What are the Rules, Anyway?

In the Alice-in-Wonderland world of the Web, things keep getting curiouser and curiouser. Before you drink that “Drink Me” hear two Berkeley economists

The freewheeling economy of the World Wide Web may seem like a lawless place-a frontier town without rules. Not so fast, say economists Carl Shapiro and Hal Varian. While technologies come and go, they argue, the laws of economics persist. As a result, the new moguls of the Web can-and should-learn from the past. Content providers can learn from Hollywood’s mistakes; e-commerce sites can take lessons from L.L. Bean; Bill Gates can discover that hundred-year-old antitrust laws apply even to him.

In their new book, Information Rules (Harvard Business School Press), Shapiro and Varian offer up a practical introduction to the economics of selling information. Shapiro and Varian explain how to maximize the value of intellectual property, differentiate products, lock in customers, negotiate standards alliances, and benefit from so-called “network effects”-the idea that the value of some goods depends on the number of people who use them. Telephones are the classic example of such a product, and in the Web age, network effects seem pervasive. It is network effects that stimulate the positive feedback that allows Microsoft’s market share to grow and grow.

Shapiro and Varian first connected in the mid-1970s when Varian was a professor at MIT and Shapiro an undergraduate. Varian is now dean of the University of California at Berkeley’s School of Information Management and Systems, and Shapiro is Transamerica Professor of Business Strategy at Berkeley’s Haas School of Business. During 1995-96, Shapiro served as chief economist in the Department of Justice’s antitrust division; he has since consulted with the U.S. government on the Microsoft case. Freelance writer Becky Waring caught up with them recently on the Berkeley campus.

TR: Why are network effects so important these days?
Shapiro: Look at Microsoft. Arguably their operating system is not all that great-it’s buggy and it has problems-and yet they still have a 90 percent market share. In time, their position might erode, but they have a lot of inertia due to the size of their installed base of users.

TR: Why does selling information require a different set of rules from selling physical goods?
Shapiro: Because the economics of information is different. Think about a book or a movie. There’s a huge upfront cost to create the content and then very little to make additional copies. That’s even more so with the Internet, where the information is in digital form and can be distributed at virtually no cost to large numbers of people. This is not the case with manufactured goods, where there is a substantial cost to produce and deliver each unit.

Varian: Another difference is on the demand side. Buyers of information goods really don’t know what they’re getting until they experience it, and by then they’ve already paid for it. The challenge that faces information providers, then, is this: How do they tell you what they’ve got without giving it all away? This is not a problem that’s unique to the Internet. Movie previews, book reviews, music radio and so on have helped solve this problem in the predigital world. Now we’re beginning to see the Web equivalents.

TR: Supposedly, the Web is going to allow us to get rid of the middleman and allow a free flow of goods and information. But aren’t you just trading one intermediary for another?
Shapiro: Yes-we like to say that the friction-free economy is a fiction. With e-commerce, the reputation of the seller, whether it’s L.L. Bean or Lands’ End, will be even more important than in the past because people are all the more concerned about things like the security of the transaction, the quality of the merchandise, service and support. Sure, people will be able to shop around efficiently for the lowest price-but reputation is always going to be very important, and that’s where middlemen come in. Take stock trading sites, which offer an inexpensive and convenient way to buy and sell securities. A lot of investors have realized that saving a small amount on a transaction isn’t worth much if the trade isn’t going to be executed properly or if they’re not getting good prices. A number of brands will survive, and some will be cut-rate. Right now, we’re in a shake-out phase.

TR: What’s the main problem facing old-line companies still struggling to understand Web commerce?
Varian: Incumbents in any industry have to grapple with their old business models. Take music retailing-record producers would love to sell directly to consumers, but they don’t want to alienate their traditional distribution channels. A company that comes along without a pre-existing distribution channel to preserve-like Amazon.com, for instance-can be much more flexible.

Shapiro: Of course, there’s nothing to bar conventional retailers from competing online as well. Look at the bookselling business. Barnes and Noble didn’t lead, but it pretty quickly followed Amazon.com. I think that’s a pattern we’ll see over and over: upstart entrants establishing a way to use the Net that works, and then the incumbents following along saying: This may cannibalize some of our existing business, but if we don’t do it, others will.

TR: What industries do you see as being the most threatened by the Web, or conversely, having the most opportunity to gain by learning the new rules?

Varian: CD-ROMs and the Web allow for a much cheaper way to distribute huge volumes of information. This forces traditional companies to radically rethink their strategies. Look at the encyclopedia business. Encyclopedia publishers have decades of experience selling at high prices to a small number of buyers. Now along comes the Web, making it possible to reach a much larger market-but also forcing a drastic reduction in price. It’s very hard to give up those high-priced sales in the hope of getting a lot of low-priced sales, but that’s what these companies have to do. The same goes for distributors of nationwide telephone directories. Just 10 years ago, the first CD phone directory sold for $10,000 a copy. Now you can buy one for $3.99-or get the numbers free on the Web.

