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BRAVE NEW WORLD As Internet changes economy, experts
debate: Does rule book need a facelift, also?
McQuaid Staff writer
As Internet use has exploded over the past five years, it
has begun to work fundamental changes on the U.S. economy.
Information is rocketing around the globe faster and in
greater volume than ever before. Productivity continues to
rise. Technology is evolving at an astonishing clip.
Although investor enthusiasm has been dampened in recent
months by the market troubles afflicting Internet enterprises,
nobody doubts that a new economic force has been unleashed on
the world and that we have seen only a fraction of its
potential impact. As a result, the Internet has sparked a lot
of radical rhetoric by information-age prophets. The Internet
is different, they say. The old economic rules do not apply.
Is the Internet economy really revolutionary? Are the
economic rules that govern the information-age businesses
somehow different than the rules other industries play by?
Economists say the Internet and the electronic commerce it
generates -- the interconnected web of computers, software,
telecommunications links and content -- does behave by a set
of rules that sometimes are radically different from those
applying to traditional brick-and-mortar industries.
Consumers already have witnessed remarkable changes in the
way business is done and companies behave. Online stores such
as Amazon.com have changed shopping habits, offering books and
other products with a mouse click. Travel agents now compete
with online travel booking sites. The Web auctioneer eBay has
created a subculture for auctions of just about anything.
The Internet might ultimately topple established ways of
doing business. Because digitized content is easily copied and
transmitted over the Internet, businesses that deal in
intellectual property, such as the publishing and recording
industries, face the threat of plummeting costs. The
music-sharing software Napster, for example, is a virtual
network made up of personal computers capable of circulating
music for free. Napster represents a threat to the structure
of the music business, which depends on getting $15 for a CD
and legal sanctions for people caught copying music.
The Internet's ability to make distance irrelevant
threatens the telephone industry. Internet telephoning, the
ability to make a long- distance call via an Internet
connection, still is a small industry, slowed by technical
limitations. But industry experts believe it could, within a
few years, change the shape of today's telephone market, where
charges now are based on distance between calling points.
The Internet began as a government-sponsored defense
computer network and has since grown into a freewheeling and
unsupervised arena. As it has become a growing economic force
in the United States and globally, with large corporations
battling for control of key resources and market share, the
government reluctantly has stepped back into the picture.
Rep. Billy Tauzin, R-Chackbay, chairman of the House
telecommunications subcommittee, is a leading critic of
government regulation of the Internet and has clashed with
those who want the government to write some rules of the road.
What makes the Internet economy special, and its behavior
sometimes counterintuitive, is that it is a network.
Networks link large numbers of people in common
relationships, and they behave in sometimes unpredictable
ways. For businesses, markets dominated by networks tend to
rapid growth and bigness. They favor a few dominant players
with the largest webs of relationships.
The Internet is a network of networks that links billions
of people around the world. It includes physical networks,
such as the "Internet backbone" of fiber-optic cables and
routing computers that transmit information. It also includes
"virtual networks," communities of people organized around a
common interest or using the same software.
In their early stages, networks often grow quickly and
virtual networks grow even faster. Internet economy is growing
and changing so quickly that rules written today might be
rendered irrelevant by the next technological innovation or
large-scale economic shift. Meanwhile, some of the old rules
quickly are becoming outdated.
"Let's just face it: Standard regulatory institutions are
not set up for this situation," said Shane Greenstein, an
economist at Northwestern University. "They are set up for a
much more mature technology that changes at a much slower
pace. It challenges them when things are changing rapidly
under their feet and they have to figure out how to intervene
-- or whether to intervene."
Even if officials were able to keep pace, they still might
have trouble predicting the behavior of new industries.
Networks exhibit several strange behaviors that explain why
big, fast-growing companies tend to dominate in some arenas
and why some companies and consumer groups are calling for
In most businesses, the number of customers or products
sold does not alone determine success or failure. Bigger might
not be better. It might cost too much to make a product or
service for large numbers of customers; if a company doubles
its output of widgets, it might not be able to sell them at a
high enough cost to make money.
Network economics, however, favors bigness. The most
valuable networks have the largest number of customers. "In a
network, the higher number of units you sell, the higher the
sales of a good, the more valuable a good becomes," said
Nicholas Economides , an economics professor at New
There is an obvious reason for this phenomenon, called
"network effects." A telephone network with one user is
worthless. One with two users has some value. One with a
million users is vastly more valuable, because any user can
call those 999,999 other customers.
