Information Rules: A Strategic Guide to the Network Economy PDF

Information Rules A STRATEGIC GUIDE TO THE NETWORK ECONOMY Carl Shapiro Hal R. Varian HARVARD BUSINESS SCHOOL PRESS BOSTON, MASSACHUSETTS Copyright © 1999 Carl Shapiro and Hai R. Varian All rights reserved Printed in the United States of America 03 02 01 00 99 5 Library of Congres§ Cataloging-in-Publication Data Shapiro, Carl. Information rules : a strategic guide to the network economy / Carl Shapiro and Hal R. Varian. p. cm. Includes bibliographical references and index. ISBN 0-87584-863-X (alk. paper) 1. Information technology—Economic aspects. 2. Information society. I. Varian, Hal R. II. Title. HC79.I55S53 1998 658.4'038—dc21 98-24923 GIF The paper used in this publication meets the requirements of the American National Standard for Permanence of Paper for Printed Library Materials Z39.49-1984. To Dawn, Eva, and Ben To Carol and Chris Contents Preface ix l The Information Economy 2 Pricing Information 19 3 Versioning Information 53 4 Rights Management 83 5 Recognizing Lock-In 103 6 Managing Lock-In 135 7 Networks and Positive Feedback 173 8 Cooperation and Compatibility 227 9 Waging a Standards War 261 10 Information Policy 297 viii I Contents Further Reading 319 Notes 327 Bibliography 329 Index 335 About the Authors 351 Preface Luck led us to write this book. Each of us became economists because we wanted to apply our analytical training to better understand how society functions. By our good fortune, the economics of information, technological change, game theory, and competitive strategy were emerging fields of inquiry when we started our professional careers. We jumped in and offered our own contributions in these areas. Never did we imagine that, twenty years later, we would find ourselves in the middle of an information revolu- tion. What started as an academic exercise, centered on research and publishing, has evolved into speeches, consulting work, expert testi- mony, government service, and even a deanship. As we strayed from academia, we often heard complaints that economics was not much use in today's economy. At first, we were per- plexed by these complaints, since they often came from the very same people who sought our advice. Then we solved the puzzle: the complaints were directed at the classical economics most people learned in school, with its emphasis on supply and demand curves and perfectly competitive markets, like markets for agricultural commodities. We had to agree: to an executive rolling out a new software product or introducing the on-line version of a magazine, supply and demand curves just don't help much. Yet we knew that a sizable body of work in the field of economics speaks directly to current issues in the information economy. Finally, we realized that our clients and friends were thirsty for knowledge about all manner of topics that we and our colleagues had been writing about for years but were rarely covered in most classes. They wanted to know how to set prices for different customer groups, how to design product lines for information goods, and how to manage their intellectual property. They wanted to know how to protect themselves from lock-in and how to take advantage of it when possible. We discovered great interest in the dynamics of software markets: why does a single company tend to dominate for a time, only to be displaced by a new leader? And we became more and more involved in the application of the antitrust laws to the information economy, with one of us heading Preface off for a stint as the chief economist at the Antitrust Division of the Justice Department. In short, we lucked out: people actually wanted to know and use research results from our chosen fields. At the same time, we kept hearing that we are living in a "New Economy." The implication was that a "New Economics" was needed as well, a new set of principles to guide business strategy and public policy. But wait, we said, have you read the literature on differential pricing, bundling, signaling, licensing, lock-in, or network economics? Have you studied the history of the telephone system or the battles between IBM and the Justice Department? Our claim: You don't need a brand new economics. You just need to see the really cool stuff, the material they didn't get to when you studied economics. So we wrote this book. Our goal is to present insights from economics research and from our own experience applying economics in the network economy in a form suitable for the managers and policy makers who have to make strategic choices involving information technology. We believe that the ideas, the concepts, the models, and the way of thinking that we describe here will help you make better decisions. We also believe that our discussion will serve you well for years to come. Even though technology advances breathlessly, the economic principles we rely on are durable. The examples may change, but the ideas will not go out of date. Of course, we are not saying that we know all the answers. Most of the time business solutions come down to "It depends." Our aim is to help you figure out what the solution depends on. And the best way to understand such dependencies is to have a framework that relates causes and effects. If you have a clear understanding of what's going on, and some examples of how other businesses have solved related problems, you will be better placed to make more informed and effective decisions. Several of our friends and colleagues have contributed valuable sugges- tions to this book. We especially want to thank Erik Brynjolfsson, Randy Katz, David Messerschmitt, John Miller, Andrew Odlyzko, Sherman Shapiro, Deepak Somaya, Doug Tygar, and Robert Wilensky for their valuable comments. Finally, we want to thank our wives and children for their patience and good nature throughout this project. The l 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 de- manded 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, some- how, the basic laws of economics asserted themselves. Those who mas- tered 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. Chapter 1 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 trees of technological change that they fail to see the forest: the underly- Technology changes. f ing economic iorces ,1,1. that determine suc- Economic laws do not. cess and failure As academics> govern. ment 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 ever- growing 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 chaoti- cally, 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 intercon- nect 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. Soft- ware and hardware are inexorably linked. Indeed, they are a leading example of complements, one of the key concepts explored in our book. The Information Economy 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 pur- poses, 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 entertain- ment 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 Chapter 1 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- Price information priced hardback; the patient ones buy according to its value, the low-priced paperback. Providers of not its cost. 