January 7, 2020

Innovation – Power Laws

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The term ‘network effects’ has become commonplace in the discussion of innovative business models, but its application dates back to before the world of Facebook and others. It’s logical enough that there the more people in a network, the more valuable it is to join. But beneath that lay the laws of nature and the age-old concept of Power Laws.

The below post is a very simplistic, illustrative example of how the topic works conceptually. It is meant for educational purposes and is not specific to any business or brand in-particular.

As we look back over the last decade and where the greatest sources of innovation emerged from, we will no doubt look at Silicon Valley and a stable of disruptors who changed the world forever with both their technologies and business models. New markets were created where none existed before, as the great expansion of companies such as Facebook, Airbnb, and Uber was coupled with the near ubiquity of cellphones. The digital space has expanded so rapidly that our brains haven’t been able to keep pace.

The Power Law Mathematical Equation

The entire principle of Power Laws is built upon the idea of exponential algebra, where a series of disparate variables cannot only impact each other but in fact amplify each other at orders of magnitude greater than originally anticipated. Power Laws apply to every aspect of life. They are observed in nature in many ways, which is why we see a basic mathematical formula to quantify how these laws function:

We see these laws happening in medicine, languages, geography, and just about every major layer in modern life. But it is precisely their non-linear nature that makes them so difficult to predict, especially for our linear minds that thrive on predictability. Virtually every graph of Power Laws looks like the following:

This example looks at the relationship between Number of Cities (Y) and City Population (X). Effectively, you can have almost an unlimited number of cities in the world with small populations, but very few with a large population. This is often linked to the Pareto Principle (or 80/20 Rule) where ~20% of one group drives ~80% of the results.

Variables That Sparked the Valley

In the case of the enormous number of high-growth Silicon Valley startup in the last decade, it can only be explained by a complex set of relationships related to:

>Moores Law – whereby technological capability doubles every 2 years, thus giving rise to smaller chips and what would eventually become the mobile phone.

> Mobile Phones – Research in Motion (RIM) kickstarted the mobile revolution in the early 2000s. Apple launched the iPhone in 2008, and then Google built its open-source Android software, creating a lower-cost alternative to Apple. Now everyone, on every continent, has a mobile phone.

>Broadband Speed – one of the reasons that Apple’s iPhone launch was so successful was because it came at a time when network companies were just beginning to launch 3G networks capable of processing large packets of data

>Apps – once all of the pieces were in place, we saw the launch of Facebook, Instagram, Airbnb and Uber on mobile, and now these apps have become part of the fabric of many’s daily lives

The complexity in observing the relationship between the factors that gave rise to the digital business model is stunning. But Power Laws dictate – as we see in the cities graph above – that only a basket can become behemoths. At a certain point, diminishing returns kick in and the relationship inverts itself. This is the point we are at now, with a mix of digital fatigue, cellphone memory limits, and the social effects these apps have on society. When diminishing returns kick in, creating more firms (or apps in this case) will create less yield or results.

Power Laws in Markets

There are various ways that this manifests in both business and markets.

First of all, most major markets exhibit these rules in what is sometimes called the Rule of Three. In any major market, you will have typically have 3 firms that command the market share in a mature market. Of those 3, one will typically control 70-80% of the market. There are many rules and factors that define the application of this rule, but in general, it applies to most markets over the long-term.

While working on our book, we analyzed data on U.S. venture capital–backed tech startups founded from 2000 to 2015 and found that category kings earned 76 percent of the market capitalization of their entire market categories. Tech analyst Michael Walkley of Canaccord Genuity looked at the earnings of smartphone companies in late 2014 and found that Apple took in 93 percent of the industry’s total profits that quarter.

Forget Disruption – Creators Dominate Markets

Part of this can be understood by the principles of economics, but part of it relates to human psyching. Choice is always a good thing, but too much choice will cause commotion (ie. the Paradox of Choice). Furthermore, the more people that use a given product or service, the more likely others are to trust said brand. Brand trust takes years or decades to build-up and requires a significant investment of time, money and talent. For this reason, we don’t see 10 Facebooks, Googles, Amazons and Ubers. There are usually competitors in each market (think Uber vs. Lyft) but in limited quantity. While monopolization of any given market is not good, the inverse is also true. That’s why observing these laws across society and nature helps us to better understand both innovation and strategy.

Even within businesses, these types of laws typically apply. Based on data that was gathered from the Farfetch Business Model Canvas, we can see that even though they have several hundred retailers, only 10 drive 22% of the platform’s merchandise volume.

“But 22% of the company’s GMV is from its top ten retailers, even though it had over 614 on the platform, showing some centralization and power law-like dynamics.”

Loose Threads

That is why we typically see some companies take a very aggressive strategy early in markets, particularly those vying to become a certain type of marketplace or eCommerce platform. They know if they can get the top percentile of supply or goods, they will likely be one of the Top 3 in the market.

Overall, Power Laws play a very important part in the development of the digital economy and explain much of the explosive growth of the Valley in the last decade. Grasping these laws, even at a rudimentary level, can help shape strategy and avoid common errors when trying to become an innovator.

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