The central question for a capital allocator—and all founders, executives, and investors are capital allocators—is not simply “is this a good market?” The question is “where in this market does power accrue, why does it accrue there, and how durable is it?”
Markets are systems, not monoliths
Most industries are better understood as a series of interconnected markets, each with its own suppliers, customers, economics, and sources of power.
Energy, for example, includes upstream production, midstream infrastructure, refining, oilfield services, trading, and distribution. Technology includes components, devices, operating systems, app stores, applications, cloud services, and attention. AI similarly includes power and data centers, chips, cloud infrastructure, foundation models, model routing, applications, workflows, and data.
Analyzing an entire industry—or even an entire market—as a single, static unit, obscures the competitive dynamics that lead to breakthrough insights about the source of durable returns.
Follow the constraint
Within each layer, ask: what is scarce, and who controls it?
Scarcity creates bargaining power. Scarcity creates leverage. The scarce resource might be physical infrastructure, a uniquely low-cost resource, distribution, customer trust, proprietary data, intellectual property, network effects, economies of scale, a novel business model that cuts against the competition’s self-interest (aka counter-positioning) or something else that competitors can’t easily copy.
In energy, low-cost resource owners can earn extraordinary returns, while constrained pipeline or refining capacity can temporarily move power elsewhere. In 19th-century railroads, strategically located tracks, bridges and terminals could become physical chokepoints while trunk lines connecting shippers with endmarkets set rates and schedules. In technology, control over the operating systems and customer relationships translate to market power.
The scarce resource might be an asset or a person that consistently delivers outcomes. The Wall Street Journal recently published an article on the Rams version of NFL moneyball—paying fair prices for extremely valuable players that have a proven track record of performance in the NFL at hard-to-replace positions.
Forbes recently wrote about how Christopher Nolan commands movie star paydays in Hollywood.
Follow the constraint to find the potential profit pool.
Then ask what protects the constraint
Scarcity alone is not enough. A temporary shortage can create enormous profits without creating durable market power.
Durable power requires some mechanism that prevents competitors from eliminating the scarcity: high switching costs, network effects, economies of scale, regulatory barriers, physical geography, proprietary resources, control of distribution, or another difficult-to-replicate advantage.
This distinction separates temporary scarcity from durable market power.
Oilfield services and equipment manufacturers can gain enormous pricing power when capacity is scarce, but competitors can eventually add capacity. A railroad controlling the only economically viable entrance into an important city possesses something much harder to reproduce.
Control of the customer relationship can be a chokepoint
The bottleneck does not have to be a physical asset.
Meta demonstrates this particularly well. It does not control the mobile operating system, but its enormous aggregation of users and attention gives it power over advertisers seeking those users. But Meta is not alone in this value chain because Apple controls access to iPhone users. In this part of the technology market system, they share power (and continue to compete against each other for more of it).
There can therefore be multiple powerful actors within the same value chain, each controlling a different scarce relationship or resource.
Distinguish present power from claims on future value
Contrasting two giants of the railroad era, Jay Cooke and Cornelius Vanderbilt, illustrates an important distinction.
Cooke was, at his core, a promoter. He was arguably the best fundraiser of his era after raising $1.6 billion for the Union government during the Civil War. Thanks to that feat, he came to be known as the “Financier of the Civil War” and became one the three or four wealthiest people in America at the time.
His power was a powerful fundraising machine built on top of an extraordinary intuition for retail financial markets. His understanding of capital markets, especially the retail market in the US, but also his relationships in Europe, made his financing machine a force of nature. His firm, Jay Cooke & Co., employed hundreds of salesmen and loosely controlled hundreds of newspapers. This network gave him the ability to target capital pools across every segment of society. No one else at the time, not even JP Morgan, had this combination of mainstream reputation and distribution.
But Cooke’s power depended on investors’ appetite and the broader health of the capital markets. The best investment bankers understand that success often depends on swimming with the current.
Vanderbilt, on the other hand, increasingly controlled productive assets—railroads that generated cash flows. By combining the Harlem and Hudson River railroads and then leveraging the chokepoint into New York City to win control of the New York Central trunk line, he could retain bargaining power over shipping rates, avoid disastrous competition with alternative routes, and deploy growth capital based on demand signals. Most importantly, he could be conservative with debt financing because he was profitable and could defend his market position.
Vanderbilt derived his market power for control over strategic, profitable assets he could defend. Cooke derived power from his ability to convince investors and from investors’ ability to fund investments.
When Jay Cooke & Co. overextended itself financially by funding runaway capital expenditures at the Northern Pacific, they put themselves in a vulnerable position financially. When the market turned in 1873 and Cooke’s distribution machine collapsed, the firm failed and its failure triggered the Panic of 1873.
Vanderbilt’s railroad empire suffered but survived, his power intact, even as his profitability and wealth temporarily eroded.
Market power follows control of scarce and valuable assets. Durable returns follow when that power is acquired for less than the value it generates—whether that’s business cash flows or box office ticket sales.
References
The Rail Revolution series by Backtest Podcast
7 Powers: The Foundations of Business Strategy by Hamilton Helmer
Nvidia’s Risky Business by Ben Thompson
The Innovator’s Dilemma: When New Technologies Cause Great Firms to Fail by by Clayton Christensen
Competitive Advantage: Creating and Sustaining Superior Performance by Michael Porter