Information Rules: A Strategic Guide to the Network Economy by Carl Shapiro, Carol Shapiro, Hal R. Varian

From the Publisher

Information Goods -- from movies and music to software code and stock quotes - have supplanted industrial goods as the key drivers of world markets. Confronted by this New Economy, many instinctively react by searching for a corresponding New Economics to guide their business decisions. Executives charged with rolling out cutting-edge software products or on-line versions of their magazines are tempted to abandon the classic lessons of economics, and rely instead on an ever changing roster of trends, buzzwords, and analogies that promise to guide strategy in the information age. Not so fast, say authors Carl Shapiro and Hal R. Varian. In Information Rules they warn managers, "Ignore basic economic principles at your own risk. Technology changes. Economic laws do not." Understanding these laws and their relevance to information goods is critical when fashioning today's successful competitive strategies. Information Rules introduces and explains the economic concepts needed to navigate the evolving network economy. Information Rules will help business leaders and policy makers - from executives in the entertainment, publishing, hardware, and software industries to lawyers, finance professionals, and writers -- make intelligent decisions about their information assets.

<br>&#151 Wall Street Journal - Stanley W. Angrist

...inexpensive, reliable computing has changed the way business is done. So how should corporations adapt? Carl Shapiro and Hal Varian, in Information Rules, offer several ideas. The authors forgo buzzwords and hype, for the most part, to describe proven strategies based on enduring economic principles.

What People Are Saying

Andrew S. Grove
An excellent book! Through a combination of clear, jargon-free English, and crisp, specific examples drawn from real life, Information Rules shows how economic principles apply in the age of Internet.

Barry Nalebuff
Forget Econ 101. Get a glimpse of Econ 2001 -- state-of-the-art ideas on how and when the market for information works, and what that means for business. Information Rules is an accessible, real-world, and ultimately practical guide.

Eric Schmidt
Information Rules is the first book to explain network economics, the new economics of our lives. Shapiro and Varian explain all the crazy things that we see happening every day in Silicon Valley and other parts of the world. This book is a must-read for every business person in the new millenium.

Michael Dolbec
I have not found a better field guide to the trench warfare of competition in the information age. Information Rules is an excellent asset for high-tech strategists. Skip that 'fog of war' feeling -- read this book to find out exactly what your competitors are doing, and how you can make their nights sleepless as you compete for the future.

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Table of Contents

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Chapter 3: Versioning Information

Personalized pricing requires knowledge about individual customers. The best intelligence about customers comes directly from them, as when customers communicate their needs and indicate the products they would like to see or the categories of information of interest to them.

We certainly encourage companies to develop and exploit two-way communications with customers. However, you can still get valuable data about customers without customer-provided profiles, without expensive marketing data, and even without consumers' active involvement. How? Answer: You can learn a great deal about your customers by offering them a menu of products and seeing which one they choose.

For example, if you offer a product line with one product targeted for professional users and one product for amateur users, you can simply observe your sales figures to see how your market splits. We call this strategy "versioning." It means offering your information product in different versions for different market segments.

in this chapter we show you how to design your "product line" to capture the greatest profit from the information you are selling. Your profits will depend on both the total value you create for your customers and the fraction of that value which you are able to extract through the fees you charge for the information. To maximize your profits, you want to make the total value created as large as possible and then extract as much of that value as you can. This observation leads to the two basic principles for designing a product line of information goods.

• Offer versions tailored to the needs of different customers. A full line of information products will maximize the total value of the information you are providing.
• Design these versions to accentuate the needs of different groups of customers. Emphasizing customer differences allows you to extract more of the value you have created, as each customer selects the version that best meets his or her needs.

Economists call the second principle sefl-selection. You don't have to figure out what value the customer Puts on your information product, because the customer reveals that value through the version that he or she selects.

Consider the Quicken example in Chapter 2. How did Intuit actually solve its pricing problem? It created two versions of the software, Basic Quicken, which sells for about $20, and Quicken Deluxe, which sells for about $60. The Deluxe version has a variety of extra features that appeal to the power users but aren't that attractive to the occasional user.

Let's see how the two above principles have been applied to one of the oldest forms of mass-market information provision: the book. How can a publisher such as Viking make the most money selling the newest Stephen King novel? Viking would like to sell the novel at a high price to the avid fans who will pay a lot for their favorite author's most recent book. But a high price would no doubt discourage purchases by those who are less enthusiastic readers of Stephen King. Ideally, the publisher would like to sell every copy of the book at a different price-that is, engage in the kind of personalized pricing that we described in the previous chapter.

