LinkedIn and the Natural Monopoly

| About: LinkedIn (LNKD)

With the success of LindedIn’s (LNKD) IPO, I want to discuss one of the reasons, in my opinion, why internet stocks caused such a frenzy a little over a decade ago.

One of the popular ideas that swept thinking circles in the mid-1990s was the impact of what economists call “natural monopolies.” The idea was also known as “the first mover advantage.” Robert Frank’s book “The Winner-Take-All Society,” also touched on these themes.

The general idea is that if a company is the first to unveil a certain type of product, it then becomes “the standard.” This is crucial because it’s in everyone’s interest to recognize it as the standard.

Probably the best example is Microsoft’s (MSFT) Windows. Once Windows was established as the standard, so the idea goes, no one can knock it off and the company enjoys an enormous competitive advantage. There’s no need to for two operating systems. Similarly, there was no need for VHS and Betamax to exist. (In econo-speak, a natural monopoly has very high fixed costs relative to its variable costs.)

Likewise, when one company is established on the internet, say selling pet supplies as advertised by a sock puppet, it will hold a near-monopoly over the entire industry. As a result, the normal metrics of valuing a company need not apply. Or so we were told.

I remember how often I was told that some Internet stock was going to be huge and that it all had to due with the QWERY keyboard. This was the easy way to explain the first-mover advantage. The story is that the QWERTY keyboard was established in the 19th century even though it’s an inefficient layout. The reason it won out, and is still around today, is that it became enthroned as the standard. QWERTY became the winner, and it took all.

The takeaway is that the better mousetrap didn’t win the race (I’m mixing metaphors, deal). The worse keyboard board won only because it was first. Again, so we were told.

It’s hard to emphasize how widespread these ideas were. In Bill Clinton’s re-election campaign, he often warned voters about the emergence of the winner-take-all society. In 1998, there was even a new tech magazine called The Industry Standard.

Today, LinkedIn potentially holds a similar hold winner-take-all grip over the resume market. Why bother being listed some place? The problem with the winner-take-all thesis is that it doesn’t always hold. Industry standards do get knocked out. It may take time, but it can happen.

By the way, not all the stories we told were true. In typing contests, for example, QWERTY has held its own as an efficient layout. The biggest threat to natural monopolies comes, not from a competitor, but from innovation. As a result, these standards can be far more vulnerable than we realize. That’s why I’m so suspicious of the elevated price for LinkedIn.

One more thing, in 2001, the The Industry Standard went bankrupt.

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