Vander Bauwhede, Heidi

English

Research Papers in Economics

Tijdschrift voor Economie en Management 
Vol. XLVII,  1, 2002 
How to Survive in the Nehvork Economy? 
An Overview of the Hdeas  of Prof. CarB 
Shapiro and Prof. Hal R. Varian 
Vander Bauwhede Heidi 
Department of Applied 
Economics, K.U.Leuven 
ABSTRACT 
In  this text, Heidi Vandei  Bauwliede reports  on tlie  reflections  offered by Pro- 
fessoi Hal Vaiian at the occasion of the tliird semiiiar, 2000-2001, o11  'E-cononiics 
of Trust' of tlie PwC Chair Vnlue and Rlslz  Tlie new nebvork econoinv differs in 
various respects froin the old ecoiioiny.  Hence,  some cal1 for a new ecoiioinic 
frainework that helps US  explain the new, infoniiation economy. Professors Carl 
Sliapiro  and Hal R  Varian  argue however that  the plieiioinena  of tlie iletwork 
econoiny can be explained by existilig, but less well-known economic principles 
This article lists tlioie principles and discusses tlie iinplications for designing suc- 
cessfi~l  business strategies in the network econoiny. 
*  Heidi Vander  Bauwhede is  postdoctoral researcher at  tlie  KULeuven. The  article is 
basically  a sutnrriary of  tlie  book  "Inforination Rules" by  Carl  Shapiro and  Hal  R. 
Varian  (1 999). I.  INTRODUCTION 
The network economy seeins at first glance totally different from tlie old 
econoiny. The widespread econoinic principles ta~tght  in basic econoni- 
ics courses are unable to explain what is going oii in the new economy. 
Soine argue therefore tliat we need a totally new economic frameworlc. 
By contrast, Carl Shapiro aiid Hal R. Varian (1999) argue in their boolt 
"lnfoniiation Rules. A Strategie Guide to tlie Networlt Econoiiiy" that 
existing, but less well-known, economic principles cali help us under- 
stand tlie new ecoiiomy and can help us  design business strategies to 
survive in it. According to Shapiro and Varian (1999) the ecoiioiiiic prin- 
ciple~  they discuss wil1 reinain relevant as the economy changes fiirther, 
Business  strategies of producers  and  sellers  of both  information 
and infonnation technology have to be tailored to the specific char- 
acteristics of their goods. The aiin of this article is then also twofold. 
The first objective is  to  give ai1  overview of the characteristics of 
information  and  information  tecliiiology  and  of  the  relevant  eco- 
nomic  frameworlc that  can help  us  explain the  new  econoiny. The 
second  objective is  to  provide  some guidelines to  design winning 
business strategies for the network econoiny. 
The remainder of the article is struck~red  as follows. In section I1 
we discuss the characteristics of information and its consequences for 
business  strategies.  We  present  the  characteristics  of  information 
leehnology  and  its  irnplications  for decisioii  iiialting in section 111. 
Section IV indicates the role of the government and regulation in tlie 
infonnation inarltet and section V concliides. 
11.  CHARACTERISTICS OF INFORMATION AND CONSEQUEN- 
CES FOR BUSINESS STRATEGIES 
Iiiforniation has the following two iinportant characteristics. First, it 
is costly to produce, but cheap to reproduce. That is, information is a 
good with high fixed costs but  low niarginal  costs. Infonnation is 
thus a good witli substantial (supply-side) economies of scale. A sec- 
ond characteristic of information  is  that  it  is  an experierzee good. 
Consumers must  experience infomation to value it. Information is 
even a very specific experience good, in the sense that it is an expe- 
rience good evevy time yozr  eonszime it. Talte for exaniple a newspa- 
per. Every day, you can only know whether the journal is worth buy- 
ing once you have read (that is, coiisuined) it. The cost-sti-ucture of infoniiatioii and its "experience-good charac- 
ter"  imposes the following cliallenges  and opportuilities on you  as 
inforinatioii provider. 
Pricit7g infor-711atiot7:  valzle-basedpricing andpr-ice dtfer-entiatiol7. 
