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Information Rules:
A Strategic Guide to the Network Economy
The Information Economy
Carl Shapiro
Hal R. Varian
Systems of Products
• Complementary products
– Hardware/software
– Client/server
– Viewer/content
• Product lines
– High fixed cost, low incremental cost
– Leaders to value based pricing
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Unique Features
• Complements
– Different manufacturers
– Strategy for complementors as well as
competitors
– Compatibility as strategic choice
– Standards and interconnection
• Product lines
– Lower quality may be more expensive
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Information
• Anything that can be digitized
– Text, images, videos, music, etc.
– a.k.a. content, digital goods
• Unique cost characteristics
• Unique demand characteristics
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Cost structure
• Expensive to produce, cheap to reproduce
• High fixed cost, low marginal cost
– Not only fixed, but sunk
– No significant capacity constraints
– Particular market structures
• Monopoly
• Cost leadership
• Product differentiation (versioning)
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Rights Management
• Low reproduction cost is two-edged sword
– Cheap for owners (high profit margin)
– But also cheap for copiers
• Maximize value of IP, not protection
• Examples
– Library industry
– Video industry
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Consumption Characteristics
• Experience good
– Browsing
– Always new
– Reputation and brand identity
• Overload
– Economics of attention
– Hotmail example
– Broadcast, point-to-point, hybrid
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Technology
• Infrastructure to store, retrieve, filter,
manipulate, view, transmit, and receive
information
• Adds value to information
– Web = 1 terabyte of text = 1 million books
– If 10% useful = 1 Borders Bookstore
– Value of Web is in ease of access
• Front end to databases, etc.
• Currency
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Systems Competition
• Microsoft-Intel: Wintel
– Intel
• Commoditize complementory chips
– Microsoft
• Commoditize PCs
• Apple
– Integrated solution
– Worked better, but lack of competition and
scale led to current problems
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Lock-In and Switching Costs
• Example: Stereos and LPs
– Costly switch to CDs
• Systems lock-in: durable complements
– Hardware, software, and wetware
– Individual, organizational, and societal
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Network Effects
• Value depends on number of users
• Positive feedback
– Fax (patented in 1843)
– Internet (1980s)
• Indirect network effects
– Software
• Expectations management
– Competitive pre-announcements
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Compatibility
• Examples
– Beta v. VHS
– Sony v. Philips for DVD
• Role of 3rd parties
• Read v. write standards
• Backwards compatibility?
– Windows 95
– Windows NT
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Basic Strategies
• Go it alone
• Partnerships (Java)
• Formal standard setting
– Widespread use
– Licensing requirements
• Competition in a market or for a market?
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Policy
• Understand environment
• IP policy
• Competition policy
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Regulation
Antitrust
• Electronic commerce
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Contracts
Privacy
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Information is Different…
but not so different
• Key concepts
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Versioning
Lock-in
Systems competition,
Network effects
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Recognizing Lock-In
• Cost of switching
• Compare
– Ford v. GM
– Mac v. PC
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What’s the Difference?
• Durable investments in complementary assets
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Hardware
Software
Wetware
• Supplier wants to lock-in customer
• Customer wants to avoid lock-in
• Basic principle: Look ahead and reason back
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Examples
• Bell Atlantic and AT&T
– 5ESS digital switch used proprietary operating
system
– Large switching costs to change switches
• Computer Associates
• Aircraft repair and cargo conversion
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Small Switching Costs Matter
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Phone number portability
Email addresses
Hotmail (advertising, portability)
ACM, CalTech
Look at lockin costs on a per customer
basis
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Valuing an Installed Base
• Customer C switches from A to "same position" w/ B
– Total switching costs = customer costs + B's costs
• Example
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Switching ISPs costs customer $50 new ISP $25
New ISP make $100 on customer, switch
New ISP makes $70 on customer, no switch
• Disruption costs
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Example: ILECs v CLECs
– Competitive market
– Profit=switching costs
– e.g. ILEC profits=customer + CLEC switching costs
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Profits & Switching Costs
In General:
• Profits from a customer = total switching costs
+ quality/cost advantages
• In commodity market like telephony, profit per
customer = total switching costs per customer
• Use of this rule of thumb
– How much to invest to get locked-in base
– Evaluate a target acquisition (e.g., Hotmail)
– Product and design decisions that affect switching
costs
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Classification of Lock-In
• Durable purchases and replacement: declines
with time
• Brand-specific training: rises with time
• Information and data: rises with time
• Specialized suppliers: may rise
• Search costs: learn about alternatives
• Loyalty programs: rebuild cumulative usage
• Contractual commitments: damages
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Durable Purchases
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Aftermarket sales (supplies, maintenance)
Depends on (true) depreciation
Usually fall with time
Watch out for multiple pieces of hardware
– Supplier will want to stagger vintages
– Contract renewal
• Technology lock-in v. vendor lock-in
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Brand-specific Training
• How much is transferable?
