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Wed, 28 April 2004
The economics of Google
John Quiggin at Crooked Timber suggests that today's equity markets don't understand a few key issues:
- The search engine business has low barriers to entry (as various little start-ups including Mooter are demonstrating).
- When you value something at over 100 times its earnings, you need a pretty fancy story about revenue growth - even if it's an Internet stock.
- That something is useful does not make it profitable. Private investors sometimes can't capture all the economic rents. This happens a lot on the Internet, and it happens for a reason.
Quiggin is a professor of economics and an eloquent voice in Australian public policy debates, and his post is worth quoting in full. I hope he won't mind.
According to this report, the widely-predicted Google IPO is likely to value the equity in Google at more than $20 billion - others suggest $25 billion. I immediately wondered whether Google was really worth $25 billion.
I started on a standard financial analysis. Although, as a private company, Google doesn't have to publish annual reports, it's been estimated that Google has annual revenues of $500 million and profits of $125 million so that the return on equity is about 0.5 per cent. We can expect that to grow reasonably fast in the next few years, but the scope for expansion in Google's core business is far from limitless. Most people in the developed world are already online and most of the heavy users already use Google (Eszter might have more to say on this). Moreover,there's no strong reason to suppose that Google will be around in, say, 20 years time. I find it hard to draw a plausible earnings path that would yield a present value of $25 billion at any reasonable discount rate.
That's a problem for the investors, though. The Google example started me thinking about the more general problem of economic valuation in the Internet era. I started by looking at this piece by Simson Garfinkelhat tip - Tyler Cowen. As well as reporting potential competition from Akamai (relevant in considering Google's longevity), Garfinkel estimates that Google operates a network of 100 000 servers, but that clever design allows the use of very cheap computers as servers. Let's and suppose an average of $500 a piece. This implies that the main piece of capital equipment operated by Google is worth around $50 million1 - a hefty sum, but a tiny fraction of the estimated equity value (and presumably there's some debt in there as well) .
Next, it's of interest to look at capital-labour ratios. Google apparently has about 1000 employees, which would suggest a total labour cost of the order of $100 million per year - a little on the low side as a proportion of revenues of $500 million, but not implausible. On the other hand, the number of employees is minuscule in relation to the valuation above, which implies a capital stock of $25 million per worker. I feel sure that this kind of ratio would imply some pretty strange organizational policies.
Then there's the question of how much Google is worth in economic terms. I would think the correct answer must be lot more than the present value of its revenues. I use Google all the time, but unless text ads have a subliminal effect for which Google is being paid, I've never contributed a penny to its revenues, and quite possibly never will.
The general problem is that, in an economy dominated by public goods, like that of the Internet, there's no reason to expect any relationship between economic value and capacity to raise revenue. Things of immense social value (this blog, for example!) are given away because there's no point doing anything else. On the other hand significant profits can be made by those who can find a suitable choke point, even if they haven't actually contributed anything of value. Assuming for the moment that SCO prevails in its attempts to extract revenue from Linux users, it won't be because SCO's code was better than some free alternative but simply because it was widely distributed before anyone found out it was copyrighted.
If the Internet continues to grow in economic importance, the central role of public goods in its formation will pose big problems for capitalism, though not necessarily to the benefit of traditional forms of socialism.
Quiggin is a critic of several strands of the neo-classical synthesis which has dominated economics since the 1980s, but I think even he underestimates the extent to which Google economics is already taking hold.
Back in the late 1980s and early 1990s, an economist called Paul Romer started modelling a world in which technological change caused some traditional rules to stop working. He was inspired by what was happening in places like the software market, where Microsoft was moving towards dominance. His work pointed out that traditional economics worked well in a world where goods were excludable (sellers could keep their stuff from buyers) and rivalrous (if you had it, I couldn't have it) and where economies of scale and scope were weak (as you sold more stuff, you didn't get disproportionately more for them, or for other things you made).
Change those rules somehow - say, by changing the way technology works - and you change economics. And as it happens, software and information tend to be non-excludable, non-rivalrous and open to economies of scale and scope.
Economists Brad DeLong and Michael Froomkin set this out nicely in a paper called Speculative Microeconomics for Tomorrow's Economy, available - of course - on the Web.
Back in 1990, as a journalist writing about Australian politics and economics, I used to walk out of my office on the second floor of Canberra's Parliament House, around the corner, and into the Parliamentary Library, where I could read this stuff to my heart's content. I loved it because it took economics beyond the debate over rules for preventing the next recession - not a bad debate, but a narrow one that was producing diminishing returns. Dozens of other economists began piling into the field (formally called "endogenous growth theory"). You could see it would soon start to affect the way people thought about public policy. And so it did. Its first effect was to make people worried that Microsoft was unstoppable, that technological change was creating a "winner-take-all" economy.
But the point that Quiggin is making is that you can equally create "winner-take-none" scenarios, where useful work creates less private profit than traditional economics would suggest it should.
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