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 pro- gress of science and useful arts, by securing, for limited times, to authors and inventors, the exclusive right to their respective writings and discov- eries. 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 instan- taneously 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 The Information Economy 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 Watt 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 Watt Street Journal is one of its chief assets, and the Journal invests heavily in building a reputation for accu- racy, timeliness, and relevance. This investment takes numerous forms, from the company's Newspapers in Education program (discussed in Chapter 1 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 s oke for us "A wealth of Information P all when he said that "a wealth of infor- creates a poverty of mation creates a poyerty of attention» 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: The Information Economy 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. Hot- mail, 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 along- side 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 8 Chapter 1 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 fascina- tion with the information economy are driven by advances in information technology and infrastructure, not The technoioav fundamental shift in the nature. ,. o r even the magnitude of the informa- infrastructure makes tion itselt. Ine °tact is, the , Web, isn t all„ information more that impressive as an information re. OCCessible and hence source. The static, publicly accessible more valuable. 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 Information Economy 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 reposito- ries. 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 yes- teryear 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 10 Chapter 1 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 collabora- tion, and the multitude of cooperative Focus not just on your arrangements, has never been greater than in the area of infotech. We de- competitors but also on scribe how firms must function in such your collaborators and a systems-rich and standards-rich envi- complementors. ronment 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 technol- The Information Economy 11 ogy 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 12 Chapter 1 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 dupli- cate 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 as- tronomical. 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 rrtultiple 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. The Information Economy 13 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. Communica- tions 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 Positive feedback makes Internet traffic did finally start growing, iar9e networks get larger. 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 encour- 14 Chapter 1 ages 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 lar e enou h customer base Network effects lead to § § > the market will build itself. However, hav- demand side economies , , , ing a supenor technology is not enough of scale and positive to ^ You may need to employ mar. feedback, keting 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, Micro- soft 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 The Information Economy 15 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 intro- duction 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 M MX 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. Mov- ing 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 Chap- ter 8. Another method for achieving critical mass is to assemble a powerful 16 Chapter 1 group of strategic partners. For this purpose, partners can be customers, complementers, 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 Communi- cations 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 men- tion 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 rfiake 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 The Information Economy 17 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 standards change complementary products. Rivalry to.... , '. , 7 , 1 ,. , competition for a market achieve cost leadership by scale economies and experience, a tried and true t0 competition Within strategy in various manufacturing con- ° WQrket. texts, 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 monopo- lies. Technology has changed radically since then. As we have stressed, 18 Chapter 1 the underlying economic principles have not. As a new century arrives, the Sherman Act is flexible enough to prevent the heavy hand of monop- oly 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. 2 Pricing Information The Encyclopedia Britannica has been regarded as a classic reference work for more than two hundred years. And, as a classic, it has com- manded a premium price: a few years ago a hardback set of the thirty- two volumes of the Britannica cost $1,600. In 1992 Microsoft decided to get into the encyclopedia business. The company bought rights to Funk 6- Wagnalls, a second-tier encyclopedia that had been reduced to supermarket sales by the time of the purchase. Microsoft used the Funk 6- Wagnalls content to create a CD with some multimedia bells and whistles and a user friendly front end and sold it to end users for $49.95. Microsoft sold Encarta to computer original equipment manufacturers (OEMs) on even more attractive terms, and many computer manufacturers offered the CD as a freebie. Britannica started to see its market erode and soon realized that it needed to develop an electronic publishing strategy. The company's first move was to offer on-line access to libraries at a subscription rate of $2,000 per year. Large libraries bought this service—after all, it was the Britannica—but smaller school libraries, offices, and homes found CD encyclopedias adequate for their needs and much more affordable. Bri- tannica continued to lose market share and revenue to its electronic 20 Chapter 2 competition. By 1996, its estimated sales were around $325 million, about half of 1990 sales. In 1995 Britannica made an attempt to go after the home market. It offered an on-line subscription for $120 per year, but this attracted very few customers. In 1996 the company offered a CD version for $200, still significantly higher than Encarta. Unfortunately for Britannica, consumers were not willing to pay four times as much for its product as for Microsoft's, and Britannica was soon on the ropes. In early 1996 Jacob Safra, a Swiss financier, bought the company, disbanded its sales network of 110 agents and 300 independent contractors, and started aggressive price cutting. He slashed the yearly subscription to $85 and