The Economics of Franchise Value

"Arguing in My Spare Time" No. 2.10

by Arnold Kling

July 25, 1999

May not be redistributed commercially without the author's permission.
Index

In response to my previous essay, "Arithmetic in a Bubble," one reader commented on the relative merits of different franchises on the Internet, such as Yahoo, eBay, and Amazon. This essay looks at franchise value from the perspective of textbook economics.

The economic theory of franchise value is quite simple. All of its elements are explained quite clearly in any freshman course. They are:

  1. Revenue
  2. Cost
  3. Barriers to entry

A valuable franchise must have a sizable revenue base. This could come from selling something in low volume at a high price. Bloomberg terminals are an example. Bloomberg leases proprietary computer terminals with information that is important to financial market participants, particularly bond traders. These users have large budgets and a strong need for the service, so that even though it is not a mass market, Bloomberg can charge high prices and earn tremendous revenue.

However, most of the other large revenue opportunities that come to mind are mass-market opportunities, often with low dollars per consumer. The Microsoft Windows operating system, for example.

Another element that a valuable franchise needs is low marginal cost. The ability to sell to the next consumer at low marginal cost is critical. That is why most computer programmers who want to get really rich would rather work for a products company than for a services company. A firm that develops web sites for other businesses can only serve new customers by adding staff. On the other hand, a company that markets software can add new customers at little or no marginal cost.

A few of the companies whose stocks have taken off in the Internet boom are web development consulting firms. Like other Internet firms, they tend to show losses. But unlike most other Internet companies, these web-consulting outfits cannot tell a story that as the Internet grows they can grow their revenue while keeping costs low. If you are losing money now in a service business, do you plan to make it up on volume?

By and large, however, most of the Internet high-flyers have good revenue potential and low marginal cost. The controversy over franchise value is likely to revolve around the third factor, barriers to entry.

If barriers to entry are low, then according to the textbooks a profitable firm is likely to face many competitors, leading to erosion of franchise value. Only if barriers to entry are high will the firm be able to earn monopoly rents for a long time.

Some columnists have advanced the conceit that porn sites are the leading edge of Internet commerce. The revenue potential of porn is high. The marginal cost of distributing to the next consumer is close to zero. Nonetheless, I suspect that the franchise value of Internet porn sites is not very high. If as many as one percent of all porn sites have sent me unsolicited advertising by email, then there have to be well over 10,000 of them out there. My guess is that while there may be some quick profits made by the cleverest entrepreneurs in the field, the long-term values of the franchises tend to be rather small.

The pundits may be correct in suggesting that we can derive insight into the future of Internet commerce by looking at the online porn industry. In this case, the inference to be drawn is that when the cost of starting a new firm is low, competition will be keen and franchise values will be limited.

Deutsche Bank Securities economist Edward Yardeni, who has an interesting web site at www.yardeni.com, believes that one of the most significant economic features of the Internet is that barriers to entry are low. Because entry barriers are low, he argues, the Internet is causing our economy to be more competitive.

(Yardeni goes on to say that having a more competitive economy creates a bias against inflation. He makes it sound as if this is a really major phenomenon, but he never quantifies the extent of the bias. My guess is that an argument can be made that an economy with low barriers to entry will have an inflation rate of 0.5 or 1.0 percent lower than an otherwise-comparable economy with high barriers to entry. However, even that case is not one I would try to make in front of a seminar at a top-20 economics department. The challenge would be trying to explain how market structure affects the rate of change of prices, as opposed to the level of prices.)

Many economists, however, would share Yardeniís intuition that the Internet reduces barriers to entry. The Internet reduces the physical capital (stores) needed to sell physical goods, and it reduces the physical capital needed to distribute information goods, such as software and music.

If the Internetís economic significance is that it reduces barriers to entry, then it is somewhat paradoxical that investors are attaching high franchise values to Internet stocks. The competitive economy which, according toYardeni, is a by-product of low entry barriers, should constrain profits and franchise values.

It may be difficult to evaluate the cost of entry in the current Internet environment, because so many companies reportedly are losing money. This may lead to less entry than will occur if and when companies start to show profits. For example, many potential competitors to Amazon in the online book-selling arena may be driven away by the reports that Amazon is unprofitable and expects to continue that way for the indefinite future. As an entry-deterring strategy, telling the world that you are losing money hand over fist has some merit. If book-selling were reputed to be as profitable as online porn, the number of companies trying to sell books online probably would be a lot higher.

