The Cambridge Analytica Incident

As I mentioned in a previous post, I found the media coverage of Mark Zuckerberg in Congress overwhelming. Not because of the articles’ import, but because of how superficial their analyses were.

The debacle frustrated me so much that I wrote a 1000 word essay on the long-term prospects of Facebook. Here’s the full essay, altered for readability purposes:

What happened?

Recently, Facebook’s CEO Mark Zuckerberg had to travel to Washington D.C. to talk to Congress about the data privacy violations committed by Cambridge Analytica. A professor named Aleksandr Kogan harvested data from 270,000 participants for research, leveraging their connections to compile extensive data on around 86 million users. Professor Kogan gave this data to Cambridge Analytica, who then used it to refine for-profit media campaigns.

Following this debacle, Congress is contemplating creating government oversight to ensure Facebook’s compliance with data privacy laws. They are also determining whether Facebook constitutes a monopoly. This is important because 58% of American adults use Facebook, spending an average of six hours a week on its website or mobile application. Additionally, Information Technology is responsible for over 7% of the U.S. GDP. Thus, investigating governmental concerns with data privacy yields important insights into the future of American business. More importantly, Congress’ reaction will have a profound effect on the way businesses interact with their consumers. There are no close product substitutes to the experience provided by Facebook to end users and marketers alike. Advertisers would have to use generic distribution channels (e.g. television) or other tech platforms that, at least in the short run, cannot offer the same demographic partitioning.

Economic Factors:

A key factor in Facebook’s competitive advantage lies in its oligopoly power. As described by Ben Thompson, Facebook is an aggregator of data that modularizes advertisements while integrating profile data with ad inventory (see image 1). This gives Facebook a monopoly on customer information, which is valuable because it allows for better advertisement targeting (e.g. targeting an adult diaper ad at only octogenarians instead of college students).

Additionally, having complete control over its own data allows Facebook to practice perfect price discrimination. The more popular a demographic or keyword is, the more it’ll cost to advertise to that group. By selecting ads on an auction basis and phasing out organic content in newsfeeds, Facebook pricing closely reflects marketer demand.

As one of a handful of data firms, Facebook can create profound market shifts with company actions. For example, along with Google, Facebook easily created user-friendly data tracking by punishing non-compliant websites and advertisers. In summary, Facebook’s monopolistic stockpile of data allows it to offer marketers niche target audiences, price differentiate based on the level of demand for certain keywords, and shape industrial policy.

Another important factor in Facebook’s success lies in its strategic acquisitions. By buying out Instagram and Whatsapp, Facebook prevented the mobile-social-media-app market from degenerating from a monopoly to an oligopoly. Additionally, it strengthened the depth and international breadth of its data pool, achieving economies of scale by allowing marketers to access (via API’s) information from users on any of the three applications. This revitalized Facebook’s competitiveness on mobile channels, allowing it (with a few feature modifications) to effectively starve other nascent applications like Snapchat and Twitter.

Finally, Facebook’s creation of secondary markets with Facebook Pixel revamped the company’s competitiveness in the face of more and more alternative data sources (see image 2).  In the early days of Facebook, the company created value by acting as a gatekeeper of sorts. If you wanted access to aggregated data for millions of consumers, you had to market on Facebook (see image 1). As Ben Thompson points out though, this created a problem when the data market shifted from a monopoly to an oligopoly. Specifically, Google differentiated its product by giving marketers information on user behavior across the whole web, while Facebook was confined to the actions people took on the website or in the application. This all changed with Facebook pixel, which allowed third-parties (i.e. individual companies) to stockpile user data for ad retargeting. It works like this: John clicks an advertisement to view webpage X. This click sets a pixel on his browser. If he then clicks through to page Y, but doesn’t buy on page Z, the pixel will save how far he progressed, create a subcollection of data for the 3rd party to use for future advertisements. This data is saved on the third party’s servers. Thus, pixels create a plethora of secondary data markets, with companies paying their insolvent counterparts for exclusive access to their data sets.

A Few Helpful Images:

Image 1
Image 2
Image 3

This graph displays the economies of scale Facebook gained by acquiring Whatsapp and Instagram. As you can see, its revenue from mobile platforms far surpassed desktop advertising following the two mergers (Instagram in April, 2012; Whatsapp in February, 2014). Equally important, Facebook only paid $1 billion for Instagram (which it made back within two years). It paid out a hefty $20 billion for Whatsapp, but has been compensated by substantial user growth on the application. This graph shows the importance of Facebook’s subsidiaries to the company’s durable competitive advantage. This relates to the Cambridge Analytica incident because subsidiary spin-offs will be the first antitrust action the U.S. takes against Facebook if it falls out of favor.

My Take:

I believe the Cambridge Analytica backlash has been exaggerated. There will not be substantial government oversight of Facebook for the foreseeable future (at least two years). There are three reasons for this.

One, Facebook has powerful lobbying forces that will help neuter any new legislation before it gets to Congress. There’s a reason why Zuckerberg talked about facilitating reform instead of outright rejecting it. In the unlikely event of a media frenzy, Facebook is poised to create substantial loopholes that allow compliance without substantial change. In other words, what it’s doing with the E.U.*

Two, technology companies benefit to an extraordinary degree from economies of scale. This is part of the reason why most tech titans are international in scope. Splitting up Facebook would reduce its competitive advantage, and create an economic vacuum for a foreign business to enter the space (e.g. Tencent). That’s a non-negotiable for the U.S. government; they simply cannot give a Chinese business (and by proxy, the Chinese government) unrestricted access to so much American consumer data without economic consequences. 

Three, politicians are operating with an apathetic constituent base. Even though more Americans become concerned with data privacy every day, very few understand how social media companies, search engines, and other user data-based services make money. Only educating the everyday consumer will lead to legislation that restricts the activities of Facebook and related companies without ruining their respective competitive advantages.

 

* The E.U. passed landmark data privacy regulation that requires Facebook make available a report of all the data it has on somebody at their request. Instead of creating comprehensive reports, the company makes it excruciatingly bureaucratic to get ahold of the document, and refuses to include data from 3rd parties (via the pixels mentioned earlier). The company argues that the cost of parsing its data to assemble these reports is restrictively expensive.

Further Reading:

https://stratechery.com/2015/aggregation-theory/

https://stratechery.com/2018/the-facebook-brand/

https://stratechery.com/2018/the-facebook-current/

https://www.facebook.com/business/learn/facebook-ads-pixel

As you can see, by putting in a little bit of work I discovered company information with a much longer half-life. Equally important, I tried to understand how Facebook makes money, why these data privacy violations recur fairly frequently, and what the company’s critical competitive advantages are. Thus, I’ll be able to analyze future developments surrounding Facebook much faster.

Interestingly enough, I also learned more about the companies Facebook jostles every now and then. Over the next few weeks, I will be reading up on Amazon, Google, Twitter, and Snapchat much more.

In closing: what’s a news soundbite you’ve heard repeatedly over the past few days? What questions do they evoke and how can you go about answering them?

 

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