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Bertrand MUNIER
Ecole Normale Supérieure de Cachan, Paris
GRID, UMR, CNRS
Introductory Background
(*) Professor, Ecole Normale Supérieure de Cachan (Paris), France, and Head of the research
Group on Risk, Information and Decision (GRID, UMR CNRS 8534). This paper has greatly
benefited from discussions with member of GRID, notably M-L. CABON, L. DEVEAUX,
B. LELOUP, C. PARASCHIV & J-CH. TAVANTI. Any remaining error would obviously be ours.
Financial Support from CNET (Research Contract Nr. 98 1B 460/ENS Cachan/France
Telecom/CNET) is gratefully acknowledged.
which do not reap any profit and are barely expected to do so in a distant
future. Finally, doubt has arisen even about the appropriateness of this
"new economy": Does it create value? Many have also voiced a fear that
markets might not be as effective and legitimate in the new world of
business which we are witnessing.
One can use many criteria to distinguish between actors in the New
Economy: technological status (access providers, portals, final sites),
access price charged (free sites versus pay sites), type of activity (products
online sellers, etc.), types of connections established (business to
consumers, business to business) are among the most quoted ones.
• Free sites are the ones which can be accessed without paying a fee.
They are primarily financed through advertising fees or/and through
subscription in some limited cases. But one should sharply distinguish
between free final sites – mostly of an official or scientific nature – and the
free intermediate or finalized sites. The latter are dispensing information on
quality, performances, price, etc. of some good(s) to help consumers
choose between variants of a product or different products. Clearly, they
B. MUNIER 93
are often financially related to the corresponding online suppliers, but not
always. On the other hand, free finalized sites are among the most
important sites on the web. They provide information formatted in such a
way that it helps buying goods or services. Price comparisons are among
the most useful informations provided by such sites. In the analysis below,
we leave aside free final sites.
• Pay sites are only accessed through the payment of a fee. But they are
to be subdivided between the three same categories as the free finalized
sites: on line products and services suppliers (typically: booksellers online),
final information sellers (sites helping to compute a driver’s road itinerary,
etc.) and the category of "pure piloting" sites, which we define and
comment upon further down.
Access provider
Pay sites
Free finalized sites
Final information
(experience good)
Products and
commercial services
Pure piloting sites: online sellers
- simple tips
- tips + inference
Information sellers - intelligent of meta-piloting sites
The impact of the new technology has to do with the way demand,
whether from final consumers or from businesses, is connected with supply.
In the "old" type of economy, consumers never consider to visit all possible
"brick and concrete" shops offering the good or service they look for in
order to compare prices and qualities in the most general sense. In the"
new economy", they can do so at negligible costs (BAKOS, 1997) . To
overcome the mentioned difficulty, it is customary in the old economy to use
"proxies" like brand, marketing devices (loyalty rewards, etc.), advertising,
etc. designed to "pilot" consumers amidst the forest of suppliers, products
types, products qualities, etc. But these proxies – we almost have forgotten
about it – have been designed to overcome the difficulty that consumers,
due to search costs, never will be able to visit all possible suppliers. This
postulate becomes if not obsolete at least way too strong in the Internet
economy. This does not mean that advertising and the other proxies
already mentioned become useless but that, under their current design and
as long as can be seen, they are considerably less effective and important
for at least part of the consumers. As soon as the consumer can check in a
minute a number of possible goods corresponding to his/her needs, their
prices and their features, why would he/she bother to try evoking the ads
he/she has seen, or trust more one brand than another? This might
represent a considerable change from the traditional situation as well as
from the usual array of management tools.
The true revolution, however, will have to do with what could be called
"pure piloting" sites. We define these sites as those for which the main
activity consists precisely in providing consumers with as complete and
refined a scheme of information as possible on the demand and supply
hinterland by suggesting, designating, showing, analyzing, comparing, etc.
products and/or services that might satisfy real or potential needs of theirs.
