Why the Internet is wreaking havoc on business models.
(originaly written by Dr. Reed) submitted by, Vinay Bhandari

Conventional wisdom is that a remarkably powerful effect known as Metcalfe's
Law is driving the growth of the Internet. The law says that the value of a
network grows in proportion to the square of the number of users, which means
that, once a network achieves a certain size, it becomes almost irresistibly
attractive. But Metcalfe's Law actually understates the potential value of the
Internet, and by a huge margin.

I'd like to suggest a new way of looking at the economics of the Internet.
I think my approach can explain why forecasters have so consistently
underestimated its growth. (And, believe me, they have: In 1995, estimates
for on-line commerce in 1998 were $2 billion to $3 billion, while the real
number turned out to be more like $13 billion.)

My approach not only should add to the urgency that businesses feel about
moving on-line but also helps identify which on-line strategies will work
and which will fail.

It helps to first understand the two laws of networks that have been around
for some time. First is what might be called Sarnoff's Law, after the pioneer
of the broadcast industry. This law says that the value of a network grows in
proportion to the number of viewers.

Second is the law named after Bob Metcalfe, the inventor of the Ethernet
computer-networking technology. He reasoned that 1,000 people on a network
can have roughly one million different conversations, so he said the value of a
network grows in proportion to the square of the number of users. The nē value
explains the growth behavior of networks, such as phone systems or
electronic-mail systems, that are mainly used for one-on-one communication.

The nē effect says that, given the choice of joining a large existing network
with many users or an incompatible new one with few users, new users will almost
always decide that the bigger one is far more valuable. The result is often
explosive, accelerating growth once a network establishes dominance.

This behavior explains why there is now one global e-mail system, while just
a few years ago there were thousands.

There's an additional law at play with the Internet because it facilitates the
formation of groups, in a way that Sarnoff and Metcalfe networks do not. The
number of groups that can be formed over the Internet isn't the Sarnoff n or
Metcalfe nē. It's 2n by the time you add up all the possible two-person groups,
three-person groups, etc. So, the value of the Internet grows in proportion to
2n. Let's call this effect the Group-Forming Law.

This law is so powerful because 2n gets impossibly large very fast. There's the
old story about the king who rewarded a wise minister by offering him anything
he wanted. The minister said all he wished for was two copper coins on the
first square of a chess board, four on the second, eight on the third, and so
on-a progression based on 2n. The king protested that the minister should
ask for gold or pearls, not copper. But, by the time the 8,192 coins were
placed on the 13th square, the king realized he'd been had-264; is more than
18 quintillion, which, if memory serves, is more grains of sand than exist in the
world. (The story has it that the king had the minister beheaded for being a wiseguy.)

All three laws, in fact, apply to the Internet. Services such as news sites that
are aimed at individuals benefit from additional users in a linear, Sarnoff way.
Services aimed at facilitating transactions,such as many commercial sites,
benefit in an nē Metcalfe way. Services aimed at building communities, such as
AOL, benefit in a 2n, Group-Forming way. What's important is that the
dominant value in a typical network tends to shift from Sarnoff to Metcalfe to
Group-Forming as the scale of the network increases. So, as the Internet
continues to expand, investments in Group-Forming networks are likely to
produce the biggest returns.

As the scale increases, what's important also shifts. When Sarnoff's Law
dominates, content such as TV programs is king.

When Metcalfe's Law kicks in, transactions are king. When the
Group-Forming Law takes hold, communities are king. The value in a
Group-Forming network is constructed jointly, whether through discussion groups,
through joint plans to buy something in bulk at low prices, or through
some other means.

But the theory is less important than the practice, at least if you're trying to
profit from the Internet, so I'll make some predictions based on the likely
effects of the Group-Forming Law:

The obvious conclusion is that whoever forms the biggest, most robust
communities will win. But the Group-Forming idea can be used to look well
beyond the obvious and discriminate among strategies that are all billed as
building communities. For instance, Internet auction pioneer Onsale, which
buys closeout products and auctions them on its Web site, will see its value
rise only in proportion to the number of users.

On-line classifieds, which connect buyers to sellers on a peer-to-peer
basis, should see a stronger, Metcalfe effect. Ebay, which began as one
person's attempt to establish a market for Pez candy dispensers, should get an
even more powerful Group-Forming effect because it helps members
act in groups as they auction off and bid for products on-line. (Other
economics work in favor of Ebay, too. Because the Group-Forming effect will give it
enormous volumes of business, it can charge a lower commission on sales. The low
fees will attract more users and produce a virtuous circle. Also, because
it's Ebay's customers who do the selling, Ebay doesn't face any inventory or
product-development issues.)

The demand for Group-Forming capabilities will change the winners and
losers in technology. IBM subsidiary Lotus, the pioneer of enterprise
groupware, has a hard time supporting ad hoc groups that span multiple
companies. So, Lotus will achieve little Group-Forming value. By facilitating
easy ad hoc creation of "teamrooms" by any group of Internet users,
Instinctive's eRoom and Excite's Excite Communities, among others, seem
likely to overwhelm Notes and capture big chunks of the groupware market.

The value of merged networks, through deals such as the Yahoo takeover of
GeoCities, may be much greater than it might seem. Say the networks each
have five users. The value of their merger isn't just the number of users in each
network added together (10) as Sarnoff's Law would imply, or even a function of
the number of users multiplied by each other (25), as Metcalfe's Law would
imply. The value instead follows a 2n Group-Forming effect, so it equals 25+5;,
or 1,024.

As digital networking brings scale and global reach to all aspects of our lives
and activities, many established business patterns will be threatened. For
example, health-care networks may move from treatment transactions to
collaborations around disease management.

The community idea applies to every company, because every company can
establish powerful communities by sharing information among its suppliers,
distributors, and customers and can figure out ways to collaborate with them
on new products and services. This last may be the most important because it
shows how everyone can translate my general observation into the only
economics that matter: the bottom line.

Dr. Reed, a consultant and entrepreneur believes the best way to predict the
future is to build it.

He can be reached at dpreed@reed.com


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