The Information Economy Carl Shapiro Hal R. Varian

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

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

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

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)

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Profits & Switching Costs In 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

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

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

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

Information & Databases Datafiles Insist on standard formats

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

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”

Loyalty Programs Constructed by firm Personalized Pricing 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?

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

Suppliers and partners Railroad spur lines Customized software

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

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

Networks and Positive Feedback Carl Shapiro Hal R. Varian

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

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”

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

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

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

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

Likelihood of Tipping

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

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

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

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

Legal Obstacles Need IP licensing Example: Sony and Philips CDs

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

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

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

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

Generic Strategies

Performance Play Introduce new, incompatible technology Examples Palm Pilot Iomega Zip Attractive if Great technology Outsider with no installed base

Controlled Migration Compatible, but proprietary Examples Windows 98 Pentium Upgrades

Open Migration Many vendors, compatible technology Examples Fax machines Some modems

Discontinuity Many vendors, new technology Examples CD audio 3 1/2” disks

Historical Examples of Positive Feedback RR gauges AC v. DC Telephone networks Color TV HD TV

Lessons Positive feedback means strong get stronger and weak get weaker Consumers value size of network Works for large networks, against small ones Consumer expectations are critical Fundamental tradeoff: performance and compatibility

Lessons, continued Fundamental tradeoff: openness and control Generic strategies Performance play Controlled Migration Open Migration Discontinuity Lessons of history