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 / First Quarter 2000 / Issue 18(originally published by Booz & Company)


To Hal Varian, the Price Is Always Right

That raises the question that Varian the economist and connoisseur of economic history finds so vexing. Two rival theories of the economic future are ruthlessly competing for tomorrow and Mr. Varian doesn't yet know how to bet. One completely logical theory predicts that organizations will get smaller. The technology enables more project teams to form to solve specific problems and/or exploit explicit opportunities - just as a Hollywood movie is made by a coalition of skilled, autonomous professionals. To use the felicitous phrasing of Professor Thomas W. Malone of M.I.T.'s Sloan School of Management, the Internet encourages an economy of "e-lancers" freed from the shackles of Weberian corpocracies. Network economies will prove so disruptive that economies of scale are consistently overwhelmed by the costs of coordination. Size is more often a hindrance than a competitive advantage.

Then again, warns Mr. Varian, the same set of technologies argue for exactly the opposite conclusion. Technology enables coordination and collaboration on a scale undreamt of by global conquerors from Alexander the Great on. The Command-and-Control Corporation can come back with a vengeance. It's back to the future, courtesy of the Internet. Virtual cartels and zaibatsus become once again the natural order of things.

"History favors the second model," says Mr. Varian flatly. "History likes 'thick' markets and 'thick' institutions. EBay is an excellent example. So is Yahoo. They're both about returns to scale."

However, he cautions, we're still in a transition phase. It seems far too early to say which model will prove triumphant - or even whether the future will feature a relentless yo-yo-ing from one to the other as the Schumpeterian process of "creative destruction" gets compressed into Internet time. This competition between consolidation and entrepreneurship may even prove to be a false dichotomy that requires a new economics of industrial organization.

But Mr. Varian doesn't think so. In fact, he shows his cards about tomorrow's Internet Economy with his prediction that "antitrust law will become more important." Why? Because he strongly believes in "the network effect." That is, in the same way producers can get increasing returns to scale on the products and services they offer, networks can provide "demand-side" returns to scale that effectively lock customers in and create exorbitant switching costs. Open standards, policed by governments and courts, is one way to mitigate the risks of monopoly associated with the network effect, says Mr. Varian.

"How do you create the rules?" he asks rhetorically. "Legislation and litigation. We're going to get lots more of both. We're also going to see companies try to arbitrage the differences between legislation and litigation in different countries. I'm very comfortable predicting that Internet law and Internet lobbying will be growth industries for the foreseeable future."

But there's no disguising the belief that the Internet represents a breathtaking opportunity for economists and economics to drive innovation and entrepreneurship in a manner that is almost without precedent since Adam Smith penned "The Wealth of Nations." Not since the Nobel-Prize-winning equations of Black- Scholes and Merton in finance has there been a fusion of technology, financial capital and human ingenuity that made economic insights and algorithms so valuable.

"What's phenomenal is that all this theory that was once regarded as the purest of the pure is now becoming the basis for new business models," says Mr. Varian, with a mix of disbelief and satisfaction. Economic theory is accelerating from the descriptive to the prescriptive at an Internet-driven pace.

The Internet and the electronic markets it enables have created a new world for economists. New theories can be empirically tested and new empirical data can be tested for theories. New market innovations can be simulated, analyzed and launched into cyber-markets in minutes or months. The opportunity costs of not being economically savvy are increasing over time, not decreasing.

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