The specific cost stiucture of information iinplies a specific pricing 
strategy. It makes iio sense that you, as iiifonnation provider, price 
througli a mark-up oii cost, because the cost of tlie first copy is per- 
haps  subctantial,  but  the  cost  of  additional  copies  is  about  zero. 
Instead of pricing  infoilnation to production  cost, you should price 
information according to consumer value (value-based pricing). This 
implies price differentiation. 
Tliere  exist  various  foïms  of  price  differentiaticin. Personalized 
priciiig (first-degree price differentiation or perfect price discrimina- 
tion),  versioning  (second-degree  price  differentiation)  aiid  group 
pricing  (tliird-degree price  differentiation).  Persoiialized  and group 
pricing  iiivolves  differentiation  based  on  individual  customer  and 
group  cliaracteristics,  respectively.  Versioning  involves  offering  a 
whole prodiict line and charge consumers different prices for differ- 
ent versions of the good. 
The key to successful product  and pricing  differentiation  is cus- 
tonier iiiforniation, which is far easier to achieve in the infonnation 
econoniy. You  can, for example, easily get deiiiograpliic information 
on your  custoiners  by  askiilg theni to  register  before  they  can get 
access to information on your web-site. You  can then use this infor- 
iiiation in differentiating your products aiid prices. 
The  exper-ience good pi-oblerîz.  The  experie~ice  good  nature  of 
infonnation faces the infonnation sellers witli the "experience good 
problem", iiainely: What is the optima1 trade-off between giving your 
information  away to  convince coiisuniers to  buy your product  and 
recovering your costs of inforinatioii production? An important rec- 
oininendation is that you break your goods in coinponents and only 
give away part of your product. 
Managing intellectual proper@. Since inforniation is easy to repro- 
diice, it is also easy to copy. While this makes rights management more 
difficult, it also offers new opportunities to owners of intellectual riglits. 
Relatively low distribution and reproduction costs of infonnation make 
it, for exainple, easy aiid cheap to let custoiners try your product. Also 
you should keep in niind that these is a natura1 limit to tlie extent of ille- 
gal  copying  in  an  environment  with  well-performing  enforcement 
mechanisms of intellectual propei-ty. The ratioiiale is that illicit copying oii a large scale in such an environment makes the likeliliood of being 
cauglit greater. Iii addition, remember that the goal is not protection of 
your intellectual property but ~?~axinzizir~g  tl~e  vulue of it. 
111. CHARACTERISTICS  OF  INFORMATION  TECHNOLOGY 
AND CONSEQUENCES FOR BUSINESS STRATEGIES 
Spvitching costs and loek-in. A first characteristic of iiifonnation tech- 
nology  is tliat  its users  are  subject  to  si.i)itching costs  and  loek-in. 
Switching costs may arise if you buy various cornplementary (coin- 
patible) assets (with different lifetimes). You not only buy hardìvarc, 
but also the software that goes with it. Therefore, if you change tech- 
nologie~,  you may have to change both assets. For example, if you 
change from Iiitel to Apple technology you not only have to change 
your hardware, but also your software. You wil1 even have to update 
your "wetware", that is your knowledge of how to use the hardware 
and software. Lock-in occurs if switching costs are substantial. 
Switching costs are not statie, but  change throughout  time. Also, 
you are not born locked-in but can become loclted-in by, for example, 
buying complementary investments to an existing asset. Shapiro aild 
Varian ((1999) p. 132) developed a diagram, the loclt-in cycle, (see 
Figure 1) to let you think dynamically about loclc-in. 
FIGUUR  1 
Tlie Lock-In Qcle 
Loclt-in  Sampliiig At the brand selection point, customers choose between alteinative 
technologies. During the sampling phase, custoniers actually try the 
brand they have chosen, and hereby profit frorii various iiiduceinents 
(sweeteners). You can think of tliis phase as, for example, custoiiiers 
using  a free sample. You  enter the  entrenchment phase  if the  cus- 
toiner sticks to the braiid, develops a preferente for it, and becoiiies 
perhaps locked-in by investing in various coiilpleineiitary assets. You 
are  back  at  the  brand  selection  point  if  the  customer  con si del.^ 
switchiiig os actually switches brands. 
