The University Record, June 19, 2000

Varian discusses innovation, irrational exuberance, survival strategies for new information economy

By Theresa Maddix

“The new economy is not new. Seek models, not trends. Seek theories, not buzzwords; analysis, not analogies,” speaker Hal Varian told the joint meeting of the IT Zone and the Ann Arbor Software Council June 8.

Former U-M professor of economics and Business Week best-selling author, Varian presented “Technology Changes, Economic Rules Do Not” at the fourth IT forum, funded in part by the Technology Management Office and the Office of the Vice President for Research.

Varian’s book, Information Rules: A Strategic Guide to the Network Economy, is widely circulating as the textbook for the new information economy. Varian, who co-wrote the book with former student Carl Shapiro, provided an overview of many of the book’s tenets in his talk and covered new ground from a forthcoming book, also written with Shapiro. The new book, Varian said, will “go up a level,” focusing much more on networks, both physical and virtual.

Varian has a manner best described by economist friends as “countrified” with a down-to-earth sensibility. It is this manner that came through in his lecture and that makes his book readable and understood by a wide audience. Talking with reporters and local businesspeople before his presentation, Varian assured the group that his new book would use the same, easy-to-follow style.

Varian, who is dean of the School of Information Management and Systems at the University of California, Berkeley, focused on three areas in his talk. He discussed innovation and its driving forces, the irrational exuberance of individuals wondering if it is the beginning of the end or the end of the beginning for the information economy, and crucial survival strategies.

Discussing innovation and “recombinant growth,” Varian cited Eli Whitney’s development 200 years ago of interchangeable parts for muskets, a key, Varian said, for the Industrial Revolution.

Now, Varian said, “the component parts of this revolution are ideas . . . They can be recombined in an endless variety of ways.” The process is the same “except it’s proceeding at a much more rapid pace.”

On the topic of irrational exuberance, Varian noted the speculative activity of the railroads in the 1880s, when many miles of track were built, followed by a period in the 1890s, when many of the companies went into bankruptcy. Laying the tracks was two-thirds of a railroad company’s costs. Operating costs were comparatively low.

The information economy has a similar structure, with high first-copy costs and low costs of reproduction. What makes the new economy different from the railroads, Varian said, is that “much of the investment is highly revisable. Wouldn’t it have been great if we could have taken the railroad tracks and turned them into highways?”

Varian broke the economic forces at work in the new economy—“the old economy with new twists”—into four categories: differentiation, switching costs and lock-in, networks and positive feedback, and standards and interconnection.

He noted instances in which different versions of the same product have been around for a long time—in the automobile, for example, where features like air-conditioning are options and cost extra. What has changed with information goods—“anything that can be digitized”—is the way versions are created. In cars, the product starts at the low end with a basic model and features are added to increase the value. Information goods, in contrast, start at the high end with the highest price and the best product—such as real time availability of stock prices on the Internet—and, and as the price decreases, the delivery time increases. People willing to wait 20 minutes can get stock quotes free—a “value-subtracted service.”

Lock-in, where consumers incur high costs for switching to another service, is something sellers want to create and buyers want to avoid or be properly compensated for. In information technology, Varian said, “the value to the user depends on having the whole system available.” Examples of having a whole system are not limited to physical hardware but expand to include numbers of other users engaged with a product.

When enough individuals are using a product, sales can reach a critical mass—a point at which it is detrimental for users to buy any other product and the company “goes zooming to success.”

Standards in the information economy can be beneficial, Varian said, to both consumers and sellers. Companies currently in a standards war should work to “make alliances, not wars.” Contradictorily, companies should “prepare for war, but make peace if you can. Sometimes, it’s important to have third parties to broker these competitions.”

When the movie industry saw the emergence of a standards war between Sony DVD and Phillips CD-Rewriter, for example, it remembered the money it lost in the Beta vs. VHS battle for videocassettes and demanded a standard.