"At last a clear and eminently practical guide to the information economy for executives and policymakers alike. Read this book-and keep it close at hand. It's the perfect antidote to the fashionable hype swirling around this brave new world of information, networks, and commerce." -PAUL SAFFO, Institute for the Future NFORMATION GOODS-from movies and I music to software code and stock quotes- have supplanted indusuial goods as the key drivers of world markets. Confronted by this New Economy, many instinctively react by searching for a corresponding New Economics to guide their business decisions. Executives charged with rolling out cutting-edge software products or on-line versions of their magazines are tempted to abandon the classic lessons of economics, and rely instead on an ever changing roster of trends, buzzwords, and analogies that promise to guide Strategy in the information age. ot so fast, say authors Carl Shapiro and Hal R. Varian. In Information Rulesthey warn managers, "Ignore basic economic principles at your own risk. Technology changes. Economic laws do not." Under tanding these laws and their relevance to information goods is critical when fashioning today's successful competitive strategies. Information Rules introduces and explains the economic concepts needed to navigate the evolving nerwork economy. The firr book to distill the economic principles of information and networks into practical business strategies, Information Ruleswill help business leaders and policy makers-from executives in the entertainment, publishing, hardware, and software industries to lawyers, finance professionals, and writers-make intelligent decisions about their information assets. Drawing from twenty-five years of economic research and their own experiences as consultants, academics, and government officials, the authors explore the underlying economic forces that determine success and failure in the Network Economy. With its detailed case studies, historical examples, and lucid explanations of key economic concepts, Information Rules explains how to: Continued on back flap Praise for Information Rules "Information Rules is the indispensable battle manual for those on the front lines of the information revolution, and it is the first book to articulate practical strategies, tactics, and rules of engagement for sur- viving and winning standards wars." —JAY M. TENENBAUM, Founder and Chairman, Veo Systems, and Founder and Chairman, CommerceNet "Full of powerful tools for strategic decision making, Information Rules is a valuable source for students, researchers, managers, and legislators." —PHILIPP AFECHE, Assistant Professor of Managerial Economics and Decision Sciences, J. L. Kellogg Graduate School of Management, Northwestern University "Forget Econ 101. Get a glimpse of Econ 2001—state-of-the-art ideas on how and when the market for information works, and what that means for business. Information Rules is an accessible, real-world, and ultimately practical guide." —BARRY NALEBUFF, Coauthor of Co-opetition, and the Milton Steinbach Professor of Management, Yale University School of Management "Shapiro and Varian offer a superb introduction to the challenging and exciting new world of information technology, as well as the opportuni- ties and problems that accompany it. Information Rules is a wonderful piece of work—both timely and right on the money." —ROBERT PITOFSKY, Chairman of the Federal Trade Commission "I have not found a better field guide to the trench warfare of competi- tion in the information age. Information Rules is an excellent asset for high-tech strategists. Skip that 'fog of war' feeling—read this book to find out exactly what your competitors are doing, and how you can make their nights sleepless as you compete for the future." —MICHAEL DOLBEC, Vice President, Business Development, 3Com Information Rules A STRATEGIC GUIDE TO THE NETWORK ECONOMY Carl Shapiro Hal R. Varian HARVARD BUSINESS SCHOOL PRESS BOSTON, MASSACHUSETTS Copyright © 1999 Carl Shapiro and Hai R. Varian All rights reserved Printed in the United States of America 03 02 01 00 99 5 Library of Congres§ Cataloging-in-Publication Data Shapiro, Carl. Information rules : a strategic guide to the network economy / Carl Shapiro and Hal R. Varian. p. cm. Includes bibliographical references and index. ISBN 0-87584-863-X (alk. paper) 1. Information technology—Economic aspects. 