Peter Thiel: Competition is for Losers - How to Build a Monopoly

Peter Theil, the billionaire behind PayPal, Palantir, and Founder’s Fund unveiled profound insights during a compelling lecture delivered at Stanford in October 2014. In the lecture, he makes bold assertions that challenge the conventional narrative of business success contending that the most valuable businesses are not those immersed in relentless competition, but rather those that can establish a monopoly.

Theil asserts that monopolies are the key to building truly successful businesses thereby challenging conventional notions of market dynamics.

“If you're starting a company, you always want to aim for monopoly, and you want to always avoid competition.

Hence, competition is for losers.”

In this article, we delve into his insights and explore his strategies for creating and capturing value in today’s competitive landscape.

Value Creation vs. Value Capture.

Peter Thiel asserts that the value of a business hinges on two critical variables:

X - total value in dollars generated by the business.

Y - the percentage(%) of X that the business captures.

In his own words;

"To create a valuable company, you have to both create something of value and capture some fraction of the value of what you've created."

Creating Value.

Value creation, within the business context, refers to the capacity to offer something that the market perceives as valuable. The pivotal term here is perceived. This could manifest as a product, service, or experience addressing a problem, enhancing lives, or fulfilling a need.

Capturing Value.

Value capture is the ability of a business or individual to translate the value they’ve created into profit.

Creating value and capturing are mutually exclusive, that is it's possible to have a big X and a small Y.

In the social media landscape, we bear witness to so many content creators who create a lot of value but are struggling with capturing some of it.

Hence creating value is not sufficient enough to last a business decades, businesses and individuals need a mechanism to capture a sufficient portion of the value they create to cover costs and invest in future growth.

Examples of how businesses capture value include, selling products, subscriptions, and offering services to clients.

Big Piece of a Small Pie

Theil goes on to give two examples to elucidate the concept of value creation and capture.

Airlines: Small Piece of a Big Pie

The airline industry is an example of perfect competition. Most airlines offer similar services, leading to the competing prices leading to razor-thin margins.

The key takeaway: Even though airlines create value(transporting people and goods), their ability to capture the created value is limited due to the existence of competition.

Google: A Big Piece of a Small Pie

Conversely, Google operates in a very big market with fewer competitors. They offer a unique and valuable personalized search experience that attracts a large user base.

As a consequence, they can capture a significant portion of the value they create through ad revenue.

Key Takeaway:

While the airline industry might appear larger in terms of revenue and global reach, its profit margins tell a different story compared to Google’s search engine. In essence, Theil highlights that size alone does not determine value. Instead, it underscores the significance of effectively capturing the value created, google has a higher market capitalization despite its smaller size in traditional business metrics.

Lies People Tell.

Theil argues that companies are incentivized to create narratives to shape how they are perceived.

The extreme binary view of the world I always articulate is that there are exactly two kinds of businesses in this world.

There are businesses that are perfectly competitive and some businesses are monopolies.

And, there's shockingly little that is in between.

This dichotomy is not understood very well because people are constantly lying about the nature of the businesses they're in.

The above statement highlights the prevalent misconception regarding the nature of businesses, emphasizing the stark contrast between perfectly competitive markets and monopolies.

Non-monopolies;

The Lie - Claims to occupy a small market, unique(e.g., “the only British food restaurant in Palo Alto”). This creates an illusion of less competition.

The Reality - Such niches are too small to make the company profitable long-term. People might be curious initially, but the customer base will remain limited.

Building a narrative around a tiny niche might be used to attract investors but blinds you to the limited market size.

Monopolies

The Lie - Downplay dominance by reframing the narrative. E.g, google with the largest share of the search market rarely calls itself a ‘search company.’

The Reality - It calls itself an “advertising company”(a much larger market);

…or a “tech company” with formidable competitors(apple, Microsoft), thus deflecting attention from search dominance;

By adopting this narrative, monopolies obscure their true power in specific markets. Theil insists that one has to always be aware of the underlying powerful incentives to distort the nature of these markets one way or the other.

Key Takeaway;

Companies, regardless of their market position, are incentivized to use narratives to shape how they are perceived.

Those with a monopoly pretend they are in incredible competition and those in hyper-competition pretend they are different from other players.

Perfect Competition versus Monopoly.

In evaluating business models, Theil provides his perspective on the pros and cons of both monopolistic businesses and the pitfalls of hyper-competitive businesses.

