The Smiling Curve

The “Smiling Curve” is one of the most important economic concepts in our world today. It explains why media companies are becoming more extreme, shows how big tech got to be as big as it is, and even explains the economics behind the newsletter you’re reading today.

This article builds on last week’s article “Internet Economics”, which broke down how a world of digital abundance broke the foundational concepts of Econ 101. The Smiling Curve is the manifestation of Internet Economics in the real world.

But first, we need to define what the curve looked like before it smiled.

The Scale Curve

In a world ruled by scarcity, the economic end state was scale as the most important differentiator and ultimately supply holding power over demand.

For example, a company that’s able to scale manufacturing will have a cost advantage that upstarts can’t compete with. Retailers at scale (think Walmart) can crush their rivals by getting better pricing and leveraging operating costs across a larger sales base.

The advantage of scale in a world of scarcity means customers don’t have much power or choice when stores are filled with big brands and competitors without scale can’t even get off the ground.

The chart above shows the excess value — or profits — a company has on the y-axis compared to the scale of the company on the x-axis. This isn’t a one-size fits all chart, but the point is that in a world of scarcity, scale often defines who makes all the money.

The Smiling Curve

The internet doesn’t eliminate advantages like scale that have always existed, especially in the physical world. What it does is shift the power dynamics from supply to demand. The companies that owned the supply (P&G, Kraft, Budweiser, etc) had the power in a world of scarcity but in a world of abundance, the companies that can aggregate demand have the power (Google, Netflix, Facebook, etc).

As a result, consumer dynamics are different in this world. In a world of abundance, the winners are chosen by consumers time and time again. You don’t HAVE to watch Netflix, you CHOOSE to. You don’t HAVE to search on Google, you CHOOSE to. This creates the virtuous cycle on the right side of the curve that I discussed last week. On the internet, winners keep winning.

But markets won by aggregating demand don’t choke off competition on the left side of the chart the way a market defined by scarcity does. It opens up new opportunities to build profitable businesses in low-scale, high-value niche markets. What you end up with is a “Smiling Curve” where there’s value to be had on the far left or far right end of the scale spectrum. You just don’t want to be in the middle.

This is why newsletters (which fall on the left side of the curve) have grown in popularity while content companies with scale like the New York Times have also done extremely well. Regional newspapers that leaned on geographic or printing press scarcity are stuck in the middle in a digital world, which is why they’re going out of business.

On the right side of the Smiling Curve, the flywheel of “Internet Economics” goes to work. Customers chose a platform, that gives the platform the money to improve the product, which attracts more customers and suppliers, and so on.

This Smiling Curve dynamic is playing out over and over again and it plays a role in many of the stocks in the Asymmetric Universe. Generally, as public investors, we are investing in the companies on the right side of the smiling curve, while entrepreneurs and creators with small — but potentially very profitable businesses — build on the left side.

Let’s take gaming as an example of this dynamic. Why does Microsoft want to buy Activision Blizzard? And why is Sony opposing the deal?

Microsoft has lost the console war to Sony and now wants to build a streaming platform, which requires a ton of content to be an attractive offering for consumers (who remember are making the choice here). Microsoft probably can’t build a big streaming business on its own today, it needs a big studio like Activision Blizzard to be a draw. Meanwhile, Activision Blizzard doesn’t want to get stuck in no man’s land as content moves to platforms or niche creators. A merger makes sense for both parties in hopes of moving to the right side of the curve in streaming gaming.

In markets like fitness, the Smiling Curve is defined by a fitness anywhere, anytime company reaching millions of subscribers like Peloton or fitness celebrities like Joey Swoll and the Bowmars who are a brand of one.

Streaming is the same. Spotify seems to have won the music streaming battle, crushing Tidal, Pandora, and others in the process. So, how do you compete? Be a brand of one! Taylor Swift is clearly the epitome of that and she got there by LEVERAGING the platforms on the right (Spotify, Instagram, etc) to build her brand.

In a digital world, the best businesses either aggregate demand to build a large business or dominate a profitable niche. Both are leveraging Internet Economics.

It should be no surprise that each of the examples above includes an Asymmetric Universe company (Sony, Peloton, Spotify). These are theories I’m putting into practice.

A Frameworks For Investing

I was reminded last week that there are plenty of cases where Internet Economics doesn’t apply. And that's true. Not every market or business fits into a clean theoretical box. But understanding the concept of Internet Economics will help us apply it to segments of almost any business and understand where there are points of strength or weakness. The same goes for the Smiling Curve.

These are frameworks for investing. If you understand Internet Economics and the Smiling Curve it goes a long way to understanding my long-term thesis on Spotify, Peloton, or Sony and why “winner-take-all” markets are a theme on the internet.

Disclaimer: Asymmetric Investing provides analysis and research but DOES NOT provide individual financial advice. Travis Hoium may have a position in some of the stocks mentioned. All content is for informational purposes only. Asymmetric Investing is not a registered investment, legal, or tax advisor or a broker/dealer. Trading any asset involves risk and could result in significant capital losses. Please, do your own research before acquiring stocks.