06/04/2010 06:20 am ET Updated May 25, 2011

Dispatch From Startup Land: Zuckerberg and Contest Economics

For decades, there's been a gentleman's agreement in the Silicon Valley. If you're the big guy, when small companies get some traction in an area you dominate, you partner with them, or buy them. Taking young startups' ideas and using dominance and power to overrun them isn't sporting.

Microsoft killed Lotus, WordPerfect, and Netscape. But the recent hurricane of criticism is hitting Facebook, and not just on privacy. They almost got into an all out war with Zynga (makers of the extremely lucrative Farmville and Mafia Wars games) and have been accused of rampantly "borrowing" ideas from Twitter, FourSquare, and many others.

"That's just not how things are done."

But why?

It seems counterintuitive from an economics standpoint. Why pay millions -- or hundreds of millions -- to buy when you can build?

Sure in some cases a new entrant poses a serious threat. When an insurgent has achieved what economists call "technological lock-in," that can be impossible to overcome.

Hotmail, who pioneered the idea of web-based email, are a classic example of a pricey acquisition that's easy to rationalize. Changing email addresses is just a pain, and they grew too fast for Microsoft to catch, so they were assimilated.

Google's absorbing YouTube is easier to question. They'd certainly gotten a tremendous head start and a formidable war chest of video content. But $1.65 billion is a lot of money, and the technology wasn't too complicated. Was that head start impossible to overcome -- to the tune of way over a billion dollars, mind you -- when you have the resources Google has? Arguable to say the least.

But the list goes on. Back to Google again, can one really justify almost a billion more for Admob, makers of ads for mobile devices? Google absolutely dominates digital advertising, and are within striking distance of dominating mobile, too, via their Android platform. It seems plausible they could throw a team at the problem, leverage tremendous market power, and annihilate.

So why didn't they?

There are examples galore, each different, many debatable. But in short, the gentleman's agreement is alive and well. It's incredibly easy to find dozens of buyouts that seem impossible to justify on strictly capitalist grounds.

How can "playing nice" be an act of self-interest? Why is paying "too much" to acquire companies that develop complementary products to yours a good business decision? How on earth can a rational profit-maximizing company justify paying more for something than it would cost to make it?

In fact, altruism and capitalism are not mutually exclusive. For more on that I've got a great illustrative story. Highlights include people getting eaten by saber-toothed tigers.

Feel free to dig in. But to skip to the conclusion: The big picture takeaway is nobody wins unless the whole village wins.

In the long run, when you you destroy the very ecosystem you live in, you kill yourself.

But what about the short term? Ruthlessness in business can yield returns. It can be a winner-take-all world. Despite the legions of morons who quote him chapter and verse, there is some insight in Joseph Schumpter's theory of creative destruction.

But even in the ruthless short term, it can be to a company's advantage to be seen as keeping the "tradition" of playing nice with others. The often overlooked reason why involves something that's occasionally called "prize economics." I prefer "contest economics" but unless I've missed it, it doesn't seem to have an established name at all.

That's a shame, as it's a good way to understand startup innovation and what this whole gentleman's agreement is all about.

Consider two notable contests: the Ansari X Prize and the Netflix recommendations engine challenge.

The Netflix prize was $1 million, awarded for anyone who could improve their algorithm for recommending movies a customer might like by 10% or more, measured by its ability to predict already known movie ratings. Dozens of teams spent thousands of hours on the project over the course of years, including scientists from AT&T labs, experienced engineers at Yahoo, and a slew of others. By the time the prize was claimed, the company claimed the million dollars was a footnote, and estimated the value of all the work they inspired as in excess of $10 million or more.

The X Prize offered up an award of $10 million for the first private team to achieve goals for repeated manned space flight. It was won in 2004, but again, the interesting part is that over $100 million was devoted to the cause by the various competing teams.

All they had to do is just announce the existence of a prize, and many, many times that amount was thrown into solving the problem they wanted solved. And the best fringe benefit? They didn't have to spend a dime unless the problem was solved.

This phenomenon repeats in many areas. Architects routinely submit for competitions, where ten firms might submit fully developed plans. The winner gets the commission. The real winner though is the sponsor, who gets a stack of plans, but only pays for one.

So when companies follow the gentleman's agreement and support successful companies in their sector, they are cannily exploiting this same math. They may not know it, but they're practicing contest economics, and when they pay "too much" for a promising acquisition, they're bestowing their award.

And as we've seen, that math can be sweet indeed.

When a big company makes clear they're going to play nice and partner rather than compete and destroy, they've just announced a contest of their own.

Acquiring a company hands over a prize to the winner, but for that prize money they aren't just getting the R&D, investment, talent, sweat, toil, and late nights that went into the company they're buying.

They're reaping the benefit of EVERY dollar invested in their entire space, everything that integrates with their platform. Every company that they didn't buy. Each dollar apparently overspent when acquiring a single company is actually multiplied many times over.

That looks a lot like self interest: spend X, reap the benefits of 10X. Hell, it looks a lot like a free lunch.

That said, if you read about the tigers, you've seen how self-interest can sometimes line up with the broader interest of the community. The tech community's venerable tradition of cooperation is a tangible example.

Bill Gates figured it out eventually, and decisively. For the sake of innovation, and the ecosystem that nurtures new ideas and new technology, here's hoping Mark Zuckerberg and Facebook are next.