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Disruption And Economic Surplus

Summary

Money illusion plays a role in price stickiness.

Economic surplus can be overstated in disrupted industries.

Equity valuations remain too high when before pricing equilibrium occurs.

Consumer purchases made beneath the highest price the consumer would pay is considered consumer surplus. What happens when she obtains a service digitally such as music that was previously a physical good? If the consumer values the service based on the nominal dollars of the physical distribution, she will find the new service to be a price reduction and feel as if there is a large consumer surplus. Is that a price reduction on the old product or a high margin new product with marginal real variable costs? Both a disruptor and the disrupted may find an overstated consumer surplus as their industry seeks equilibrium.

The other variable needed to calculate economic surplus is producer surplus which is simply margin.

Consumer surplus+ Producer surplus = Economic surplus

Irving Fisher wrote about a concept he called money illusion where consumers base their decisions regarding price changes in nominal not real terms. This leads to price stickiness in the transition from physical to digital because there is a framing of value around the traditional physical price not the digital cost. This allows for the buyer to view this as a larger consumer surplus while the producer has a larger surplus as business scales due to very little variable costs. However, the profit pool of the industry has shrank. Thus, the consumer surplus is not representative of the current economic model, the top price a consumer would pay is relevant to her, but it is not relevant to the new business model. There is an imaginary consumer surplus based on poor framing by the consumer. A disrupted market begins with the consumer looking at the difference in nominal costs and believing they are getting a larger consumer surplus. The producer surplus in a disruptor may start out negative because it is subsidized by venture capital (and potentially labor in the Gig economy). The negative impact on the producer is a benefit to the consumer but it is not in equilibrium. The usual mantra of the disruptor is to take share and then lift pricing which will put the equation back into balance.

The subsidies benefit the disruptor in the first phase but what about after the share grab game is over? Now the producer needs to raise prices to get back to equilibrium to either negate the subsidies or deal with increasing costs from non-digital inputs. Uber signaled this dilemma in their prospectus, price increases are needed to compensate labor, but the service is far from a monopoly and suffers from lower demand at increased prices due to substitute products.

If the economic surplus equation is not brought into equilibrium, then scale is not the answer. However, the investors in market share grabbing companies always believe that scale is all that is needed. If it will fix poor operating margins in a business with virtually no variable costs, then the equity valuation should consider the probability of meeting the various margin scenarios. Yet, it is not a given that scale will lead to nirvana if pricing must be considered.

Advertising and Surplus

In 2012, Boston Consulting Group wrote a white paper espousing the fact that each connected consumer in the United States had a consumer surplus of over $900 per year from on-line media. Social Media, still in its relative infancy, was over 30% of the surplus. That number was touted as significant as on-line media was 15% of media and would be growing significantly. If Facebook had utilized the strategy of shrinking the consumer surplus to maximize the producer surplus by charging for the service, we believe that the business would be worth far less today. If Facebook solved for price elasticity of the service, they would have confronted the largest money illusion, exiting free and entering pay.

Was there ever large excess consumer surplus for content in advertising-based models? The argument can be made that once the advertising time is satiated then the next lever to pull is pricing for the service. However, the media industry found that once they wanted to price for the service in a traditionally free radio business, the consumers balked on advertising intrusion. Somewhere in this equation the consumer surplus for traditional media content was overstated. As the consumer surplus of streaming content without advertising is solved for there will be downward pricing on pay rates.

Sticky Situations

While Uber will face stickiness increasing prices, the traditional media market may have seen its best days as prices have been sticky on the way down. Both situations lead to overvalued equities as the prices seek equilibrium. Dow Jones may be benefitting from a $3.00 price on the physical copy of the paper when pricing the on-line service but when the pricing umbrella is gone, how will they raise subscription prices? The consumer surplus to the base readership is large but is lacking for the marginal subscriber. If the digital subscription rates are not at equilibrium, how can we model them up or down? For a business with substantial inflationary physical costs such as a newspaper the problem isn’t going to resolve itself easily.

Disrupted

Following the consumer surplus is one method to gain a view into pricing in a given industry. Disrupted industries produce an opaquer picture and it not until the pricing equilibrium is solved for can an investor assess the future. Subsidies of capital and labor produce too much consumer surplus in disruptors while the money illusion produces too little consumer surplus temporarily for the disrupted. Neither one is beneficial in valuing equities in disrupted industries.