experimented with a direct mail campaign offering CDs at different prices in an attempt to estimate demand. Everyone agrees that the quality of the product is high; PC Magazine gave it the top rating in its comparison of multimedia encyclopedias. But these efforts yielded only 11,000 paid subscribers. The big question Britannica now faces is whether it can sell to a large enough market to recover its costs. Meanwhile, prices for CD versions of encyclopedias continue to erode. Britannica now sells a CD for $89.99 that has the same content as the thirty-two-volume print version that recently sold for $1,600. In a flyer we received recently from a computer store, Microsoft's Encarta matched Britannicas $89.99 price... and threw in a mail-in rebate for an additional $20.00 off. THE COST OF PRODUCING INFORMATION The Britannicd example illustrates some of the classic problems of information pricing. One of the most fundamental features of information goods is that their cost of production is dominated by the "first-copy costs." Once the first copy of a book has been printed, the cost of printing another one is only a few dollars. The cost of stamping out an additional CD is less than a dollar, and the vast bulk of the cost of those $80 million movies is incurred prior to the production of the first print. What's more, with recent advances in information technology, the cost of distributing information is falling, causing first-copy costs to comprise an even greater fraction of total costs than they have historically. Just Pricing Information 21 compare the printing, selling, and distribution costs for the traditional printed version of Britannica with the costs of the CD version or the on-line version. Information delivered over a network in digital form exhibits the first-copy problem in an extreme way: once the first copy of the information has been produced, additional copies cost essentially nothing. As we said Information fc cost[ to in Chapter 1, intormation is costly to u u i produce but cheap to reproduce. produce but cheap to In the language of economics, the reproduce. fixed costs of production are large, but the variable costs of reproduction are small. This cost structure leads to substantial economies of scale: the more you produce, the lower your average cost of production. But there's more to it than just economies of scale: the fixed costs and the variable costs of producing information each have a special structure. The dominant component of the fixed costs of producing information are sunk costs, costs that are not recoverable if production is halted. If you invest in a new office building and you decide you don't need it, you can recover part of your costs by selling the building. But if your film flops, there isn't much of a resale market for its script. And if your CD is a dud, it ends up in a pile of remainders at $4.95 or six for $25. Sunk costs generally have to be paid up front, be/one commencing production. In addition to the first-copy sunk costs, marketing and promotion costs loom large for most information goods. As we said in Chapter 1, attention is scarce in the information economy, and sellers of content have to invest in marketing new products to grab their potential customers' attention. The variable costs of information production also have an unusual structure: the cost of producing an additional copy typically does not increase, even if a great many copies are made. Unlike Boeing, Micro- soft does not face appreciable and lasting capacity constraints. Normally there are no natural limits to the production of additional copies of information: if you can produce one copy you can produce a million copies, or 10 million copies, at roughly the same unit cost. It is this combination of low incremental costs and large scale of operation that leads to the 92 percent gross profit margins enjoyed by Microsoft. The low variable cost of information goods offers great marketing 22 Chapter 2 opportunities. We said earlier that information is an experience good— you have to experience it to know what it is. Just as sellers of new brands of toothpaste distribute free samples via direct mail campaigns, sellers of information goods can distribute free samples via the Internet. The toothpaste vendor may pay a dollar or two per consumer in production, packaging, and distribution to promote its product; but the information vendor pays essentially nothing to distribute an additional free copy. For information goods, copies are free for the producer as well as for the consumer; we will investigate the implications of this fact in detail in Chapter 4. Large fixed costs and small incremental costs—that is, substantial economies of scale—are hardly unique to information goods. Many other industries have cost structures that share these characteristics. It costs a lot to lay optical fiber, buy switches, and make a telecommunications system operational. But once the first signal has been sent, it costs next to nothing to send additional signals over the fiber, at least until capacity is reached. It costs United a huge amount to purchase and operate a 747, but the incremental cost of an additional passenger is tiny, so long as the plane is not full. The first-copy costs common to information goods are "merely" the extreme version of what we see in other industries where scale economies are powerful, which includes many high technology industries like chip fabrication. COSTS AND COMPETITION So far we've seen that: Information is costly to produce but cheap to reproduce. t Once the first copy of an information good has been produced, most costs are sunk and cannot be recovered. Multiple copies can be produced at roughly constant per-unit costs. There are no natural capacity limits for additional copies. These cost characteristics of information goods have significant implications for competitive pricing strategy. The first and most important point is that markets for information Pricing Information 23 will not, and cannot, look like textbook-perfect competitive markets in which there are many suppliers offering similar products, each lacking the ability to influence prices. Such a market structure may be a plausi- ble description of the market for wheat or government bonds, but it has little relevance to information markets. We've seen business plans for "information auctions," where digital content is sold to the highest bidder(s). That sort of market structure works well for goods in fixed supply, like stocks or airline seats, but it simply isn't viable for a good in which the incremental cost of production is zero. Selling a generic product—say, a digital map, for 10 cents— isn't viable when your competition can sell the same map for 9 cents and still make a profit. When Information Is Commoditized To see why "information commodity markets" don't work, let's examine the history of CD phone books. CD phone books first appeared in 1986 when Nynex developed a directory of the New York area. Nynex charged $10,000 per disk and sold copies to the