The Competitive Techscape: Dispelling the Monopoly Narrative
One of the hotly debated topics in investing is whether the technology sector can give rise to durable monopolies. Let’s explore this question by addressing the key sources of competitive advantage that define monopoly power.
- Network effects
- High switching costs
- Economies of scale
- Non-replicable physical assets
Networks can create monopolies. Each incremental user of the network increases the value of that network for all other users strengthening its position. A good example is a financial exchange – traders find the exchange more valuable the more other traders join and liquidity and depth grows. Technology is notoriously associated with network effects in areas like social media.
However, practice has shown that many technological networks are prone to disruption. This is in part because social media competes for the same 18-19 hours of the day of attention. At a point in 2018, Facebook and Snapchat woke up to realize that the biggest advertiser on their platforms was a competitor, TikTok, who had bought 25% of all the ads seen on US Apple devices on the Facebook ad network1. What happened next was a substantial shift among young audiences towards TikTok.
Monopoly Criteria: Network Effect
While networks can lead to monopolies due to their increasing value with each new user, technology companies, especially in areas like social media, do not always meet the monopoly criteria. This is due to their susceptibility to being disrupted and competition for a finite amount of user attention, as exemplified by Facebook and Snapchat's experience with TikTok's rise as a competitor for young audiences' attention and advertising revenue.
FAIL (and increasingly so)
Another source of monopoly power is high switching costs. Through their unique feature or quality, products or services can become mission-critical, that customers’ cost of switching becomes prohibitive. In the technology sector, disruption poses a problem to establishing this position. The pace of disruption is only accelerating. It took Netflix three-and-a-half years to reach 1 million users. That same feat was achieved by ChatGPT in a record five days, posing a threat to the dominance of big technology companies like Meta and Google for the first time.
Interestingly, even as these new technologies burst on the scene their budding moats are weaker than previous generations. Many, including famously Google in a recently leaked , argue that AI will have no moat at all.
It isn’t just software where disruption happens in tech. Hardware market share shifts happen as well because of computing paradigm shifts. It seems that the market's perception today is that Nvidia, with its graphic processing unit (GPU) chips, will win the AI market. Much of Nvidia’s advantage stems from its CUDA language for hardware developers which they cleverly gave away to students, resulting in a generation learning on it and high switching costs. However, as the chart below shows the dominant framework for deep learning (i.e., AI) is Pytorch, which works out of the box on Nvidia’s rival AMD’s chips. This could break Nvidia’s dominance in the new phase of the AI markets development.
The history of the tech sector is littered with examples of dominance being wiped away by something entirely new. Remember Myspace (Facebook), Nokia (Android/Apple), Kodak (digital cameras), iTunes (Spotify), Internet Explorer (Firefox/Chrome) to name a few2.
Monopoly Criteria: Switching Costs
The increasingly rapid pace of disruption in the technology sector challenges the establishment of monopolies through high switching costs, as exemplified by the quick adoption of ChatGPT and the potential ease of switching between rival AI services. This disruption extends beyond software to hardware markets, as seen with Nvidia's dominance in AI being potentially challenged by shifts like the growing use of Pytorch on rival AMD's chips, ultimately undermining the perception of unassailable moats built on high switching costs in the industry.
FAIL (and increasingly so)
Economies of scale
Competitive advantage can also be built up by scale, which leads to a lower unit cost of production than rivals. Scale in technology is possible in some areas (e.g., semiconductor manufacturing), but in others must contend with the weight of money invested in technology by upstarts. Just in the last ten years, $1.3 Tn has been invested in OECD countries in technology venture capital. In the same period in the US nearly 800,000 new companies were formed using “Information”, i.e. tech, as their line of business3. A lot of these new ventures, emboldened by the success of Amazon, go for a huge scale strategy creating a very unstable environment. This scale and speed of disruption is not seen in other more traditional sectors of the economy.
One interesting feature of this venture boom is that seemingly disparate technologies and disruptions, from Uber to ecommerce to grocery delivery, are converging on a single market: advertising dollars. This is because serving up cabs (Uber, Lyft) or instant grocery deliveries (Instacart) tend to be rather unprofitable business models with a low or negative gross margins4. Advertising in contrast tends to have very high gross margins, and as these companies mature and more users come onto their platforms, they shift to monetizing users via advertising. Amazon has shown the way here and now makes far more money from advertising than it does from e-commerce.
Of course, if everyone converges to compete for the same dollars, competition increases and reduces the ability to reach “scale”.
