Information Rules, by Carl Shapiro and Hal Varian

Amazon link
Google books link, which appears to have most of the book’s content available (not surprising as Hal Varian is Google’s Chief Economist).

According to the preface, this book arose because these two economics professors were perplexed by complaints that “economics was not much use in today’s economy” even as they were getting hired as consultants by the same people doing the complaining. They realized that what most people knew of economics was Econ 101, the classic supply and demand curves with perfect competitive markets. But there was an undiscovered trove of economics research on exactly the sorts of issues facing companies, and this book is a summary of that research, applied to the “information economy”. What really impressed me about this book is that it was written in 1999, and unlike most business books written in the dot-com era, this one still is perfectly applicable today, lending credence to the book’s thesis: “Ignore basic economic principles at your own risk. Technology changes. Economic laws do not.” The authors support this thesis by using examples from throughout history to illustrate “information economy” principles.

The book starts with a discussion of pricing information. We all know that information has a somewhat unusual cost profile – it’s expensive to produce the first copy, but all subsequent copies are extremely cheap, bordering on free. The free part is what makes information different – unlike other products with economies of scale like toys, there is no lower bound to how low the price can go after the sunk costs of originally producing the information – “Competition among sellers of commodity information pushes prices to zero”. To survive in such a market, companies must either differentiate their product by adding value to the raw information, or achieve cost leadership by increasing sales volume so that initial sunk costs are spread over more and more copies. This means avoiding greed – it’s better to make less money per copy if it means scaring off other potential competitors for the market.

Differentiation of the product can be achieved with a number of different strategies. One is to offer different versions (get the information faster for more money e.g. real-time stock quotes costing more than quotes delayed by 20 minutes). Another is to use intellectual property or licensing rights to restrict access to the information, but the authors observe “the basic trade-off: more liberal terms and conditions will tend to raise the value of your product to consumers but may reduce the number of units sold”. The book spends a chapter delving into the potential benefits and difficulties of each of these options.

The book next discusses the phenomenon of lock-in, where choosing to buy a product locks one into that company’s products in the future (with classic examples like AT&T’s 5ESS switches forcing customers like Bell Atlantic to come to AT&T for aftermarket software upgrades). One interesting result discussed in this chapter is that the profit associated with a customer can be estimated as the total switching costs associated with that customer, summing up the costs borne by the customer and the costs borne by the new supplier. In other words, the present provider of a service can afford to charge up to the total switching costs as a premium over the market rate because other providers would have to pay that much to convince the customer to switch. I still haven’t quite wrapped my head around this concept, but it’s definitely thought-provoking.

The book then spends several chapters covering how to handle network effects, where the value of a product increases with the size of the community of other people using that product in a positive feedback loop. Industrial companies leveraged supply-side economies of scale, where the variable costs of production were driven down by increasing production volume; however, these economies of scale eventually ran out when confronted with the difficulty of managing the large organizations necessary to produce such large volumes. Information companies, on the contrary, leverage demand-side economies of scale, which have no such limits; because the distribution and reproduction costs are minimal, the positive feedback cycle can continue until the market is saturated in a winner-take-all scenario.

The authors continue by discussing the various competitive scenarios that play out in an information economy. New entrants need to decide between evolution (providing a risk-free backwards-compatible bridge to their product) or revolution (depending on superior performance to convince existing customers to take the leap). They also discuss the balance of openness vs. control and emphasize what I consider to be a key point: “your ultimate goal is to maximize the value of your technology, not your control over it… [the value equals the] total value added to industry multiplied by your share of industry value.” In other words, it may be worth it to pursue an open strategy if it will grow the industry sufficiently to offset the potential market share loss. This continues into a discussion of alliance building and standards setting (including a chapter on waging a standards war).

The book ends with a discussion of information policy and government regulation. As Varian put it in one interview, if a company successfully executes the strategies from the rest of the book, they’ll have to deal with the anti-trust provisions of the government discussed in the last chapter.

Excellent book. Well worth a read from anybody making strategy decisions in the information economy.

2 thoughts on “Information Rules, by Carl Shapiro and Hal Varian

  1. Economics promises so much, but the process of abstraction used to generate economic theories, always means it fails to deliver in particular cases. There is a joke among marketers that marketing only exists because the assumptions of economics are false.

    One of those assumptions is that there are such things as commodities. If in any real marketplace, a true commodity exists, then some marketing manager is not doing his or her job. Even natural resources, such as coal, are not commodities in the sense understood by mainstream economists, since factors such as the quality of the resource from a paricular location, the time and costs of delivery from and to particular locations, the likelihood of strikes disrupting supply, etc, enable buyers to differentiate between different sources of supply. Talk to Australian coal miners, competing against their counterparts in Brazil for contracts in China and Japan, and you won’t hear anyone mention the word “commodity”.

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