FBI, the IRS, and others. The Nynex executive in charge of the product, James Bryant, left to set up his own company, Pro CD, to produce a national directory. A consultant who worked on the project, Claude Schoch, had the same idea and created Digital Direc- tory Assistance. The phone companies wouldn't rent their computerized listings to the CD companies at a reasonable price, since they didn't want to cannibalize their $10 billion Yellow Pages services. So Pro CD hired Chinese workers to do the transcriptions in a Beijing factory, at a cost per worker of $3.50 per day. These Chinese workers typed in all the listings in every phone book in the United States—in fact, they typed them in twice to check for errors! The resulting database had more than 70 million listings. These data were used to create a master CD, which was then used to create hundreds of thousands of copies. These copies, which cost well under a dollar a piece to produce, were sold for hundreds of dollars in the early 1990s and yielded a tidy profit. But other producers caught on: within a few years competitors such as American Business Information adopted essentially the same 24 Chapter 2 business model, with minor variations. By now there are at least a half- dozen companies that produce CD telephone directories, and prices have fallen dramatically. You can buy CD phone directories for less than $20, and there are also several directory listings on the Internet that provide the same service for free, covering their costs through advertising. The story of CD telephone directories is a classic one: once several firms have sunk the costs necessary to create the product—be it a CD or a rail line—competitive forces tend to move the price toward marginal cost, the cost of producing an "additional" copy. To see why, consider a simple example. Suppose that Numbers R Us and Fone Your Friends each offer a CD telephone directory for $200 a disk. Imagine that these two CDs are essentially identical—they have the same amount of information and similar user interfaces, and they are both reasonably current. What happens if Numbers R Us decides to cut its price to $189.95? Since the products are essentially identical, consumers gravitate to the cheaper product. In response, Fone Your Friends cuts its price to $179.95. Numbers R Us responds with a $169.95 price... and so it goes. This downward spiral of prices may be hard to prevent. Once the sunk costs have been sunk, there is no natural floor to the price except the cost Competition among of producing and distributing another CD, which is only a few dollars. Nowa- sellers of commodity days, CD telephone directories sell for information pushes $19.95 or less, a far cry from the heady prices to zero. days of the 1980s. Commentators marvel at the amount of free information on the Internet, but it's not so surprising to an economist. The generic information on the Net—information commodities such as phone numbers, news stories, stock prices, maps, and directories—are simply selling at marginal cost: zero, Market Structures for Information Goods The high sunk cost, low marginal cost feature of information markets has significant implications for the market structure of information industries. In the final analysis, there are only two sustainable structures for an information market. Pricing Information 25 1. The dominant firm model may or may not produce the "best" product, but by virtue of its size and scale economies it enjoys a cost advantage over its smaller rivals. Microsoft is everyone's favorite example, since it controls the market for operating systems for desktop computers. 2. In a differentiated product market we have a number of firms producing the same "kind" of information, but with many different varieties. This is the most common market structure for information goods: the publishing, film, television, and some software markets fit this model. Amalgams of the two models are not uncommon; many software markets involve both differentiated products and disparate market shares. Indeed, one can say that all products are differentiated, it's just a question of how much. TV listings are an interesting example. TV Guide is the dominant firm in this industry, selling nearly a billion copies a year and offering some differentiated content. However, there are many local advertiser-supported guides, distributed for free as standalones or with hundreds of Sunday newspapers, that compete with the commodity information in TV Guide. After a period of relative calm, the TV listings market is gearing up for a heated battle with GIST TV and other on-line TV listing services. On-line listings are likely to give the print media a run for their money, especially if Web TV takes off. Your basic strategy will depend on what kind of industry you are in. At the most fundamental level, we have the classic time-tested principles of competitive strategy: Differentiate your product. If you are in a differentiated products industry, you must add value to the raw information, thereby distinguishing yourself from the competition. Achieve cost leadership. If you are in a dominant firm industry, your strategy should be to achieve cost leadership through economies of scale and scope. These classic prescriptions are just as valid as they ever were, but the unique characteristics of information markets offer new opportunities to implement them. Pricing policies are central to successfully implementing either strategy. To succeed, you must either become the price and cost leader 26 Chapter 2 based on your scale, or you must create a unique information resource and charge for it based on the value that it offers to consumers. Even if you have the good fortune to dominate a market and don't have to worry about competitors, you still have to worry about pricing, since you need to price your products in ways that maximize their value. Stockholders naturally want high returns on their investments and can be just as difficult to deal with as competitors. Differentiation The lesson of the CD phonebook example is clear: don't let your information product become a commodity. Do everything you can to make sure there are no close competitors by differentiating your product from others that are available. We opened this chapter with a description of the Britannica and Encarta battle. The latest strategy in that competition involves product differentiation. As we indicated earlier, Britannica's product is far more complete and authoritative than Microsoft's. Simply on the dimension of quantity, Britannica's 44 million words dwarf Encarta's 14 million. Britannica's price cuts have certainly had an effect on Encarta's sales: Microsoft's share of unit sales of multimedia encyclopedias was 27.5 percent in 1996, down from 44.8 percent in 1995. But Microsoft is striking back. It increased the word count in the most recent release of Encarta by 30 percent and has purchased rights to use content from Colliers, a highly respected print encyclopedia. It now looks like the market might be