2. Information society. I. Varian, Hal R. II. Title. HC79.I55S53 1998 658.4'038—dc21 98-24923 GIF The paper used in this publication meets the requirements of the American National Standard for Permanence of Paper for Printed Library Materials Z39.49-1984. To Dawn, Eva, and Ben To Carol and Chris Contents Preface ix l The Information Economy 2 Pricing Information 19 3 Versioning Information 53 4 Rights Management 83 5 Recognizing Lock-In 103 6 Managing Lock-In 135 7 Networks and Positive Feedback 173 8 Cooperation and Compatibility 227 9 Waging a Standards War 261 10 Information Policy 297 viii I Contents Further Reading 319 Notes 327 Bibliography 329 Index 335 About the Authors 351 Preface Luck led us to write this book. Each of us became economists because we wanted to apply our analytical training to better understand how society functions. By our good fortune, the economics of information, technological change, game theory, and competitive strategy were emerging fields of inquiry when we started our professional careers. We jumped in and offered our own contributions in these areas. Never did we imagine that, twenty years later, we would find ourselves in the middle of an information revolu- tion. What started as an academic exercise, centered on research and publishing, has evolved into speeches, consulting work, expert testi- mony, government service, and even a deanship. As we strayed from academia, we often heard complaints that eco- nomics was not much use in today's economy. At first, we were per- plexed by these complaints, since they often came from the very same people who sought our advice. Then we solved the puzzle: the com- plaints were directed at the classical economics most people learned in school, with its emphasis on supply and demand curves and perfectly competitive markets, like markets for agricultural commodities. We had to agree: to an executive rolling out a new software product or introduc- ing the on-line version of a magazine, supply and demand curves just don't help much. Yet we knew that a sizable body of work in the field of economics speaks directly to current issues in the information economy. Finally, we realized that our clients and friends were thirsty for knowledge about all manner of topics that we and our colleagues had been writing about for years but were rarely covered in most classes. They wanted to know how to set prices for different customer groups, how to design product lines for information goods, and how to manage their intellectual property. They wanted to know how to protect them- selves from lock-in and how to take advantage of it when possible. We discovered great interest in the dynamics of software markets: why does a single company tend to dominate for a time, only to be displaced by a new leader? And we became more and more involved in the application of the antitrust laws to the information economy, with one of us heading Preface off for a stint as the chief economist at the Antitrust Division of the Justice Department. In short, we lucked out: people actually wanted to know and use research results from our chosen fields. At the same time, we kept hearing that we are living in a "New Economy." The implication was that a "New Economics" was needed as well, a new set of principles to guide business strategy and public policy. But wait, we said, have you read the literature on differential pricing, bundling, signaling, licensing, lock-in, or network economics? Have you studied the history of the telephone system or the battles between IBM and the Justice Department? Our claim: You don't need a brand new economics. You just need to see the really cool stuff, the material they didn't get to when you studied economics. So we wrote this book. Our goal is to present insights from economics research and from our own experience applying economics in the network economy in a form suitable for the managers and policy makers who have to make strategic choices involving information technology. We believe that the ideas, the concepts, the models, and the way of thinking that we de- scribe here will help you make better decisions. We also believe that our discussion will serve you well for years to come. 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. Of course, we are not saying that we know all the answers. Most of the time business solutions come down to "It depends." Our aim is to help you figure out what the solution depends on. And the best way to understand such dependencies is to have a framework that relates causes and effects. If you have a clear understanding of what's going on, and some examples of how other businesses have solved related prob- lems, you will be better placed to make more informed and effective decisions. Several of our friends and colleagues have contributed valuable sugges- tions to this book. We especially want to thank Erik Brynjolfsson, Randy Katz, David Messerschmitt, John Miller, Andrew Odlyzko, Sherman Shapiro, Deepak Somaya, Doug Tygar, and Robert Wilensky for their valuable comments. Finally, we want to thank our wives and children for their patience and good nature throughout this project. The Information l Economy As the century closed, the world became smaller. The public rapidly gained access to new and dramatically faster communication technolo- gies. Entrepreneurs, able to draw on unprecedented scale economies, built vast empires.