For some high tech companies, this recession has been the best thing that’s happened to them in a long time.
Recessions do some crazy stuff to product markets. When you have a recession, or in general when there’s a lot less spending going on by your consumers (businesses or people), the available revenue for all firms in the industry decreases. It’s sort of like rainwater collecting in a bowl. When there’s a drought, there’s less rain and less water collecting in your bowl. Consequently, there’s less water in the bowl at any given time, and only companies that are very good at drinking from the lower water levels can survive.
In economics terms, this ability to survive on less communal water has to do with something called cost optimization. Companies will always produce at the quantity where marginal cost (MC, the cost to produce the next level of output) equals marginal revenue (MR, the revenue you get from producing at the next level of output). Profit is the difference between the revenue you get at this intersection (point a) and where the point maps on the average total costs (ATC, all of the costs it takes to produce the good including the startup costs to get the company and operation up and running). This difference – positive being a profit and negative being a loss – is economic. It’s not just money; it takes into account essential things that aren’t easily represented on a balance sheet like how much time it takes to sell and produce a good or what the company could’ve been doing otherwise.
In this graph the company is operating at an economic loss: the amount of revenue they get for producing at output level q* is less than their ATC for producing at q* (see point b).
Now a firm can continue to live while producing at an economic loss point. Neither Google nor Facebook was profitable for a long time, and many of the big names aren’t making positive profits compared to last year. Maybe this company is a new tech startup and are still operating “in the red”, or maybe there’s a recession going on and the water isn’t as high as it used to be (the water being the little blue bar – the demand for the product and also the marginal revenue in a market where every product is the same, there’s lots of folks producing stuff, and it’s easy to get in and get out of the market). Producing at this level of economic loss isn’t that bad if you know you can get back to a break-even level or even make positive profits in the future.
But if you make less than the average variable cost (AVC, the average cost it takes to actually make each good and not just what it took to get the whole operation running) you’re in trouble. Then you’re losing money/capital/hopes and dreams/whatever it takes to power the creation of you’re product on every sale. Death comes quicker here: you can survive for a little bit on when you’re bleeding from a pinprick, but at this point blood is simply gushing out of your company. Life does not look good for your company here, sport. Soon your operation will perish into the economic oblivion known as shut down.
This is where things get interesting – and profitable. If for some reason your marginal costs are lower to factor for the water drying up, or you’ve got a ton of money saved up, you can sweep up those firms that are shutting down with your extra cash and buy their tasty trade secrets and technology. In tech companies this is basically all of the secret sauce that makes everything so cool: intellectual property, the brilliant engineers that made that IP, the secret machines and tools used to build shiny things. Just because a firm is suffering huge economic losses or even is about to shut down doesn’t mean their technology isn’t valuable. Recessions are horrible for the unprepared, small companies that don’t have money in the bank to deal with them. But they’re awesome for the big guys that have billions stashed up and are ready to go on an acquisition spree. It’s a freaking fire sale in high tech, and everyone’s invited.
We’ve all seen this in the real world. Oracle acquired Sun, once one of the great software titans in the world but recently struggling with marketing and selling their products and servers in this recessionary market. With their “pennies on the dollar” purchase of Sun (a result of their stock being abysmally low compared to the early 2000′s) Oracle picked up a huge commanding share over the database market and the hardware IP to start taking over the data center. HP’s acquisition of 3Par worked the same way: take the struggling company, buy them up when they’re dirt cheap, and get some sweet technology and engineers to make better products that advance your market position down the road.
Now this usually isn’t a bad thing in economics. Sooner or later, as these big firms compete heavily and start to all “look alike” in their products, commoditization will occur and small guys can come in and start to get things more competitive. This is essential to innovation, the lifeblood of high tech. Competition breeds great technology and lower prices because companies have to work harder in delivering better products – lest they die. Without such a competitive market and pressures from Apple and Linux, it’s unlikely that Windows 7 would have been much better than Windows Vista. In a competitive market, Adam Smith’s “invisible hand” will make everything right once again and we’ll be back to low prices and high competition as usual.
Except that’s not how high tech works. High tech software (particularly web software) is generally competitive. But computer hardware, networking, and software industries protected by government exclusivity/top secret clearance requirements, are expensive to start a company in, or otherwise are extensively guarded by licenses and patents are not so competitive.
Many of these industries are oligopolies – places where there’s only a few guys around the block. You see this a lot in commercial operating systems: you buy Windows, OSX, or “purchase” Linux (i.e.: paying the cost in crying over trying to fix it at 2AM in the morning when you rm -r‘d your home directory). You also see this a ton in places like processors. 99.9% of every computer you’d see at Best Buy is powered by either an Intel or AMD processor. The processor industry is actually frighteningly mired in patents, licensing, and high startup costs. It’s not very competitive because two kids in a garage can’t come in and dethrone Intel or AMD, unlike the market for mobile games or web services.
The recession’s effect on narrowing the market in key industries like computer hardware and networking may have very serious consequences for our ability to innovate in those fields. Without competition, companies will have less incentive to release better products and engage in daring feats of research to push the boundary. This isn’t good, because right now the laws of physics are catching up to us in these fields. Things like Moore’s Law – that predicted that effectively the processing power of a computer chip will double every 18 months – are starting not to apply anymore because it’s getting too difficult to make chips smaller and faster. Without incentives and an environment that’s easy to innovate in, we may see technology in these fields stagnate.
Have no doubts: stagnation is the death knell for any tech industry. High tech is a business formed on pushing boundaries. If you can’t move forward, you die.