The problem is, the publisher has no way to tell what any given individual is willing to pay for the book. Politely asking those customers who place the highest value on the latest Stephen King book to pay extra" because they like it so much will not do the trick for obvious reasons. (Even if Viking or its distributors could keep track of readers who had rushed out to buy prior Stephen King books, attempting to charge more to this group would only encourage them to hide their identity or buy the book through another channel.) So it appears that the best the publisher can do is to differentiate the price by groups: sell at one price to the book club members, say, and at another price to retail book stores.

In fact, the publisher can do much better by applying our second principle: designing versions to emphasize customer differences. Here, high-value customers are impatient to get the book, while lower-value customers can more easily wait. The main difference here involves patience. Thus, the key to versioning books is to delay before offering less expensive versions. This is precisely what publishers do. After selling hardback copies to the intense fans, libraries, and book clubs, Stephen King's publisher then releases the book in paperback-so all those other fans can purchase it. And finally, after a few years, the book might even be remaindered and sold at an even lower price to those who scrounge around on the bargain tables. The book example is no doubt familiar to you. But our extraction principle applies widely to the sale of information of all types.

When you think about it, releasing different versions over time is a pervasive strategy for selling information. Movie producers initially release their productions in first-run theaters. After a few months they move to the hotel and airline market. A few months after that, they sell to the home video market. All those young, impatient people go to the movies. Parents with small children and empty nesters stay home and watch the videos a few months later.

DESIGNING YOUR PRODUCT LINE So how can you use versions of your information in a way that induces self-selection? The key is to identify dimensions of your information product, such as timeliness, that are highly valued by some customers yet of little importance to others. Then offer versions that differ notice...

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Chapter One

The
Information
Economy

As the century closed, the world became smaller. The public rapidly gained access to new and dramatically faster communication technologies. Entrepreneurs, able to draw on unprecedented scale economies, built vast empires. Great fortunes were made. The government demanded that these powerful new monopolists be held accountable under antitrust law. Every day brought forth new technological advances to which the old business models seemed no longer to apply. Yet, somehow, the basic laws of economics asserted themselves. Those who mastered these laws survived in the new environment. Those who did not, failed.

    A prophecy for the next decade? No. You have just read a description of what happened a hundred years ago when the twentieth-century industrial giants emerged. Using the infrastructure of the emerging electricity and telephone networks, these industrialists transformed the U.S. economy, just as today's Silicon Valley entrepreneurs are drawing on computer and communications infrastructure to transform the world's economy.

    The thesis of this book is that durable economic principles can guide you in today's frenetic business environment. Technology changes. Economic laws do not. If you are struggling to comprehend what the Internet means for you and your business, you can learn a great deal from the advent of the telephone system a hundred years ago.

    Sure, today's business world is different in a myriad of ways from that of a century ago. But many of today's managers are so focused on the treesof technological change that they fail to see the forest: the underlying economic forces that determine success and failure. As academics, government officials, and consultants we have enjoyed a bird's-eye view of the forest for twenty years, tracking industries, working for high-tech companies, and contributing to an evergrowing literature on information and technology markets.

    In the pages that follow, we systematically introduce and explain the concepts and strategies you need to successfully navigate the network economy. Information technology is rushing forward, seemingly chaotically, and it is difficult to discern patterns to guide business decisions. But there is order in the chaos: a few basic economic concepts go a long way toward explaining how today's industries are evolving.

    Netscape, the one-time darling of the stock market, offers a good example of how economic principles can serve as an early warning system. We're not sure exactly how software for viewing Web pages will evolve, but we do know that Netscape is fundamentally vulnerable because its chief competitor, Microsoft, controls the operating environment of which a Web browser is but one component. In our framework, Netscape is facing a classic problem of interconnection: Netscape's browser needs to work in conjunction with Microsoft's operating system. Local telephone companies battling the Bell System around 1900 faced a similar dependency upon their chief rival when they tried to interconnect with Bell to offer long-distance service. Many did not survive. Interconnection battles have arisen regularly over the past century in the telephone, the railroad, the airline, and the computer industries, among others. We wonder how many investors who bid Netscape's stock price up to breathtaking heights appreciated its fundamental vulnerability.

    We examine numerous business strategies on both the information (software) and the infrastructure (hardware) sides of the industry. Software and hardware are inexorably linked. Indeed, they are a leading example of complements, one of the key concepts explored in our book. Neither software nor hardware is of much value without the other; they are only valuable because they work together as a system.

