The Semantic Economy

We’ve recently seen Facebook go public with a $100 billion valuation and General Motors, formerly the world’s biggest company, go effectively bankrupt and need to be bailed out by the US government.

Meanwhile, the new web darlings, Instagram and Pinterest, have built communities of millions of people in a matter of months, not years and they have done it with a staff that can fit in my living room (which, I might add, is not that big).

What’s amazing is that we have come to take things like these in stride.  Such events have become not exactly the rule, but not the exception either.  In short, we have witnessed the complete transformation of business as we knew it.  The scale economy has become the semantic economy, where value chains have been subsumed by value networks.

The Nature of the Firm

To understand how things have changed, we first need to understand how corporations produced value in the past.  As I noted in an earlier post about creating value there is no better place to start than Ronald Coase and his 1937 paper, The Nature of the Firm.

Coase argues that firms’ advantage lies in minimizing information and transaction costs. Increases in scale can improve access to information, allow for a better negotiating position with suppliers and customers and make possible investment in proprietary processes and technology which raise efficiency and quality.

On the other hand, he also noted that with increased scale comes increased organizational costs.  As I explained in another post about the dangers of growth, those costs are very real can overwhelm promising young companies.

Successful companies then, must realize value in the reduction of informational and transactional costs that exceeds increased organizational costs and still earn profits in excess of their cost of capital.  That’s a tall order and, until now the gold standard of achieving such a lofty goal was the work of Harvard’s Michael Porter.

The Rise and Fall of Porter

In 1985, Porter published Competitive Advantage, which quickly became the standard reference for business strategy.  At the heart of his framework was the value chain:
 

 
Porter argued that in order to attain competitive advantage, you need to look at the entire value chain. In Coasean terms, transaction and informational costs exist all along the path from raw material extraction to the point of sale and therefore companies must build competencies throughout the value chain, as Wal-Mart did with logistics.

Intrinsic to the value chain framework is a scale advantage.  Bigger companies can invest in building multiple competencies along the value chain and in doing so capture value that exceeds increased organizational cost.  It’s no wonder that Porter’s ideas have set the standard for strategy for over a generation.

However, as Nilofer Merchant argues in a thought provoking HBR post, that’s changing. Today, businesses revolve around the consumer.  In her view, conditions have changed and the advantage goes to the lean and nimble.  In the social era, organizational costs are more likely to exceed informational and transaction costs.

I think she’s on to something, but not because of the “social era.”  Rather, because of a important technological change in the way information flows.

The Semantic Web

In 1999, Tim Berners-Lee published his memoir, Weaving the Web, which chronicled the creation of the most consequential innovation of our time (and is a must read for anyone interested in the digital space).  In it, he also spelled out his vision for a new semantic web. The idea was as simple as it was ingenious.

The first web broke down barriers to people communicating with each other.  Through a system of links and markup tags, any document could be rendered universal.  No matter what machine it was created on, anyone could view it.  The problem was that data in machines was still sequestered.  Once you entered it in a database, it was stuck there.

His solution was to create a new system of data markups (called RDF) and online libraries called ontologies that would allow machines to communicate seamlessly.  More than a decade later, his vision is finally taking shape.  To get an idea of what it looks like, check out this schematic of how ads are delivered online today (click to enlarge).
 

 
The details are hard to see at this scale, but even expanded it’s difficult to decipher. Nevertheless, in the millisecond that it takes for an ad to appear on a web page, it traverses this maze of companies.  Some of them, like ad giants WPP and Publicis on the left and Google, Facebook and Yahoo on the right are large enterprises, but most are not.

When innovation moves that efficiently, the Coase/Porter world of capturing value through minimizing information/transaction costs appears far less tenable.  In fact, it looks like the new key to competitive advantage is creating valuable new information that can be leveraged across the whole ecosystem.

What’s more, some version of the Rube Goldberg like chart above is being created in every sector of the economy.  A new semantic infrastructure is being created and, much like the railroads or the intestate highway system that came before it, it’s changing business as we know it. Value chains are giving way to value networks.

(For more on value networks, check out Verna Allee)

Elements of The New Semantic Economy

The semantic economy is still evolving.  The technology and those with the expertise to use it effectively are still too new to be well understood.  The full ramifications are still years, if not decades off.  Nevertheless, some of the major elements are already taking shape:

Big Data: Vast, abundant storage, powerful processors and clever algorithmic techniques are combining with the semantic web to create analytical engines of almost unimaginable power.  They being deployed in areas as diverse as bioinformatics to marketing models.

Sometimes, though, they backfire, as Target found out when an angry father called to complain when their model detected that his teenage daughter was pregnant and started sending her coupons for baby clothes and cribs.  It turned out that she was indeed, as the embarrassed man soon found out.

The Web of Things:  One of the hottest things at CES 2012 was smart homes, a vision where everything in your home can be controlled through your smart phone.  Ford Sync allows you to connect everything to your car’s entertainment system on an open standard that developers can add to.

There will be lots more to come as well.  IBM recently launched MQTT, a protocol specifically designed for machine to machine communication.

Co-Creation: Many companies, like LEGO and Nike are finding the best way to design products is in partnership with customers.  Co-Creation is becoming hot in venture capital circles as well, as this article in VentureBeat explains.

In coming years, we can expect the pace of change to accelerate.  With new technologies like 3D printing and programmable matter, design is increasingly becoming the product itself and that design will be created through a complex network of entities.

The semantic economy means that competitive advantage will be conferred not on those who best reduce informational costs, but those who create new informational value for the entire network.

So while Porter is not exactly dead, he has been outsourced.

– Greg