Value Creation vs. Value Capture: Musings on the New Economy

It's easy to see that we live in a natural world that was given to us "for free" and how much of the value we enjoy as a society was not created but extracted from that feedstock of abundance. But it is important to realize that even in the world of discovery and intellectual innovation, there are those who create value, and those who merely extract it.

Consider this: when John von Neumann and his team at the Institute for Advanced Studies at Princeton developed the fundamental architectural approach of modern computing, they put their work into the public domain. When Paul Baran developed the fundamental concepts of packet networking that underlie the internet, he did the same thing. So too did Vint Cerf and Bob Kahn with the TCP/IP protocol, and Tim Berners-Lee with HTTP and HTML, the technologies that underly the World Wide Web.

These pioneers created enormous value, yet they didn't capture very much of it for themselves. That was left for others who built on what they gave to the world for free.

On the other side of the ledger, consider the Wall Street mavens who created new instruments to suck value out of the financial system while damaging the economy as a whole, culminating in the 2008 financial crisis that the world is so painfully digging itself out of today.

Consider the patent trolls who invent nothing, but file patents in legal language so broad that they constitute a drift net in which real inventors who later come up with actual new inventions successfully put into practice can conveniently be caught and shaken down.

Or consider the whole world of what Umair Haque calls "thin value" - the bait and switch techniques of airlines who lock in customers through frequent flyer programs that fail to provide the benefits they promise, the phone companies that require you to extend your servitude every time you upgrade to a new phone, or the packaged food companies that tout "new and improved" products every time they replace a natural ingredient with cheaper substitutes.

These examples should be enough to convince you that value creation and value capture  are not the same thing. An individual or a company can create enormous value for society but not capture very much of it; an individual or a company can capture a great deal of value without creating very much, or even while destroying economic value.  Ideally, those who create value are rewarded for doing so, but it is often the case that those who merely extract value do better financially.

Why does this matter? It seems to me that as economists and government policy makers think about innovation, they are trying to foster the wrong thing. Innovation often begins with people who have no thought of value capture, who have no idea that what they create will become valuable. Incentives that reward entrepreneurs, for instance, miss the fact that many of the great innovations of modern technology began with people just having fun! Companies begin at a later stage in the economic process. 

And of course, as a result of crony capitalism, companies that are adept at value extraction without value creation foster policies that support their extractive businesses. The result may be an increase in measured GDP, but not in the true health of the economy or the wealth of society.

We need to begin studying the economics of value creation, not just the economics of value capture.

In a recent series of talks, I've invoked an article written nearly forty years ago by alternative energy activist Steve Baer entitled "The Clothesline Paradox." Baer noted that when you put your clothes in the dryer, the energy you use is measured and counted, but when you hang them on the clothesline, the energy you save simply "disappears" from the economy. Of course, it doesn't disappear, but shows up in money that was saved and thus spent elsewhere.

We recently wrote an O'Reilly Radar report about the Clothesline Paradox with regard to open source software and the web hosting industry. Web hosting is a simple subscription model for access to free and open source software like Linux, Apache, MySQL, PHP, Wordpress, and the domain name system. The value created by these open source projects was captured in the economy not just by hosting companies like Bluehost, our partner in the study, but also by internet service providers ranging from Comcast to local companies like Sonic.net, our internet provider at O'Reilly. But more importantly, the value was captured by every business for whom having a website is now an important way to reach customers and grow their revenue and profitability.

You can imagine how a policy that encouraged the growth of ISPs might have had economic benefits. But how much more benefit would be policies that encouraged the development of more open source software? Favoring a particular industry is a recipe for economic distortion. But policies that favor precursors to economic activity - value creation without value capture - don't pick winners. They enrich the soil in which anything can grow!

Open source software didn't just give root to companies that explicitly monetize it, as Red Hat did Linux, but to whole new industries.  Internet Service Providers, web design firms, ad agencies, giant new companies like Google, Amazon, and Facebook, all flourished in the rich soil of open source software. Even proprietary companies like Apple took in open source software and used it as the basis for a new generation of products.

Government can encourage open source software by using more of it, by releasing more of the software it develops itself as open source, and by promoting related policies, like open access to data produced by government research. 

Investing in value creation rather than value capture is a kind of long term thinking.  There was a great piece about Mark Zuckerberg in New York Magazine that talked about long term thinking. 

"When talking about Zuckerberg’s most valuable personality trait, a colleague jokingly invokes the famous Stanford marshmallow tests, in which researchers found a correlation between a young child’s ability to delay gratification—devour one treat right away, or wait and be rewarded with two—with high achievement later in life….

"Most Wall Street investors would perform miserably on the marshmallow test. Over the past couple of decades, as the money-management business has gotten ever more competitive, they have elevated the narrowly defined concept called 'shareholder value' to an absurdly exalted status. Shareholder value, in the minds of most investors, is synonymous with 'today’s stock price.' If today’s stock price is higher than yesterday’s stock price, a company’s management is said to have 'created' share­holder value. If today’s stock price is lower, management 'destroyed' it. It doesn’t matter that the decisions and priorities that boost stocks in the short term—such as inflating this year’s earnings by firing people or cutting product-development spending—are often at odds with decisions and priorities that create greater value over the long haul."

The epitome of that kind of over-financialized short-term thinking, the phenomenon that drove the 2008 financial crisis, was predicted by economists George Akerlof and Paul Romer in their 1996 paper Looting:

"…the normal economics of maximizing economic value is replaced by the topsy-turvy economics of maximizing current extractable value, which tends to drive the firm's economic net worth deeply negative. Once owners have decided they can extract more from a firm by maximizing their present take, any action that allows them to extract more currently will be attractive--even if it causes a large reduction in the true economic net worth of the firm.  A dollar in increased dividends today is worth a dollar to owners, but a dollar in increased future earnings is worth nothing because future payments accrue to the creditors who will be left holding the bag."

It's easy to point a finger at Wall Street when condemning this kind of short term thinking, but it seems to me that every startup whose business plan begins with getting venture capital and ends up with an exit is playing the same game. A company that truly wants to create value rather than just capture it has plans to be around for the long haul. 

Any farmer knows that if you want to keep growing crops year after year, you have to put as much into the soil than you take out, or it becomes depleted.  That's why our business touchstone at O'Reilly is the maxim, "Create more value than you capture."