Monopoly Criteria: Economies of scale
While some technology areas can benefit from scale, where producing more becomes cheaper, this advantage is being challenged by the huge wave of tech investment a new ventures. These ventures, after building user bases and maturing, are converging on the advertising market,is making it harder for any one company to become extremely large and dominant.
Some monopolies exist by explicit regulation. A natural question to ask of the tech sector is: if it is so competitive, why does the sector dominate headlines related to anti-trust action? Indeed, there has been a concerted effort by authorities in the US (especially the Federal Trade Commission under new chairman Lina Khan5) and Europe to investigate large tech firms for potentially abusive behavior in existing business lines and mergers.
Interestingly, a lot of these efforts, at least when it comes to merger control, have recently not succeeded in court, whether it is VR fitness (Meta acquiring Within) or cloud gaming (Microsoft acquiring Activision). The problem is that competition regulation is backward-looking, often acting when it is too late. It also does not move as fast as tech changes and is ultimately left arguing about a highly uncertain future state of competition in markets. The courts, especially as companies concede remedies, have so far shut down these arguments.
"[T]here are no internal documents, emails, or chats contradicting Microsoft’s stated intent not to make Call of Duty exclusive to Xbox consoles,"
"Despite the completion of extensive discovery in the FTC administrative proceeding, including production of nearly 1 million documents and 30 depositions, the FTC has not identified a single document which contradicts Microsoft’s publicly-stated commitment to make Call of Duty available on PlayStation (and Nintendo Switch)."
Extracts from the Microsoft v FTC trial ruling
These decisions suggest that despite the “competition is for losers” (Peter Theil6) mentality popularized in the tech scene, certain tech sub-segments, like gaming and media, are fiercely competitive. In fact, Bain & Company7 found most tech M&A doesn’t hamper competition at all.
“When the facts are reviewed, most big tech M&A spending actually benefits consumers and doesn’t hamper competition.”
Bain analysis, 2021
Monopoly Criteria: Regulation
Despite seemingly widespread concerns about monopolistic practices in the tech space, the regulatory attempts, especially related to mergers, have frequently failed in court due to their retrospective nature, sluggish pace in response to fast-paced tech changes, and difficulties in proving future competition concerns. This indicates that while there is significant anti-trust action, it rarely results in successful outcomes.
Non-replicable physical assets
It would be excusable for the reader to dismiss this source of competitive advantage outright given the “intangible” nature of most technology. Yet it is exactly in having a “physical” advantage, where we think it is possible to find technology monopolies.
- For example, tax preparation and small business software is a competitive segment. However, because of regulation and tax rules, one or two firms typically dominate a particular geography as they offer the necessary support. This support involves years of training and large call centers to be offered at scale.
- Semiconductor equipment is another area where monopolies endure, most notably ASML which has 100% market share in next generation lithography (EUV) machines. There are many reasons why this is the case, such as consolidation of the main players, the leading edge of technology requiring huge R&D budgets, the brutal cyclicality leading to few survivors, and lack of instant reward meaning very little venture money goes into semiconductor design. The web of these factors suggests durable monopolies.
Monopoly Criteria: Non-Replicable Physical Assets
Although technology is often considered intangible, there are instances where having a physical advantage, such as specialized tax support services or semiconductor equipment manufacturing, can lead to enduring monopolies due to factors like regulatory requirements, training investments, and consolidation among main players, contributing to the presence of non-replicable physical assets.
While competitive advantage and resulting monopolies typically stem from five distinct sources, at least four of these sources do not convincingly apply to the technology sector, casting doubt on the prevalence of enduring monopolies in this industry. The network effect is counteracted by rapid disruptions, high switching costs face constant technological changes, economies of scale are challenged by a dynamic venture landscape, and regulatory efforts struggle to keep up with technological advancements. However, the presence of non-replicable physical assets, such as specialized services and unique manufacturing capabilities, does offer a viable avenue for establishing enduring monopolies in technology. This single criterion can indeed allow exceptions in the space to be seen as true monopolies, but in general, the technology sector is not an area where one should primarily seek to capture significant investment returns from traditional monopoly advantages.
2https://www.cato.org/publications/policy-analysis/time-different-schumpeter-tech-giants-monopoly-fatalism#great-atlantic-pacific-tea-company-ap – an excellent study of all of these examples and more.
4Some have argued Uber will never make any money - https://americanaffairsjournal.org/2019/05/ubers-path-of-destruction/
5Lina Khan actually penned several academic papers on Amazon’s dominance.
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