in the short term, but may hurt the company and its investors in the longer term. In both cases, the manager is highly incentivized to increase risk behind a curtain of reduced transparency.

Which brings us to reputation, which is often cited as a factor that helps to solve this problem. The idea is that the above may work short term, but the manager’s career will be over when this hidden risk-taking inevitably comes to light. But this argument loses its force when today’s pay scales are considered. Loss of reputation has got to seem less threatening to many managers if the short term reward is so high that it permanently moves the manager into a new wealth strata. Many recent articles have made the point that top pay scales are really set by cultural norms; the reputation problem is at least one good argument for lowering these norms.

This reminds me of my foray into tagging, where I had to dust off my own understanding of distributions. On the one hand, the fact is that the topic can just be plain hard, and at times pretty counterintuitive. On the other, I’m sure that numbers themselves seemed hard until they became part of almost everything we do.

One point that seems like a good one: it’s true that statistics are essential to understanding things like news reports, Google Analytics, sales dashboards, sports stats, etc., and it probably wouldn’t be a bad idea for this fact to be reflected in school curriculums.

This sheds new light on the stats regularly circulated about the growth of Internet advertising as a whole. Apparently, a fixed pot of money has just been getting re-allocated among various players, while Google has single-handedly been responsible for nearly all of the actual growth since 2002. Amazing.

The issue is that entrepreneurs are usually most interested in one number: percentage. As in, what percentage of the company will I own after raising money? This can confuse things because the way financing works, percentages aren’t treated as inputs; they’re treated as results of decisions on value. It was suggested that I lay this out in a blog post, so, here it is.

At its most basic, the important inputs to financing math are the pre-money valuation, and the amount raised. These numbers result in percentages. So let’s say for example that two founders decide to each own 50% of a company, and then they decide to raise $500k on a $1M pre-money valuation. That means that before the financing, the company is worth $1M, and right after the financing, the company is worth $1.5M (since it now has $500k in the bank). So, since the investors contributed $500k of the $1.5M post-money value, they now own 33% of the company. That means that the founders now own 33% each — they’ve been “diluted”.

This approach makes sense since the focus is on something that shouldn’t depend on how much money is raised: how much the company is worth right now. Then, depending on how much money is raised, the existing shareholders are diluted to lower percentages to make room for the investors.

Here’s a quick spreadsheet to play with that hopefully will make this all clear. The yellow bolded cells are the ones where you enter values; everything else then falls out from there. The number of shares per dollar of value is totally arbitrary; here it’s pegged at 10 cents a share.

I can see his reasoning: a way to do good is to make tons of money and give it away to help people. So if you leave potential money unearned, you’re either shortchanging yourself or the people you would have helped. This especially seems like a compelling argument when it comes to advertising, which appears to be “free” money since it is only exchanged for the momentary attention of users.

But the fact is, the absence of ads on CraigsList represents value for users. How big a value is it to not have to see a few ads? My own feeling is that it’s not all that big, but I think it’s safe to say that most people would choose a site without ads over one with ads if given the choice. And since there’s no shortage of CraigsList imitators, that translates to what could be a very important competitive advantage.

So you can view the decision to not run ads as a bet: a bet that in the long term, this will enable CraigsList to keep their lead in the market. Sure, they could run ads now and send a few billion to charity, but that would be short-lived as they lost users. GM could sell all their assets and send it all to charity too, but there wouldn’t be any GM in the morning.

Now I have no idea if Craig or anyone else at CraigsList thinks of it this way, but you can view this decision as the application of a straightforward business philosophy: listen to your users fanatically and give them exactly what they want as long as you can cover costs. By never building any excess profit cushion into your business, you never leave the door open to a competitor to undercut you. And as a bonus, customers love you.

I would even say that as everything about web apps gets easier and easier, this might well become one of the only ways to build a sustainable business on the Internet. The barriers to both building apps and to users switching are getting lower all the time. This leaves critical mass and customer loyalty as two of the only real competitive advantages left. Charging the minimum to users, both in terms of fees and distractions, is a solid strategy. It’s a way to build and defend mass and loyalty against the competitive apps that will inevitably be chasing the same users in short order.