Having a large customer base does not in itself constitute a barrier to entry. A large customer base can be converted into a barrier to entry by creating and exploiting switching costs. If I place a high value on a personalized portal page, and if it is difficult for the consumer to set up a personal portal page, then once I have set up a personal page with, say, Excite, then it will be costly for me to switch to Yahoo.

Setting up "one-click ordering" with Amazon has a similar effect. It is time-consuming for me to set up one-click ordering with someone else, so that I may be reluctant to switch to a different retailer.

Markets where switching costs are important can give rise to battles over customer acquisition. Switching costs give you some temporary power to mark up your prices, because your customers do not want to switch to a competitor. However, one may spend so much on marketing and incentives to attract customers that the lifetime value of a customer may not exceed the cost of obtaining that customer.

Another issue with switching costs is that they can be made obsolete. Technology to overcome switching costs for features such as personalization or one-click ordering can readily be imagined.

In the case of one-click-ordering, there exists already the ability to embed the necessary information into the Web browser. America Online plans to use this capability to enable any web site to set up one-click capability with respect to AOL users.

In the case of personalization, one scenario is that I will carry a smart card that includes, in addition to digital identification and digital money, digital preferences such as which stocks I follow or which news categories interest me. In that case, I can go to any site that recognizes preferences in a standard format and have it be "personalized."

Whether preferences are stored on a smart card or somewhere on the Net does not matter. Once they are in standard format, and I have an easy way to authorize revealing some of them to a web site, then no web site will have a competitive advantage based on "knowing" my preferences. No one is going to "own" my personal information. I may store it on a particular smart card or at a particular database, but I will have the ability to move it with one click to a different smart card or database.

A more plausible source of long-term barriers to entry is "network effects." When the value of a service to me depends on the size of the community that participates in the service, there are network effects. For example, because my daughters have friends who use AOL chat rooms, an AOL account has value to them.

Classified advertising also has the potential for network effects. If you have a car to sell, you are not interested in advertising it on the site that draws the fifth-most number of consumers. The original franchise value of Yahoo was as a classified advertising vehicle, where the listings were for web sites. Ebay also has franchise value that comes from the same type of network effects as classified advertising. Auctions can be set up anywhere, but only on Ebay can one expect to find large numbers of buyers and sellers.

Microsoftís franchise arguably rests on network effects. That is, because so many consumers use the Windows operating system, developers tend to develop for that operating system, which reinforces its position in the market.

The question about network effects is whether they are permanent or whether they will be subject to the forces that Joseph Schumpeter called "creative destruction." Those forces affect Microsoft.

In August, 1995, George Gilder predicted that Microsoft would lose to Java, because computer software would become nomadic. This scenario has not played out.

However, nomadic hardware that draws its capability from the applications housed on Web servers is becoming increasingly important. Can Microsoft develop software that is used in this environment? Yes. But will Internet appliances that use Windows have more capabilities than non-Windows appliances? No. Will software developers who focus on applications that run on Web servers be focused primarily on Windows as a platform? No. Therefore, if you are looking forward to an environment in which Microsoft has to compete without the benefit if network effects, there now is light at the end of the tunnel.

Returning to Internet franchises, the forces of creative destruction threaten them as well. For example, AOLís network-effect advantage in chat could be short-lived. Microsoft is proposing that all chat software be inter-operable. If this inter-operability develops, and it reaches a point where AOL chat rooms can be accessed from any Internet provider, then the basis of AOLís network effect will have eroded considerably.

For classified advertising, the ability of "robots" to search multiple sources may erode the advantage of any single advertising site. For example, there are now search engines that look at multiple directories to find Web sites. Moreover, if the potential of XML is fully realized, robots that are looking for used car listings will be able to find the car that I have for sale whether I list it on a well-known site or on my own personal home page. A similar combination of robots and XML could erode the network effects now enjoyed by eBay.

The barrier to entry in which I believe the most is the learning curve. In my opinion, most of the value of the franchises of Yahoo, Amazon, and even AOL and Microsoft stems from the fact that those companies have learned a tremendous amount. I know that in the case of the web business that I started, homefair.com, one of the most amazing phenomena to observe is the extent to which would-be competitors try things that we know have failed. I view business as a complex game in which even the best players often make mistakes. Learning helps to cut down your mistakes.

How one interprets the absence of profits at Internet franchises depends a great deal on the extent to which one credits network effects or the learning curve with being the most powerful form of entry barrier. To the extent that network effects are important, then a company that loses money today to build its consumer network may be profitable tomorrow. To the extent that learning is what is important, the best indicator that a company will be a valuable franchise in the future would be if it were earning high returns today.