INFORMATION

We use the term information very broadly. Essentially, anything that can be digitized--encoded as a stream of bits--is information. For our purposes, baseball scores, books, databases, magazines, movies, music, stock quotes, and Web pages are all information goods. We focus on the value of information to different consumers. Some information has entertainment value, and some has business value, but regardless of the particular source of value, people are willing to pay for information. As we see, many strategies for purveyors of information are based on the fact that consumers differ greatly in how they value particular information goods.

    Of course, information is costly to create and assemble. The cost structure of an information supplier is rather unusual. Since the very nature of competition in information markets is driven by this unusual cost structure, we begin our overview of information strategy there.

The Cost of Producing Information

Information is costly to produce but cheap to reproduce. Books that cost hundreds of thousands of dollars to produce can be printed and bound for a dollar or two, and 100-million dollar movies can be copied on videotape for a few cents.

    Economists say that production of an information good involves high fixed costs but low marginal costs. The cost of producing the first copy of an information good may be substantial, but the cost of producing (or reproducing) additional copies is negligible. This sort of cost structure has many important implications. For example, cost-based pricing just doesn't work: a 10 or 20 percent markup on unit cost makes no sense when unit cost is zero. You must price your information goods according to consumer value, not according to your production cost.

    Since people have widely different values for a particular piece of information, value-based pricing leads naturally to differential pricing. We explore strategies for differential pricing in detail in Chapters 2 and 3. Chapter 2 is concerned with ways to sell an information good to identifiable markets; Chapter 3 examines ways to "version" information goods to make them appeal to different market segments which will pay different prices for the different versions.

    For example, one way to differentiate versions of the same information good is to use delay. Publishers first sell a hardback book and then issue a paperback several months later. The impatient consumers buy the high-priced hardback; the patient ones buy the low-priced paperback. Providers of information on the Internet can exploit the same strategy: investors now pay $8.95 a month for a Web site that offers portfolio analysis using 20-minute delayed stock market quotes but $50 a month for a service that uses real-time stock market quotes.

    We explore different ways to version information in Chapter 3 and show you the principles behind creating profitable product lines that target different market segments. Each version sells for a different price, allowing you to extract the maximum value of your product from the marketplace.

Managing Intellectual Property

If the creators of an information good can reproduce it cheaply, others can copy it cheaply. It has long been recognized that some form of "privatization" of information helps to ensure its production. The U.S. Constitution explicitly grants Congress the duty "to promote the progress of science and useful arts, by securing, for limited times, to authors and inventors, the exclusive right to their respective writings and discoveries."

    But the legal grant of exclusive rights to intellectual property via patents, copyright, and trademarks does not confer complete power to control information. There is still the issue of enforcement, a problem that has become even more important with the rise of digital technology and the Internet. Digital information can be perfectly copied and instantaneously transmitted around the world, leading many content producers to view the Internet as one giant, out-of-control copying machine. If copies crowd out legitimate sales, the producers of information may not be able to recover their production costs.

    Despite this danger, we think that content owners tend to be too conservative with respect to the management of their intellectual property. The history of the video industry is a good example. Hollywood was petrified by the advent of videotape recorders. The TV industry filed suits to prevent home copying of TV programs, and Disney attempted to distinguish video sales and rentals through licensing arrangements. All of these attempts failed. Ironically, Hollywood now makes more from video than from theater presentations for most productions. The video sales and rental market, once so feared, has become a giant revenue source for Hollywood.

    When managing intellectual property, your goal should be to choose the terms and conditions that maximize the value of your intellectual property, not the terms and conditions that maximize the protection. In Chapter 4 we'll review the surprising history of intellectual property and describe the lessons it has for rights management on the Internet.

Information as an "Experience Good"

Economists say that a good is an experience good if consumers must experience it to value it. Virtually any new product is an experience good, and marketers have developed strategies such as free samples, promotional pricing, and testimonials to help consumers learn about new goods.

    But information is an experience good every time it's consumed. How do you know whether today's Wall Street Journal is worth 75 cents until you've read it? Answer: you don't.

    Information businesses--like those in the print, music, and movie industries--have devised various strategies to get wary consumers to overcome their reluctance to purchase information before they know what they are getting. First, there are various forms of browsing: you can look at the headlines at the newsstand, hear pop tunes on the radio, and watch previews at the movies. But browsing is only part of the story. Most media producers overcome the experience good problem through branding and reputation. The main reason that we read the Wall Street Journal today is that we've found it useful in the past.

