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January 2, 2001
The executives of Yahoo! appear to be dusting off their copies of "Information Rules." Their challenge, as Shapiro and Varian could have warned them, is to come up with strategies for charging for content that can be distributed at essentially zero marginal cost.
The strategies that Yahoo! is considering include "versioning" (coming up with a premium version of their services for which they will charge a fee) and bundling (trying to charge for a subscription to a bundle of premium services). Both of these strategies are being aimed at the business market.
Yahoo!'s immediate problem is a drop in profits, which reflects a fall in one of their key ratios, revenue per one thousand page views. In the fourth quarter of 2000, this ratio fell to $3.80, the lowest it has ever been. At its peak, it reached $4.70 per page view.
During the dotcom bubble, it was fashionable for Internet companies to "invest" in advertising in order to "build a brand." Now that the bubble has burst, these advertising budgets are being cutback, affecting everything from new economy magazines to the Super Bowl to Yahoo!
For the most part, Yahoo!'s strategy for expanding profits is to extract revenue from other businesses. In other words, its profits are to come out of some other company's profits. This leads to what might be called the Paradox of Profits.
Keynes coined the term "paradox of thrift" to describe a possibility in which the attempt to increase savings could cause savings to decrease. He pointed out that savings and investment necessarily balance. If desired investment is fixed, and people try to save more, then that means that they consume less. This means that total demand falls, total income falls, and total savings very well could fall.
In the national income accounting system, business profits act very much like personal saving. Just as individuals may try to increase their saving by reducing spending, businesses may try to increase their profits by cutting back on their purchases of business services, such as advertising or consulting services.
Many businesses in today's economy do not sell final output directly to consumers. Instead, they sell products and services to other businesses. For example, Yahoo! obtains most of its revenue from other businesses.
For a given level of consumer spending, there is only so much revenue available to businesses. If one business increases its revenues, then another business in the value chain must receive lower revenues.
The paradox of thrift is that with investment fixed, not all consumers can increase savings at once. The paradox of profits is that with consumer spending fixed, not all businesses can increase revenues at once.
In recent months, the stock market has become obsessed with profits. As a result, companies such as Yahoo! are under pressure to try to increase profits. In the aggregate, the result may be cutbacks in spending on business services as well as on internal staff.
For the economy as a whole, the consquence of these cutbacks could be lower overall profits. This in turn would lead to more pressure to increase profits, more cutbacks, etc. This is exactly the type of "multiplier" that Keynes described with the paradox of thrift.
According to economic theory, corporations always should be trying to maximize profits. Therefore, we should not observe spending cutbacks and the paradox of profits.
However, companies in fact try to maximize shareholder value. Shareholders seem to dislike volatility in profits. Apparently, they would rather see a smooth stream of profits than a slightly higher but volatile stream.
This concern with smoothness encourages companies to spend relatively freely when times are good, because shareholders are content with reasonable profits. However, when times are bad, shareholders demand the maximum possible short-term profits, and this leads firms to cut spending.
This model of corporate behavior creates the paradox of profits. If that model is valid, then we may see that the harder companies try individually to increase profits, the weaker will be the economy and the lower will be profits as a whole.