• Software
• Competitors want to lower switching costs
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Borland and Quattro Pro help
Word and WordPerfect help
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Information & Databases
• Datafiles
– Insist on standard formats
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Specialized Suppliers
• Advertising, legal, accounting firms
• Pentagon
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Dual sourcing
Intel and AMD
Adobe PostScript
Java
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Search Costs
• Transactions cost in finding new supplier
• Also costs borne by new supplier
• Promotion, clsoing deal, setting up account,
credit risks
• Example: Credit Cards
– $100 million in receivables sells or about $120
million
– Market valuation of “loyalty”
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Loyalty Programs
• Constructed by firm
– Frequent flyer programs
– Frequent coffee programs
• Personalized Pricing
– Gold status
– Example: Amazon and Barnes and Noble
– Amazon Assocates Program v. B&N's
Affiliates program
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Add nonlinearity?
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Contractual Commitments
• “Requirements contract”:
Purchase supplies from one supplier
• Beware of “evergreen contracts”
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Suppliers and partners
• Railroad spur lines
• Customized software
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Follow the Lock-in cycle
Brand Selection
Sampling
Lock-In
Entrenchment
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Lessons
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Switching costs are ubiquitous
Customers may be vulnerable
Value your installed base
Watch for durable purchases
Be able to identify 7-types of lock-in
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Information Rules:
A Strategic Guide to the Network Economy
Networks and Positive Feedback
Carl Shapiro
Hal R. Varian
Important Ideas
• Positive feedback
• Network effects
• Returns to scale
– Demand side
– Supply side
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Positive Feedback
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Strong get stronger, weak get weaker
Negative feedback: stabilizing
Makes a market “tippy”
Examples: VHS v. Beta, Wintel v. Apple
“Winner take all markets”
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Sources of Positive Feedback
• Supply side economies of scale
– Declining average cost
– Marginal cost less than average cost
– Example: information goods
• Demand side economies of scale
– Network effects
– In general: fax, email, Web
– In particular: Sony v. Beta, Wintel v. Apple
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Network Effects
• Real networks
• Virtual networks
• Number of users
– Metcalfe’s Law:
Value of network of size n proportional to n2
• Importance of expectations
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Lock-In and Switching Costs
• Network effects lead to substantial
collective switching costs
• Even worse than individual lock-in
• Due to coordination costs
• Example: QWERTY
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Don’t Get Carried Away
• Network externalities don’t always apply
– ISPs (but watch out for QoS)
– PC production
• Likelihood of tipping
– See next slide
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Likelihood of Tipping
Low Scale High Scale
Economies Economies
Low Demand
For Variety
Unlikely
High
High Demand
For Variety
Low
Depends
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Chicken & Eggs
• Fax and fax machines
• VCRs and tapes
• Internet browsers and Java
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Igniting Positive Feedback
• Evolution
– Give up some performance to ensure
compatibility, thus easing consumer adoption
• Revolution
– Wipe the slate clean and come up with the best
product possible
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Evolution
• Offer a migration path
• Examples
– Microsoft
– Intel
– Borland v Lotus
• Build new network by links to old one
• Problems: technical and legal
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Technical Obstacles
• Use Creative design
• Think in terms of system
• Converters and bridge technologies
– One-way compatibility
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Legal Obstacles
• Need IP licensing
• Example: Sony and Philips CDs
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Revolution
• Groves’s law: “10X rule”
• But depends on switching costs
• Example: Nintendo
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Openness v. Control
• Your reward = Total added to industry x
your share
• Value added to industry
– Depends on product and
– Size of network
• Your share
– Depends on how open
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Openness
• Full openness
– Anybody can make the product
– Problem: no champion
• Alliance
– Only members of alliance can use
– Problem: holding alliance together
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Control
• Control standard and go it alone
• If several try this strategy, may lead to
standards wars
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Generic Strategies
Compatible
Control
Open
Controlled
Migration
Open
Migration
Incompatible Performance Discontinuity
Play
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Performance Play
• Introduce new, incompatible technology
• Examples
– Palm Pilot
– Iomega Zip
• Attractive if
– Great technology
– Outsider with no installed base
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Controlled Migration
• Compatible, but proprietary
• Examples
– Windows 98
– Pentium
– Upgrades
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Open Migration
• Many vendors, compatible technology
• Examples
– Fax machines
– Some modems
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Discontinuity
• Many vendors, new technology
• Examples
– CD audio
– 3 1/2” disks
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Historical Examples of
Positive Feedback
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RR gauges
AC v. DC
Telephone networks
Color TV
HD TV
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Lessons
• Positive feedback means strong get stronger
and weak get weaker
• Consumers value size of network
• Works for large networks, against small
ones
• Consumer expectations are critical
• Fundamental tradeoff: performance and
compatibility
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Lessons, continued
• Fundamental tradeoff: openness and control
• Generic strategies
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Performance play
Controlled Migration
Open Migration
Discontinuity
• Lessons of history
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