shaking out into two or three segments: a multimedia, bells-and-whistles market, an educational market, and an authoritative reference market. However, these market segments are still' being contested. Whichever industry player wins these various market segments, consumers are likely to be the ultimate win- ners. Despite the intense competition and steep price declines, industry revenues surged 32 percent last year to about $60 million. Even information commodities can be successfully differentiated if you exploit the unique features of the Internet. Bigbook is one of several business directories available on the Internet. These directories are essentially nationwide Yellow Page servers that allow the user to look up businesses by name or category. But Bigbook has a gimmick that differ- entiates it from its paper-based competitors. It has linked a geographic Pricing Information 27 information system with its database of phone numbers and addresses, allowing it to display maps showing the location of each business the user looks up. These maps help to differentiate Bigbook's product from other business directories. However, even this clever idea isn't immune to competition—there are other sellers of geographic information systems, and competitors have already started to copy the idea. One way to avoid such copying is to assert intellectual property rights to protect information commodities. West Publishing offers a good example of this strategy. Historically, only a few firms went to the trouble of collecting and publishing statutes and legal opinions. With high sunk costs, there was only room in the market for a limited number of competitors. But now, because these materials can be scanned and put onto a CD and are available in electronic form from the government, the fixed costs of collecting the information has fallen and several new suppliers have entered the market. CDs containing huge amounts of valuable legal information became available at bargain-basement prices. Fortunately for West, it was able to differentiate its product, notably through its copyrighted key number system, so as to protect its margins and survive, at least for a time. In the fall of 1996, U.S. Judge John S. Martin ruled that West could not claim copyright in its citation system, allowing rivals to cross-reference West numbers. West, seeking to protect an important source of product differentiation, appealed this ruling, hoping to maintain its primary competitive advantage. Cost Leadership If it is hard to differentiate your product, you can at least try to sell a lot of it. If you can sell more than others, your average costs will be the lowest, allowing you to make money when others cannot. But be careful—to sell a lot you will need to lower your price (at least to match any discounts offered by others) and so will necessarily earn a smaller amount on each unit sold. To win, you have to make up for it in volume. You also have to prevent others from capturing the inside track by selling more than you do. This can be a dangerous game; if two or more firms discount heavily, counting on the scale economies that come with market leadership, both cannot succeed. When Microsoft priced En- carta at $49.95, it was betting that it could move a lot of CDs at that price and drive competitors out of the mass market. Distribution skills, 28 Chapter 2 marketing expertise, and channel control are critical in this type of pricing game. In traditional industries, reducing your average cost of production usually means focusing on unit costs of production: using supply chain management, workflow analysis, and other tools to cut costs of parts, assembly, and distribution. With information goods, unit costs of production are negligible and supply chain management and related tech- niques usually don't help much with the first-copy costs. The key to reducing average cost in information markets is to increase sales volume. One great thing about information is that you can sell the same thing over and over again. Think of how a TV show is marketed. It's sold once for prime time play in the United States. Then it's sold again for reruns Reduce average cost during the summer. If it is a hot prod- by increasing volume uct, it's sold abroad and syndicated to through reuse and resale. local stations. The same good can be sold dozens of times. The most watched TV show in the world is Baywatch, which is available in 110 countries and has more than 1 billion viewers. In the United States, Baywatch isn't even broadcast on national networks; it is available only via syndication. The shows are cheap to produce, have universal appeal, and are highly reusable. One company that is trying to exploit this strategy in the information industry is Reuters. Its core business is financial information; Reuters provides data to more than 255,000 terminals around the world, more than twice as many as its nearest competitor. It currently controls about 68 percent of the information market for foreign exchange, 33 percent of the equity market, and 24 percent of the fixed income market. Reuters also provides news stories as a complement to its data services. Though its managers would be loathe to admit it, this is pretty much a commodity business. Several other news services, such as Asso- ciated Press, Bloomberg, and Dow Jones, sell similar material. Despite the commodity nature of the news product, Reuters has managed to do well at this business. One of the reasons is that it has been able to package news items that are of interest to particular industries. This packaging adds value to the product by providing filtering and sorting services—services that are highly valuable to customers suffering from information overload. Pricing Information 29 For example, if you are in the shipping industry, you can purchase a news service from Reuters that will send you news that is relevant to shipping. Currently, these customized news services also cover foreign exchange, money, securities, fixed income, commodities, and energy. Much of the news in these industries overlaps, allowing Reuters to sell many of the same pieces of information over and over again. The company avoids the trap of having its prime product commoditized by organizing it in ways that are useful to customers, thereby differentiating its product from the competition. Reuters has been experimenting with Internet news services for several years. It has been a long-time supplier to ClariNet, an early on-line news provider. Recently Reuters has begun selling news feeds to Web-based news providers, such as PointCast. PointCast is a combination Web browser/screensaver that displays noteworthy headlines in catego- ries chosen by the user. When a user clicks on a headline, the whole article appears. Furthermore, users can customize the browser/screensaver so that only information about certain industries, cities, or sports teams is displayed. Since Reuters already classifies its news items as a matter of course, it is easy for PointCast to organize them for its