1. The Information Economy
Carl Shapiro
Hal R. Varian

2. 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

3. 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

4. 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

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 Apple Intel Microsoft
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 Backwards compatibility? 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 Computer Associates
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
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 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

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 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?

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
Lock-In
Sampling
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, , 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 Alliance 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

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

52. Controlled Migration Compatible, but proprietary Examples Windows 98
Pentium
Upgrades

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

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

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

56. 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

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