Switching costs and lock-in niay be costly for you as a buyer and 
as a seller of iiiformation teclinology. Understaiiding the concepts of 
switchirig cosis  aiid  lock-iii  is  cïucial foï developing  strategies  to 
make  switcliiiig costs and lock-in worlt to your  advantage. Shapiro 
and Varian (1999) describe soine of those basic  strategies. One of 
their most important arguments is tliat you (either as buyer or seller) 
should evaluate tlie consequences of a decision over the entire loclt- 
in cycle. 
The basic  strategy for the  bziyer to iiiiiiiiiiize switching costs and 
lock-in  includes  the  following  two  tactics  (Shapiro  aiid  Variaii 
(1999), p. 136): 
"Bargain hard at the outset of the lock-i11 cycle for a sweetener 
os some fonn of long-terin protection before you becoine locked 
iii" . 
"Talte  steps to minimize your switching costs duriiig the loclt-in 
cycle". 
"Sweeteners"  can come in fonn of additional discounts on hard- 
ware, an extended warranty, support iil switching froin your previous 
systein,  free upgrades  for some period  of time.. . Iinpoi-tant is  that 
you negotiate for this ltind of "sweeteners"  before you get loclted-in 
because your bargaining power is at that moineiit largest. 
You  inay follow various tactics  to bargaiii for sweeteners. Tliose 
tactics iiiclude: 
*  Coiivincing  the  suppliers that  changing systeiils wil1 be  costly 
and  that  your  cussent  system,  aild that  of  your  colleagues  or 
competitors, still worlts properly; 
Convincing  tlie  suppliers that  you  are  an  attractive  custoiner 
(that is wortli a discount) because you need follow-on purchases; e  Conviiicing the  supplier that you  can influence other potential 
customers; 
Conviiicing that you will bear veiy high switching costs later in 
the lock-in cycle. (Note however that tlie latter strategy may be 
a tricky  business  because  a possible  consequence is  that  you 
become subject to monopolistic charges.) 
The  basic  strategy  for szlpplier*~  to  deal  with  lock-iii  is  (l) to 
invest  in  an  installed  base  of  customers,  (2)  aiin  for  custoiner 
entrerichinent and (3) maximize the value of your installed base by 
selling compleineiitary  products to  loyal customers and by selling 
access  to  these  customers  io other  suppliers (Shapiro  and Varian 
(19991, p. 142). 
Since the market for information services is characterized by per- 
fect competition, you will have to compete and invest heavily in an 
installed  base.  Lock-in  will  however  allow you to gain  substantial 
operatiiig margins oii your installed base, so that the net result will be 
a normal rate of return oii your investments. 
Network externalities, network effects and demand side economies 
of scale. A second characteristic of information technology products 
is  that  they  exhibit  nehvork  externulities or  network  effects.  This 
means that the value of infomlation technology products (for exam- 
ple, communication technology products such as telephones, e-mail 
and fax machines) typically depends on how maiiy other users there 
are. This also iinplies collecttve switchirig costs when clialiging froli~ 
one technology to another. As a producer of iiifoi~liation  technology, 
your survival chances will depend on whether you are able to achieve 
the demand side  economies of scale generated by network  effects. 
That  is, you will  have to  reach critica1 mass  or  you  will  have  to 
become the standard. You can either compete to become the standard 
yourself,  or  you  can  cooperate witli  rivals  to  establish  staildards. 
Either way, you will have to take into account that positive feedback 
is crucial for the successful introdiictioii of a product with network 
externalities. Coiisuiiier expectations  and expectations' management 
are critica1 in this process. If consumers expect you to become tlie 
standard, you will become the standard. Those characteristics again 
cal1 for appropriate business strategies. 
In order to ignite positive feedback, you wil1 have to make two 
choices. The first  choice is whether you will make your technology compatible  with  tlie  existing  one  or  whether  you  will  build  ai1 
entirely  new  but  far  better  perforining  technology.  The  former 
allows custoiiiers to switch iiiore easily between technologies ("evo- 
lution-approach") than the latter, which rests on the hope tliat your 
techiiology  is that performaiit  that enough custoiiiers are willing to 
bear  the  huge  switching  costs  ("revolution-approach").  Both 
approaches have their own risks. Tlie "evolution approach involves 
that you will have to  overcome technica1 and legal obstacles. Tlie 
technica1 obstacle iiivolves that you will have to develop a technol- 
ogy that  is at the  same time  conipatible  with  and yet  superior to 
existing products. The legal obstacle involves tliat you will need the 
right to sell products that are compatible with other products. Risks 
of the "revolution  approach"  are that you need  a big performance 
advance, which is inherently difficult to measure because technolo- 
gie~  follow an S-shaped os logistic growth pattern. Also, it cannot 
work on a smal1 scale and you need a powerhl group of strategic 
partners that support your technology  (Shapiro and Variail (1999), 
p.196). 
