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Volume 25, No. 2

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December / January 1999

 

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Hal Varian
Six Forces Shaping the Network Economy


by Steve Hardin

Some observers say we need new economic models to deal with the new facts of the information economy. The Dean of the School of Information Management and Systems at the University of California at Berkeley believes otherwise. Hal R. Varian, who co-wrote the 1998 book Information Rules: A Strategic Guide to the Network Economy with Carl Shapiro, says the issues we are seeing in the information economy were present in the industrial economy.

Varian spoke on Six Forces Shaping the Network Economy at the final plenary session at the Annual Meeting of the American Society for Information Science in Pittsburgh.

Varian discussed six themes present in his book. First is the issue of differentiation of products and pricing. Varian defined information goods as anything that can be delivered over the Internet. They have very high first-copy costs and very low incremental costs. The first-copy, fixed costs - sunk costs - are not recoverable. If you start to build something in a factory, and it does not sell, you can at least sell the factory. But if a movie is a flop, there is not much of a market for the script. Also, the variable costs of production are often negligible. There are no capacity constraints. The problem with this kind of cost structure is that once you have sunk the cost to get it up and running, there is no natural price floor. We saw this with CD-ROM telephone directories. The first CD phone directory sold for $10,000. But the producers had a falling out, and two competing companies were set up. Once there was competition and each company tried to undercut the other, the price moved rapidly toward zero. Now you can buy all the phone books in the United States on CD-ROM for $4.95. So how do producers keep this from happening?

The Internet has opened up a much broader and dispersed audience than has been traditionally available. For example, some of the very high quality products that are good for the American market are less appropriate for international sales. A lower quality, less expensive product may sell better overseas. So how can producers sell into that broader market without having to cut prices and quality among their traditional users? "Versioning" is the answer - they can sell the high-priced, high-value version to the top-end users and the lower-priced, lower-value version to the low-end users. We see this, Varian says, in the book publishing industry. People anxious to read a book when it first comes out pay the higher hardback price; others wait for the less expensive paperback. The same goes for movies - people who want to see a film right away will pay the higher price to view it in the theater; others will wait until they can rent it on video. The process has found its way to the Internet, too; a real-time feed of stock prices costs $30-$40 per month, while a feed delayed by 15
minutes is essentially free.

Varian notes that the traditional approach to versioning has been to add value to a basic product to produce a more expensive version. But with information goods, you generally start with a high-value version and take value away to get a lower-end product. In some cases, it is even more expensive to produce the lower quality good. (For example, the producers have to hold stock prices for 15 minutes to get the delay for the cheaper version.) He says IBM produced a professional version printer that put out 10 pages per minute; for the home version, they added a chip with a "wait" routine to make the printer put out five pages per minute. These effects are largely benign, Varian says, because IBM probably would never have sold to the home market if their home printer took away sales from the professional market.

A second issue for U.S. information providers is rights management. Producers of information have both the benefit and the cost of easy production. It is easier for people to produce content, but also easier for others to copy that content. Should a producer allow lending or sharing of its information product?

Varian and Shapiro contend that content owners are too conservative with their approach to rights management. For example, some of the first libraries targeted to middle-class users appeared in Britain in the late 18th and early 19th centuries. These libraries started by renting novels. People who could not afford to purchase a book could rent it. Publishers opposed the idea, but during the 50 years of this practice, reading for pleasure dramatically increased, which led to increased demand for books. Publishers profited. The same thing happened when videos were introduced. First, they were toys for the rich; no one could afford VCRs or tapes. But someone got the idea of renting tapes and VCRs, and that stimulated demand as well as the number of outlets for video content. Video stores are much like libraries, but with the addition of the profit motive. What happened with book publishers 200 years ago has now happened with video producers. Hollywood originally resisted the idea of video rental, but now the movie industry makes more money from video than from theaters. The idea is to maximize the value of intellectual property, not to maximize its protection. Learn how to take advantage of new modes of distribution; do not fight them.

A third issue involves lock-ins and switching costs. A network can be "real," like the Internet, or virtual, like the network of Mac users. In either case, the value of participating in the network depends on how many other users there are. Switching one component of the network can be costly, because you have to change other components as well. For example, switching from LPs to CDs necessitates changing players, storage shelves, etc. This situation can lead to a lock-in, where the user is forced to use the same technology to avoid all the additional costs of changing. The seller is trying to get the user locked in to one technology; the buyer is trying to avoid it. One of the most common ways to lock in consumers is to sell complementary products to the one you are really trying to sell.

