Not enough people are paying attention to this economic trend

The supply and demand diagram, at the time I was in college (which was longer ago than I like to admit), was basically how the global economy worked:

supply and demand diagram

There are two assumptions you can make based on this chart. The first is still more or less true today: as demand for a product goes up, supply increases, and price goes down. If the price gets too high, demand falls. The sweet spot where the two lines intersect is called equilibrium. Equilibrium is magical, because it maximizes value to society. Goods are affordable, plentiful, and profitable. Everyone wins.

The second assumption this chart makes is that the total cost of production increases as supply increases. This is true for the things that dominated the world’s economy for most of the 20th century.

Software doesn’t work like this. Microsoft might spend a lot of money to develop the first unit of a new program, but every unit after that is virtually free to produce. Unlike the goods that powered our economy in the past, software is an intangible asset. And software isn’t the only example: data, insurance, e-books, even movies work in similar ways.

The portion of the world’s economy that doesn’t fit the old model just keeps getting larger. Capitalism Without Capital by Jonathan Haskel and Stian Westlake is about as good an explanation for why this matter. They start by defining intangible assets as “something you can’t touch.” It sounds obvious, but it’s an important distinction because intangible industries work differently than tangible industries. Products you can’t touch have a very different set of dynamics in terms of competition and risk and how you value the companies that make them.

Haskel and Westlake outline four reasons why intangible investment behaves differently:

  1. It’s a sunk cost. If your investment doesn’t pan out, you don’t have physical assets like machinery that you can sell off to recoup some of your money.
  2. It tends to create spillovers that can be taken advantage of by rival companies. Uber’s biggest strength is its network of drivers, but it’s not uncommon to meet an Uber driver who also picks up rides for Lyft.
  3. It’s more scalable than a physical asset. After the initial expense of the first unit, products can be replicated ad infinitum for next to nothing.
  4. It’s more likely to have valuable synergies with other intangible assets. Haskel and Westlake use the iPod as an example: it combined Apple’s MP3 protocol, miniaturized hard disk design, design skills, and licensing agreements with record labels.

The book is eye opening, but it’s not for everyone. Although Haskel and Westlake are good about explaining things, you need some familiarity with economics to follow what they’re saying.

What the book reinforced for me is that lawmakers need to adjust their economic policymaking to reflect these new realities. Measurement isn’t the only area where we’re falling behind—there are a number of big questions about policy that lots of countries should be debating right now.

It took time for the investment world to embrace companies built on intangible assets. In the early days of Microsoft, I felt like I was explaining something completely foreign to people. Our business plan involved a different way of looking at assets than investors were used to. They couldn’t imagine what returns we would generate over the long term.

The idea today that anyone would need to be pitched on why software is a legitimate investment seems unimaginable, but a lot has changed since the 1980s. It’s time the way we think about the economy does, too.s

See you tomorrow