Update:

Some commenters in the original NYT article point out that ad revenues can also be used to address the “unmet needs” of CraigsList users, and that if this investment is not made, CraigsList will lose to a competitor that does fund this additional work via ads. This is a valid point, but I’d argue that the success of CraigsList so far is evidence that the company is keeping profits at the right level to develop *only* those features that user really want. This is a judgement call, and so far at least, it looks like they’ve made the right calls.

Other commenters say that CraigsList is engaging in “predatory pricing”, and that this pricing is putting others like newspapers out of business. I don’t find this a convincing argument. Predatory pricing (or loss-leading or dumping) is when a company sells a product at a loss in order to either build market share or drive others out of the market. CraigsList is profitable. While they are not *maximizing* short-term profits, this may be exactly what is needed to stay a viable business. The fact that classified ads are not bringing newspapers the same revenues as they used to is just further evidence of this; evidence that minimizing excess profits is what’s needed to compete in a market where it’s so easy for ideas to be realized and for users to switch.

In the 1960s, 85% of known reserves worldwide were fully open to the international oil companies. That number is now 16%. The rest of the world’s oil and gas is either restricted or entirely cordoned off. National champions such as Saudi Aramco, Kuwait Petroleum, and Mexico’s Pemex outweigh publicly traded oil companies in the production contest.

When it comes to commodities, public ownership is a major meta. The article makes the well-documented point that national oil companies are not profit-driven, and so tend to lag in technology, production capacity, and information transparency. This has historically led to a more expensive, volatile market for oil. Now, while it seems clear that price volatility is an enormous negative, both for the world economy and for investments in new energy sources, it isn’t so clear that slower production and higher prices are such a negative.

Let’s assume that the perfect competitive market for oil existed. Then prices would be close to that necessary to cover the cost of extracting enough oil to meet world demand at that moment in time. Adding in speculation and derivatives might help prices take into account likely world demand in the near future, but uncertainty wipes out the possibility of taking into account any longer-term costs.

So in this scenario, the likely outcome seems to be the one widely feared: that prices will remain relatively low until demand outstrips supply given current extraction techniques, at which point prices will spike. While new technologies will be deployed as prices rise enough to justify them, there’s certainly a good chance that the time window affecting prices will be shorter than the time needed to develop and deploy these new technologies. In this case, volatility would be extreme, and the high societal cost of this volatility would have been an externality, missed by the market.

Could it be that the poor performance of nationalized oil companies, by reducing effective supply prematurely, might help correct for this missed cost? By leading to higher prices earlier, it could be argued that they could lengthen the window available to develop new energy sources. The key seems to be that to encourage this development, the reduced supply and higher prices must be consistent and reliable.

Unfortunately, history seems to indicate that in general, national oil companies drift lower and lower in production until additional funds are desperately needed by the government. At this point international oil companies, always waiting in the wings, are called in to help fix things; then production surges, prices plummet, and any efforts to develop alternatives are wiped out. If anything, steady constriction of supply seems to work best under authoritarian regimes, such as OPEC since the 70s, where powerful governments are able to dictate production to oil companies, regardless of whether they are privately or publicly owned.

So it seems to me that the answer is no, nationalization doesn’t really help the situation overall. If it could somehow be ensured that national policies would take advantage of not needing to maximize profits, instead reliably and consistently restricting overall supply, then it could be possible that the impact of “peak oil” could be blunted. But at least in democracies, political motivations can be at least as short-sighted as economic ones; and if they are allowed to share in the profits, private oil companies will always be eager to help out. All this makes it hard to imagine a scenario where nationalization could effectively help matters.

PS: A great resource for thinking about this stuff is Daniel Yergin’s “The Prize”, as I was reminded by Ethan Stock’s latest at OnoTech.

Update: Hugo Chavez of Venezuela has made a novel proposal: to offer long-term deals for oil at $50 a barrel. His purpose is right in line with the above: to prevent future price plunges from destroying the worth of alternative sources invested in now. Chavez is interested in his own “tar sands,” which if economically recoverable would give Venezuela the highest reserves in the world. $50 is $15 less than current prices, but $10 more than the price needed to make this alternative source of oil viable.

This same approach could also make Canada’s tar sands viable, potentially blunting the power of middle eastern oil and removing the threat of any near-term shock from “peak oil”. Of course, the problem with this entire approach is that middle eastern oil is extractable at around $2 a barrel, much less than any tar sands source. Which brings the issue back to political will: if offered lower prices by middle eastern sources, the enormous amount of money and economic leverage involved makes reneging on any such long-term deals (or smuggling) close to impossible to resist.

