Tag Archives: supply and demand

Notes – The Art Of Profitability: Switchboard Profit (#profitability, #business, @CreditBubbleStocks)

(A multi-part co-blog series with CreditBubbleStocks.com about the book The Art of Profitability, by Adrian Slywotzky)

Chapter 4, Switchboard Profit

The Switchboard Profit model combines three essential elements to generate outstanding profit:

  1. Packaging; the provision of necessary component resources for a task in one place/package that can be hired together instead of separately
  2. Monopolization; control of a critical resource that all users need to hire
  3. Market share; control of a critical mass of the total market (approximately 15-20% minimum in practice) which gives the perception of dominance and incentivizes economic actors to utilize the switchboard firm, thereby creating a multiplicative network effect that enhances the value of the switchboard with every additional increase in market share

Those are the essential ingredients. The way they work together to create outstanding profit opportunities is like so: limiting competition and reducing transaction costs. Those are the primary principles at work. By putting together various resources which would normally be hired separately (and thus, would be exchanged each in their own competitive markets), the Switchboard Profit model brings these resources under one roof where they can be hired together (packaging), where they can be hired no place else (monopolization) and where other similar resources, typically skilled labor, are thus attracted to because they see the probability of being hired at advantageous rates themselves to be much higher by participating in the network effect of the Switchboard Profit model firm (market share).

The result is a constrained supply which can negotiate for a higher total hire price. It is valuable for those hiring the products of the Switchboard Profit model firm to pay this higher price because they save on search costs and they also face the alternative option of hiring lower quality substitutes. The more that the resources in question come under the control of the Switchboard Profit model firm, the greater profit the firm can generate from being the central hub for hiring the resource out.

One company that sounds like a Switchboard Profit model on its face is Amazon, a logistics giant that aggregates numerous consumer goods in one place. This satisfies the packaging criteria, and it almost satisfies the market share criteria as suppliers of goods want to participate in Amazon’s marketplace because it can increase their market exposure and thus the chance that the product will be purchased. But Amazon does not maintain anything close to a monopoly on these goods because they’re widely available “commodities” rather than unique or limited supply products carried only by Amazon.

The example given in the book was the Hollywood talent agency of Michael Ovitz. Ovitz combined top star power with “total production resources” (writers, actors, directors, etc., all in one place) and he commanded a large share of the market such that additional writers, actors, directors, etc., had a strong incentive to join his firm and thus increase his profitability as his market share grew. An obvious additional example would be any other large, dominant talent agency such as for sports stars, musicians or other celebrities who each represent unique products that can be easily “controlled” and “constrained” by one firm.

The network effect seems to be a key aspect to the profitability of the Switchboard Profit model. Google’s dominance in search means it is largely the central hub by which people conduct their internet searches, meaning a person buying ad space in the Google network is getting a better package deal than other search network ad buyers.

A television network might also qualify as a Switchboard Profit model: if you have the best shows on TV and a large market share with all the kinds of shows in one place that people might want to watch, advertisers will be more attracted to you and so will TV show producers and so, too, will TV viewers. And the more people who utilize your TV network, the more valuable it is to everyone involved.

Other examples might include a health insurance network which includes top medical professionals under the insurance plan; a legal association with the best legal minds in a market in one place; or even a top university or research institution known to have the brightest minds.

Something interesting about the Switchboard Profit model is that most of these businesses seem to revolve around human resources, rather than non-human resources (commodities which are common or rare alike).

The Best Interview On Gold, The Gold Market And Investment Implications I’ve Ever Read (#gold, #economics)

In “What is the key for the price formation of gold?” at GoldSwitzerland.com, SF-based software developer Robert Blumen covers a lot of fascinating and, to my eyes, original ground in an interview with the site’s host.

This has got to be the best interview on the subject of gold in general, the functioning of the gold market and the implications for investors that I’ve ever come across. Blumen not only covers these specific subjects related to gold, but also discusses the Chinese economy, the US economy and the state of monetary and fiscal affairs and even the attitudes of value investors, demonstrating thoughtful familiarity with all he touches. Blumen is well-versed in Austrian economic philosophy and applies this theory to the various practical considerations resulting in surprising new perspectives on common themes.

