Re-thinking the Network Economy
Professor of Economics
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In the Fall of 1995. Netscape had recently had its IPO and I watched its shares soar. I considered its price to be wildly unrealistic and quickly shorted it. I wasn’t sure what the business model was that Netscape was going to apply to make the type of profits that would justify its seemingly lofty market capitalization. After a few ups and downs, I was able to make a small profit, but Netscape’s fortunes were thwarted more by Microsoft’s introduction of Internet Explorer than by any realism that had returned to the market.
After Netscape I shorted Yahoo in April of 1996, an action I was soon to regret. Stocks related to the Internet, particularly Yahoo, climbed to achieve greater and greater dizzying heights. I was way too early on the short side and I soon found myself shorting a company that was undergoing one of the great financial run-ups of all time. I soon found myself deep in the red. After watching a very large chunk of the money that I had put away for my daughters’ college education evaporate before my eyes, and after many a sleepless night, I threw in the towel in April of 1998, took my losses, and vowed to expose what I saw as insanity in the business press that was helping to stoke what was by then, as it appeared to me, a mad Internet frenzy among investors of all kinds. That was when I first conceived of writing this book, as a salve to my wounded ego and to help promote some sanity in a market I saw as totally insane. Not necessarily the best of motivations, but not the worst either.
My academic research on several related fields of economics seemed to provide me a particularly good fit to discuss e-commerce and other aspects of the Internet. I had done research on network effects and lock-in, two concepts that seemed to largely underpin the thinking that I saw displayed among the many uncritical Internet mavens. I had also done research on television advertising and the impact of new technologies on copyright owners. Ever since owning an Atari 800 in the early 1980s I had read computer magazines for fun, and had been an avid fan of technology for a very long time. It was my experience in these areas that convinced me that the Internet phenomenon was just a temporary, unsustainable aberration.
But working on this book soon took a back seat to another project that had come up. My academic work with Stephen Margolis was suddenly propelled into the mass of publicity surrounding the Microsoft antitrust case. We were the leading critics of the theory that the government was relying on to support its case. We had thought about writing a book about those theories and the Microsoft case provided a golden opportunity which we took advantage of during 1998 when we wrote the manuscript. That book, Winners, Losers, & Microsoft was published during 1999, and a revised version was published in 2001.
This current book took shape in early 2000, just before the onset of the Internet meltdown. Books about the Internet were everywhere and in general weren’t selling all that well. A fortuitous circumstance, however, allowed me to show the book outline to the folks at Amacom publishing, who in the Fall of 2000 asked me to proceed with writing the manuscript.
For various personal reasons, the book has taken longer to write than it should have. By the time I was seriously at the keyboard writing the book I realized that, at the least, I had to change all the tenses in the outline from the future to the past.
E-commerce is viewed quite differently now than it was when I began writing this book. At that time, firms with any Internet association were still highly valued and those laggards who appeared to be missing the ‘wave’ were being compared to lumbering dinosaurs, sure to fail in the years ahead.
How quickly things have changed. The technology meltdown that has seen the Nasdaq average fall from over 5000 to below 2000 began with the decline of the Internet stocks. I was hoping when I began writing this book to help in my small way to bring some rationality to the market. My goals have changed as events have unfolded. Now I would be content merely to provide some understanding of these markets.
Although Internet stock prices are now far more sensible, I still do not believe that there is much understanding of why things went awry. The Internet does provide important business opportunities. The main point learned in the last few years seems to be that firms need to be able to demonstrate the capability of generating profits some time in the future if they are to carry lofty stock valuations. Why the Internet stocks were not able to do so, and which market models can still work on the Internet are, in my opinion, not much better understood now than they were at the height of the frenzy. This book still, therefore, has an important role to play.
I was able to change the tense from future to past without much difficulty. But it was far more difficult to keep up with the rapidity of market changes related to Internet commerce. The lengthy chapter on the sale of music online and the impacts of copying on sites such as Napster, for example, has been revised every few weeks since I first wrote it, and I am sure events will have made much of what is currently there passé by the time this book is published. Nevertheless, the concepts propounded in that material will remain unaltered.
I want to extend my appreciation to the folks at Amacom Press who let me pass the deadlines with nary a complaint.