Perfect Competition;

Pros

Easy to model - perfectly competitive markets are straightforward to analyze and understand, they easily facilitate economic analysis and predictions.

Efficient in a static world - In a stable world, such businesses promote efficiency in resource allocation, maximizing societal welfare.

Politically Salable - this concept aligns with the ideals of fairness and open competition, making it palatable and politically acceptable.

Cons

Psychologically unhealthy - intense competition can negatively impact a business as it acts as a distraction from innovation. In addition to this, nobody makes any money because all value is competed away.

Irrelevant in a dynamic world - perfect competitive businesses struggle to survive in a dynamic world with technological advancements and evolving consumer preferences.

Prepmts the question of value - By focusing solely on competition, such businesses overlook the fundamental question of value creation and capture which leads to sub-optimal results.

Monopolies

Pros

The incentive to innovate - by dominating the market, such businesses can innovate and drive progress due to high incentives

Stable, long-term planning - monopolies enjoy a stable market position that allows them to engage in long-term strategic planning and investment.

Symptomatic of creation - oftentimes, monopolies emerge from groundbreaking innovations and disruptive ideas, symbolizing entrepreneurial creation and ingenuity.

Cons

Lower output, higher prices - Monopolies can restrict output and charge higher prices due to their position in the market, potentially leading to consumer welfare losses.

Price discrimination - monopolies can engage in discriminatory pricing thus exploiting market power to extract higher prices from certain consumer segments.

Stifle Innovation - without competitive pressures, monopolies can become complacent, stifling innovation and hindering progress in terms of technology.

Tying - monopolies can force consumers to purchase additional products or services, thereby limiting consumer choice and competition.

How to Build a Monopoly

To create monopolistic business success, Theil advocates a strategic approach involving starting small, dominating that small niche, the expanding concentrically.

Here is the concise breakdown;

Start small.

Don’t chase big markets, there is fierce competition that will eventually be a distraction from innovation. Instead, find a small niche that you can establish authority over. This will allow you the space and time to develop unique value propositions.

Amazon started as an online bookstore(a small market), and it is dominated by offering a wider selection than any existing alternatives.

Dominate - Offer superior value, and learn from your small customer base. Being a leader in a small market provides you credibility and brand recognition thus laying a foundation for future expansion.

Concentrically expand - Gradually expand into related markets, building upon initial success, while avoiding direct competition in a larger, saturated market.

Slowly amazon transitioned into a general e-commerce store for everything and as of this writing, they lead in the cloud computing arena.

Facebook after capturing a large share of Harvard students, expanded into other universities and later the general public.

Characteristics of a Monopoly Business

“All happy companies are different because they're doing something very unique.

All unhappy companies are alike because they fail to escape the essential sameness that is competition”

While there is no single recipe when it comes to monopolistic businesses, successful tech monopolies exhibit characteristics that contribute to their market dominance.

Proprietary Technology - Monopoly businesses often possess proprietary technology that gives them a significant advantage over competitors. A great example is Google’s early dominance in search thanks to its proprietary PageRank algorithm. Pagerank made Google’s search results more relevant than competitors solely relying on keyword matching.

Network Effects -It is like these businesses benefit from network effects, where the value of a service increases as more users join the network. For example, social networks such as Facebook where, as more users join the network, existing users gain even more value.

Economies of Scale - Monopolies leverage economies of scale to their advantage. While they may incur high initial operating costs as they get started, the marginal cost of serving additional users is relatively low. A good example of this is software companies. A piece of software could have running costs of $100 per month and any additional users will not impact this figure greatly. This allows for rapid scaling and maintaining market share.

Branding - Strong branding is another hallmark of monopoly businesses. A strong brand sticks with users and fosters loyalty. Think apple. Theil admits difficulty in understanding how it works, however it plays a crucial role in maintaining market dominance.

By leveraging the above, monopolies solidify their position in the market and continue to capture value long-term.

Key Takeaway.

In tech, there is no single formula for success. According to Theil, the history of technology is such that every moment happens once. The next Mark Zuckerberg won't build a social network and all. Instead of chasing yesterday’s successes - focus on creating something uniquely valuable that will ensure long-term profitability.

The Last Mover Advantage

It is conventional business wisdom to move first - the one who enters early is perceived to have an advantage. However, Theil challenges this asserting that the last movers gain a significant advantage over their predecessors.

