One of the fundamental ideas behind a sound economic model is that when individual agents pursue their self-interests, the collective benefits. Adam Smith’s concept of the “invisible hand” is fascinating, allowing a system to achieve outcomes beyond individual pursuits. This notion suggests that we can construct systems that are inherently “better” or more “moral” than the flawed, greedy entities that we are.

However, I question whether the startup world adheres to this principle. In the current startup landscape, individual pursuits of self-interest seem to diminish the overall pie for everyone involved. Situations akin to the prisoner’s dilemma or tragedy of the commons arise, resulting in lose-lose outcomes. Though I don’t claim the entire startup ecosystem is flawed or ill intended, it confronts sufficient challenges to justify a closer examination, as it can seem like positive impact on the world and customers is not indirectly and directly rewarded enough in the market.

Before delving further, I must clarify that I am not an economist. This is an opinion piece, not a comprehensive study. I have observed systemic incentives and behaviors that suggest a deviation from the invisible hand principle, and I believe it is crucial to share these insights.

1) Focus Issue

• For customers: In a free market, most purchases are a result of an act of free will, meaning that what sells is what people want, not what people need. And humans are fundamentally bad at knowing what is good for them, overly prioritizing short-term gratification to long-term benefits (e.g. around 20% of bikers wear a helmet). Businesses are rewarded for focusing not on people's problems but on people's desires, the result of which might have a very bad impact on the customers themselves, and potentially the world at large (e.g. the CFC era).
• Investors and founders, driven by rational self-interest, lean towards ventures with high success probabilities within a short timeframe. Consequently, ventures that want to address complicated and impactful problems tend to be ignored.
• Thus, there is an excessive concentration of resources (brains, money, time, etc) on a very small subset of the world's problem space. It leads to insanely high competition, where founders are desperate to find “problems”. How can one say “we need to find problems” when there are still so many infant deaths, war, radicalization, and suffering around us? The fact that 35% of startups failed because of a lack of market need should be a telltale sign of how much human and financial capital are being wasted. And yet, somehow, the startup world’s answer tends to be “smaller profitable niches”, rather than questioning why is it happening so much.
• Some businesses will end up artificially creating pain points for their customers as a way to keep growing and acquiring revenue. For example by making their free or lower tier intentionally frustrating, in order to bump customers to a more expensive premium. Are we living in a world where we can afford to artificially create pain points, and divert resources to “solve” those?

2) For-profit investors incentives.

• VCs best expected value? Unicorns.

  But what is a unicorn? It’s a statistical aberration. It’s the result of the highest risk, highest rewards play, for many many plays. Which is why VCs incubate so many seed startups, so that it’s the one in 1000’s that pays for the whole portfolio. In the meantime, there are fewer incentives to build long-term, medium-sized, or averagely profitable businesses, which could be of great value to society.

  Furthermore, being forced to play the most unlikely outcome can be hard for naive founders as they are basically thrown in a meat grinder. Side note for an interesting counterpoint: some experienced founders I talked to actually appreciate knowing their investors think they have no chance, as it relieves some pressure.

  Of course, the point is not to stop trying to grow unicorns, but to evaluate the contextual cost and societal values of building an average business vs a unicorn to know when to focus on which.

• Ponzi scheme incentives

  Investors’ incentives prioritize selling businesses at higher valuations, often based on growth. This pursuit of infinite growth contributes to artificial pain points and inhibits ventures from stabilizing after solving customer problems. The system resembles in practice, if not in intent, a Ponzi scheme system, with long-term sustainability and reliable valuation taking a back seat to short-term gains. In this case, the biggest losers at the end of the scheme often are pension funds and the everyday Joe.

  It is no surprise to me that there are so many stories like WeWork, Theranos, and FTX. Of course, the individuals need to be blamed for their part in it, but they were born, bred, and enabled by a system that rewards that kind of behaviour. VCs and investors should be held responsible too for prioritizing short-term greed over due diligence and reliable valuation.

3) Non (just) for profit investors incentives

Investors motivated by reasons beyond monetary gains receive two types of direct rewards: social capital and personal gratification. However, these rewards are often unfairly distributed between short-term and long-term. An example is politicians benefiting from votes gained by investing in a popular field (say green energy) while their career might be done by the time the investment actually achieves its impact (say a functional fusion plant).

In complex problems with a low likelihood of success, the ratio of reward per capital invested just tends to diminish with time, with the exception of when and if the investment succeed. Indeed rewards only happens at the very beginning (the decision) and (maybe) on success, while costs in time and capital just keep growing. This could drive investors to focus on quantity rather than quality, discouraging persistence in projects until they deliver meaningful results. An extreme result is “pledges” where the “investors” get 100% of the feel-good feeling without any cost or effective outcomes.

4) Unaligned business reward and customer goals

Some business models, particularly in apps, do not reward companies for prioritizing customer interests. For instance, the freemium model in language-learning apps like Duolingo incentivizes prolonged usage rather than efficient language acquisition.

Indeed, Duolingo is rewarded:

• By the time you use the app (free version), as it converts into ad viewing.
• By the time you are subscribed to the app (paid version). The longer the better.

Which means that Duolingo is incentivized to make you take as long as possible, with as many sessions as possible. This incentive could be great for a practicing app to maintain a language level, but that’s not exactly how they advertise themselves.

This misalignment questions the efficacy and efficiency of the product, and if it ultimately harms users in the long run.

Following personal incentives doesn’t even work for individuals

All of those issues highlight how the current system might need to be addressed.

There are too many incentives rewarding actions that result in a smaller pie for everyone.

But I would even go one step further, and say that it’s not just the total pie that’s getting smaller, but also the part of each individual agent as most of them are statistically not winning. Most founders do not become rich as they hoped, most for-profit startup investors are not turning in a profit, and customers pay more and more money to solve more and more artificial pain points. A counterargument is that a lucky few gains can make the overall expected value positive, to that, I would ask if luck and inequality of wealth should be concepts we want to sustain in our future?

If the system is geared in such a way that not only does it not follow the invisible hand principle, but also does not even deliver its intended benefits to individual agents, isn’t it truly due for a check-up? There is so much to be won in fixing it, in growing the pie. And it’s not a subjective moral stance, a better world benefits us all in the long term.

So the next logical question, are we currently with a Pareto optimal between internal agents chasing self benefits (founder, investor, etc), and external agents (customers) and society at large? If we are not, then could we change incentives to create a positive sum game situation, where both sides would be better rewarded. If we are, then is the current balance between the two sides fair, or should it need economic or legislative rebalancing?

I lack the expertise to propose specific options, but I welcome your thoughts and insights, connect with me on Linkedin!