The underlying flaw in Facebook's business model

The Harvard Business Review makes a point we made several days ago with respect to the problem with Facebok's business model:

Facebook's imbroglio over privacy reveals what may be a fatal business model. I know because my students at Parsons The New School For Design tell me so. They live on Facebook and they are furious at it. This was the technology platform they were born into, built their friendships around, and expected to be with them as they grew up, got jobs, and had families. They just assumed Facebook would evolve as their lives shifted from adolescent to adult and their needs changed. Facebook's failure to recognize this culture change deeply threatens its future profits. At the moment, it has an audience that is at war with its advertisers. Not good.

To understand this war we use the system dynamic model above. What it shows is that Facebook is essentially involved in a vicious circle in its business model. The initial condition is that Facebook set up a fairly secure environment for people to share data with their immediate social network, but has then steadily opened it up to try and monetise it. In doing this they are storing up the seeds of their own demise.

The underlying problem is that the average revenue per user on a social network from straight up Ads is very small - certainly not enough to justify a $15bn plus valuation! Thus they have to explore every facet of datamining possible to maximise that tiny revenue stream and potentially open up others.

So, what happens is this - initial condition is a fast growing and secure private social network. What they then do (starting with Beacon) is ratchet up the "unprivacy" scale ("Start Here" on the chart). Their aim is to expose more data and thus monetise it

The problem they have is that the user data on Facebook is not a static thing - it is managed by another agent in the system aka the user. The user (with a time lag, and in different ways) slowly - and over time more rapidly starts to get nervous about this, and starts to react. This takes the form of some or all of:

- no longer sharing as much data
- falsifying data
- interacting less with the system, slowly resetting their privacy controls etc
- no longer clicking on Ads
- as a last resort, exit (Facebook may well keep the data but it still loses value over time

The net effect is, en masse, to reduce the average value of the user to Facebook's real customer - the advertisers (A "customer" is someone who pays you money, a "User" doesn't and gets used - never confuse these two in a FreeConomic model)

The problem Facebook then has is that it needs to open up the privacy even more to extract the same amount of value. This is why we see the steady erosion of user privacy (see the diagram below to see how much they have moved since 2005)



But this action brings a user reaction, as more users get more skittish and more start to ratchet back on the data they display, thus reducing their value further. To prevent this Facebook tries to implement things like its Byzantine Privacy System but this in itself prompts further distrust, and so it goes on.

In other words a "vicious cycle" has opened up. This can to an extent be mitigated when there is still new user growth as the value of new users added hides the losses from old users ratcheting back - but unless broken it will ultimately be net value destructive for Facebook. It starts to rear its head above the waterline as new user growth slows, and/or if new users are more savvy and enter Facebook with all the privacy safeguards on high.

Their calculation right now must be about where they will be at the time of their IPO. Can they keep growth going at such a rate, and keep ratcheting down on the privacy, so that they can IPO before the vicious cycle becomes visible in the numbers.

To this end, they need attempts to regulate them to do "Opt In" approaches and to simplify the user privacy settings like they need a hole in the head. Little surprise then that the recent brouhaha has finally forced their hand and they have had to promise to essentially regulate themselves by changing the privacy settings rather than risk outside interference. Whether it, together with their lobbying Washington, will be enough remains to be seen - as they are being closely watched now from all over.

By the way, I always thought Facebook's best option would be to sell online goods that allow one to play the "game" of Facebook better. That is a far more benign way of monetising than strip-datamining.