He gives examples of Google being the last search engine, and Microsoft being the last operating system for many decades.

The following key points justify his conclusions;

1. Future Value - Theil emphasizes that most of a tech company's value comes from far-future cash flows and not immediate growth and profits. Therefore the durability of a company and its ability to stay profitable in the long run is essential.

He remarks the following about PayPal regarding future value;

“…And it turned out that about three-quarters of the value of the business, as of 2001, came from cash flows in years 2011 and beyond.”

2. Network Effects - the value of networks and network effects only begin to show later as the network grows. Last movers capitalize on this by entering markets with ready-created network effects allowing them to benefit from the momentum created by earlier players.

3. Durability - Lasting breakthroughs are those that have never been contested, only improved upon. By focusing on long-term dominance, last movers position themselves to build sustainable businesses that withstand competition and remain relevant.

Theil compares this business strategy to chess. While the first mover has a slight advantage, the true winner strategically plans for the endgame(long-term dominance). Like Capablanca - a chess champion who focused heavily on his endgame, Theil suggests that companies should prioritize strategies that will bring lasting success.

The History of Innovation.

When a business succeeds, people focus on the winners and losers, forgetting the role the industry they were in played. This leads to misconceptions about who gets rewarded for innovating.

Theil explores the following two pervasive myths;

The Science Myth; Contrary to popular belief, scientists are not indifferent to financial gains however, often, they fail to capture the value of their discoveries.

This myth perpetuates the notion that scientific pursuits are purely driven by curiosity, masking the inherent challenges in translating innovation into monetary rewards.

In Theil’s words;

“I would suggest that the history of science has generally been one where Y is 0% across the board. 

The scientists never make any money.

They're always deluded into thinking that they live in a just universe that will reward them for their work and for their inventions.

And this is probably the fundamental delusion that scientists tend to suffer from in our society.”

The Software Myth; The software industry indeed generates substantial wealth for its players, its success is attributed to the industry structure rather than the nature of innovation itself.

Theil emphasizes that the industry structure is what allows software companies to easily capture a large share of the value they create.

The Two Successful Business Models.

Vertically integrated Monopolies.

These businesses have complex structures, coordinating multiple moving parts, and capturing the most value out of each.

Despite being very difficult to establish, once created, the business accumulates a significant advantage over competitors.

Tesla vertically integrates, car dealerships on top of car production and owning their mines. Their objective? Control the entire production chain, thereby securing a considerable advantage and capturing a larger share of created value.

Software with Network Effects.

Software businesses that win long-term benefit from low marginal costs, economies of scale, and rapid adoption with network effects. This allows them(Silicon Valley tech companies) to take over an industry quickly and capture a larger share(Y) of the value they create.

The Psychology of Competition.

We have been conditioned to view competition as a path to success. From academic grading to the job market, the narrative of outperforming others permeates our psyche.

Theil challenges this conventional wisdom, suggesting the fixation on competition hinders innovation and the long-term profitability of a company.

The key takeaways;

1. Memetic Desires - humans are naturally inclined to imitate others - ‘monkey see, monkey do’, leading us down a beat path with limited opportunities. This desire steers us away from exploring less competitive, potentially lucrative avenues.

2. Popularity != Value - Just because something is popular does not mean it is valuable. Let’s look at Hollywood, it's a market saturated with competition, which often makes success elusive for its players. Theil remarks that in such an industry the benefits are all competed away, in his words;

“…It's just another movie, in which case, there are lots of those, it's super competitive, incredibly hard to make money. No one ever makes money in Hollywood doing movies. It's really hard.”

3. Losing Focus - The intense focus on beating others can make us lose sight of our own goals and values. We can get so caught up in winning that we forget what truly matters.

Theil suggests that instead of blindly following the competitive herd, we should consider alternative paths. There might be unexplored opportunities with far less competition waiting for those who dare to look beyond the well-trodden routes.

Summary.

There are two types of businesses; monopolies and perfectly competitive businesses. Monopolies are more valuable than the former because they can capture a larger share of the value they create.

Perfectly competitive businesses are efficient but don't make as much money because they have to compete with many other businesses.

Monopolies create a lot of value and capture a larger share of that value.

Competition is s distraction from innovating.

References.

1. Lecture 5 - Competition is for Losers (Peter Thiel)