I need to thank my
I also would like to thank my daughters, Tania and Lauren, who have heard about this book for several years and graciously acted as if they thought its publication was actually a worthwhile event.
I am grateful to the
Finally, over the last several years my students at UTD have used incomplete chapters as reading materials for my course in “The Economics of Information Goods”. They made comments on several subject areas that improved the content.
A book like this, on a subject matter that changes so rapidly, is never really finished. News articles on these topics are coming out as I am sending the manuscript to the publisher. I hope that main ideas in this book are more enduring than the particular facts to which they refer, which have evanescent lifespans.
The Internet changes everything. That was a common refrain just a very short time ago. Almost no one seems to believe it anymore.
In fact, the Internet changes very few of the tried and true business strategies. Like other important technological advances, the Internet will change many aspects of our lives. But the economic and business rules that worked in previous regimes will largely continue to work in the new regime. These rules of business endure because economic forces do not change, and can not be changed by mere changes in technology, no matter how much some of us might wish it were so. It is just our hubris at work when we start to think that our technology can change forces that are not of our conscious creation.
After reading this paragraph the reader may ask: so why continue with this book if nothing is new? The answer is that although the economic forces haven’t changed, understanding how these forces will act to shape the Internet and commerce on the Internet is still quite incomplete. In the pages that follow I hope to provide some additional understanding. But not complete understanding. First, I am not in a position to know all the ways in which the Internet might impact the economy. Instead I have focused on a few important issues with which I am familiar, and have built the book around those issues.
In large part, the book applies very simple economic concepts to particular aspects of the Internet economy, or more particularly e-commerce, and tries to provide some insights that might prove helpful to anyone doing business, or contemplating doing business where the Internet might play a role.
Additionally, the book tries to answer some questions that are somewhat more academic in nature, such as why things went so very wrong with the early prognostications about the Internet. This is academic not because it is necessarily studied by academics, but because in a sense it doesn’t matter. The past is the past. Still, this very recent past is an episode that many of us are unlikely to see duplicated again, on the same scale, in our lifetimes. It is, in and of itself, an interesting story. The book doesn’t focus on the history per se, but instead focuses on understanding why financial events went so awry.
Even though the Internet-stock collapse has brought forth a resurgence of Internet skepticism, a logical framework to replace the previous thinking about Internet business strategy has yet to take hold. Firms still need to determine how to incorporate the Internet into their business models. Even with so many of the first generation of Internet firms crashing and burning, and with Internet stock market valuations now so much reduced, the Internet is going to be an important tool and business managers need to understand the economic forces at work in Internet based markets.
Many of the prognostications about the internet—rapidly increasing number of users, rapidly increasing advertising revenues, rapidly increasing sales—fertilized wildly optimistic prognostications for the performance of Internet firms, as if a virtual cornucopia of wealth would come streaming down upon investors in those companies [and it did for those lucky enough to get in early and leave before the deluge]. But even if all the prognostications of users and revenue growth had been true, as some of them were, that would not have assured the rosy financial scenario that so many investors and analysts anticipated.
One of the main focuses of this book is an examination of whether the rewards to successful technology firms, including Internet firms (yes, there will be some successful Internet firms), are going to flow almost entirely to early-birds, with laggards lucky to get the scraps, or whether this view, otherwise known as first-mover-wins, is misplaced. This material is covered at length in Chapter 3 which discusses the literature on lock-in, the economic concept that is the basis for the first-mover-wins claims. And it is the claim of first-mover-wins that dominated the thinking that eventually roiled the markets and led to the closings of so many Internet startups.
There are several major themes that run throughout the book.
The Internet is likely to change many lives and provide a great deal of new wealth to society—but that doesn’t necessarily lead to above normal profits for those who invest in the Internet activities, whether firms or individuals. The idea that large technological advances must be accompanied by above normal profits for firms wise enough to invest in these markets is not a law of economics. The optimists correctly point to the large and rapidly growing demand in such markets. But one ignores the forthcoming supply at one’s peril. As has always been the case, an understanding of the interaction of supply and demand is critical to truly understanding how any market, even high tech markets, will play out. In the long run, free entry into Internet markets can be expected to keep profits down, and in the short run profits might be below average if there is over-investment by firms erroneously believing that any growing industry must throw off great profits.
