The Information Economy

1. The Information Economy Carl Shapiro Hal R. Varian

2. Systems of Products • Complementary products • Hardware/software • Client/server • Viewer/content • Product lines • High fixed cost, low incremental cost • Leaders to value based pricing

3. Unique Features • Complements • Different manufacturers • Strategy for complementors as well as competitors • Compatibility as strategic choice • Standards and interconnection • Product lines • Lower quality may be more expensive

4. Information • Anything that can be digitized • Text, images, videos, music, etc. • a.k.a. content, digital goods • Unique cost characteristics • Unique demand characteristics

5. Cost structure • Expensive to produce, cheap to reproduce • High fixed cost, low marginal cost • Not only fixed, but sunk • No significant capacity constraints • Particular market structures • Monopoly • Cost leadership • Product differentiation (versioning)

6. Rights Management • Low reproduction cost is two-edged sword • Cheap for owners (high profit margin) • But also cheap for copiers • Maximize value of IP, not protection • Examples • Library industry • Video industry

7. Consumption Characteristics • Experience good • Browsing • Always new • Reputation and brand identity • Overload • Economics of attention • Hotmail example • Broadcast, point-to-point, hybrid

8. Technology • Infrastructure to store, retrieve, filter, manipulate, view, transmit, and receive information • Adds value to information • Web = 1 terabyte of text = 1 million books • If 10% useful = 1 Borders Bookstore • Value of Web is in ease of access • Front end to databases, etc. • Currency

9. Systems Competition • Microsoft-Intel: Wintel • Intel • Commoditize complementory chips • Microsoft • Commoditize PCs • Apple • Integrated solution • Worked better, but lack of competition and scale led to current problems

10. Lock-In and Switching Costs • Example: Stereos and LPs • Costly switch to CDs • Systems lock-in: durable complements • Hardware, software, and wetware • Individual, organizational, and societal

11. Network Effects • Value depends on number of users • Positive feedback • Fax (patented in 1843) • Internet (1980s) • Indirect network effects • Software • Expectations management • Competitive pre-announcements

12. Compatibility • Examples • Beta v. VHS • Sony v. Philips for DVD • Role of 3rd parties • Read v. write standards • Backwards compatibility? • Windows 95 • Windows NT

13. Basic Strategies • Go it alone • Partnerships (Java) • Formal standard setting • Widespread use • Licensing requirements • Competition in a market or for a market?

14. Policy • Understand environment • IP policy • Competition policy • Regulation • Antitrust • Electronic commerce • Contracts • Privacy

15. Information is Different…but not so different • Key concepts • Versioning • Lock-in • Systems competition, • Network effects

16. Recognizing Lock-In • Cost of switching • Compare • Ford v. GM • Mac v. PC

17. What’s the Difference? • Durable investments in complementary assets • Hardware • Software • Wetware • Supplier wants to lock-in customer • Customer wants to avoid lock-in • Basic principle: Look ahead and reason back

18. Examples • Bell Atlantic and AT&T • 5ESS digital switch used proprietary operating system • Large switching costs to change switches • Computer Associates • Aircraft repair and cargo conversion

19. Small Switching Costs Matter • Phone number portability • Email addresses • Hotmail (advertising, portability) • ACM, CalTech • Look at lockin costs on a per customer basis

20. Valuing an Installed Base • Customer C switches from A to "same position" w/ B • Total switching costs = customer costs + B's costs • Example • Switching ISPs costs customer $50 new ISP $25 • New ISP make $100 on customer, switch • New ISP makes $70 on customer, no switch • Disruption costs • Example: ILECs v CLECs • Competitive market • Profit=switching costs • e.g. ILEC profits=customer + CLEC switching costs

21. Profits & Switching CostsIn General: • Profits from a customer = total switching costs + quality/cost advantages • In commodity market like telephony, profit per customer = total switching costs per customer • Use of this rule of thumb • How much to invest to get locked-in base • Evaluate a target acquisition (e.g., Hotmail) • Product and design decisions that affect switching costs