users. As of 1996, Reuters was the dominant news service on the Internet, supplying stories to thirty-five Web sites and making a profit doing so. This example shows that a volume-based strategy of cost leadership must be rooted in adding value to raw information to broaden appeal and fully exploit the economies of scale and scope. Not surprisingly, Reuters' success has caught the attention of other information providers, most notably Michael Bloomberg, who has forged agreements with @Home, CNet, and AOL to provide on-line content. Bloomberg makes no secret of the fact that he wants to become "the business-news site for a very large percentage of the world's In- ternet users." Reuters has a head start, but it will have to fight hard to keep its market share. First-Mover Advantages We have suggested that market leadership through aggressive pricing can be a successful strategy in the presence of the scale economies endemic to information industries. However, such leadership may not be worth winning if victory only comes after a bloody price war. The 30 Chapter 2 best way to secure such a leadership position is through an early presence in the market, combined with a forward-looking approach to pricing. As the Encyclopedia Britannica example shows, historical leaders in many information markets are at risk today of losing their leadership positions, as new technologies arise that vastly reduce the cost of creating or distributing the information that has been their mainstay. Reuters has responded by filtering and sorting its information to add value; West has protected its position by using its copyrighted key number system of legal references. Differentiation strategies such as these are often en- abled by the very same new technologies that threatened to dethrone the industry incumbents. Even if differentiation is difficult or limited, incumbent information providers are well placed to adopt a cost leadership position, so long as they are not rigidly wedded to their historical pricing practices. Owing to strong economies of scale, the market leader often tends to be the cost leader. If you have the good fortune to be the historical market leader, and if you are on par with a newcomer in terms of cost and technical prowess, you should be able to find a pricing strategy to retain your leadership position. Indeed, if you are alert, scale economies should work to your advantage, not against you. After all, you have the scale to start with. Just don't think you are entitled to continue to set selling prices as high as you have in the past. A two-pronged approach offers the best chance for the historical leader in an information category to make money, even if it cannot prevent its information from becoming a commodity. First, don't be greedy. Even while the incumbent remains the sole supplier of certain types of information, the threat of entry by look-alike information providers is very real for most information. Rec- ognizing this, incumbents should be willing to sacrifice some of their short-term margin by dropping prices to make their markets less attractive to would-be entrants. This is what economists call limit pricing: set prices as high as you can without encouraging others to invest the sunk costs necessary to enter your market. If the information you sell is durable, like a piece of computer software or a reference tome, more aggressive pricing today can slow down or prevent entry tomorrow by taking some customers out of the market for a time: your sales today reduce demand for similar information in the future. Sales today may also serve the function of locking in customers who find it costly to Pricing Information 31 switch from one supplier to another as they update their information (see Chapter 5). For all of these reasons, it pays to sacrifice some current profits through lower prices when facing a real threat of entry. Play tough. Turn the threat of commoditization on its head and use it to your advantage. The key is to find a way to send a credible signal that entry will be met with aggressive pricing. After all, who would invest in duplicating the information you provide if convinced that you would lower prices aggressively to meet any new competition? One way to establish this reputation, painful though it may be in the short run, is to fight tooth and nail when faced with me-too entries for specific information products, both to hold your ground on the threatened product and to send a signal to companies who might otherwise attack you in other product areas. If you can convince potential entrants that you will respond with dramatic price cuts if they enter, then you won't have to lower prices now to discourage entry. A credible threat of price cuts after entry may be enough to convince would-be competitors that they won't be able to recover their sunk costs and thus discourage them from entering the market in the first place. It's true that cutting prices in the wake of entry can precipitate a price war—so you should do it only if you think you can win. When trying to estimate the benefits of price cutting, it is important to realize that you are investing not only in eliminating a potential competitor but also in establishing a reputation as a formidable opponent. This investment will be amply repaid down the road by discouraging potential entrants. In our experience, information providers with established brand names often hesitate to drop prices quickly enough to warn off potential entrants, perhaps because they think their brand name shields them from competition. Sure, a valuable brand name will allow you to command some premium, but it will not guarantee you the same prices or margins you enjoyed before new information technologies arrived that caused per-copy and distribution costs to fall. ^. ,..,. To discourage entry, Companies slow to accept the inevi- tability that new technologies will force avoid 9reed and lower prices for basic information may P'°y tough. find themselves losing market share rapidly on all fronts. Competitive advantages based on access to raw information are under siege; the trick is to migrate incumbency and 32 Chapter 2 scale advantages into value-added aspects of information, where advantage is more sustainable. If you think your position as a market leader is totally secure, try reciting the following mantra three times: "CP/M, WordStar, VisiCalc." Each of these products had, at one time, a 100 percent market share. But because their producers failed to respond to the competition quickly enough, each is now history. PERSONALIZING YOUR PRODUCT If you are successful in creating a unique source of information and avoiding commoditization, you have some breathing room in terms of both pricing and product design—that is, how you package and present your information. But how do you make the most ofthat room? How do you extract the most value from the information you have created? The answer comes in two parts: First, personalize or customize your product to Personalize your product generate the most