Investors usually do not part with their money without some explanation of why they should. Such an explanation was forthcoming from the proponents of the Internet revolution. The intellectual underpinnings of the claims that ‘the Internet changes everything’ derives from a belief that Internet markets were first-mover-wins, which is itself derived from certain fashionable academic theories known as path dependence and lock-in. Although these theories were in vogue at leading academic institutions, they were nonetheless without any real world support. Chapter Three analyzes the claim that technology markets are first-mover-wins.
As I explain in Chapter Three, the often-cited ‘network effects’ will usually be minor for most business conducted on the Internet. Contrary to common misconceptions, network effects do not come about just because business is conducted on a network. Nor are economies of scale likely to be greatly enhanced for most e-commerce firms. Yet, without these preconditions, winner-takes-all results will be no more likely for Internet incarnations of these industries than for the brick-and-mortarcounterparts. And if markets are not winner-takes-all, then being first should impart no extra advantage relative to brick-and-mortar versions of these industries.
But even when markets are winner-take-all, that doesn’t translate into first-mover-wins. The idea that firms must be willing to sacrifice almost everything, including quality, so as to get to market first was constantly repeated during the Internet heyday, but incessant repetition does not make it true. Everything else equal, being first usually does provide some advantage, whether we are talking about brick-and-mortar firms or Internet firms. But everything else is rarely equal and the missives of Internet gurus to get to market first so as to lock-in customers were not correct. In Chapter Three I explain why these theories were wrong.
Online retailing provides convenience and benefits to consumers—it is fast, it is easy to search and compare prices, and you can shop from your living room. But not everything can be easily sold on the Internet.
Chapter Four delineates the conditions under which selling over the Internet makes sense, and given those conditions, it is likely that only a minority of industries will find the Internet to be their primary mode of operation. The belief that virtually anything could be successfully sold by virtual firms on the Internet—from dog food to potatoes—ignored, among other things, the nature of the evolution of many industries in achieving greater efficiencies in such mundane matters as distribution and logistics. It also ignored the fact that for many products, perhaps most, consumers will prefer brick-and-mortar retailers with their dressing rooms, instant gratification, fast return-of-merchandise, and other characteristics that will never be imitated in the virtual world. One of the themes that will recur several times is that old-time competitive industries are usually very good at what they do, and starry eyed, well-funded newcomers fresh from MBA programs are unlikely to be able to compete, either in the knowledge they bring or overall competence. Lack of respect for established players and business methods was a major shortcoming of Internet start-ups.
Still, some products should do well being sold on the Internet and in Chapter Four I examine which products those might be. I also examine the nature of Internet pricing and whether auction-based selling is really the form of selling that makes the most sense. There are good economic reasons that retailing has evolved the way it has, and auctions, because they are a step backward in that evolution, are not going to become the dominant form of pricing. Auctions only make sense for odd-lots, surplus, one-of-a-kind items, or items where the audience likes the thrill of the chase.
E-commerce firms do not need to expend resources on physical stores, providing them with what should be a cost advantage over their brick-and-mortar counterparts. But this does not imply that Internet firms will be more profitable than their higher-priced brick-and-mortar versions. Chapter Five explores the manner in which profits are generated long-term and concludes that the future is not bright for easy profits on the Internet. Above-normal profits are normally due to a lack of competition. The Internet, with its free entry, would be expected to promote competition—good for consumers, but bad for producers.
Given the cost structure of Internet firms, one would expect that their advantage will actually lead to lower margins, as they are normally measured, not the higher margins that were envisioned by most commentators. The problem with the high-margin claim is its implicit assertion that competition will largely occur between Internet firms on the one hand and brick-and-mortar firms on the other. In reality, Internet firms will largely compete with other Internet firms, and brick-and-mortar firms will largely compete with one another. Therefore, even if online retailers have lower costs than brick-and-mortar retailers, it is inappropriate to conclude that online retailers will be more profitable—in fact, we would expect quite the opposite.
