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 / Fourth Quarter 2001 / Issue 25(originally published by Booz & Company)


Best Business Books: Internet

Given the healthy cynicism that the reader, circa fall 2001, now feels toward New Economy books, it’s refreshing to pick up a volume from 1999 that opens with a hearty dose of curmudgeonry. The authors of Information Rules: A Strategic Guide to the Network Economy, Carl Shapiro and Hal R. Varian, are both professors at Berkeley, and together they’ve written a surprisingly age-free book that holds up admirably in today’s bruised times: “The thesis of this book is that durable economic principles can guide you in today’s frenetic business environment. Technology changes. Economic laws do not.”

What distinguishes Information Rules is a rigorous attempt at quantifying change through economic models, as opposed to models-by-analogy. Since no one, certainly not New Economy business managers, has time to read books anymore, it’s best to cut to the chase, and get to the “takeaway,” as PowerPoint jockeys put it.

The takeaway in Information Rules is that what makes the New Economy new is the confluence of two powerful forces — supply-side economics and demand-side economics. The first, and older, force, supply-side economics, is the traditional effect of economies of scale. It simply states that larger companies tend to have lower unit costs. General Motors is a classic example of traditional economies of scale at work. What complicates things, however, is that companies have a natural “ceiling,” a point at which the complexity of running and maintaining the organization starts to undercut whatever economies of scale exist (again, General Motors is an example). Or, as the authors of Information Rules put it:

Positive feedback based on supply-side economies of scale ran into natural limits, at which point negative feedback took over. These limits often arose out of the difficulties of managing enormous organizations. Owing to the managerial genius of Alfred Sloan, General Motors was able to push back those limits, but even Sloan could not eliminate negative feedback completely.

Enter a new force: “network economics.” This force, a creature of the Information Age, is driven by demand-side economics, as opposed to the supply-side economics inherent in the economies-of-scale theory. In the economy of networks, demand creates efficiency. The authors cite Microsoft as a classic example:

Microsoft’s dominance is based on demand-side economies of scale. Microsoft’s customers value its operating systems because they are widely used, the de facto industry standard. Rival operating systems just don’t have the critical mass to pose much of a threat. Unlike the supply-side economies of scale, demand-side economies of scale don’t dissipate when the market gets large enough: if everybody else uses Microsoft Word, that’s even more reason for you to use it too.

It’s just not much more difficult to sell 10 million copies of MS Word than 1 million, especially when it comes bundled and preinstalled on other companies’ computers, such as those sold by Dell and Compaq.

The kicker here is not demand-side economies of scale in action. They’ve been around for a while, as evidenced by earlier standards wars, such as Betamax versus VHS (where the “better” technology lost out to the more “open” technology; consumer demand preferred the openness of VHS to the picture quality of Betamax).

What really makes the New Economy new is the convergence of supply-side and demand-side economics into one powerful force. The trick is finding an industry that is naturally subject to this convergence of effects. Most are not, and probably never will be. Either they move too many atoms (General Motors, for instance), so the complexity of supply-side management will always stalk them and constrain growth, or they’re just too “virtual” and can’t function by being “closed.” This is the plague of so many dot-coms — in the attempt to get eyeballs, they never charged for anything, and thus, while enjoying certain demand-side effects, couldn’t monetize everyone’s attention. Examples of a company that enjoyed the “double whammy,” as Shapiro and Varian put it, are rare. They cite Nintendo (more than 100 million Game Boys sold to date). Others I would add: eBay, ICQ (now AOL Instant Messenger), AOL itself, Microsoft, and possibly Palm.

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