value for your cus- and personalize your tomers. Second, establish pricing ar- prices. rangements that capture as much of that value as possible. A good example of how information technology can be used to personalize information services and thus add value is the previously mentioned news provider PointCast. The news stories that a user sees are highly personalized. If you are interested in the Boston Red Sox, the computer industry, international business, and the weather in New Eng- land, you can instruct PointCast to show you news headlines and stories on those topics., What is even more interesting is that PointCast will show you ads that are personalized in the same way—ads having to do with baseball, fast food promotions, discount travel agencies, and Boston restaurants. This ability to customize and personalize advertising is a very powerful marketing tool that Internet businesses are only beginning to understand and exploit. Intermediaries like Doubleclick and Softbank Inter- active Marketing sell ads targeted by day of week, time of day, conti- nent, country, state, or operating system, and they are adding more capabilities each day. Pricing Information 33 Table 2.1. Bulk versus Targeted Ad Rates for Web Search Engines (Cents per View) Site Bulk Targeted DejaNews 2.0C 4.0C Excite 2.4 4.0 Infoseek 1.3 5.0 Lycos 2.0 5.0 Yahoo! 2.0 3.0 Source: Michael Lesk. "Projections for Making Money on the Web." In Deborah Hurley, Brian Kahin, and Hal Varian, eds., Internet Publishing and Beyond. (Cambridge, Mass.: MIT Press, 1998). Search engines such as Yahoo! provide another example of this kind of personalization: when you search for Web sites about, say, "fishing," you will be shown a list of sites having to do with fishing... along with an ad for some fishing-related product. When we tried this recently, we saw an ad for the Florida Keys touting the great deep sea fishing in the area. Yahoo!, like other search engine companies, sells ads linked to search terms ("hot words") for a premium price. Table 2.1 shows some rates search engine companies charge for bulk and targeted ads. Note that targeted ads sell for about 50 percent more than bulk ads. The reason is simple: consumers of the targeted ads likely put a higher premium on the product being advertised and hence are more likely to buy. "Search engine spamming" is a variant on this theme. For example, one Web site selling children's clothing added hidden tags containing the words "child care." The operators of the site figured that people looking for child care would also be interested in children's clothing. The search engine operators are fighting this practice, since it reduces the value of their product. Several refuse to index invisible words. In September 1997 the U.S. District Court in San Francisco issued an injunction against a Web site that used the invisible words "playboy" and "playmate" in its Web site, upholding Playboy's claim of copyright in- fringement. Being invisible was no defense! KNOW YOUR CUSTOMER If you want to personalize your information product, you have to know something about your customers. The hoary injunction "Know Thy 34 Chapter 2 Customer" is as important in the information economy as in the industrial economy, if not more so. What has changed is that the two-way communication offered by the Web greatly increases the opportunities for information providers to learn about their customers. While cable television companies know where their subscribers live and what channels they subscribe to, information providers on the Web have the ability to know what Web surfers are actively looking for, where they spend their time, and more. Those companies that are first, and best, at figur- ing out how to use the unique customer information available on the Web stand ready to reap substantial rewards. Consumer information is valuable, however you seek to generate revenues: by subscription, by pay per use, or by advertising. If you require users to pay, you need feedback on what they like and dislike. If you are supporting your content with advertising, you need feedback on who your users are and whether they are likely to buy the products that your advertisers want to sell. The two main ways to get user information are (1) registration and billing, through which you can ask for demographic information, and (2) observation, which allows you to get information about customer behavior by means of their search queries and clickstream (both to be explained shortly). Registration and Billing The New York Times Web site doesn't charge users for content but does require them to register. This allows the Times to collect information on the demographics and reading habits of 2.1 million users, which can then be used to set ad rates. The Times asks for the classic information used in the paper-based subscription business, the ZAG: zip code, age, gender. Zip code information is an automatic requirement for mail-based subscriptions. These numbers convey a lot of information about the customer, which makes it easy for a publication to describe the demographics of their subscribers to advertisers. Web sites, on the other hand, have had a very difficult time getting users to provide information about themselves. Remember the joke about the two dogs at the computer, where one says to the other, "On the Internet no one knows you're a dog"? Well, no one knows your zip code either—unless you tell them. Pricing Information 35 Sites that require payment, such as the Watt Street journal, ask for your zip code as part of the billing process. This number can be checked against credit card records, which makes it pretty reliable. Registration and billing are fine for major sites such as the New York Times or Wall Street Journal. But many Web sites don't require registration, either because of the nature of the content they provide or because of user resistance. But Internet services providers (ISPs) such as AOL do have access to this critical piece of information about their customers. Since AOL bills users and authenticates them at log-in, AOL can provide advertisers with information on user demographics. This gives ISPs a big advantage in marketing and allows them to charge a premium for hosting Web sites. Remember the AOL-Amazon.com deal described in Chapter 1? Part of that $19 million is payment for customer demographics. Obviously, content providers would prefer to have direct access to their users' demographics rather than pay AOL a premium for that information. Their strategy should be to bribe users to give them the appropriate demographics, which can in turn be passed on to advertisers. One way to do this is with promotional offers: send out a coupon that will be honored only if the user returns it with the requested demographic information. Reliable demographics will become more and more valuable as the on-line advertising market heats up. Another way to get this kind of information is to offer a valuable service in exchange. Recall the example of Hotmail, described in Chapter 1, which offers free e-mail services in exchange for responses to its questionnaire. Consumers are often reluctant to provide information about themselves since they don't know how it will be used. According to a study by Donna Hoffman, Tom Novak, and Marcos Peralta of Vanderbilt Univer- sity, 94 percent of Web users surveyed have refused to provide information to a Web site, and 40 percent have given fake information. There are two interesting developments in this area, one technological, the other institutional. The technological development is the open profiling standard being developed by the W3 group. This is a way for consumers to store information about themselves, such as name, address, buying habits, interests, etc., and release it on a controlled basis. Such a standard should make it both easier and safer for individuals to manage their personal information. 