"KING OF HEARTS" Rules

"Arguing in My Spare Time" No. 20

by Arnold Kling

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

Index

Hal Varian kindly sent me a prepublication copy of "Information Rules," a book that will appeal to everyone who reads these essays. Varian, a renowned economist now at Berkeley, co-authored the book with Carl Shapiro, another star in the profession. Ordinarily, someone who has been out of the academic loop as long as I have would not be competent to review work by such high-powered theorists. However, by aiming for a target audience of business executives, Varian and Shapiro have stooped to my level.

Varian and Shapiro (henceforth VS) argue that economics is applicable to the Information Age, even though information has characteristics that differ from those of ordinary goods. As they put it,

"Even though technology advances breathlessly, the economic principles we rely on are durable. The examples may change, but the ideas will not go out of date." (preface, p. viii)

"markets for information will not, and cannot, look like textbook-perfect competitive markets..." (p. 22-23)

In other words, the asylum of economic analysis is still sturdy, even though it may resemble the movie "King of Hearts," in which the inmates are in charge. In this case, the inmates are phenomena that formerly were regarded as theoretical curiosities: zero marginal cost, significant complementarity, etc.

Chapter one, "The Information Economy," describes the erstwhile exceptions that now are the rule.

1. high fixed costs, low marginal costs. It may cost a lot to collect a set of data or to develop a piece of software, but once you have the information the cost of distributing each additional copy is close to zero.

2. information as an "experience good," meaning that you do not know whether it is worth buying until you have tried it

3. attention as a key scarce resource. Because there are many would-be sellers of information, the challenge is to allocate the attention of consumers, who cannot possibly absorb all that is available.

4. complementarities. How a product integrates with related products may be much more important than the stand-alone features of that product.

5. switching costs or lock-in effects--somebody who has all their computer files on one operating system will be loathe to change operating systems.

6. network effects, in which the value of a product to one consumer may depend on the number of other consumers using the product.

The rest of the book traces through the implications of these characteristics. There exists no single overarching framework to cover all of these issues. There is sufficient difficulty in considering each of them in turn.

Chapters 2-4 focus on the challenge of pricing an experience good where marginal cost is close to zero. This topic was raised in an earlier aimst essay, "Does software want to be free?" VS describe "group pricing" as one solution, which relates to my proposal for "software clubs." However, they provide a much richer and more systematic description of solutions to the problem of pricing information goods.

In general, VS propose that firms should try to use pricing and versioning tactics to segment consumers so that consumers who value a product more highly end up paying a higher price. VS, writing for a business audience, do not concern themselves with the social implications of price discrimination. Price discrimination clearly is good for maximizing profits, but from an overall social perspective it is not necessarily desirable. Before the days of zero marginal cost, economists used to teach that price discrimination is bad from a social perspective. However, after reading these chapters, it occurred to me that one of the ways that firms have been able to increase profits without raising productivity ("The Junta hypothesis") probably has been by engaging in price discrimination with increased success.

Chapters 5-9 examine the implications of phenomena that affect the demand side of the market: lock-in effects, network effects, complementarity, and compatibility. Many of these phenomena appear to justify what I have disparagingly called "The McKinsey business plan," in which a firm is willing to lose money in order to gain market share, because market share can be a valuable asset.

My personal opinion is that execution trumps strategy. For example, my earlier essays on Microsoft were designed to highlight the superiority of its software development processes relative to those in the Dilbert Sector and those of many of its would-be rivals, such as Netscape. I am not prepared to concede that very much, if any, of Microsoft's success is due to superior strategy. However, the analysis presented by VS was compelling enough to give me second thoughts about dismissing lock-in and network effects.

The stronger one's belief in the efficacy of business strategy and tactics as opposed to superior execution and operational effectiveness, the more likely one is to favor active government intervention. Indeed, VS argue that existing antitrust laws can and should be applied in this arena. Given the significant ways in which the conditions of the information industry depart from those which give rise to textbook perfect competition, the potential for imperfect social outcomes to arise in the absence of government intervention is irrefutable.

However, the likelihood of government involvement leading to inferior results concerns me much more than it appears to concern VS. This has less to do with one’s economic theory than one’s model of the political process. I am more of the cynical "Chicago" school in that regard.

Mass-market business books instead tend to focus on providing affirmation, not information. ("You can be great, too! Here is the recipe for success!"). Many authors use jargon and metaphors to try to make their ideas sound more radical and important than they really are. VS offer neither chicken soup nor cyberbabble. They provide business executives with advice that is unconventional from a traditional vantage point and yet is well-grounded in economic reasoning.

As someone who finds pure intellectual curiosity sufficient motivation to read about this subject, I found "Information Rules" to be very worthwhile. The book is rich with substance, which can be conveyed only superficially in a brief review. It gave me fresh insights that helped to clarify my thinking.

Fortunately, relative to the aimst essays, "Information Rules" does not tackle every issue or resolve every question. Indeed, it stimulated me to continue pondering and writing on these topics.