FT INTERVIEW: Carl Shapiro and Hal Varian
Managers need to put technological progress in perspective, Carl Shapiro and Hal Varian tell Louise Kehoe

logo"As the century closed, the world became smaller. The public rapidly gained access to new and dramatically faster communications technologies. Entrepreneurs . . . built vast empires. The government demanded these powerful new monopolists be held accountable under antitrust law."*

That could be a description of today's information technology industry, the emergence of the global internet and the antitrust charges facing Microsoft and Intel. But Carl Shapiro and Hal Varian, professors at the University of California, Berkeley, are referring to the emergence of telephone networks 100 years ago.

"People get carried away with breathless talk of a new economy," says Prof Shapiro. Executives charged with rolling out cutting-edge software products or online versions of their magazines are tempted to abandon the classic lessons of economics, he suggests. "We think a dose of historic reality is called for."

The economic impact of the internet and corporate computer networks is similar to that of earlier "networks" such as the railways, telephones and bank machines, the Berkeley economists maintain.

The common characteristic is that the value of a network is enhanced by the number of people who use it. Telephones, for example, became useful only when many people had them installed. Similarly, electronic mail and the worldwide web derive their value from their reach.

Rapid growth of the internet has demonstrated the self-reinforcing "positive feedback" loop of network economics, for which Prof Shapiro (with Michael Katz, also of Berkeley) coined the term "network effects" in 1985. Big networks - whether real ones such as the internet, or virtual networks comprising the users of a particular software product - tend to grow bigger, while smaller networks shrink. Eventually, the winner takes all.

Microsoft and Intel's domination of world markets for software and semiconductor chips respectively, demonstrates this. Whereas the industrial economy was driven by economies of scale that tended to create oligopolies, the information economy is driven by the economics of networks, which tend to create monopolies, say Profs Shapiro and Varian. (These monopolies have not been bad for consumers, according to Prof Shapiro. A consultant to Intel, he maintains the chip company's rapid development of ever-faster microprocessors has benefited computer users.)

For producers of IT products, the effects of positive feedback can be either a boon or a threat. The Berkeley economists warn: "If consumers expect your product to become popular, a bandwagon will form . . . butif consumers expect your product to flop . . . thevicious cycle will take over."

So, in this winner-takes-all world, what hope is there for smaller, regional suppliers? According to Prof Shapiro: "The threat is to the small player who does not get a partner, not to companies in any particular part of the world."

The key for companies trying to build markets, or government entities establishing policies, is to "look at the industry and gauge the extent to which there are network effects and the extent of switching costs, and build your strategy around this", Prof Varian advises.

Old economic rules may still apply, but the "network economy" is driven by "information goods" - ranging from computer software to stock data. Moreover, the internet has become part of the infrastructure of industry.

But the professors are quick to cut through the internet hype. "The web is not that impressive as an information resource," says Prof Varian. It contains about two terabytes of information, roughly equivalent to a million books, he estimates. "The US Berkeley Library has 8m volumes, and the average quality of the Berkeley library content is much higher.

"People are always talking about information overload, and the quantity of information on the internet, but the real change is that the cost of accessing information has fallen dramatically."

Information technology has vastly increased our ability to store, retrieve, sort, filter and distribute information, adds Prof Shapiro. He offers the example of a distribution company which uses on-board computers to access information, updated in real time, on the cheapest source of fuel within 100 miles of its lorries.

Varian points to the use of IT by supermarkets which analyse consumers' buying habits and then offer them price discounts on an individual basis, via direct mail or with coupons on the back of their receipts. "They are saving hundreds of thousands of dollars per store on broadcast newspaper adverts."

The publishing industry, similarly, is moving toward customised or even "personalised" products. Although the internet is often seen as a threat to magazine and newspaper publishers, "content providers should not be afraid of this. They should look at it as a way to distribute their content to many more people at low cost." They can create different product versions and pricing schemes to specialise their offerings.

Amid the hype, the professors urge business people to keep a sense of perspective: "Many of today's managers are so focused on the trees of technological change they fail to see the forest: the underlying economic forces that determine success and failure."

*Information Rules: A Strategic Guide to the Network Economy, Carl Shapiro and Hal R. Varian, Harvard Business School Press. Publication date November 10 1998.

Carl Shapiro is Transamerica Professor of Business Strategy, Haas School of Business and Department of Economics, UC Berkeley. Hal R. Varian is Class of 1944 Professor and the Dean of the School of Information Management and Systems, UC Berkeley.