    The brand name of the Wall Street Journal is one of its chief assets, and the Journal invests heavily in building a reputation for accuracy, timeliness, and relevance. This investment takes numerous forms, from the company's Newspapers in Education program (discussed in Chapter 2), to the distinctive appearance of the paper itself, and the corporate logo. The look and feel of the Journal's on-line edition testifies to the great lengths designers went to carry over the look and feel of the print version, thereby extending the same authority, brand identity, and customer loyalty from the print product to the on-line product. The Wall Street Journal "brand" conveys a message to potential readers about the quality of the content, thereby overcoming the experience good problem endemic to information goods.

    The computer scientists who designed the protocols for the Internet and the World Wide Web were surprised by the huge traffic in images. Today more than 60 percent of Internet traffic is to Web sites, and of the Web traffic, almost three-fourths is images. Some of these images are Playboy centerfolds, of course--another brand that successfully made the move to cyberspace--but a lot of them are corporate logos. Image is everything in the information biz, because it's the image that carries the brand name and the reputation.

    The tension between giving away your information--to let people know what you have to offer--and charging them for it to recover your costs is a fundamental problem in the information economy. We talk about strategies for making this choice in our discussion of rights management in Chapter 4.

The Economics of Attention

Now that information is available so quickly, so ubiquitously, and so inexpensively, it is not surprising that everyone is complaining of information overload. Nobel prize-winning economist Herbert Simon spoke for us all when he said that "a wealth of information creates a poverty of attention."

    Nowadays the problem is not information access but information overload. The real value produced by an information provider comes in locating, filtering, and communicating what is useful to the consumer. It is no accident that the most popular Web sites belong to the search engines, those devices that allow people to find information they value and to avoid the rest.

    In real estate, it is said that there are only three critical factors: location, location, and location. Any idiot can establish a Web presence--and lots of them have. The big problem is letting people know about it. Amazon.com, the on-line bookstore, recently entered into a long-term, exclusive agreement with America Online (AOL) to gain access to AOL's 8.5 million customers. The cost of this deal is on the order of $19 million, which can be understood as the cost of purchasing the attention of AOL subscribers. Wal-Mart recently launched the Wal-Mart Television Network, which broadcasts commercials on the television sets lined up for sale at the company's 1,950 stores nationwide. Like AOL, Wal-Mart realized that it could sell the attention of its customers to advertisers. As health clubs, doctors' offices, and other locations attempt to grab our valuable attention, information overload will worsen.

    Selling viewers' attention has always been an attractive way to support information provision. Commercials support broadcast TV, and advertisement is often the primary revenue source for magazines and newspapers. Advertising works because it exploits statistical patterns. People who read Car and Driver are likely to be interested in ads for BMWs, and people who read the Los Angeles Times are likely to be interested in California real estate.

    The Internet, a hybrid between a broadcast medium and a point-to-point medium, offers exciting new potentials for matching up customers and suppliers. The Net allows information vendors to move from the conventional broadcast form of advertising to one-to-one marketing. Nielsen collects information on the viewing habits of a few thousand consumers, which is then used to design TV shows for the next season. In contrast, Web servers can observe the behavior of millions of customers and immediately produce customized content, bundled with customized ads.

    The information amassed by these powerful Web servers is not limited to their users' current behavior; they can also access vast databases of information about customer history and demographics. Hotmail, for example, offers free e-mail service to customers who complete a questionnaire on their demographics and interests. This personal information allows Hotmail to customize ads that can be displayed alongside the user's e-mail messages.

    This new, one-to-one marketing benefits both parties in the transaction: the advertiser reaches exactly the market it wants to target, and consumers need give their attention only to ads that are likely to be of interest. Furthermore, by gathering better information about what particular customers want, the information provider can design products that are more highly customized and hence more valuable. Firms that master this sort of marketing will thrive, while those that continue to conduct unfocused and excessively broad advertising campaigns will be at a competitive disadvantage. We'll examine strategies for customizing information in detail in Chapters 2 and 3.

TECHNOLOGY

We have focused so far on the information side of "information technology." Now let's turn to the technology side--that is, the infrastructure that makes it possible to store, search, retrieve, copy, filter, manipulate, view, transmit, and receive information.

    Infrastructure is to information as a bottle is to wine: the technology is the packaging that allows the information to be delivered to end consumers. A single copy of a film would be of little value without a distribution technology. Likewise, computer software is valuable only because computer hardware and network technology are now so powerful and inexpensive.