It’s a long interview and it will only fully reward those determined to dive all the way in. Here’s an excerpt:

There are two different kinds of commodities and we need to understand the price formation process differently for each one. The first one I’m going to call, a consumption commodity and the other type I’m going to call an asset.

A consumption commodity is something that in order to derive the economic value from it, it must be destroyed. This is a case not only for industrial commodities, but also for consumer products. Wheat and cattle, you eat; coal, you burn; and so on. Metals are not destroyed but they’re buried or chemically bonded with other elements making it more difficult to bring them back to the market. Once you turn copper into a pipe and you incorporate it hull of a ship, it’s very costly to bring it back to the market.

People produce these things in order to consume them. For consumption goods, stockpiles are not large. There are, I know, some stockpiles copper and oil, but measured in terms of consumption rates, they consist of days, weeks or a few months.

Now for one moment I ask you to forget about the stockpiles. Then, the only supply that could come to the market would be recent production. And that would be sold to buyers who want to destroy it. Without stockpiles, supply is exactly production and demand is exactly consumption. Under those conditions, the market price regulates the flow of production into consumption.

Now, let’s add the stockpiles back to the picture. With stockpiles, it is possible for consumption to exceed production, for a short time, by drawing down stock piles. Due to the small size of the stocks, this situation is necessarily temporary because stocks will be depleted, or, before that happens, people will see that the stocks are being drawn down and would start to bid the price back up to bring consumption back in line with production.

Now let’s look at assets. An asset is a good that people buy it in order to hold on to it. The value from an asset comes from holding it, not from destroying it. The simplest asset market is one in which there is a fixed quantity that never changes. But it can still be an asset even when there is some production and some consumption. They key to differentiating between consumption and asset is to look at the stock to production ratio. If stocks are quite large in relation to production, then that shows that most of the supply is held. If stocks are small, then supply is consumed.

Let me give you some examples: corporate shares, land, real property. Gold is primarily an asset. It is true that a small amount of gold is produced and a very small amount of gold is destroyed in industrial uses. But the stock to annual production ratio is in the 50 to 100:1 range. Nearly all the gold in the world that has ever been produced since the beginning of time is held in some form.

Even in the case of jewelry, which people purchase for ornamental reasons, gold is still held. It could come back to the market. Every year people sell jewelry off and it gets melted and turned into a different piece of jewelry or coins or bars, depending on where the demand is. James Turk has also pointed out that a lot of what is called jewelry is an investment because in some parts of the world there’s a cultural preference for people to hold savings in coins or bars but in other areas by custom people prefer to hold their portable wealth as bracelets or necklaces. Investment grade jewelry differs from ornamental jewelry in that it has a very small artistic value-added on top of the bullion value of the item.

So, now that I’ve laid out this background, the price of a good in a consumption market goes where it needs to go in order to bring consumption in line with production. In an asset market, consumption and production do not constrain the price. The bidding process is about who has the greatest economic motivation to hold each unit of the good. The pricing process is primarily an auction over the existing stocks of the asset. Whoever values the asset the most will end up owning it, and those who value it less will own something else instead. And that, in in my view, is the way to understand gold price formation.

Many of the people who follow and write about this market look at it as if it were a consumption market and they look at mine supply and industrial fabrication as the drivers of the price as if it were tin, or coal, or wheat. People who look at gold as if it were a consumption market are looking at it the wrong way. But now you can see where the error comes from. In many financial firms gold is in the commodities department, so a commodities analyst gets assigned to write the gold report. If the same guy wrote the report about tin and copper, he might think that gold is just the same as tin and copper. And he starts by looking at mine supply and industrial off-take.

I wonder if more equity analysts or bond analysts were active in the gold area, if they would be more likely to look at it the same way they look at those assets.