A second  choice you  will  have  to  make  is  whether  you  will 
choose  for an  "open  approach"  by  offering the necessary inter- 
faces aiid specifications available to others, or whether you try to 
keep coiitrol by keepiiig your systeii? proprietary. Your objective is 
to maxiinize the value of your technology. The value of your tech- 
nology  equals  your  share  of  the  industry  value.  The  "open 
approach" aims at maximizing the total value added to the iiidus- 
try, while the "csntrol approach" aims at inaximiziiig your share of 
the industry. Which one of the two approaches is tlie better one foi- 
you will depend on how strong you are to ignite positive feedback 
oii your  own. Note  that  intermediate approaches can be used  as 
well. 
Given the two choices you have to inake, you will end-up in olie 
of  four generic  strategies  for  cornpanies  seelting to  introduce  new 
infoimation technology int0 the market place (p.203) (see Table  1): 
Controlled inigration, open migration, performance play os disconti- 
nuity. If two players in  a inarket witli inconipatible techiiologies are 
engaged in a battle to build their own new networks (a standards war) 
then the nature of the battle will depend on the pair of generic strate- 
gies employed by the combatants. TABLE 1 
Genei.ic Netn~or-k  Str-ategles 
Coi>lpatrbiIrr)~  1  Coiltrolled inigratioil  /  Open migration 
Pel-fornlnlice  1  Perforinailce play  /  Discontinuity 
IV.  THE GOVERNMENT'S INFORMATION POLICY 
The information sector is liltely subject to the government's anti-trust 
policy  and regulatioii.  Knowledge  of tlie  governrnent's  informatioii 
policy,  and  talting  this  policy  int0  account  wlien  developing  and 
iniplementiilg business strategies inay be csucial for surviving in the 
network economy. 
V.  CONCLUSION 
This article presents a short overview of the major characteristics of 
information and infonnation technology and its implications for busi- 
ness  strategy. The major  characteristics  of information are  its cost 
structure (liigh fixed, but low marginal costs) and its experieilee good 
character,  whirh  hâve  consequences  for  pricing  sti-ategies, rights 
inanageinent  and  inarlsetiilg strategies.  It  is,  for  exainple, recom- 
ineildable to differentiate your prices, to maximize the value of your 
intellectual property rather than to protect your intellectual property 
aild to provide free samples to attract custorners. 
The  major  characteristics  of  inforiilatioii  technology  are  that  it 
iinposes switching costs on the custoiners and that it exhibits network 
effects os network externalities. Major lessoils are that you, as either 
buyer os seller of information, should evaluate the consequeilces of a 
decisioii over the entire loclt-in cycle, and  that consuiners expecta- 
tioiis are critica1 in ignitiiig positive feedback iil order to achieve crit- 
ical inass and demand side econoinies of scale. 
Finally, knowledge  of  the  governinent's  inforinatioil  policy  and 
taking this into account when developing business strategies may be 
critica1 to survive in the iietwork econoiny. R.Shapiro,  Carl and Hal R. Varian,  1999, Inforixiation  Rules. A  Strategic  Guide to the 
Network Econoiny. (Harvard Business School Pi-ess, Boston Massachusetts). 
Varian, Hal R., 2001,  Econoinic  Forces  in the Network Econorny, Ecoiloiilic Dir-ectiotis 
11,  2, (Center  for  Ecoilornic  &  Policy  Education),  1-8.  (Saint  Viilcerlt  College, 
Latrobe). 

How to survive in the network economy? An overview of the ideas of Prof. Carl Shapiro and Prof. Hal R. Varian.

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How to survive in the network economy? An overview of the ideas of Prof. Carl Shapiro and Prof. Hal R. Varian.

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