    In short, today's breathless pace of change and the current fascination with the information economy are driven by advances in information technology and infrastructure, not by any fundamental shift in the nature or even the magnitude of the information itself. The fact is, the Web isn't all that impressive as an information resource. The static, publicly accessible HTML text on the Web is roughly equivalent in size to 1.5 million books. The UC Berkeley Library has 8 million volumes, and the average quality of the Berkeley library content is much, much higher! If 10 percent of the material on the Web is "useful," there are about 150,000 useful book-equivalents on it, which is about the size of a Borders superstore. But the actual figure for "useful" is probably more like 1 percent, which is 15,000 books, or half the size of an average mall bookstore.

    The value of the Web lies in its capacity to provide immediate access to information. Using the Web, information suppliers can distribute up-to-date information dynamically from databases and other repositories. Imagine what would happen if the wine industry came up with a bottle that gave its customers easier, quicker, and cheaper access to its wine. Sure, the bottle is only infrastructure, but infrastructure that can reduce cost and increase value is tremendously important. Improved information infrastructure has vastly increased our ability to store, retrieve, sort, filter, and distribute information, thereby greatly enhancing the value of the underlying information itself.

    What's new is our ability to manipulate information, not the total amount of information available. Mom-and-pop hardware stores of yesteryear regularly checked their inventories. The inventory information now captured by Home Depot, while surely more accurate and up-to-date, is not vastly greater than that of a generation ago. What is truly new is Home Depot's ability to re-order items from suppliers using electronic data interchange, to conduct and analyze cross-store demand studies based on pricing and promotional variations, and to rapidly discount slow-moving items, all with minimal human intervention.

    Indeed, in every industry we see dramatic changes in technology that allow people to do more with the same information. Sears Roebuck popularized catalog sales more than a century ago. Lands' End does not have that much more raw information than Sears did. Like Sears, it has a catalog of products and a list of customers. What is new is that Lands' End can easily retrieve data on customers, including data on previous purchases, that allows it to engage in targeted marketing. Furthermore, Lands' End can use the telecommunications and banking infrastructure to conduct transactions in real time over the telephone and on-line.

    Content providers cannot operate without infrastructure suppliers, and vice versa. The information economy is about both information and the associated technology.

Systems Competition

Systems show up everywhere in information technology: operating systems and applications software, CPUs and memory chips, disk drives and controller cards, video cassette recorders and the videotapes themselves. Usually, one firm cannot hope to offer all the pieces that make up an information system. Instead, different components are made by different manufacturers using very different production and business models. Traditional rules of competitive strategy focus on competitors, suppliers, and customers. In the information economy, companies selling complementary components, or complementors, are equally important. When you are selling one component of a system, you can't compete if you're not compatible with the rest of the system. Many of our strategic principles are specifically designed to help companies selling one component of an information system.

    The dependence of information technology on systems means that firms must focus not only on their competitors but also on their collaborators. Forming alliances, cultivating partners, and ensuring compatibility (or lack of compatibility!) are critical business decisions. Firms have long been faced with make/buy decisions, but the need for collaboration, and the multitude of cooperative arrangements, has never been greater than in the area of infotech. We describe how firms must function in such a systems-rich and standards-rich environment in Chapter 8.

    The history of the Microsoft-Intel partnership is a classic example. Microsoft focused almost exclusively on software, while Intel focused almost exclusively on hardware. They each made numerous strategic alliances and acquisitions that built on their strengths. The key for each company has been to commoditize complementary products without eroding the value of its own core strengths. For example, Intel has entered new product spaces such as chipsets and motherboards to improve the performance of these components and thereby stimulate demand for its core product: microprocessors. Intel has helped to create a highly competitive industry in component parts such as video cards, sound cards, and hard drives as well as in the assembly and distribution of personal computers.

    Microsoft has its following of independent software vendors (ISVs), and both companies have extensive licensing programs with original equipment manufacturers (OEMs). And they each have each other, an extraordinarily productive, if necessarily tense, marriage. It's in the interest of each company to create multiple sources for its partner's piece of the system but to prevent the emergence of a strong rival for its own piece. This tension arises over and over again in the information technology sector; Microsoft and Intel are merely the most visible, and profitable, example of the complex dynamics that arise in assembling information systems.

    Apple Computer pursued a very different strategy by producing a highly integrated product consisting of both a hardware platform and the software that ran on it. Their software and hardware was much more tightly integrated than the Microsoft/Intel offerings, so it performed better. (Microsoft recognized this early on and tried to license the Apple technology rather than investing in developing its own windowing system.) The downside was that the relative lack of competition (and, later, scale) made Apple products more expensive and, eventually, less powerful. In the long run, the "Wintel" strategy of strategic alliance was the better choice.