A great example is GDP, recently dubbed “Grossly Distorted Picture” by the Economist (subscription required, unfortunately). GDP is a very limited and inaccurate measure of economic activity, let alone national well-being. In fact, GDP was initially created to just be a planning tool for wartime production in WWII. But nevertheless, boosting GDP has become a central goal of many countries, which sometimes can lead to strange distortions.

Another example is Alexa’s measure of pageviews to a web site, which has become an easy way to gauge the “success” of a site. But as Alex Castro points out, this measure is in some ways even worse than GDP. Not only can a site attract lots of pageviews without doing anything useful for users, but sites that use AJAX, Flash, or other modern technologies are perceived as less successful because of the fewer page views they generate.

The need to simplify isn’t going anywhere, and so neither are measures and their problems; but it seems worth keeping in mind that any given simplification might be hiding important details, and that it might be worth taking a closer look before drawing any conclusions.

A much-touted feature of many search engine keyword auctions is that even if you bid a high amount on a given keyword, the amount you actually pay is reduced to be a penny above the next-lowest bid. This tends to make advertisers feel safer in placing bids that are high; in fact, at least in the past, it was argued that it made the best approach “truth-telling,” or bidding the actual value of what the ad is worth to you. Google even justified this by referring to Nobel prize winning research showing that such truth-telling had been proven to be the optimal strategy for bidders in “Vickrey auctions” like Google’s.

Truthful bidding is simple and easy for advertisers, and by discouraging low-bidding, tends to increase search engine revenues; so it would seem everyone wins. But as the paper shows, the system used by search engines isn’t a true Vickrey mechanism and does *not* lead to truth-telling being the optimal strategy. In fact, the paper shows that truth-telling under this system always leads to higher prices for advertisers than in a true Vickrey system.

Here’s a quick summary of the paper. If there were only one position in sponsored search listings, reducing the top bidder’s price to be essentially equal to the next highest bidder would be a “second price” auction. In reality there are multiple positions, with different values in terms of CTRs. In this case the obvious generalization, which Google and Yahoo use, is to reduce each winning bidder’s price to the next-highest bidder; this is called “generalized second price” or GSP. Vickrey-Clarke-Groves (VCG) is a more complicated system than this. VCG reduces each winning bidder’s price to be equal to the value lost to all lower winning bidders by being knocked down a position. As the paper shows, this price is always less than under GSP, and leads to truth-telling being the optimal strategy.

So a true VCG auction would better serve advertisers by really making truth-telling the best strategy and by lowering prices paid. But it would probably reduce search engine revenues as compared to the current GSP approach, and would eliminate the systems used by some sophisticated advertisers to constantly try to game GSP, which is inherently unstable and presents fleeting opportunities for gain via low-bidding. The paper points out that Ask and MSN, having less invested into GSP, have an opportunity to attain a comparative advantage over Google and Yahoo by using VCG to reduce these inefficiencies.

All this reminds me of another inefficiency in the online ad market: the high CPCs currently being paid for contextual placements due to mixing search keyword bids with contextual keyword bids. Google’s AdSense is certainly the most relevant example here. In the same way that advertisers are encouraged to bid their true value even though it might not be the most effective strategy, advertisers are also encouraged to extend their keyword bids to contextually targeted ads, even though such ads are known to have lower value than search ads. In fact, although it’s possible to enter different bids for contextually targeted ads, or to skip them altogether, the default behavior is for keyword bids to apply to all ads placed by Google anywhere; and defaults matter.

The result is that for publishers, AdSense has two enormous advantages over other ad networks:

(1) Every search advertiser on Google is by default an advertiser under AdSense. This automatically provides a large and varied pool of advertisers.

(2) The CPC paid by advertisers is by default set by the value of an audience who is actively searching for the keywords bid on. This leads to much higher prices than those actually based on the value of an audience who is just reading text containing the keywords.

In general, these advantages come at the expense of advertisers; it seems to me that this situation presents another great opportunity for competitors like Ask and MSN to differentiate themselves.

An interesting question is raised here: assuming conversion rates for contextual clicks are lower than those for search clicks, automatic inclusion in AdSense must lower the overall conversion rates for advertisers on Google. A recent report shows that indeed, Google comes in dead last among major search engines when it comes to conversion rates. The report attributes this to demographics, but maybe AdSense has just as much to do with it.

