Competing under the same old rules

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The dynamics of the new economy are not so far removed from those of the traditional business world. Network externalities and compatibility standards do not have the significance people think.

The market value of Amazon.com may have fallen by almost 70 per cent from its peak of $36.4bn. But the internet retailer is still worth far more than some of the great names of US business. It is one of the most admired companies in America. The threat of being ‘Amazoned’ preoccupies many businesses. And Amazon has done all these things without ever making a profit.

A few months ago, hardly anyone found this phenomenon odd. The “new economy” had changed the rules of business. Traditional measures of business performance were no longer relevant. It sounded like the 1980’s, when we were assured that conventional ways of measuring profits and valuing businesses were inappropriate in Japan. The following decade, it was discovered that these conventional procedures had some merits after all. The same is coming true for the New Economy.

Proponents of the new economics have emphasised two ideas: network externalities and compatibility standards. First in knowledge-based production, in contrast to physical manufacture, almost all the costs are incurred at the beginning. The marginal costs of dissemination are close to zero. Second, once an intellectual standard has been widely disseminated, the company that owns it has an unbeatable advantage because everything has to be compatible with it. So the theory runs monopoly will be endemic and first mover advantages unassailable. There will only be a few winners, they will be big ones, and it is essential to be early to be among them.

The economics of the new economy may be different in some ways, but not as different as that.

Take network externalities first. In the old economy, marginal and average costs of production are similar. You need the same amount of steel, the same amount of rubber, and almost as much labour to produce the millionth car as you needed to produce the first.

In the new economy, marginal costs of production are well below average. The costs of the knowledge economy are in developing knowledge, and the costs of distributing it are falling all the time. Surely this creates economies of scale and new opportunities for market dominance?

But look at established markets with these same characteristics: low marginal costs, high average costs. Markets for existing knowledge products, such as books or recorded music. Most of the costs of creating a book or a disc are associated with the first copy, and the run-on costs are small. The logic of costs and technology suggest that there should only be one publisher and one book. Presumably the Bible, with its large first mover advantage.

In practice, the logic of the market produces a different result. Henry Ford did well in the automobile market with long runs of a single, cheap, uniform product (though not indefinitely), but the book market has never been like that. Even the car market was not like that for long: Ford’s insistence on uniformity meant that his company was overtaken by General Motors, more sensitive to the range of its customers’ needs.

We are willing to pay more for variety and choice. There is always an opening for a book that is slightly differentiated from an existing product. The constant publication of new titles ensures that only the most successful books are profitable. There are economies of scale at the level of the individual book title not for the publishing business. And the industry as a whole is no more profitable than others.

Second, consider compatibility standards. The success of Microsoft is built on such standards. The text book example of a compatibility standard is the QWERTY keyboard layout, still in use after more than a century despite its notorious inefficiency. We are all locked into QWERTY and while we might all be better off if we changed, there is no market mechanism that can bring this about.

Once you have compatibility standards in mind you find them everywhere. They determine the languages we speak, the side of the road we drive on, the shape of the plugs on our electrical appliances, the size and wavelength of the television pictures we watch. But no-one owns the intellectual property in these standards.

The usual result of proprietary control of a standard is that the market does not adopt it. That is the lesson of the disappearance of Sony’s Betamax, the eclipse of the American Express card by Visa, and the fate of Apple in the personal computer market itself. Imagine how rich you would be if you owned the rights to the English language. But imagine only for a moment, because if you had attempted to control and profit from these rights English would never have become the world language.

The operating system for the personal computer is an almost unique case of a compatibility standard controlled by a private corporation. The shadow of Microsoft’s success hangs over every analysis of the business implications of new technology. But it is a success that is not likely to be replicated elsewhere in the new economy.

There is rarely monopoly in new economy industries, as in the old economy, unless a government is in the background. Even Microsoft’s dominance relies on an intellectual property régime that gives too strong protection to its source material. Without these legal restrictions on market entry, there would have been competing sellers of Windows years ago. And, as Microsoft has discovered, monopoly attracts regulation.

Amazon’s achievements are not based on compatibility standards, or network externalities, and have little to do with the new economics of knowledge. Amazon’s market share is the product of old economy business virtues in a competitive market: an innovative product, efficient sales and service, and low prices.

If Amazon.com can actually make money from doing these things, which it has yet to demonstrate, it will be a good business. But, like all good businesses, it will remain vulnerable to attack from someone who can offer a slightly better combination of product, efficiency, price and service. The rules for success in the New Economy are extraordinarily similar to the rules for success in the old economy.

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