Lock-In and Switching Costs

Remember long-playing phonograph records (LPs)? In our lexicon, these were "durable complementary assets" specific to a turntable but incompatible with the alternative technology of CDs. In plain English: they were durable and valuable, they worked with a turntable to play music, but they would not work in a CD player. As a result, Sony and Philips had to deal with considerable consumer switching costs when introducing their CD technology. Fortunately for Sony and Philips, CDs offered significant improvement in convenience, durability, and sound quality over LPs, so consumers were willing to replace their music libraries. Quadraphonic sound, stereo AM radio, PicturePhones, and digital audiotape did not fare as well. We'll see how the new digital video (or versatile) disks (DVDs) will do in the next few years.

    As the impending problem of resetting computers to recognize the year 2000 illustrates, users of information technologies are notoriously subject to switching costs and lock-in: once you have chosen a technology, or a format for keeping information, switching can be very expensive. Most of us have experienced the costs of switching from one brand of computer software to another: data files are unlikely to transfer perfectly, incompatibilities with other tools often arise, and, most important, retraining is required.

    Switching costs are significant, and corporate information officers (CIOs) think long and hard about changing systems. Lock-in to historical, legacy systems is commonplace in the network economy. Such lock-in is not absolute--new technologies do displace old ones--but switching costs can dramatically alter firms' strategies and options. In fact, the magnitude of switching costs is itself a strategic choice made by the producer of the system.

    Lock-in arises whenever users invest in multiple complementary and durable assets specific to a particular information technology system. You purchased a library of LPs as well as a turntable. So long as these assets were valuable--the albums were not too scratched and the turntable still worked--you had less reason to buy a CD player and start buying expensive CDs. More generally, in replacing an old system with a new, incompatible one, you may find it necessary to swap out or duplicate all the components of your system. These components typically include a range of assets: data files (LP records, COBOL programs, word processing documents, etc.), various pieces of durable hardware, and training, or human capital. Switching from Apple to Intel equipment involves not only new hardware but new software. And not only that, the "wetware"--the knowledge that you and your employees have built up that enables you to use your hardware and software--has to be updated. The switching costs for changing computer systems can be astronomical. Today's state-of-the-art choice is tomorrow's legacy system.

    This type of situation is the norm in the information economy. A cellular telephone provider that has invested in Qualcomm's technology for compressing and encoding the calls it transmits and receives is locked into that technology, even if Qualcomm raises the price for its gear. A large enterprise that has selected Cisco's or 3com's technology and architecture for its networking needs will find it very costly to change to an incompatible network technology. Whether the enterprise is locked in to proprietary Cisco or 3Com products or to an "open" standard with multiple suppliers can make a big difference.

    Lock-in can occur on an individual level, a company level, or even a societal level. Many consumers were locked into LP libraries, at least in the sense that they were less inclined to purchase CD players because they could not play LPs. Many companies were locked into Lotus 1-2,-3 spreadsheets because their employees were highly trained in using the Lotus command structure; indeed, Lotus sued Borland for copying the 1-2-3 command structure in its spreadsheet product, Quattro Pro, a dispute that went all the way to the Supreme Court. Today, at a societal level, most of us are locked into Microsoft's Windows desktop operating environment.

    We explore lock-in and switching costs in Chapters 5 and 6. We'll examine the different kinds of lock-in, strategies to incorporate proprietary features into your product, and ways to coordinate your strategy with that of your partners. We'll explain how to exploit lock-in when you are offering an information system and how to avoid it, or at least anticipate it, when you are the buyer.

Positive Feedback, Network Externalities, and Standards

For many information technologies, consumers benefit from using a popular format or system. When the value of a product to one user depends on how many other users there are, economists say that this product exhibits network externalities, or network effects. Communications technologies are a prime example: telephones, e-mail, Internet access, fax machines, and modems all exhibit network externalities.

    Technologies subject to strong network effects tend to exhibit long lead times followed by explosive growth. The pattern results from positive feedback: as the installed base of users grows, more and more users find adoption worthwhile. Eventually, the product achieves critical mass and takes over the market. Fax machines illustrate nicely the common pattern. The Scottish inventor Alexander Bain patented the basic technology for fax machines in 1843, and AT&T introduced a wire photo service in the United States in 1925, but faxes remained a niche product until the mid-1980s. During a five-year period, the demand for and supply of fax machines exploded. Before 1982, almost no one had a fax machine; after 1987, the majority of businesses had one or more.

