The Birth of the Modern Shark Tank Economy

imagePaula and I are both readers. Except in the case of a movie night or some other exceptions the TV doesn’t get a lot of play time in the Golbabai house. One of those exceptions however is our favorite Friday night tradition: putting the kids to bed and watching Shark Tank over a bowl of ice cream. As an economics blogger, I find the show fascinating because in just a few short minutes it is a perfect microcosm of how our modern economy thinks and rewards. For those not familiar with the show, the premise is a small upshot business pitches to a group of wealthy investors for the capital they need to scale up their business. In exchange for this capital, the business owners generally give up a significant percentage of their ownership stake in their company (in the rare instances where equity is not exchanged debt or a percentage of future revenues is used instead). The investors, or sharks, ask a series of questions about price points, unit costs, profit margins, sales to date, and sales growth trends. All of these questions tend to one ultimate point the sharks are trying to discover: can this business or product be mass produced and mass distributed and does it have the right reward potential to be worth risking their capital? If so, there’s a potential financial windfall for both the investor and the entrepreneur.

In my post last month, I pointed out that this idea of “scaling up” your small business beyond a local or regional level is actually quite a new concept. Before the mid-1800s, human limits in the area of production and transportation acted as a natural cap to expansion. But the few decades between 1840 and 1900 saw such advancements that soon the playing field was quite different: the new technology of the industrial revolution allowed for mass production; the telegraph allowed for rapid communication; and the railroad enabled distribution on a level never seen before. In this brave new world, numerous industries suddenly transformed, clusters of many small businesses were supplanted by a very few enormous corporations and institutions. The following passage pertaining to the cigarette industry from Alfred D. Chandler’s book The Visible Hand: The Managerial Revolution in American Business perfectly illustrates what happened over and over again during this time period:

visible hand“As a newcomer [James Buchanan] Duke was searching for a way to break into the [cigarette] market. In 1884, shortly after a sharp reduction in taxes on cigarettes permitted a major price cut to consumers, Duke installed two Bonsack machines. With each machine producing 120,000 cigarettes a day, he could easily saturate the American market. To test the world market, Duke had sent a close associate, Richard M. Wright, on a nineteen-month tour overseas. In June 1885 Duke signed a contract with Bonsack to use the machine exclusively to make all his cigarettes, high-quality as well as cheap, in return for a lower leasing charge.

Duke’s gamble paid off. Output soared. Selling became the challenge. Even before Duke had made his basic contract with Bonsack, he built a factory in New York City, the nation’s largest urban market, and set up his administrative offices there. He immediately intensified a national advertising campaign. Not only did Duke rely on advertising agencies but his own staff distributed vast quantities of cards, circulars, and hand bills – all proclaiming the virtues of his products.”

Imagine the industry disruption this event was. Prior to mechanization, highly skilled workers at the time were making 3,000 cigarettes a day. When a competitor suddenly increased output to 240,000 per day, you can believe that other cigarette producers felt forced to follow suit by mechanizing their processes and focusing on advertising or risk obsolescence (interestingly the art ceased to be the product itself and became instead the marketing of that product). There was a great consolidation of cigarette producers as few small shops could afford this type of equipment, and finally in 1890 those five largest cigarette producers merged, forming the American Tobacco Company.

Sound familiar? I know for myself, seeing the origin of our modern economy of mass production, mass distribution, and mass advertising suddenly puts our culture’s obsession with technology into a whole new light. Technology is the key to unlocking a new scale of production at a cheaper price. In order to actually sell all this supply, technology again has the answer: whether by the railroad of the 19th century or the Internet of today, the linchpin of this whole system is the discovery or creation of new markets to keep the production going. Those who have the capital and means to successfully employ these tools can crush their competition by flooding the market and undercutting prices. In his book, Chandler describes how some of our most iconic brands today – Cambell Soup, Heinz, Quaker Oats, Kodak Film – all emerged in this way. Little wonder then that our economic system is so focused on technology and mass advertising.  If you can produce it in great quantities, you need to be able to sell it and distribute it in similar quantities. Do this successfully and you can dominate industries and accumulate wealth previously unknown to man.

Of course this newfound wealth is not without its unintended consequences. In the area of implications for man and environment, our favorite encyclical, Pope Francis’ recent Laudato Si, is one of the latest works to beautifully synthesize the issues with this type of economics.

1) For man: If, because of technology, only a small fraction of people are mass producing and mass distributing, what are the rest of us doing to make a living? This in a nutshell is the key to understanding our present hot button issue, the growing income inequality gap. In the words of Pope Francis:

We were created with a vocation to work. The goal should not be that technological progress increasingly replaces human work, for this would be detrimental to humanity. Work is necessary, part of the meaning of life on this earth, a path to growth, human development and personal fulfillment. Helping the poor financially must always be a provisional solution in the face of pressing needs. The broader objective should always be to allow them a dignified life through work. Yet the orientation of the economy has favored a kind of technological progress in which the costs of production are reduced by laying off workers and replacing them with machines. This is yet another way in which we can end up working against ourselves.”

2) For the environment: In that our technology has made it easier and easier to extract from the earth, what is the future of environmental sustainability and our planet? On this topic Pope Francis’s encyclical brilliantly articulates this problematic link between our finance driven economy and its effect on the environment.

“The principle of the maximization of profits, frequently isolated from other considerations, reflects a misunderstanding of the very concept of the economy. As long as production is increased, little concern is given to whether it is at the cost of future resources or the health of the environment; as long as the clearing of a forest increases production, no one calculates the losses entailed in the desertification of the land, the harm done to biodiversity or the increased pollution. In a word, businesses profit by calculating and paying only a fraction of the costs involved. Yet only when ‘the economic and social costs of using up shared environmental resources are recognized with transparency and fully borne by those who incur  them, not by other peoples or future generations,’ can those actions be considered ethical. An instrumental way of reasoning, which provides a purely static analysis of realities in the service of present needs, is at work whether resources are allocated by the market or by state central planning.”

Rapidly scaling up one’s business from small and local to a national and international brand is a fairly recent phenomenon made possible by our industrial technology, robust transportation networks, and mass media communication channels.  These advancements have enabled a small group of producers to mass produce, mass distribute, and mass advertise to the detriment of small-scaled, human powered and decentralized local competition. Over the last two centuries, in industry after industry, a place-based, relationship-based economy got squeezed out by productive methods that won by saturating the market with products made cheaper by mechanization and cost-effective transportation. This has created a classic and amplified case of the tragedy of the commons, in which what’s in the best interest of individual entrepreneurs and investors is not in the best interest of the common resources shared by everyone. To this end, it’s clear to me where local competes is not on price but on value, on those topics that the sharks ignore: value in relationships (producer-consumer and management-worker), in quality products, and in environmental sensibilities. Thus, it is imperative that each place build these alternative local institutions to provide people with choices.  Like craft beer, there’s a very real chance that local can come back in a big way. And once we become empowered to locally produce, locally distribute, and advertise by talking with our neighbors once again, I believe there’s a path for scaled-down grassroots economies to out-compete the mass production, mass distribution, and mass advertising economics of Shark Tank.

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