In the late 1990s, firms bet billions of dollars on a theory that turned out to be wrong. It said that in e-commerce, what mattered most was being first. Don’t worry about being best, if that slows you down. Sell your product at a loss, give it away, pay people to take it: just build your base of customers fast. Why? Because the weird economics of the Internet — network effects, enhanced economies of scale and lock-in — gave a decisive advantage to first-movers.
Now that something approaching 100% of the Internet economy’s first-movers have gone bust, this theory looks less plausible. Yet the logic once seemed persuasive. Where exactly did Internet economics go wrong? A new book by Stan Liebowitz, a professor of economics at the University of Texas at Dallas, and a long-time sceptic of the view that the Internet changes all the rules, gives the most thorough answer so far. “Re-Thinking the Network Economy” (Amacom; $27.95) explains what the Internet did change and what it did not, so far as economics is concerned — and it does so in a witty and accessible way. It is the best book to date on the fallacies of the e-commerce craze.
Mr Liebowitz covers a lot of issues: the exaggerated advantages of Internet retailing over conventional retailing; the false claim that the Internet’s lower costs would give Internet firms bigger profits; the inadequacies of the broadcast-television model of advertising revenues; the poorly understood questions of copyright and digital-rights management. But the crux of the book is two chapters devoted to attacking the theory of lock-in. This was the notion that caused the biggest mistakes — and the area where many economists were most at fault.
They Just Didn’t Get It
As the story was told, Internet lock-in happens largely because of network effects. When the value of a product to consumers increases with the popularity of the product, that is a network effect. (A telephone is worthless if you own the only one; the wider the network, the more useful a phone becomes.) Given strong network effects, a company that gains a big share of the market will be protected from competition from late-movers. Even a plainly better product may fail, because people, much as they may prefer it in itself, will wait for others to buy it first. The implication for business is that moving first is all-important.
In refuting this, Mr Liebowitz emphasises the distinction between two kinds of lock-in. The question of compatibility is central to both. One kind of lock-in arises simply because switching to a new product involves a cost beyond the purchase price: costs of learning how to use it, for instance, or the difficulty of using it alongside products you already own. Mr Liebowitz calls this self-incompatibility, or weak lock-in. But there is also strong lock-in. This arises if a new product is incompatible with the choices of other consumers — and if, because of network effects, this external incompatibility reduces the value of the product.
The point is that weak lock-in is very common, indeed pervasive. Many new products have to overcome self-incompatibility. People do not buy a new computer every three months even though the product is improving all the time. Learning to use a new word processor is a bore; for most users, a rival has to be much better, not merely a bit better, to be worth the trouble. Note that if slightly better products are rejected because of self-incompatibility, this is not inefficient: it would be inefficient to buy such a product, incurring all the costs, unless the improvement was big enough to justify it. To repeat, weak lock-in is nothing new.
Strong lock-in is different, because of the network aspect. Strong lock-in means that consumers won’t move to a new and much better product unless a lot of others jump first. If they could somehow agree to move together, they would all be better off. But they cannot. Strong lock-in reflects a failure of co-ordination, it causes economic losses, and in theory it does create opportunities for decisive first-mover advantage. But how common is it, even in the new economy? Mr Liebowitz is forthright on this. Strong lock-in is not merely uncommon, he says, there is actually no known instance.
The lock-in literature leans heavily on just two examples: the persistence of the supposedly inferior QWERTY keyboard and the triumph of the VHS video standard over the supposedly superior Betamax. Both examples, Mr Liebowitz shows, turn out to be bogus. The QWERTY keyboard is about as fast to use as the most plausible alternatives, and VHS had important non-network advantages over Betamax — notably, longer tapes. Neither case shows strong lock-in.
Name a plainly superior technology that society has set aside not because of private cost or self-incompatibility, but because wide adoption was a precondition for its success. Not easy. Network effects do exist, and in principle they could work as the advocates of strong lock-in say, but in practice they have turned out to be far milder than e-commerce zealots supposed — in case after case, too weak to suppress plainly superior products.
Long before the Internet, consumers had plenty of experience adopting better technologies despite network-effect obstacles: cars (you need petrol stations), telephones, fax machines and, most recently, generation upon rapidly succeeding generation of network-dependent consumer-electronics devices. If a new product offers a clear margin of improvement over a competing one, consumers not only want to take it up themselves, they expect others to do the same. In this way, even where network effects apply, a sufficient margin of improvement achieves the necessary co-ordination among consumers.
In short, quality matters. Even in industries where the winner takes all (also rarer than you might think), having the best product matters more than being first to market. That may be old economics, but keeping it in mind would have saved a lot of people a lot of money.