    The Internet exhibited the same pattern. The first e-mail message was sent in 1969, but up until the mid-1980s e-mail was used only by techies. Internet technology was developed in the early 1970s but didn't really take off until the late 1980s. But when Internet traffic did finally start growing, it doubled every year from 1989 to 1995. After the Internet was privatized in April 1995, it started growing even faster.

    But network externalities are not confined to communications networks. They are also powerful in "virtual" networks, such as the network of users of Macintosh computers: each Mac user benefits from a larger network, since this facilitates the exchange of files and tips and encourages software houses to devote more resources to developing software for the Mac. Because these virtual networks of compatible users generate network externalities, popular hardware and software systems enjoy a significant competitive advantage over less popular systems. As a result, growth is a strategic imperative, not just to achieve the usual production side economies of scale but to achieve the demand side economies of scale generated by network effects.

    We explore the implications of network externalities for business strategy in Chapter 7. The key challenge is to obtain critical mass--after that, the going gets easier. Once you have a large enough customer base, the market will build itself. However, having a superior technology is not enough to win. You may need to employ marketing tools such as penetration pricing to ignite the positive feedback.

    The company that best understands information systems and complementary products will be best positioned to move rapidly and aggressively. Netscape grabbed the Web browser market early on by giving away its product. It lost money on every sale but made up for it in volume. Netscape was able to give away its browser and sell it, too, by bundling such critical components as customer support with the retail version and by selling complementary goods such as server software for hefty prices.

    In competing to become the standard, or at least to achieve critical mass, consumer expectations are critical. In a very real sense, the product that is expected to become the standard will become the standard. Self-fulfilling expectations are one manifestation of positive-feedback economics and bandwagon effects. As a result, companies participating in markets with strong network effects seek to convince customers that their products will ultimately become the standard, while rival, incompatible products will soon be orphaned.

    Competitive "pre-announcements" of a product's appearance on the market are a good example of "expectations management." In the mid-1980s, when Borland released Quattro Pro, a new spreadsheet, Microsoft was quick to counter with a press release describing how much better the next release of its comparable program, Excel, would be. It didn't take long for the press to come up with the term vaporware to describe this sort of "product." Microsoft played the same game IBM had played in an earlier generation, when IBM was accused of using pre- announcements to stifle competition. When network effects are strong, product announcements can be as important as the actual introduction of products.

    Product pre-announcements can be a two-edged sword, however. The announcement of a new, improved version of your product may cut into your competitors' sales, but it can also cut into your own sales. When Intel developed the MMX technology for accelerating graphics in the fall of 1996, it was careful not to advertise it until after the Christmas season. Likewise, sales of large-screen TV sets in 1997 declined as consumers waited for digital television sets to arrive in 1998.

    Because of the importance of critical mass, because customer expectations are so important in the area of information infrastructure, and because technology is evolving so rapidly, the timing of strategic moves is even more important in the information industry than in others. Moving too early means making compromises in technology and going out on a limb without sufficient allies. Japan's television network NHK tried to go it alone in the early 1990s with its own high-definition television system, with disastrous consequences: not only has NHK's analog MUSE system met with consumer resistance in Japan, but it has left the Japanese behind the United States in the development and deployment of digital television. Yet moving too late can mean missing the market entirely, especially if customers become locked into rival technologies. We'll explore timing in Chapter 7 along with our discussion of critical mass, network externalities, standards, and compatibility.

    Whether you are trying to establish a new information technology or to extend the lifetime of technology that is already popular, you will face critical compatibility decisions. For example, a key source of leverage for Sony and Philips in their negotiations with others in the DVD alliance was their control over the original CD technology. Even if Sony and Philips did not develop or control the best technology for DVD, they were in the driver's seat to the extent that their patents prevented others from offering backward-compatible DVD machines. Yet even companies with de facto standards do not necessarily opt for backward compatibility: Nintendo 64 machines cannot play Nintendo game cartridges from the earlier generations of Nintendo systems. We explore a range of compatibility issues, including intergenerational compatibility, in Chapter 8.

    Another method for achieving critical mass is to assemble a powerful group of strategic partners. For this purpose, partners can be customers, complementors, or even competitors. Having some large, visible customers aboard can get the bandwagon rolling by directly building up critical mass. In November 1997 Sun took out full-page ads in the New York Times and other major newspapers reciting the long list of the members of the "Java coalition" to convey the impression that Java was the "next big thing."