One of the early surprises with Internet enterprises was the choice by many web sites to model themselves on the broadcast television industry, which is entirely advertising based. Earlier prognostications had assumed that subscription fees would be the primary form of revenue generation. In Chapter Six I examine the choice of broadcast television as the model for Internet sites. A model that includes both advertising and subscriptions easily beats an advertising-only model and is the model most commonly used in other parts of the economy. Further, while online advertising does allow very precise targeting of advertisements and immediate feedback on the impacts of the advertising, enhancing the ability of Internet sites to raise revenues, there doesn’t seem to be much room for Internet advertising to grow since the current advertising revenues appear to be higher than can be justified when compared to other mediums. Therefore, Internet advertising, will not generate sufficient dollars to support the many web sites that were hoping to pay for content with it.
Chapter Seven contains a lengthy discussion of the sale of music and other copyrighted material on the Internet. This is an issue that has been much in the news, and the sale of music and other digital products promises to be one of the largest and most successful venues for Internet sales. I take the reader on an extended review of the impacts of copying, on a history of previous instances when the owners of copyright have ‘cried wolf’ about their demise, only to be proven wrong by events as they unfolded. I move on to the current arguments about the impacts of the Internet and the evidence surrounding the Napster case. I also explain how record companies might have made an important tactical mistake in shutting Napster down since new technologies based on such Gnutella protocols are likely to be a more fearsome threat to copyright owners.
This chapter also discusses new technologies known as digital rights management. These technologies are viewed with great suspicion by many analysts who view them as providing far too much power to the sellers and possibly engendering a diminution of free speech. My analysis, however, suggests that these fears are unwarranted.
Finally, the overriding myth of the Internet frenzy was that the laws of supply and demand did not apply to the Internet. My goal, when the reader has finished the book, is to have illustrated that economic laws transcend changes in technology. I would go so far as to say that they will apply to all markets at all times since I am confident I will not be proven wrong in my lifetime. Nevertheless, care needs to be taken in using economic concepts. Even economists can get carried away with trendy ideas and forget to use the scientific method in judging theories. There is an important lesson here, because the abandonment of sound economic principles in favor of faddish impulses has the potential to cause great damage to the economy.
The supposed death of supply and demand was born of monumental hubris championed most fervently by those largely unschooled in economic analysis. For example, the author of that article provided several illustrations of how this belief had entered managerial thinking. He quoted Mark McElroy, a principal in International Business Machines Corp.'s Global Knowledge Management Practice as saying: "Conventional economics is dead. Deal with it!" He also quoted Danny Hillis, vice president of research and development at Walt Disney Co. as saying that the new economy "is actually much broader than technology alone. It is a new way of thinking."
Thomas Petzinger, the author of that article, and my foil for the next few pages, explains that mainstream economists were loathe to accept that their prized theories were no longer applicable to the new economy:
You can understand why economists throw cold water on the new-economy concept, since accepting it would require them to abandon many of their dearest tools and techniques. It has become cliched to cite the historian Thomas Kuhn's 40-year-old concept of a "paradigm shift" -- a revolution in knowledge that forces scientists to give up the beliefs on which they have staked their careers. But that's exactly what economics and accountants could be facing.
It is instructive to follow Petzinger in his thinking, since it nicely encapsulates many of the points that were made in previous chapters. What was it that was causing the concepts of supply and demand to be overturned? He provides several reasons.
First, he claims, the sources of wealth had changed.
On an economywide level, these accelerating improvements may now be entering a supercritical phase in which they compound exponentially. Inventories, which once triggered or prolonged recessions, are not just declining but in many places evaporating…"Economists fail to realize that these improvements are reducing costs so radically as to enable entirely new ways of doing business," says telecom consultant David Isenberg of isen.com, Westfield, N.J…. Creativity is overtaking capital as the principal elixir of growth. And creativity, although precious, shares few of the constraints that limit the range and availability of capital and physical goods. "In a knowledge-based economy, there are no constraints to growth," says Michael Mauboussin, CS First Boston's managing director of equity research. "Man alive! That's not something new?"
It should be easy to recognize that almost all the ideas in this paragraph are complete nonsense (if not, go back and read the earlier chapters!). But for many industry analysts prior to the Internet meltdown these claims seemed perfectly reasonable, and anyone who didn’t believe them just ‘didn’t get it’. Economists often were accused of just that, in part because the basic premise of economics has always been that scarcity is an unfortunate fact of life, Internet or no Internet. This scarcity assumption, although a bit of a downer, is not going to be overturned. Beware anyone who says otherwise. Note, however, that some of the claimed new ideas in the above paragraph were not even new. For example, economists have long known that capital was not the major ingredient to growth, and that new knowledge was the most important factor in economic growth.
