In the Fall of 1995. Netscape had recently had its IPO and I watched its shares soar. I considered its price to be wildly unrealistic and quickly shorted it. I wasn’t sure what the business model was that Netscape was going to apply to make the type of profits that would justify its seemingly lofty market capitalization. After a few ups and downs, I was able to make a small profit, but Netscape’s fortunes were thwarted more by Microsoft’s introduction of Internet Explorer than by any realism that had returned to the market.

After Netscape I shorted Yahoo in April of 1996, an action I was soon to regret. Stocks related to the Internet, particularly Yahoo, climbed to achieve greater and greater dizzying heights. I was way too early on the short side and I soon found myself shorting a company that was undergoing one of the great financial run-ups of all time. I soon found myself deep in the red. After watching a very large chunk of the money that I had put away for my daughters’ college education evaporate before my eyes, and after many a sleepless night, I threw in the towel in April of 1998, took my losses, and vowed to expose what I saw as insanity in the business press that was helping to stoke what was by then, as it appeared to me, a mad Internet frenzy among investors of all kinds. That was when I first conceived of writing this book, as a salve to my wounded ego and to help promote some sanity in a market I saw as totally insane. Not necessarily the best of motivations, but not the worst either.

My academic research on several related fields of economics seemed to provide me a particularly good fit to discuss e-commerce and other aspects of the Internet. I had done research on network effects and lock-in, two concepts that seemed to largely underpin the thinking that I saw displayed among the many uncritical Internet mavens. I had also done research on television advertising and the impact of new technologies on copyright owners. Ever since owning an Atari 800 in the early 1980s I had read computer magazines for fun, and had been an avid fan of technology for a very long time. It was my experience in these areas that convinced me that the Internet phenomenon was just a temporary, unsustainable aberration.

But working on this book soon took a back seat to another project that had come up. My academic work with Stephen Margolis was suddenly propelled into the mass of publicity surrounding the Microsoft antitrust case. We were the leading critics of the theory that the government was relying on to support its case. We had thought about writing a book about those theories and the Microsoft case provided a golden opportunity which we took advantage of during 1998 when we wrote the manuscript. That book, Winners, Losers, & Microsoft was published during 1999, and a revised version was published in 2001.

This current book took shape in early 2000, just before the onset of the Internet meltdown. Books about the Internet were everywhere and in general weren’t selling all that well. A fortuitous circumstance, however, allowed me to show the book outline to the folks at Amacom publishing, who in the Fall of 2000 asked me to proceed with writing the manuscript.

For various personal reasons, the book has taken longer to write than it should have. By the time I was seriously at the keyboard writing the book I realized that, at the least, I had to change all the tenses in the outline from the future to the past.

E-commerce is viewed quite differently now than it was when I began writing this book. At that time, firms with any Internet association were still highly valued and those laggards who appeared to be missing the ‘wave’ were being compared to lumbering dinosaurs, sure to fail in the years ahead.

How quickly things have changed. The technology meltdown that has seen the Nasdaq average fall from over 5000 to below 2000 began with the decline of the Internet stocks. I was hoping when I began writing this book to help in my small way to bring some rationality to the market. My goals have changed as events have unfolded. Now I would be content merely to provide some understanding of these markets.

Although Internet stock prices are now far more sensible, I still do not believe that there is much understanding of why things went awry. The Internet does provide important business opportunities. The main point learned in the last few years seems to be that firms need to be able to demonstrate the capability of generating profits some time in the future if they are to carry lofty stock valuations. Why the Internet stocks were not able to do so, and which market models can still work on the Internet are, in my opinion, not much better understood now than they were at the height of the frenzy. This book still, therefore, has an important role to play.

I was able to change the tense from future to past without much difficulty. But it was far more difficult to keep up with the rapidity of market changes related to Internet commerce. The lengthy chapter on the sale of music online and the impacts of copying on sites such as Napster, for example, has been revised every few weeks since I first wrote it, and I am sure events will have made much of what is currently there passé by the time this book is published. Nevertheless, the concepts propounded in that material will remain unaltered.

I want to extend my appreciation to the folks at Amacom Press who let me pass the deadlines with nary a complaint.

I need to thank my frequent coauthor, Steve Margolis, for much of the material in chapters two and three. He was kind enough not only to let me rework in this book material that was as much his as mine, but instead of criticizing me for this rather selfish act, he actually agreed to read through it. Of course, although he has coauthored many articles with me over the last decade, he is much better classified as a friend than a mere coauthor.

