Is the real fundamental value of Amazon.com the $40+ billion the stock market gave it last December? The $12 billion the stock market gives it today? Or something much, much smaller? Is JDS Uniphase fundamentally worth today's $90 billion? Or last summer's $18 billion? How about Kana Communications--today's $3 billion, or last January's $21 billion, or next to nothing at all? The unusually wide recent fluctuations in stock market valuations reflect the marginal investor's oscillation between two different views of the new economy: two radically inconsistent and incompatible views.
The first view is that the technological leap forward made possible by our brand-new computer and communications technologies is competition's friend. It reduces the frictions that in the past gave nearly every producer in the economy a little bit of monopoly power. It enables swift searches that reveal the prices and qualities of every single producer, while in the past such information could only be acquired by a lengthy, costly, painful process. In the past you could find comparison-shop for books only by trudging from store to store, or possibly by making guesses from advertisements that covered only an infinitesimal fraction of their stock. In the present you can use the world wide web to surf to www.isbn.nu--and nearly instantaneously discover the prices charged by eight online bookstores.
According to this view, in the new economy edges based on past reputations or brand loyalty or advertising footprints will fade away. As they do so profit margins will fall: competition will become swifter, stronger, more pervasive, and more nearly perfect. Consumers will gain and shareholders will lose. The new technologies of data processing and data communication will raise all of our standards of living, but will in the process lower stock prices and lower the value of the portfolios of those of us who own stocks. New economy technologies are immensely valuable as creators of wealth and utility. New economy stocks are--in the long run, once the bubble bursts and people realize what is going on--dogs.
The second view is that the technological leap forward made possible by our brand-new computer and communications technologies creates a large host of winner-take-all markets. In the old days a manufacturer gained perhaps a 10% unit cost advantage by producing at twice the scale. In these new days if you are producing an information good--a computer program, a piece of online entertainment, or a source of information--the work only needs to be done once and then it can be distributed to a potentially unlimited number of consumers for pennies: producing at twice the scale gains you nearly a 50% cost advantage. Moreover, information goods produced at larger scale are more valuable to consumers. The version with the largest market share becomes the standard--the easiest to figure out how to use, the easiest to find support for, the one that works best with other products (which are, of course, designed to work best with it).
In this new economy of network externalities, supply-side economies of scale, and demand-side economies of scope, the first firm to establish a dominant market position gains a nearly overwhelming position. Its products are most valuable to customers. Its cost of production is the least. Unless its competitors are willing to take extraordinary and extraordinarily costly steps--like those Microsoft took against Netscape, pouring a fortune into creating a competitive product and then distributing the competing Internet Explorer for free, all the while threatening computer manufacturers with dire consequences should they dare to preinstall Netscape Navigator--the first firm to establish a dominant market position gains a license to print money. This is the story of Microsoft--which went for market share while Apple sought high margins--with Windows. This is the story of Cisco with routers. This is the story of JDS Uniphase with fiber.
According to this second view, new economy technologies are immensely valuable as creators of wealth and utility. Those companies smart enough to make large up-front investments in market share will reap a large share of this additional wealth created as profits. And the new economy stocks of firms that successfully make such investments in market position are--if anything--still undervalued.
About half the time you ear some new economy guru speak, you will hear the first view. About half the time you will hear the second view. When the marginal mutual fund manager whose decisions about at what prices to buy and sell determine today's stock prices goes and hears a guru of the first kind, high-tech and internet economy stock values fall. When he or she goes and hears a guru of the second kind, high-tech and internet economy stock values rise. Dogs or gold mines? Hype or substance? It is hard to recall a time when the set of potential valuations and futures had such a wide spread.
Yet there is a strong sense in which both kinds of gurus are correct: like the story of the blind philosophers studying the elephant, each accurately reports what he or she feels but each only feels a part of the whole animal. The problem with new economy presentations lies not in the structure of the analysis but in the inappropriate generalization to all the high technology-making and high technology-using sectors. For our modern computer and communications technologies do both. They reduce frictions and improve competition where frictions exist and competition can be improved. They create massive economies of scale where economies of scale are there to be created. And the balance between the two for any one industry depends on exactly what that industry's product is.
In industries like software it really is the case that the product needs to be made only once and then can be sold everywhere, and it really is (nearly) the case that ten times the sales mean one-tenth the unit costs. In such industries economies of scale dominate. What good is a computer search that tells you the prices of five competing products all the search tells you is that the market leader has much lower costs? In each softwear market segment there is space for a market leader to make lots of money, space maybe for a single also-ran to break even, and other producers are out of luck. The major curbs on the profits of the market leader are competition from their installed base of past purchases of old versions, the fear that too-high a price will unleash massive software piracy, and the antitrust division of the Justice Department.
And do not think that such winner-take-all markets are limited to software only. Economies of scale outweigh reduced frictions and more nearly perfect competition in microprocessors (Intel), in routers (Cisco), in fiber (JDS Uniphase), and even in the mass distribution of large numbers of different kinds of retail goods (Walmart). Anywhere fixed costs are sufficiently important, and anywhere that standards and seemless integration are sufficiently important and are someone's intellectual property, there the second kind of guru is correct. On such fields the new economy is the source of massive wealth not just for consumers but for shareholders of dominant companies as well.
But there are a host of other industries in which economies of scale are not salient. Is it really possible for anyone to acquire significant economies of scale by writing a single suite of software that will cover the heterogeneous purchasing requirements of millions of businesses seeking to streamline their operations by using the internet? Is it really possible for anyone to acquire significant economies of scale by using the internet to distribute information about groceries? It seems very doubtful. And here the logic of reduced frictions takes over: for without a large scale economy-driven cost advantage, the effect of the new economy is not to increase but to reduce margins, and make profits harder to earn and keep.
We can see this process at work in Amazon. Shipping books--products that are completely specified once one has written down their ISBN numbers, where there is no opportunity at all to add value to the final product--is not a high-profit business. Amazon has its own warehouses. Other online book sellers use Ingram's warehouses. So how is Amazon to make even one percent of the profits it needs to justify its stock market valuation given the existence of other online booksellers, and given the existence of information-aggregation comparison-shopping sites like www.isbn.nu?
As we watch Amazon evolve, the answer is clear: it will try by *not* being a bookseller--it will sell other physical goods than books as well, and hope that the convenience of being a single-stop shopping destination will generate some profits; and it will sell information in the sense of trying to become *the* place to pick up information about what books you might like. Browsing will become their business. (Of course, how Amazon will induce people to then buy their books onsite rather than dropping to www.isbn.nu and looking for the best price remains unclear.)
The lessons for businesses are clear: high margins can be sustained in the new economy only if computing and communications technology enables the creation of economies of scale. The lessons for investors are clear: internet hype is believable if the products sold are information goods or if there are other obvious sources of *large* supply-side economies of scale in production and demand-side economies of value in use, otherwise not. The lesson for the economy as a whole--will the coming of the new economy raise profits and increase economy-wide average margins or lower them?--is still up for grabs.