The word "piloting" is used here to mean that the activity does not only
consist in providing information to each side on the other, but entails indeed
a transformation process of demand as well as of supply. As a matter of
principle, piloting may be free (financing relies then purely on publicity) or
charged to the consumer (financing of the site relies then purely on a
percentage of the price paid by the consumer) or charged to the producer
(financing of the site relies then purely on a percentage of the price paid by
the producer) or mix any combination of these three possibilities. Piloting
costs are not zero, by any means, but may be essentially of a fixed type for
large ranges of number of clients served. One can intuitively feel that if
major competitive advantages can be found in the new economy with
respect to the old one, they should lie precisely in pure piloting. How can
B. MUNIER 95
Whereas density and thinness call in electronic commerce for little trade-
off, as has been argued above, relevance clearly implies somewhere a trade-
off with the two other factors of specific competitive advange in the Internet
economy. In some specific domains "which necessitate a very complete
personal adaptation" of preferences, whether on physical goods (restaurants,
elegant clothing) or on experience services (art pieces, personal working
tools, etc.), it even makes density and thinness poor competitive advantages
of internet commerce (MUNIER, 1985). Generally speaking, relevance is to
some extent antagonistic to density and thinness and softens the competitive
advantage of virtual commerce with respect to brick and concrete
distribution.
(2) Relevance is yet the most important factor of the three, while density and thinness are
fairly obvious and easy to acquire advantages. EVANS & WURSTER (1999) use related
concepts, but fail to identify the third and most important internal factor of competitive
advantage, as well as the external factors. Moreover, density and thinness should relate, in
our view, to preferences transformation by Internet. SAVAGE (1972) already discussed the
importance of being fine and tight for a preference relation. Morgenstern wrote in the Sixties
on similar ideas. This motivates our terminology, which sets the course to more formalized
models of the Net economy.
98 COMMUNICATIONS & STRATEGIES
Incumbent producers have little choice: if they want to survive, they have
to create the conditions of it, by entering online business and/or
establishing partnerships with pure pilots. We show hereunder why. Of
course, small publishers (or entrants) do not mind Amazon selling online:
this gives them a chance to have their books sold and read, without having
to make the enormous investment of buying a well located window (or
renting space in it) in the largest shopping mall of the city. But incumbents
do mind Amazon. Due to internet pilots, their brands will not bring them in
the future as large an advantage over entrants or small little known
producers as it used to do, for the books of the latter will appear on Amazon
the same way as theirs will. Small almost anonymous producers won’t
suffer anymore the disadvantage to have neither a pretty maid, nor a
learned connoisseur serving books in the lavish bookstore that great and
established publishers may afford to own or to be associated with. Internet
puts producers pretty much on the same starting line when it comes to sell
or buy their products.
(3) This might not be easy to do. Again, Amazon offers a good example: when it came to
France, having failed to buy one similar online company in the country, it offered to buy
catalogs or database on French books. But no one accepted to sell any database. So,
Amazon bought one copy of every French book on (brick and concrete) publishers’ catalogs
(publishers may not refuse that on legal grounds) and recorded them. Another close example
is Cdnow’s effort to block out BargainFinder browsing for best prices, which failed (DE LONG
& FROOMKIN, 1998). Such a blocking strategy is therefore mentioned here only for
completeness’ sake.
B. MUNIER 99
another one seems to enter the new economy and go online. This is a
gametheoretic situation. Which outcome can we guess?
Let us look at the type of game which arises in such conditions. If the
incumbent refuses to enter e-commerce and if all other publishers,
including entrants, were to do the same, the payments could be stylized by
(1,1), i.e. 1 for the incumbent, 1 for each other publisher, where "1" means
that the corresponding player gets its usual result (presumably more for the
incumbent than for each small publisher or entrant, but that plays no role
here). If some incumbent refuses, but other publishers go online, this
incumbent will lose a large part of its clientele to others and entrants, who
will be in a much better situation. The converse will be true if other
publishers and entrants refuse the web, whereas the incumbent goes
online alone. Finally, if everyone goes online, competition will become
sharper and everyone might face a partial loss in its usual surplus.