Look at printers, Varian says. More than a third of Hewlett-Packard's profits in its printers division comes from selling cartridges. You can buy a cheap printer, but then have to pay big for cartridges. This strategy is as old as giving away the razor and selling the blades. Dell has been offering system administration services by partnering with companies that will offer those services only for Dell machines. So now, if you want to switch away from Dell, you must switch not only your hardware but also your system administrator.

We hear a lot of talk about the "friction-free" economy - "the competition is just a click away."
Varian and Shapiro are skeptical. As fast as the frictions are removed, we see the creation of new frictions to replace them. For example, consider "loyalty programs," in which you are rewarded by an airline when you limit your flight business to that particular carrier. Amazon.com has its affiliates program - when you put up a link to Amazon.com from your Web page, you get something from them for every sale they make through your link. Amazon.com now has thousands of affiliates, all very loyal. In many cases, competition among producers and vendors is competition for the best rewards they can give their customers.

Next, Varian turns his attention to the effects of networks and positive feedback. The value of a network to the individual user depends on the number of other network users. This concept
appeared in 1974 when economist Jeffrey Rohlfs created it to explain the commercial failure of the picturephone. There are two equilibrium outcomes, Rohlfs said: one in which everyone expects a product to fail, so no one will buy it; and a second in which everyone expects a product to succeed, so they want to buy it. The trick is to sell enough to get to the critical mass to achieve the second equilibrium. This paper was not cited for eight years, Varian says, because no one cares about failures. But after all, it is just as important to know why a product fails as why it succeeds. The seller needs to persuade people through marketing that the product will be successful. Last year there were two standards for high-speed modems, K56flex and x2. Both were marketed very aggressively to show they were winners. The same goes for Netscape and Internet Explorer; both are trying to show they are the people's choice.

The fifth issue, Varian says, is standards and interconnection. In order to resolve the stalemate
between the competing x2 and K56flex modem standards the producers got together and set up a common standard. Standards, Varian observes, change competition for the market to competition in the market. He offers historical examples. In the early days of radio, Marconi sold maritime radio services. The company would not sell services to a customer unless the customer used its equipment. Marconi wanted to keep people using its system. It gave subsidies to its big customers, and arranged things so that Lloyd's of London would not insure a ship unless it had a Marconi set. But in 1912, an American shipping act decreed interoperability. Bell did similar things; in towns with competition, Bell would not let its competitors access Bell's long distance service. After they gained critical mass, they went back and picked off those single-city providers.

It is important to consider and recognize your value as your share of the market times the total
market value. Strategies such as standards can affect both your share and the total market value. If the total value goes up through interoperability, there should be a way to manage profits for all. Sometimes a third party forces a standard. Hollywood forced video producers to settle on a single read standard for DVD. So, Varian says, he and Shapiro recommend "make alliances, not wars."

Varian's sixth issue is antitrust and competition policy. He says it is important to know what antitrust law says and does not say. The antitrust laws try to produce competition as a process. It is permissible to be a monopolist as long as you get there fair and square. The government's role is not to pick winners, but to set the rules of the game. We want to be sure the race goes to the fastest runner, not the person most adept at tripping other runners. Antitrust cases always focus on practices. One practice is exclusive dealing, in which a monopolist says to other firms, "If you deal with me, you cannot deal with anyone else." Varian says much of the government's case against Microsoft runs along this line. A second practice is tying - that is, in order to buy a product from a monopolist you must buy other products as well. A producer must allow each of the markets for which it makes products to be competitive. It is important to realize these tactics may be legal for a firm with a 10% market share, but illegal for a firm with a 90% market share. This fact is one of the reasons Microsoft and Intel are fighting suits so vigorously; if they are branded monopolists, it limits the tactics they can use.

In short, many of the aspects of the information economy were present long ago. Varian's conclusion: the new economy really is not so new after all. Much more information is available at the Information Rules web site.


Steve Hardin is associate librarian, Cunningham Memorial Library, Indiana State University. Before launching his career in librarianship, Steve was a broadcast journalist. He has just completed a term as ASIS director-at-large
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Last Update: February 21, 1999