The real question, though, is this: have lower conversion rates led to lower keyword bids at Google as compared to other search engines? If so, this represents an effective transfer of money from search profits, where Google is already dominant, to buying market share in the placing of ads on other properties, where Google clearly plans to become dominant. As with the GSP/VCG issue, it’s impossible to say how much of this is accidental and how much is deliberate; but in the end, it amounts to both an impressively effective strategy for Google and a significant opportunity for competitors as these inefficiencies become understood and are wrung from the market.

Update: Ed Clarke, the Clarke in VCG, shows up in the comments! Blogs are amazing.

A (separate) emailed comment notes that Google’s “smart pricing” automatically lowers bids for contextual ad space using an algorithm that is supposed to take into account its lower value. I hadn’t been able to find any mention of this on the Google site, but searching more broadly, I found this and this: looks like this has been around since ’04. Thanks for the correction, and sorry I missed this!

The thing is, it makes me wonder even more: if “smart pricing” is really taking ROI into account accurately, why are overall conversion rates so low on Google? Maybe it really is demographics…or maybe the algorithm still results in higher than justified CPCs paid. It’s hard to know for sure, since the alorithm is not public, but two facts seem to remain: compared to other search engines, Google conversion rates are low; and compared to other contextual ad networks, Google CPCs paid are high.

The liquidity in the maturing online advertising industry, which allows new applications to monetize utility to users quickly and directly.

In other words, if you can build an application that has enough utility for a decent number of users to start using it, you can turn that utility into dollars by, say, slapping up AdSense, which pays the bills and keeps the app up and running (perhaps competing with a platform aspiring to monopoly power).

The problem with this in the real world is that AdSense, which at the moment is the easiest way to put advertising on a small site, doesn’t really pay the bills all that well. One big reason for this is that the ads are usually pretty badly targeted when the context is a dynamic app, or a constantly changing document like a blog.

This is where the Web is different from other media: as many people have pointed out, the Web is neither one-to-many (broadcast) nor one-to-one (email); it’s many-to-many. That means that everyone can provide data as well as receive it. In particular, users can “pay” for content with more than just their attention; they can pay by supplying data about their interests that lets ads be better targeted. Although smaller sites currently have a hard time monetizing this data, in theory web applications should become economically viable at a much lower user base due to both more valuable targeted ad space and the previously discussed reductions in development and operations costs.

This idea of paying with data isn’t new, we already do it in several ways:

– Supplying search terms is a payment: your interests at that moment are targeting data (e.g. Google AdWords)
– Reading content is a payment: the content itself represents your interests (Google AdSense)
– Frequenting a site is a payment: your history at that site represents your interests (e.g. Amazon)
– Registering at a site is a payment: facts like zip code, age, and gender act as proxies for your probable interests (e.g. NYT)

This trade of data for content is what Matt Blumberg calls the “New Media Deal”, as I just found out by following a link from Fred Wilson. Matt’s description of this deal is really great, but it doesn’t mention what I think is a big problem: most people don’t get what the deal is! I don’t have any handy stats, but I’d bet that if you took a survey, most people wouldn’t know that the reason they’re always being asked to register and fill out forms is to help the site pay its bills by serving up more relevant ads. They probably think it’s to spam them or do market research or something (er, well, both of which might sometimes be the case actually).

It seems to me that asking users for data might work a lot better if users really understood what it was for. Matt addresses this in part with his next deal incarnation involving more user participation, the “We Media Deal”:

The more transparent the value exchange, the more willing you are to share your data.

But the examples he gives, of us being more likely to care about sharing our data if we know we can delete it and that it will be attributed to us, isn’t really what I have in mind here. Instead of trying to get data from users in indirect ways like surveys, registration, and tracking, why not just make the deal explicit? People understand that someone has to get paid to develop apps or write articles, and if we can pay with something other than money, that’s great!

I think it’s true that a lot of people are used to thinking in the “old media” way: as Matt puts it, we pay by “tolerating” a blizzard of ads, most of which are totally irrelevant to us. If the New Media Deal is made more explicit, I think people will see that everyone wins: a less painful type of payment can support a greater diversity of sites, where participation and mutual respect are values that are reinforced by capitalism and self-interest.