The unscaling myth

The unscaling myth

Izabella Kaminska | Mar 27 15:05 | Comment Share

Part of the GROSS DOMESTIC COLLABORATION SERIES

Unscaling is made possible by the number of Internet-based platforms and cloud-based services and tools now available to startups and small businesses in general. New companies can now be launched without a massive investment in personnel and IT infrastructure. They can quickly get to market, and compete effectively with far larger companies. Mobile Internet platforms, in particular, make it easier and cheaper to experiment in the marketplace. While most such experiments will likely fail, some, like Airbnb, will succeed and can then quickly scale up their capabilities as their businesses grow.

That’s from the blog of former IBMer Irving Wladawsky-Berge, who is riffing on the back of a Newsweek piece by Kevin Maney on the “end of mass production”.

The basic premise is that information technology is enabling the niche and the unique to find a market like never before, and as a result the end of mass production is nigh.

Airbnb is used as a key example of the “unscaling” or “decentralized production” process. The piece argues that the only reason impersonal hotel chains grew to prominence in the first place was because there was a lack of information in the marketplace about smaller, more personal offerings.

As Maney writes:

In the middle of last century, cars and highways made the world far more mobile. Many more people traveled to towns they didn’t know, and they needed places to sleep. They had no way to know which hotel or boarding house might be nice or offer amenities they wanted. Travel guides, like Mobil’s, popped up in the 1950s, but for the most part information remained scarce. Chains took advantage of that data deficit. If you knew a Holiday Inn in one town, you knew the Holiday Inn in the next town would be roughly the same. The brand’s motto played off this: “The best surprise is no surprise.” The uniformity and comfort of a chain trumped the risk of an unknown, independent place.

Much of this reasoning neglects a key issue.

It’s not so much that internet platforms are revolutionising the production process. It’s that the scaled up production process has oversaturated the world with perfectly reasonable but impersonal services, and in many cases supply has simply outpaced demand.

It’s unlikely that, say, the Ritz and the Dorchester will be worried about Airbnb displacing their markets any time soon, as there’s a reason why high-end personalised offerings such as boutique hotels usually come at a premium. They’re costly to provide.

Furthermore, it stands to reason that in an abundant world the key way to draw revenue is by offering more-creative personalised services, for which you need information about people’s likes and dislikes.

There is a fundamental paradox with unscaling as a result. In unlocking capacity which was previously unavailable — because the cost advantage associated with scaled up industry made it noncompetitive — information technology ends up flooding the system with even more supply.

So yes, a platform like Airbnb can attract untold inventory into the system — much of it more bespoke and personal in nature — but its ability to do so on a consistent basis is questionable.

For now, someone with a spare room is only incentivised to rent it because the revenue they receive makes it worth their while. To capture that revenue, however, they need to offer prices which compete both with professional impersonal services and the high-end personal ones.

True, their prices only need to beat the overall break-even rates offered by scaled up industry by a tiny margin to attract customer flow. But as more and more unscaled supply hits the market that margin will suffer. Add regulatory, tax and general compliance costs and that margin will suffer even further.

As soon as the margin doesn’t cover the burden of hosting guests, unlike professional suppliers, Airbnb suppliers have little reason to stick around.

You’d think that would keep the rents at a constant market clearing rate. But in reality all it will do is force operators who wish to depend on Airbnb income to invest in added value services, so as to avoid being driven out of the market when competition gets too tough.

The irony is as soon as operators begin to invest capital — whether that’s investing in dedicated cleaning staff, food or better rooms — they end up replicating the existing professional system because they end up with fixed costs of their own.

Which is why calling it unscaling or decentralised production is a misrepresentation. What’s really going on is much more akin to swing producing in the commodity sense — i.e. a process by which the market can tap free spare capacity if and when professional capacity, whose spare inventory has fixed costs attached to it, falls short.

The same mechanics apply to commodity producers who keep spare capacity on hand to deal with unexpected supply disruptions, but who also know that when the excess supply is no longer needed it should be withdrawn from market or risk crashing the entire market outright.

Which brings us to Maney’s information point, which we think gets the causation wrong.

It’s not that a lack of information about small operators created a preference for impersonal big brands with known values but, rather, that a lack of dependable capacity and hard to predict seasonal demand created a need for spare capacity to be carried cheaply by industry.

On which note, consider the ancient divine right of hospitality, which for generations allowed travellers to depend on a quid pro quo system to guarantee shelter for themselves. The code was very simple. When you travelled in a foreign land you could expect to be taken in by households, fed and watered, on the expectation that if the host was ever to find himself in your home area, you would provide him with a similar service.

Not that it mattered to whom you would eventually return the favour. The code dictated that providing everyone operated on the same basis, the system would clear itself. And it worked, not because everyone could rate each other on an internet platform, but because cheating the system meant upsetting your divine overseer — and because flows were generally matched, meaning spare inventory wasn’t really needed.

But two things eventually destabilised the system, or at least pushed it to the periphery. One was the concentration of travellers in particular locations (usually near trade routes), which over-burdened particular hosts and diminished the chances of them ever being able to redeem what was due to them — which in turn forced them to seek compensation in different ways, and eventually created the incentive for them to carry spare inventory surplus to their own needs. The second was the secularisation of society, which removed the regulatory role played by the divine entity in keeping the system in check.

Professional services consequently became preferable because a) because they catered to traveller needs specifically and didn’t require offsetting arrangements back at home, and b) these services, unlike private hosts, were accountable to a government authority.

Those pitching the unscaling theory, however, would have us believe that replacing the need for either a government authority or a god to regulate the system somehow changes the dynamics of the existing system.

It doesn’t.

All it really does is transfer the cost of carrying spare capacity away from professionals and to amateurs, and in so doing turns hotel rooms increasingly into a commodity which is either in demand or not.

None of which is a bad thing in and of itself. Freed of carrying costly unused inventory, professional operators will focus on offering bespoke personalised services to differentiate themselves. Eventually nothing will be standard.

It’s just that none of this is unscaling or decentralised production. It’s just conventional efficiency.

 

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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