A Strategic Guide to the Network Economy
Carl Shapiro and Hal R. Varian
It’s more critical than ever for today’s managers to understand how to produce, price, market, and protect their intellectual property. But how can they develop effective strategies for competing when advances in technology keep changing the rules of the game?
The thesis of this book is that durable economic principles can guide managers in today’s frenetic business environment. Technology changes, but economic laws do not. Many of today’s managers are so focused on the trees of technological change that they fail to see the forest: the underlying economic forces that determine success and failure. Information technology is rushing forward, seemingly chaotically, and it is difficult to discern patterns that guide business decisions. But there is order in the chaos: a few basic economic concepts go a long way towards explaining how today’s industries are evolving.
You define information very broadly—essentially, as anything that can be digitized. Do the strategies you outline apply to industries outside "traditional" information-intensive industries like software, publishing, and law?
The core industries that we examine are in the ICE sector: information, communication, and entertainment. Intellectual property, switching costs, and network effects are especially strong for these industries. But some of these concepts are useful for understanding other industries that aren’t particularly high-tech. For example, network effects are important in the fashion industry. And since virtually every industry uses information technology, it’s important to understand the effects driving that industry.
If a company is an historical leader in an information category, is strong brand recognition enough to ward off new competitors?
A valuable brand name allows a company to command some premium, but won’t guarantee the same prices or margins enjoyed before new information technologies arrived that caused per-copy and distribution costs to fall. In our experience, information providers with established brand names often hesitate to drop prices quickly enough to warn off potential entrants, perhaps because they think their brand name shields them from competition. Companies slow to accept the inevitability that new technologies will force lower prices for basic information may find themselves losing market share rapidly on all fronts. To take just one example: CNET has been a leader in the online news area precisely because they’ve been willing to experiment with new business models without having to worry about cannibalizing a print publication.
In terms of personalizing content, do you see pockets of opportunity in this area that haven’t exploited?
The ability to customize and personalize advertising is a very powerful marketing tool that Internet businesses are only beginning to understand and exploit. Intermediaries like DoubleClick and Softbank Interactive Marketing sell ads targeted by day of week, time of day, continent, country, states, or operating system, and they’re adding more capabilities each day. Search engines such as Yahoo sell ads linked to search terms for a premium price. If you’re a biking enthusiast and searching for mountain bike trails, an ad might pop up for related biking gear. We’ll see more and more of this kind of customized advertising in the future.
What are your thoughts on managing intellectual property—are we worrying too much or not enough?
Many content producers have come to view the Internet as one giant, out-of-control copy machine. Despite the dangers inherent in the easy copying and transmittal of digital information, we think that content owners tend to be too conservative with respect to the management of their intellectual property. You can look at the video industry as a good example of this. Hollywood and the TV industry were petrified by the advent of videotape recorders. Ironically, Hollywood now makes more money from video than from theater presentations for most productions. When managing intellectual property, your goal should be to choose the terms and conditions that maximize the value of your intellectual property, not those that maximize its protection. On the technology side, we encourage companies to engage in licensing to help assemble allies and most of their patents.
There’s been a lot of discussion around the value of giving away content. What is your view on this?
Ultimately, we believe that digital technology and the Internet offer great opportunities for the creative use of informational free samples, whether the content consists of images, news articles, databases, or stock quotes. The obvious way to turn users of this free material into revenue generators is by versioning—making the free version limited in scope, convenience, quality, and/or quantity. The beauty of information is that it is particularly easy to give free samples of something that has zero marginal cost of distribution. The trick is to break your product up into components; some you give away, others you sell. The parts that are given away are the advertisements—the infomercials—for the parts you sell.
Traditional rules of competitive strategy focused on competitors, suppliers, and customers. You say that in the information economy, complementors (companies selling complementary components) are equally important. Explain.
When you are selling one component of a system, you can’t compete if you’re not compatible with the rest of the system. The dependence of information technology on systems means that firms must focus not only on their competitors but also on their collaborators and complementors. Forming alliances, cultivating partners, and ensuring compatibility (or lack thereof) have become critical business decisions. Firms have long been faced with make/buy decisions, but the need for collaboration, and the multitude of cooperative arrangements, has never been greater than in the area of infotech. If your partner fails to deliver their piece of the system, you're dead in the water before you even get to face the competition.
Some say that the Internet will herald the dawn of the "friction-free economy." You say this is fiction—why?
It’s very ironic that the event that will usher in the new millenium is the dreaded Year 2000 Problem, which is really a testament to the enormous rigidities that plague the information economy. Like it or not, in the information age, buyers often must bear costs when they switch from one information system, or even one brand, to another. Users will face more instances of lock-in, not less, in the coming years. And brand names will become more important, not less, as electronic commerce takes hold, leading consumers to rely on brand names and reputation instead of physical inspection to judge more and more products.