22. Classification of Lock-In • Durable purchases and replacement: declines with time • Brand-specific training: rises with time • Information and data: rises with time • Specialized suppliers: may rise • Search costs: learn about alternatives • Loyalty programs: rebuild cumulative usage • Contractual commitments: damages

23. Durable Purchases • Aftermarket sales (supplies, maintenance) • Depends on (true) depreciation • Usually fall with time • Watch out for multiple pieces of hardware • Supplier will want to stagger vintages • Contract renewal • Technology lock-in v. vendor lock-in

24. Brand-specific Training • How much is transferable? • Software • Competitors want to lower switching costs • Borland and Quattro Pro help • Word and WordPerfect help

25. Information & Databases • Datafiles • Insist on standard formats

26. Specialized Suppliers • Advertising, legal, accounting firms • Pentagon • Dual sourcing • Intel and AMD • Adobe PostScript • Java

27. Search Costs • Transactions cost in finding new supplier • Also costs borne by new supplier • Promotion, clsoing deal, setting up account, credit risks • Example: Credit Cards • $100 million in receivables sells or about $120 million • Market valuation of “loyalty”

28. Loyalty Programs • Constructed by firm • Frequent flyer programs • Frequent coffee programs • Personalized Pricing • Gold status • Example: Amazon and Barnes and Noble • Amazon Assocates Program v. B&N's Affiliates program • Add nonlinearity?

29. Contractual Commitments • “Requirements contract”: Purchase supplies from one supplier • Beware of “evergreen contracts”

30. Suppliers and partners • Railroad spur lines • Customized software

31. Follow the Lock-in cycle Brand Selection Sampling Lock-In Entrenchment

32. Lessons • Switching costs are ubiquitous • Customers may be vulnerable • Value your installed base • Watch for durable purchases • Be able to identify 7-types of lock-in

33. Networks and Positive Feedback Carl Shapiro Hal R. Varian

34. Important Ideas • Positive feedback • Network effects • Returns to scale • Demand side • Supply side

35. Positive Feedback • Strong get stronger, weak get weaker • Negative feedback: stabilizing • Makes a market “tippy” • Examples: VHS v. Beta, Wintel v. Apple • “Winner take all markets”

36. Sources of Positive Feedback • Supply side economies of scale • Declining average cost • Marginal cost less than average cost • Example: information goods • Demand side economies of scale • Network effects • In general: fax, email, Web • In particular: Sony v. Beta, Wintel v. Apple

37. Network Effects • Real networks • Virtual networks • Number of users • Metcalfe’s Law: Value of network of size n proportional to n2 • Importance of expectations

38. Lock-In and Switching Costs • Network effects lead to substantial collective switching costs • Even worse than individual lock-in • Due to coordination costs • Example: QWERTY

39. Don’t Get Carried Away • Network externalities don’t always apply • ISPs (but watch out for QoS) • PC production • Likelihood of tipping • See next slide

40. Likelihood of Tipping

41. Chicken & Eggs • Fax and fax machines • VCRs and tapes • Internet browsers and Java

42. Igniting Positive Feedback • Evolution • Give up some performance to ensure compatibility, thus easing consumer adoption • Revolution • Wipe the slate clean and come up with the best product possible

43. Evolution • Offer a migration path • Examples • Microsoft • Intel • Borland v Lotus • Build new network by links to old one • Problems: technical and legal

44. Technical Obstacles • Use Creative design • Think in terms of system • Converters and bridge technologies • One-way compatibility

45. Legal Obstacles • Need IP licensing • Example: Sony and Philips CDs

46. Revolution • Groves’s law: “10X rule” • But depends on switching costs • Example: Nintendo

47. Openness v. Control • Your reward = Total added to industry x your share • Value added to industry • Depends on product and • Size of network • Your share • Depends on how open

48. Openness • Full openness • Anybody can make the product • Problem: no champion • Alliance • Only members of alliance can use • Problem: holding alliance together

49. Control • Control standard and go it alone • If several try this strategy, may lead to standards wars

50. Generic Strategies