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Farewell Facebook?

So farewell, then, Facebook! That is the conclusion of a highly technical paper by two Princeton researchers, John Cannarella and Joshua Spechler, which received a lot of publicity in the press last week. The authors conclude that “Facebook will undergo a rapid decline in the coming years, losing 80 per cent of its peak user base between 2015 and 2017”.

The natural reaction of an economist to such a prediction is to ask whether the scientists have taken positions in options on Facebook’s future share price. If they prove to be correct, they stand to make a fortune. It is easy to be cynical about this kind of prediction, but a couple of important points can be drawn from the theme of the paper and the approach which is used.

Facebook currently has over 1 billion users worldwide, and a market capitalisation of around $130 billion. It might seem implausible to many that this giant company might collapse so rapidly. But this is exactly what happened to MySpace, the most visited website in the world from 2005 to early 2008. By 2011, it had all but disappeared. Even giant firms fail. This is the lesson of economic history, ever since companies operating on a truly global scale began to appear in the late 19th century. Of the world’s top 100 non-financial companies a century ago, in 1914, all with market capitalisations of many billions in today’s prices, most have either gone bankrupt or are mere shadows of their former selves. Some of them disappeared very quickly. Even the largest company can collapse.

The second point is about why people choose one thing rather than another. Economists try and explain this by referring to the observable attributes of the alternatives, such as price and quality. If a service like Facebook is fantastically popular, it must be because the product not only provides features which many people want, but because it does so much more effectively than its rivals. A dominant market leader can only be displaced, on this view of the world, if either a superior rival emerges, or if there is some unforeseen and sudden shift in consumer tastes.

This is not at all the approach taken by Cannarella and Spechler. Their model takes no account at all of the features of Facebook or its online social network competitors.  Instead, the decision whether to start using Facebook, to carry on using it, or to abandon it, is made solely by taking into account what your friends are doing. The approach provides a startlingly good account of the rise and fall of MySpace.

This is just one example of the mathematical models which are now being used to explain, very successfully, many aspects of consumer behaviour on the internet. Factors such as price and quality can be added to them. But the main driver of an individual’s choice is, quite simply, what other people are choosing. Marketing departments and ad agencies increasingly need top quants just as much as they need creative.

Paul Ormerod
As Published in City Am on Wednesday 29th January 2013

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