The second equilibrium however is much more likely to occur, for the
corresponding strategies are dominating ones for each player respectively.
This simple gametheoretic analysis suggests therefore that it will be very
(4) This kind of outcome refers to what has been called "Cooperative Game Theory", but
repetition leads to a similar result in "Non cooperative Game theory". Needless to say, such
agreements are forbidden by Law.
(5) In gametheoretic terminology, a Nash equilibrium.
100 COMMUNICATIONS & STRATEGIES
unlikely that any incumbent producer stays out of the Web, even if it had
the capacity to keep its own products out of the online business.
Online producer II
If each one of them sells only its own products - and assuming
temporarily here that no one else enters the market online -, little will be
changed with respect to the physical situation: piloting the consumers will
still depend primarily on publicity, brand image, loyalty rewards and all the
usual marketing actions. We set this outcome as (1; 1). If both sell or let sell
both products (and, presumably, all their close substitutes), competition will
be harsher because online consumers will be made more clearly aware of
existence of and differences between the different products and brands.
Economic theory predicts that, in general situations, more of the global
surplus will flow to consumers rather than to producers, hence the (0,5; 0,5)
stylized outcome. But what will happen if player I sells only its own products
whereas player II chooses to let both products (and all substitutes) be sold
on the same site? Clearly, competition will be increased, as before, but
density as defined above will play its role and most online consumers will
presumably go over to player II, who should then receive X>1. The
outcome will be of the (0,5; 2) type, as in the previous game. But thinness
B. MUNIER 101
and relevance play here in the other direction (after all, who could, better
than the producer itself, give detailed, well-documented, and relevant,
information on its own product?). Thus, some compensation, indeed even
overcompensation, might occur. One might as well have X<1, and the
outcome might be of the (0,5, 0,75) or of the (0,5 ; 0,25) type.
If X>1, two different "equilibria" will exist as above and, again, the most
likely will be the isolated rational one (All products sold by or on behalf of
each producer).
If X<1, two equilibria will still exist, but both will be isolated rational ones
(Nash equilibria) and it is impossible to decide from a gametheoretic point
of view which one will be more likely to be preferred, for no strategy will
dominate the other for any player.
(1; 1) (-0,5; 2)
(6) Of course, such a strategic equilibrium would not be sustainable for a long time, as argued
further down. But it will anyway not be tested, as the (0,0) equilibrium will ensue, as shown here.
102 COMMUNICATIONS & STRATEGIES
Whatever the reasons (7), this basic and quick game theory analysis
suggests that online producers won’t confine online sales to their own
brand’s products. If they were to do it, the market would threaten to exclude
them. Markets may be sometimes accused of being a relatively poor tool to
produce value creative firms, but they are a very performing tool to exclude
lower value creating businesses!
(7) If both producers hesitate between both game structure perceptions, whatever their
beliefs, the outcome will the same, i.e. (0, 0). This is why game theorists might prefer to more
subtly view the situation as one leading to a Bayesian Nash equilibrium with two supports of
beliefs. The basic idea is quite close to the interpretation given here above.
B. MUNIER 103
(8) Some authors argue that they might indeed profit of it, for hyper- and super-markets would
be more affected than shops and urban centers might correlatively be revived. See LANGDON
(2000).
(9) Can we imagine what would become of Paris without any other shops than restaurants,
chic clothing and touristical trash ones? What about Vienna, London without Harrod’s? They
certainly would not be turned into ghost cities, but they might be substantially affected.