I also would like to thank my daughters, Tania and Lauren, who have heard about this book for several years and graciously acted as if they thought its publication was actually a worthwhile event.

I am grateful to the UTD Management School and its Dean, Hasan Pirkul, who helped support this research. My colleagues at UTD also listened to my complaints about writing a book that never seemed to be finished. Peter Lewin deserves special credit for having read through some of the manuscript.

Finally, over the last several years my students at UTD have used incomplete chapters as reading materials for my course in “The Economics of Information Goods”. They made comments on several subject areas that improved the content.

A book like this, on a subject matter that changes so rapidly, is never really finished. News articles on these topics are coming out as I am sending the manuscript to the publisher. I hope that main ideas in this book are more enduring than the particular facts to which they refer, which have evanescent lifespans.

Chapter 1 Introduction

The Internet changes everything. That was a common refrain just a very short time ago. Almost no one seems to believe it anymore.

In fact, the Internet changes very few of the tried and true business strategies. Like other important technological advances, the Internet will change many aspects of our lives. But the economic and business rules that worked in previous regimes will largely continue to work in the new regime. These rules of business endure because economic forces do not change, and can not be changed by mere changes in technology, no matter how much some of us might wish it were so. It is just our hubris at work when we start to think that our technology can change forces that are not of our conscious creation.

After reading this paragraph the reader may ask: so why continue with this book if nothing is new? The answer is that although the economic forces haven’t changed, understanding how these forces will act to shape the Internet and commerce on the Internet is still quite incomplete. In the pages that follow I hope to provide some additional understanding. But not complete understanding. First, I am not in a position to know all the ways in which the Internet might impact the economy. Instead I have focused on a few important issues with which I am familiar, and have built the book around those issues.

In large part, the book applies very simple economic concepts to particular aspects of the Internet economy, or more particularly e-commerce, and tries to provide some insights that might prove helpful to anyone doing business, or contemplating doing business where the Internet might play a role.

Additionally, the book tries to answer some questions that are somewhat more academic in nature, such as why things went so very wrong with the early prognostications about the Internet. This is academic not because it is necessarily studied by academics, but because in a sense it doesn’t matter. The past is the past. Still, this very recent past is an episode that many of us are unlikely to see duplicated again, on the same scale, in our lifetimes. It is, in and of itself, an interesting story. The book doesn’t focus on the history per se, but instead focuses on understanding why financial events went so awry.

Even though the Internet-stock collapse has brought forth a resurgence of Internet skepticism, a logical framework to replace the previous thinking about Internet business strategy has yet to take hold. Firms still need to determine how to incorporate the Internet into their business models. Even with so many of the first generation of Internet firms crashing and burning, and with Internet stock market valuations now so much reduced, the Internet is going to be an important tool and business managers need to understand the economic forces at work in Internet based markets.

Many of the prognostications about the internet—rapidly increasing number of users, rapidly increasing advertising revenues, rapidly increasing sales—fertilized wildly optimistic prognostications for the performance of Internet firms, as if a virtual cornucopia of wealth would come streaming down upon investors in those companies [and it did for those lucky enough to get in early and leave before the deluge]. But even if all the prognostications of users and revenue growth had been true, as some of them were, that would not have assured the rosy financial scenario that so many investors and analysts anticipated.

One of the main focuses of this book is an examination of whether the rewards to successful technology firms, including Internet firms (yes, there will be some successful Internet firms), are going to flow almost entirely to early-birds, with laggards lucky to get the scraps, or whether this view, otherwise known as first-mover-wins, is misplaced. This material is covered at length in Chapter 3 which discusses the literature on lock-in, the economic concept that is the basis for the first-mover-wins claims. And it is the claim of first-mover-wins that dominated the thinking that eventually roiled the markets and led to the closings of so many Internet startups.

A. What you will find in later chapters

There are several major themes that run throughout the book.

The Internet is likely to change many lives and provide a great deal of new wealth to society—but that doesn’t necessarily lead to above normal profits for those who invest in the Internet activities, whether firms or individuals. The idea that large technological advances must be accompanied by above normal profits for firms wise enough to invest in these markets is not a law of economics. The optimists correctly point to the large and rapidly growing demand in such markets. But one ignores the forthcoming supply at one’s peril. As has always been the case, an understanding of the interaction of supply and demand is critical to truly understanding how any market, even high tech markets, will play out. In the long run, free entry into Internet markets can be expected to keep profits down, and in the short run profits might be below average if there is over-investment by firms erroneously believing that any growing industry must throw off great profits.

Investors usually do not part with their money without some explanation of why they should.