The second major reason that the old economics failed, according to Petzinger, was that the fundamentals of pricing and distribution had changed. Here his arguments should have a very familiar ring, and some of our old friends reappear as authorities supporting this view.
In his classic undergraduate text "Economics," Paul Samuelson noted that any second grader could figure out that increased supplies cause lower value. But that was before Windows 95, automatic teller machines and Nike shoes. Products used in networks -- whether computing, financial or social -- increase in unit value as the supply increases…Former Stanford economist W. Brian Arthur has popularized this more-begets-more concept under the banner of "increasing returns." The timeless notion of diminishing returns isn't dead, of course, but it applies to an ever-shrinking proportion of value-added activity, such as grain harvests and polyvinyl-chloride production… This explains why a seemingly insane strategy such as giving away your basic product has become a strategy of choice in the new economy…[T]he vendor collects revenue from another source, such as from selling upgrades, support or advertising. (Radio and television broadcasters -- networks, after all -- have always operated this way.) Another network, the cell-phone system, exploded when telecom companies began providing phones for practically nothing, even free of charge, and reaping increasing returns from air-time charges…
The future for economists surely looked bleak to Mr. Petzinger. Economists are relegated to studying those few markets like “grain harvests and polyvinyl-chloride production” –whatever those two markets might have in common. Note that Mr. Petzinger makes the fundamental error of assuming that television networks have network effects just because they called themselves networks. He also believed, incorrectly, that network effects somehow naturally led to advertising-based revenue models, apparently as a result of the facile comparison of television “networks” with the Internet “network.” His claim that cell-phone systems reap increasing returns from air-time charges revealed a lack of understanding of that concept as well.
Our 500-year-old system of accounting has grave limitations in this world.. But for now, according to the CS First Boston atoms-to-bits report, "there is a substantial and growing chasm between our accounting system and economic reality"…[I]n an economy awash in capital, the endgame, not the score at the end of each quarter, is all that counts…"Earnings are a decision variable, not a requirement," says Prof. Arthur, the economist. "If everyone thinks you're doing fine without earnings, why have them?"
This is a truly great quote. Why have earnings? Do we really need to ask? What, after all, is the value of a piece of stock if the underlying company doesn’t have any earnings to show. Surely Professor Arthur had been imbibing before he was quoted. Or maybe not.
And since traditional accounting practices didn’t seem to agree that money-losing practices were the road to riches, they were to be thrown out along with all those other outdated ideas that economists were found of. Except, of course, for Professor Arthur’s ideas. Apparently a little knowledge can be a dangerous thing, but a little mis-knowledge can be even more dangerous.
Finally, Mr. Petzinger thinks that the structure of economic decision-making had changed.
Knowledge-fueled growth and hyperefficiency account for only part of the this robustness. One additional factor is that the economy is smarter than ever…"At one time, if you had 50 or 100 giant companies doing the same thing in lockstep at the same time, you could destroy an economy," says Mr. Birch of Cognetics. "But you don't have that anymore."
When words like ‘hyper’ start appearing as prefixes in paragraphs (unless it is about mathematics), it is usually a sign to start looking for a shovel. But in an odd way, the point Mr. Birch makes is valid, although not in the specifics he gives. Mr. Birch was wrong about which firms were marching in lockstep. The firms marching in lockstep were the Internet firms, and the old fashioned firms, the ones that didn’t follow the advice to ‘get it’, are the ones who didn’t march. As it is, a large enough number of firms (usually startups) did march, like lemmings in lockstep, right off the cliff. If the entire economy had gone the way of the Internet firms, we would be in pretty big trouble. The dinosaurs, in other words, saved the economy from a far worse fate.
Making fun of the poorly thought out ideas that were so common just a year or two ago is great sport, but it hides a more serious agenda. The general rules that have formed our understanding of markets have been developed over a period of centuries. Every now and then a new ‘paradigm’ is presented as a replacement. The death of supply and demand has been prematurely announced numerous times. But like a modern horror movie villain, supply and demand keep arising from the grave. It does so because it is a wonderful tool that imparts extremely useful knowledge about markets.
