Railroaders and net buccaneers

May 21, 1999

INFORMATION RULES: a strategic guide to the network economy. By Carl Shapiro and Hal Varian. Harvard Business School Press, 362pp $29.95/Pounds 22.95 - ISBN 0 87584 863 X.

This book is a must read for anyone with the slightest interest in the information economy. For anyone running a company that sells information products or services, or providing services to such a company, reading and absorbing this book is probably one of the most useful things they could do.

I suggest that it is also a good model for academic writers. Its clarity of exposition of economic theory applied to a particular industry does a lot to raise the credibility of professors of economics in the business world.

It is also a relatively easy read for consumers. It tells us why we all use Windows and it explains some of the rationale behind the pricing of internet stocks. It illuminates why mobile telephones are far easier to use in 108 countries around the world than in the United States and it gives us very good advance warning of how we will participate in electronic commerce. Generally it explains, albeit in chilling fashion, how we consumers are being treated by the communications industry.

But it is most interesting to policymakers. It is written from the economic perspective of producers, with limited acknowledgement of wider public interest issues surrounding the information age. It should help regulators and competition authorities know the enemy.

Do start with Chapter 7 on networks and positive feedback. This chapter illustrates with examples from the past 150 years of technological progress in networked industries, how the technology changes, as does the cast of characters, but not the underlying economics. Do you want to know why we say "Hello" when we answer the telephone? Why railroad gauges in the US settled on 4'81/2"? Why the United States has poor colour television standards? Why the US is behind Europe in mobile telephony?

In every case, one network or one standard (hello or GSM) it does not matter) came to be the network that everyone "had to join" or "had to use". In each case, what is illuminating is the nature of the intervention by the state - as legislator, or regulator or purchaser - and crucially, the timing of that intervention, development of products or services, and commercial standards and network battles. When is consumer welfare maximised by a push in one direction or the other? A point that the authors do not bring out is how the cycle of positive network feedback is always ten to 15 years. I suggest it will be the same for the public packet switched data networks (otherwise known as the internet). We are five to six years into answering questions like "what standards?": "how will the packet switched circuit switched battle be settled?" "how will we address each other?" If I am right, the basic infrastructure and applications that the next generation will take for granted will be settled around 2003-05. Which puts the hype that seven internet years equal one ordinary year in perspective.

But to understand why producers are behaving the way they do, retreat to chapter one and get into the meat of the book - the economic imperatives behind the production and marketing of information goods and the networks over which they travel. The authors take the concepts of expensive to produce, free to reproduce; switching costs - for producers and consumers; network externalities; option values and bundling. They then explore how these interact to create a powerful framework for business strategies. As an ex-regulator and businessman, I am delighted to see the focus on pricing, pricing, pricing. This is good stuff. Read it.

So far, then a paean of praise. But alert consumers and public policymakers will be uneasy right from the opening index of chapter headings - perhaps even with the title. This is a book for producers. Consumers are just that, consumers. Not citizens, not people who might want protection from the abuse of a dominant position. There are issues here of customer lock in, the use to which information about you is put, control of content standards, information have-nots and the like. Even more important, the particular nature of information goods - that they are our window on the world - matters an awful lot. What happens to information as it passes over the gateways controlled by multinational commercial companies? How much of what we might want never gets produced at all? Or we do not get to see, hear or read it? And what is happening at the point of interaction with information providers? Not just what choices we make, but how we made the choice. What websites we visited. How long we stayed. What advertisements and information we accessed.

The authors devote one late, quite thin chapter to public policy, aimed at "how to factor government policy and regulation into your (producer) strategy".

What public policymakers need is a framework as powerful as this and as well-founded in hard economic analysis. What might that look like?

First, do what effective CEOs do instinctively - recognise what choices their customers will have. That means seeing the way technology is eroding boundaries and received views. Services tend to be specific to networks (voice and the telephone, broadcasting and the television set). In the future, with the erosion of network capacity constraints, and common transmission standards, things will be different. The relevant economic market is electronic communications networks. Government departmental and ministerial structures do not match this. Neither do regulatory structures, nor consumer bodies. This is a recipe for a less than effective public policy response, to put it mildly.

Second, recognise that legislation and regulation is no longer dealing with factory rules and relatively stable market structures of some large producers, many others, in which a dominant position is hard to get and even harder to sustain and exploit. In the application of general competition law, the tendency of networks and applications to tip to a market structure with one dominant firm has to be courageously tackled.

But nevertheless, do try to maintain the primacy of general competition law and avoid an undisciplined retreat to regulation. My experience at Oftel offers few clues as to how easy such a discipline might be. UK competition law was lousy, and I had to fall back on virtually sanctionless enforcement under the Telecommunications Act. I wonder, if armed with the Competition Act 1988, would I be disciplined? However, across the US, Europe and almost all the rest of the world, regulators cannot use the general competition law. And if appointed a regulator, what else is there to do but regulate? Fine, but just do it within the economic and legal disciplines of the general competition law. Regulation is required, however, to counter the network effects that the authors emphasise. There is a powerful framework in the UK of rules on interconnection, disclosure of interfaces and so on. It is based on economic pricing (no state-imposed cross-subsidies as in the US) and offers a stable, transparent set of entry pricing signals. It needs extending to cover all electronic communication networks, not just telecommunications services. Whether there is a set of ex ante rules required to deal with vertical integration and the leverage of market power from one market to an adjacent one is more problematic. The recent Manchester United FC /BSkyB decision is interesting. Sky was refused ownership of a football club with some market power because of its own dominant position in the pay television market. This was a good example of the primacy of general competition law over ex ante regulation, and is to be welcomed. But it also shows how difficult this issue is. The Microsoft/Netscape decision will be a better test.

Next, government needs to use the same network effects that producers exploit, to benefit society. I have in mind universal service ideas, a determination to empower information have-nots. These should be captured without distorting competition. But that needs ex ante transparent rules on transfers of costs from one group of consumers to another.

Then, the scope and power of regulators need to be matched to the relevant economic market and producers' scope of business, that is, from creating content through to operating the networks over which voice, data, and entertainment flow in common form.

When the tempo is right, government leadership of standards making is required. There is hope here. Two examples: the EU has taken strategic leadership in the standards for data protection while the US and the EU have judged well the timing of pressure on industry to deliver a worldwide standard for next-generation mobile communications services.

There are risks, but this late 20th-century method of pressure on industry, stopping short of civil servants and ministers making decisions, promises well.

That is a quick run-through of the book. Perhaps I should write the sequel to strike a better balance for consumers. Without it, producers may be too well armed with the book's insights.

Donald Cruickshank is chairman of Action 2000.

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