Network effects favor companies that command large customer
bases. A familiar example is Microsoft, whose customers form a
virtual network because they share common operating systems
and software. In general, the more computers that use a
particular operating system and software, the more people can
share files and communicate. As Microsoft became the dominant
operating system globally, with millions of customers,
competitors such as Apple fell by the wayside.
The downside of this, of course, is that network markets
might unfairly limit consumer choice, something Judge Thomas
Penfield Jackson said had happened in his decision sanctioning
"The network industries present pretty complicated issues,"
Economides said. "You have a natural equilibrium in
which one winner takes over most of the market. That presents
special challenges for people doing antitrust or public
Economists have analyzed some of the processes networks
undergo as they get bigger and allow companies to gain market
share and the upper hand. They are hotly debated concepts
among economists because they call into question the notion
that market forces invariably create the best range of choices
for consumers. In the case of networks, markets may lead to
monopolies and limited choices.
-- Positive feedback. Classical economics predicts that
markets tend toward an equilibrium in which several companies
compete with each other, none dominating. If one develops a
small advantage, the others can compensate for it. Competition
makes for better products and more choices.
But in the world of network economics, small advantages can
quickly turn into big advantages, and an ideal balance between
competitors might never come about. If companies get more
valuable as their customer base grows, it can become a
self-reinforcing cycle. A company grows, becomes more
valuable, which sparks another round of growth. The cycle is
called positive feedback because it is analogous to what
happens when a small noise cycles through an unbalanced sound
system, emerging as an ear-splitting electronic shriek.
-- Path dependence. Network economics emphasizes the
importance of the historical "path" a company takes. If a
company gains a small advantage early in the history of a
fledgling market, it might end up turning that into market
domination down the line. That means what happens early in the
lifetime of a new market is very important. Even small, chance
occurrences might tip the balance toward one company or
One oft-cited example of path dependence is the
videocassette market. In the 1970s, two types of
videocassettes were competing: Beta and VHS. Beta had an
advantage of compactness, but VHS got a leg up in the
marketplace and eventually became the industry standard. Some
economists dispute this example, however, noting that Beta
started out with more customers and that VHS eventually
overcame the advantage with features, such as longer tape
times, that appealed to consumers.
-- Lock-in. When a company comes to dominate with a
particular networked product or service, it might be almost
impossible to dislodge, even by companies offering superior
products. It is locked in. The logic of lock-in is
straightforward: If all the customers on a network use one
operating system or type of Internet connection, for example,
the advantages of sticking with it may outweigh the costs of
switching to another one.
The classic example of this is the standard QWERTY
keyboard, which has been around since the typewriters of the
19th century. It has no inherent advantage over other keyboard
arrangements, but virtually all keyboards have it, people are
trained to use it, and the costs of switching to a more
efficient alternative would be high. Here, too, some
economists dispute the notion that there are significantly
better alternatives and say that if there were, market forces
would favor them.
As officials examine the rollout of high-speed Internet
services by competitors in the cable, phone, wireless and
satellite industries, everyone is worried that the dynamics of
networks could lead to monopolies or dominance by a few large
players, perhaps re- creating a situation similar to a century
ago, when AT&T consolidated its telephone monopoly.
Tauzin, for example, raises the specter of a monopoly by
cable giants as a rationale for his bill granting regulatory
relief to the big Bell telephone companies.
But there is no consensus among economists about the
ultimate shape of the broadband marketplace. It depends partly
on the federal government. The path-dependence idea means that
modest actions taken today might have enormous ramifications
later on, for good or ill, increasing both the potential risks
and rewards for any action.
It is possible that if a single industry develops a
superior and cheap standard way to deliver high-speed
connections, it will quickly take over the marketplace. But it
also is possible that the diversity of technologies, the range
of customers and the chaotic democracy of the Internet might
mean that none among the four may come to dominate.
"The big difference with AT&T is it had a concentration
of patents and engineers on the frontier," Greenstein, the
economist, said. "They had technological assets nobody could
replicate. That's partly what led to their dominant position
in the industry. If you look at the Internet today, basic
technical capabilities are widely dispersed. It's not hard to
do a lot of this stuff on hardware and the software side, and
it's not that expensive to assemble a bunch of people who can