    Having suppliers of complements aboard makes the overall system more attractive. And having competitors aboard can give today's and tomorrow's customers the assurance that they will not be exploited once they are locked in. We see this strategy being used with DVD today; Sony and Philips, the original promoters of CD technology, have teamed up with content providers (that is, customers) such as Time Warner and competitors such as Toshiba to promote the new DVD technology. Both player manufacturers and disk-pressing firms are on board, too. The same pattern occurs in the emergence of digital television in the United States, where set manufacturers, who have the most to gain from rapid adoption of digital TV, are leading the way, with the Federal Communications Commission (FCC) dragging broadcasters along by offering them free spectrum for digital broadcasts.

    Very often, support for a new technology can be assembled in the context of a formal standard-setting effort. For example, both Motorola and Qualcomm have sought to gain competitive advantages, not to mention royalty income, by having their patented technologies incorporated into formal standards for modems and cellular telephones.

    If you own valuable intellectual property but need to gain critical mass, you must decide whether to promote your technology unilaterally, in the hope that it will become a de facto standard that you can tightly control, or to make various "openness" commitments to help achieve a critical mass. Adobe followed an openness strategy with its page description language, PostScript, explicitly allowing other software houses to implement PostScript interpreters, because they realized that such widespread use helped establish a standard. Nowadays, participation in most formal standard-setting bodies in the United States requires a commitment to license any essential or blocking patents on "fair, reasonable and non-discriminatory terms." We explore strategies for establishing technology standards in Chapter 8.

    A go-it-alone strategy typically involves competition to become] the standard. By contrast, participation in a formal standard-setting process, or assembling allies to promote a particular version of technology, typically involves competition within a standard. Don't plan to play the higher-stakes, winner-take-all battle to become the standard unless you can be aggressive in timing, in pricing, and in exploiting relationships with complementary products. Rivalry to achieve cost leadership by scale economies and experience, a tried and true strategy in various manufacturing contexts, is tame in comparison. Just ask Sony about losing out with Beta in the standards war against VHS, or the participants in the recent 56k modem standards battle. We explore effective strategies for standards battles in Chapter 9.

POLICY

The ongoing battle between Microsoft and the Justice Department illustrates the importance of antitrust policy in the information sector. Whether fending off legal attacks or using the antitrust laws to challenge the conduct of competitors or suppliers, every manager in the network economy can profit from understanding the rules of the game. We explore government information policy in Chapter 10, including antitrust policy and regulation in the telecommunications sector.

    Microsoft's wishes to the contrary, high-tech firms are not immune to the antitrust laws. Competitive strategy in the information economy collides with antitrust law in three primary areas: mergers and acquisitions, cooperative standard setting, and monopolization. We explore the current legal rules in each of these areas in Chapter 10.

    Overall, we do not believe that antitrust law blocks most companies from pursuing their chosen strategies, even when they need to cooperate with other industry members to establish compatibility standards. Now and then, companies are prevented from acquiring direct rivals, as when Microsoft tried to acquire Intuit, but this is hardly unique to the information sector.

    The Sherman Anti-Trust Act was passed in 1890 to control monopolies. Technology has changed radically since then. As we have stressed, the underlying economic principles have not. As a new century arrives, the Sherman Act is flexible enough to prevent the heavy hand of monopoly from stifling innovation, while keeping markets competitive enough to stay the even heavier hand of government regulation from intruding in our dynamic hardware and software markets.

HOW WE DIFFER

We've explained what this book is about. We also should say what our book is not about and what distinguishes our approach from others.

    First, this book is not about trends. Lots of books about the impact of technology are attempts to forecast the future. You've heard that work will become more decentralized, more organic, and more flexible. You've heard about flat organizations and unlimited bandwidth. But the methodology for forecasting these trends is unclear; typically, it is just extrapolation from recent developments. Our forecasting, such as it is, is based on durable economic principles that have been proven to work in practice.

    Second, this book is not about vocabulary. We're not going to invent any new buzzwords (although we do hope to resurrect a few old ones). Our goal is to introduce new terms only when they actually describe a useful concept; there will be no vocabulary for the sake of vocabulary. We won't talk about "cyberspace," the "cybereconomy," or cyber-anything.

    Third, this book is not about analogies. We won't tell you that devising business strategy is like restoring an ecosystem, fighting a war, or making love. Business strategy is business strategy and though analogies can sometimes be helpful, they can also be misleading. Our view is that analogies can be an effective way to communicate strategies, but they are a very dangerous way to analyze strategies.

    We seek models, not trends; concepts, not vocabulary; and analysis, not analogies. We firmly believe the models, the concepts, and the analysis will provide you with a deeper understanding of the fundamental forces at work in today's high-tech industries and enable you to craft winning strategies for tomorrow's network economy.