36 Chapter 2 The institutional development is the creation of "privacy auditors," such as TrustE, that will verify that firms' claimed privacy practices are in fact followed. Such neutral auditing may play a critical role in induc- ing consumers to give content providers the information they want. With reasonable safeguards, we expect that many consumers will be happy to sell information about themselves for a nominal amount, in part because consumers value receiving well-targeted information, especially via asynchronous communication channels that allow consumers to control when they receive the information. Observation The other primary way to learn about your customers is by observing their on-line behavior. Most Web sites now allow users to search their contents. But the Web hosts rarely save the users' queries. Knowing what your users are looking for—and whether they find it—is extremely valuable information; save it and analyze it. In addition to monitoring searches, you should also monitor your customers' "clickstream," the sequence of actions they take while visit- ing your site. Web log files contain much useful information about user behavior, but they are difficult to analyze for several reasons. First, there is simply a lot of data—sorting through it all takes time and effort. Second, the HTTP protocol that underlies the Web is "connectionless." The protocol treats each request (or hyperlink click) from each user as a separate transaction: there is no explicit concept of a series of transactions with a particular user. This means that the Web developer has to build in support for recognizing a series of interactions with a given user. This information can be stored on the server side (in memory for short transactions, or on disk for extended ones) or on the browser side in the form of "cookies," files stored on the user's hard drive that contain information about the browser-server interaction. Neither of these options is as powerful as one would like, however, since the design of the HTTP protocol makes it difficult to observe a lot of useful information about user behavior. For example, psychological studies have shown that user ratings of "interesting items" are very highly correlated with how long they look at the item. (Think of how you read the newspaper.) But the standard browser-server interaction makes it very hard to collect this information. Pricing Information 37 Java offers a very promising solution to this problem. With Java, you can write your own browser and measure every aspect of user behavior that you want—including time spent inspecting each item. This allows you to collect a much, much richer set of information about your users. How can this information be used? Consider an on-line shopping service such as Peapod. Peapod, whose slogan is "Smart shopping for busy people," allows you to order groceries over the Internet, which are subsequently delivered to your home. Peapod gives you significantly more information about products than is available at the supermarket. For example, you get the price per unit, to enable comparison shopping, as well as detailed nutritional information. Imagine how useful it would be to marketers to know what aspects of product information people really look Thf} jntemet makes if at and care about. Such information is , ,, ,. ,., easy to personalize valuable to any on-line retailer, whether in the business of selling computer information products, components or automobiles. When you thereby adding value. know more about your customer, you can design and price products in ways that better match consumer needs. Obtaining and using such customer infonnation is essential to maximizing the value of your business. PRICING YOUR PRODUCT In addition to making it easy to personalize your product, the Internet also makes it easy to personalize your price. If the information products you sell are highly tuned to your customers' interests you will have a lot of pricing flexibility, since you won't have to worry as much about generic competitive products. The purest example of tailored goods are research reports, such as those produced by Gartner Group, Forrester Research, the Research Board, and other similar organizations. The Research Board, for example, sells research reports to CIOs that are highly targeted to their interests and needs. In exchange, member companies pay subscription fees of $50,000 to $70,000 per year for this information, simply because it is hard to find such detailed and personalized information elsewhere. But it isn't only high-priced information that can be personalized. You can do much the same thing with mass-market consumer informa- 38 Chapter 2 tion goods. To see the basic trade-offs, put yourself in the place of the marketing director at Intuit, who is trying to decide how to price the company's next release of its home accounting software, Quicken. The company recognizes that consumers have different values for this software: some can't function without it, others are only casual users. If you set your price at $60 only the zealots will buy. If you set your price at $20, you will sell to lots of casual users but will pass up the potential profits from selling at a high price to the zealots. Which way should you go? Answer: It depends on how many customers of each type there are. If there are 1 million zealots and 2 million casual users, you would sell to a million people if you set a price of $60 and 3 million people (the zealots plus the casual users) if you set a price of $20. In this example you make the same revenue either way, but if there are more than 2 million casual users, the $20 price generates more revenue. This simple calculation gives us the revenue picture; to figure out which price is more profitable, we would have to know something about the production, distribution, and support costs. In the interests of sim- plicity, we will ignore these costs for the moment and focus just on revenues. We can use the numbers in this simple example to plot a bar chart showing the relationship between price and sales in Figure 2.1. Panels A and B show th

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