The most recent new paradigm is the Internet economy, which was supposed to stand the old rules about markets and economies on their collective heads. The laws of supply and demand are not so fragile as to be overcome by anything so small as a new method of communicating with one another. After all, economic laws have survived the invention of the steam engine, the harnessing of electricity, the invention of the telephone, radio, television, computer, and the atom bomb. Long after the Internet craze is an interesting footnote in history, the rules of supply and demand will continue to describe the behavior of markets.
I do not want to diminish the fact that life changes, and technology along with it. That sometimes there is something new under the sun. That often, our theories and ideas turn out to be wrong. But the new theories and ideas that have been put forward in this instance are not more powerful alternatives that tell us something new and truthful about the world. Sometimes the new and intriguing ideas turn out to be wrong ideas. Probably more often than not. In this case, the new ideas had largely been demonstrated to be wrong before the Internet craze took off. But only a handful of academics were aware of these events. And truth is often less important than glamour.
A facile reading of the previous chapters might give the impression that there really is nothing new or different about conducting business on the Internet. That is not quite accurate.
Because the Internet enhances the transmission of information, the role of information is enhanced. Information, as a product, has some very different characteristics than more traditional products that can be touched, used-up, and easily defined.
The previous chapters provide a set of rules for the reader wondering how to use the Internet to best advantage. They warn against the expectations of easy and quick riches, of rushing off to catch the wave, of eschewing product quality because of the delay it might cause to product introduction. They reaffirm old standards such as slow and steady wins the race, build a better mousetrap, and there’s a sucker born every minute.
Readers should understand that business on the Internet is likely to be at least as competitive as business in the brick-and-mortar world. There will be no cornucopia of profits. Instead, firms will need to create superior and difficult-to-imitate business models. They must discover the products that work best being sold over the Internet. They must figure out efficient pricing mechanisms. They must not waste vast resources in a mad race to be first in a market since being first is not the key to long term success.
Most importantly, I hope these chapters provide some understanding and, hopefully, appreciation of how markets work, both the high tech variety and the more traditional markets. Readers will understand how it is that markets generate profits, and they will hopefully learn that you can’t correctly analyze a market by looking only at demand, or only at supply. And that you certainly cannot correctly understand a market by ignoring both.
If you understand this, you understand most of what you need to know about Internet markets, and to a large extent you understand what you need to know about most other markets. That is the most important lesson that was lost in the last few years.
 Economists argue about whether certain events, such as tulipmania in Holland, a famous seventeenth century instance of skyrocketing tulip prices that on the surface appeared to bear little semblance of sanity, were actually instances of financial ‘bubbles’. Economic models generally claim that bubbles exist when investors acknowledge no fundamental reason for high prices, but invest anyway in the expectation that prices will rise. In other words, these models put forward a form of the ‘greater fool’ family of theories which has investors operating on the assumption that others (the greater fools although not necessarily motley ones) will be left holding the bag. The definition of a bubble in this literature is that prices are high only because prices are expected to be high, not because there is an inherently foolish’ reason put forward that nonetheless seduces some investors. The fact that investments may appear foolish, to almost all in hindsight and to many during the event, is not evidence of a bubble, not in the economics literature. Thus there is likely to be a disconnect between economists and non-economists who would most likely consider a bubble to exist whenever large numbers of investors bet incorrectly and in a very big way on unproven theories. See the symposium on Bubbles in the Spring 1990 volume of the Journal of Economic Perspectives, Volume 4, number 2, pages 13-102.
 Apologies to millennium purists such as my daughter Lauren, who will point out that the new millennium began in year 2001.
 “So Long , Supply and Demand: There's a new economy out there -- and it looks nothing like the old one”, by Thomas Petzinger Jr., 01/03/2000, The Wall Street Journal, Page S1.
 At the risk of being labeled as change-impaired by the change-management gurus, it is fair to say that most of what are labeled as new ways of thinking are mostly just wrong ways of thinking. The few new thoughts that turn out to be better than the old will in due course become part of the received wisdom with which later ‘new’ ideas will do battle.
 At the risk of appearing snide, my understanding is that Professor Arthur doesn’t really have a degree in economics but instead has one in operations research. On the other hand, he did publish articles in economics journals and does have a following within the field.