TR: How do you recommend that companies get the most out of their intellectual property in the Web era?
Varian: Many companies fall into the trap of thinking that they should maximize the protection of their property. Your real goal should be to maximize its value. When videos first came out, the movie industry was frightened out of its wits. Moviemakers tried to preserve the old business model by selling only to the high end of the market. Hollywood didn’t realize that low-price, mass-market videos could be very profitable. Now, video sales and rentals account for more than half of Hollywood’s revenue. On the Internet, you can increase the value of your products to the consumer by making your terms and conditions more liberal. Of course, this means you might sell less of it. The question is which of those effects will dominate.

TR: Having just published a book, you’re in a position to test this out for yourself.
Varian: Yes, and we recently signed a contract with Rocket E-Book to publish the book in electronic form. Clearly there’s a danger there-people might copy the text and give it away, undercutting book sales. On the other hand, electronic books have a huge potential, and the users are the sort of technological leaders that we’re after, so we think it’s very sensible. We’re also posting a chapter on Amazon.com: If you want people to consume your information, you have to give them a good idea of what you have to say.

TR: A lot of Web businesses are offering “personalized” service, which requires that they gather information about each customer. Do you see a conflict between personalization and privacy?
Varian: I think there’s only an apparent conflict. The real question is whether the firms truthfully disclose what they will do with the information; consumers have a right to know how information about them is going to be used. If those uses have sufficient value to them, and they trust the technological and legal infrastructure to make sure that their information is used in a secure way, both buyers and sellers can be better off with some information disclosure. It’s hugely beneficial for people who supply things to me to know quite a bit about me-as long as they don’t abuse that information. Right now we’re in a transition stage where we don’t have the institutions to guarantee that trust, so there is some abuse of the system. Ultimately, this is going to require some regulatory oversight.

Shapiro: We’ve been waiting for industry to get its act together and do this on a voluntary basis. If they don’t work something out pretty soon, government will need to step in. But intervention ought to be light-handed-aimed at providing options and flexibility rather than restrictive mandates.

TR: What would be the most important issues the government should focus on to enable the new economy to work smoothly?

Varian: My top three are intellectual property, privacy and Internet governance. The main worry I have about intellectual property is that it’s driven by the content providers, who are putting a lot of lobbying money into strengthening copyright laws to cope with the Internet. With privacy, the danger is getting railroaded into a bad policy as a way to placate a public outcry. The Communications Decency Act, for example, was a knee-jerk reaction to the threat of online pornography. Finally, the governance problems facing the Internet are huge; they’re difficult enough at the national level, yet they ultimately require international coordination. I think that we’re going to see a lot of wasteful legal suits by disgruntled participants in the next few years.

Shapiro: Another thing the government has to keep an eye on is antitrust. I take the view that the legislation passed a hundred years ago has now been elaborated. The basic legislation said, “You can’t monopolize a market. Don’t stifle competition.” Now we have a hundred years of court decisions explaining what that means. This legal structure is, I think, quite flexible: It has handled many new industries and new technologies. If there’s a worrisome area there, it’s sorting out the boundary between antitrust and intellectual property. One troubling decision, for instance, essentially forces Eastman Kodak to license its patented technology for servicing high-volume photocopiers. I’m doing work for Intel now and I’m concerned about the Federal Trade Commission’s action against Intel as a precedent for forcing companies to divulge intellectual property under conditions they would not agree to voluntarily. [The FTC accused Intel of violating antitrust law by denying its customers technical information they needed to develop computer systems based on Intel microprocessors.]

TR: Say “antitrust” and most people are going to think of Microsoft.
Varian: The press has focused on Microsoft vs. Netscape or Microsoft vs. Sun. But the real role of antitrust is not to choose winners but to define the rules of the game. The most important outcome of the Microsoft case is going to be the precedent it sets for future competition.

Shapiro: The challenge for antitrust is: Do network effects lead to durable monopoly power? And in the presence of network effects, what conduct stifles competition and innovation? Linux is out there as an alternative operating system that’s quite good, but it doesn’t yet have critical mass. Can it really take off and succeed? This is not a new issue. In the 1950s FTD, the floral service, tried to impose a rule that a florist could not join another network if it wanted to be a part of FTD. The Justice Department said, basically, not so fast-you guys have a monopoly over floral networks, and that’s exclusionary. And so FTD agreed to drop that provision, the same way the Justice Department is now asking Microsoft to drop provisions that make it difficult for America Online to distribute Netscape.
varian: The point is that if you’re in a race, it’s fine to run as hard as you can, but it’s not fine to trip the other guy. The important thing is to make sure that you have appropriate rules of conduct for those firms that end up having dominant market positions.

Shapiro: Microsoft says in its defense: We have to run as fast as we can because technology is changing. If we slow up or don’t give good value to our customers, we’re going to be out on our ear.

TR: Is that true?
Shapiro: I don’t think so. In any event, Microsoft is running down the racetrack, and certainly improving its product, but the question is whether some of its tactics are designed to stiff-arm competitors. And that’s the role of antitrust law: to make sure that competition is not blockaded, and then let the consumers decide.

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