How pervasive is lock-in and who needs to be concerned about it?
The fact is that switching costs are the norm, not the exception, in the information economy. If you are a supplier seeking new customers, you have to overcome customer inertia and lock-in to rivals. If you are a locked-in customer, you may find yourself in a weak bargaining position that could have been avoided by negotiating protections for yourself at the outset. Most managers operating in business today recognize lock-in and switching costs as factors they must deal with on a regular basis. For example, their customers may become locked into their products and services, and the company itself is almost certainly susceptible to lock-in in their own use of data and information systems. Businesses compete at their own peril if they don’t recognize lock-in, protect themselves from its adverse effects, and use it to their advantage when possible.
You say that the timing of strategic moves is even more important in the information industry than in others. Why?
A variety of factors play into this. One is the importance of achieving critical mass for your product. Another is that customer expectations are critical to information infrastructure: the product that consumers expect to become the standard will become the standard. Another factor is the simple truth that technology is evolving so rapidly, you don’t want to introduce your product only to find a new technology has already made it obsolete. This becomes a very tricky game. Moving too early means making compromises in technology and going out on a limb without sufficient allies. Japan’s television network NHK tried to go it alone in the early 1990s with its own high-definition television system, with disastrous consequences. Its MUSE system has met with consumer resistance in Japan, and has also left the Japanese behind the U.S. in the development and deployment of digital television. Yet moving too late can mean missing the market entirely, especially if customers become locked into rival technologies.
How can a company or entrepreneur determine when the time is right to release their product?
The answer is very context dependent. Does the company have significant financial resources to build a new market? Has it formed an alliance with firms that supply complimentary products? Do they have the intellectual property rights locked up, or do they have competitors breathing down their necks? Will a product introduction pre-empt their rivals, or will it just give them time to perfect the next generation of the technology?
If a company or start-up owns valuable intellectual property but needs to gain critical mass, how can it know whether to choose a "go-it-alone" strategy, or to participate in a formal standard-setting process?
A "go-it-alone" strategy typically involves competition to become the standard. Participating in a formal standards-setting process essentially means assembling allies to promote a particular version of technology. This strategy typically involves competition within a standard. Don’t plan to play the higher-stakes, winner-take-all battle to become the standard unless you can be aggressive in timing, pricing, and in exploiting relationships with complementary products.
Do larger companies always have the "upper hand" in formal standards-setting processes, or does it benefit small companies or entrepreneurs to take part in them too?
Very often, the most important rule is simply to show up at standard-setting meetings to make sure a "consensus" adverse to your company’s interests does not form. Smaller companies sometimes find attendance burdensome, allowing larger firms to steer the process to their advantage. If a smaller company can’t spare someone to attend, they should consider teaming up with other small players whose interests are aligned with theirs, and send a representative.
Many of the examples in the book are of larger companies and organizations. How can smaller companies and entrepreneurs benefit from the strategies you outline?
Most smaller companies we know want to become larger, so it is critically important for them to understand the strategies that large companies used to become large. But lots of what we say about versioning, rights management and pricing is just as relevant for small companies as large ones.
CARL SHAPIRO: You helped lead the Justice Department’s investigation of Microsoft from 1995-1996, and are currently advising Intel Corp. in its defense against the Federal Trade Commission. Based on your experience, when do you think antitrust authorities should step in to curb high-tech monopolies?
First and foremost, durable high-tech monopoly is a rare beast. Antitrust authorities should forebear from pursuing companies that temporarily obtain market dominance based on innovation. Even a company that manages to maintain market leadership for a number of years has nothing to fear if it wins by competing on the merits. The danger area for high-tech leaders is reached when they employ business strategies that exclude rivals by impeding their ability to reach and deal with customers or complementors. Microsoft stands accused of using such exclusionary contracts with OEMs and ISPs. Smaller companies that dominate a niche can be sued for such practices, too, but most high-tech firms have nothing to fear so long as they steer clear of exclusionary practices.
Do you think that antitrust laws block companies from carrying out their chosen strategies?
Overall, we don’t believe this to be true, even when companies need to cooperate with other industry members to establish compatibility standards. Occasionally, companies are prevented from acquiring direct rivals, as when Microsoft tried to acquire Inuit—but this is hardly unique to the information sector. The Sherman Anti-Trust Act was passed in 1890 to control monopolies. As we enter a new century, we believe it is still flexible enough to maintain the critical balance between preventing monopolization from stifling innovation, while also keeping markets competitive enough to prevent government regulation from intruding in our dynamic information-driven markets.