104 COMMUNICATIONS & STRATEGIES
This is all the more true, because such an income source is compatible
with another very important source of income, which exploits the value of
the data base generated by piloting. Such a data base will have all the
more value, the more density, the more thinness and, to some extent, the
more relevance, because the pilot will have built into its site a learning
process on preferences, purchasing history, etc. This shows how such
finalized or intermediary free sites sit at the interface of the traditional and
of the virtual commerce.
(10) Analysts extrapolating over long periods the present upward tendency in total quantity of
advertising will go wrong at some point. It is already common to read statements by site
owners to the effect that people do not click on advertising stripes on top of screens.
B. MUNIER 105
In other words, strategic rules on Internet have to cope with (i) offering
services which the traditional economy does not offer, at least in terms of
the density, thinness and relevance it can afford and (ii) to avoid the costs
the traditional economy has to incur in terms of massive transactional
marketing, in terms of inventory holding, in terms of logistics and correlative
salary.
If many actors can be expected to end up doing more or less the same
thing on Internet – which decidedly deserves the name of shopbots
economy – they will nevertheless do it under different denominations, each
of these denominations relating to a specific service on which the site is
focusing. Of course, this service will be delivered to the clientele, but it will
not be the one effectively sold on the market and yielding money to its
supplier. To that extent, we call here this service a "window denomination"
or a "window service". This does not mean that it is indifferent whether such
or such window service is offered to determine how much value creation
happens. The fact that this service is bundled together with another one or
other ones may determine the clientele to visit the site. Hence, choice of the
window service partly determines value creation whether or not explicitly or
directly paid for by clients.
The less a market for a window service exists in the traditional economy,
the more real will be value creation by the site offering it. An example of a
window service which does not exist and cannot exist in the traditional
economy (due to something economists subsume under "transaction
costs") is the wishlist service. It amounts to making immediately available to
those interested the list of presents someone would love receiving, with an
immediate connection to online sellers: you can have your carefully
updated list on some site and make it accessible to the persons you
determine. Conversely, you might see whether such or such person has a
list on the site that you might use to honor her with a present. In the brick
and concrete economy, such a service would be very hard to offer, because
it would have to be in a shop having a huge number of potential gifts.
Storage costs would immediately be prohibitive if a special brick and
concrete shop were to exist, except when presents to be offered belong to
a given specific category, like in the case of wedding presents, where a few
specialized shops exist. Alternatively, transaction costs would be prohibitive
for the client ready to offer something, if lists were to exist in many different
shops for a same person.
these expectations are only part of the story. Techniques used in Internet
business culture together with investors risk psychology, as experimental
economics has taught it to us in the last twenty years, explain the other
part. In this respect, overvaluation can be regarded as indeed rational. We
explain why in this section. Let us first recall the frame of analysis which
investors quite rationally can rely upon.
V= V(R, µ, L, X, t) [1]
where R stands for (intensity of) sales revenues, µ for the anticipated rate
of growth of R, L for the (instantaneous) loss carry-forward (12), X for the
amount of cash available, t the dates at which each of the former variables
can be estimated. These variables are not independent of each other, as
can be easily seen. If (each variable being indexed in t) Y = (R- COGS –
SG&A – other costs) (1-τ), where t stands for rate of profit taxation (13),
then, either dL = -Ydt (L>0) or dL = max (-Ydt, 0), while dX = Y dt. Applying
Ito’s lemma to the V(·,·,·,·) formula leads to the dynamics of the value and of
(11) The basic idea is to consider investing in the company. The value of the ‘underlying’
stock depends then on the inflow of revenues (net of costs) which can be obtained from
exercising the option, i.e. from investing.
(12) If the loss carry-forward is positive at some time t, the tax rate in t is zero.
(13) For readers not familiar with American accounting, COGS stand for costs of goods sold
and SG&A stands for selling, general and administrative expenses. In the case of Amazon,
the latter seem to have developed substantially above the linear tendency observed in 1996-
1998 starting early 1999.
B. MUNIER 109
The authors fed such a model with figures drawn from the Amazon case,
with T=25, and ran a Monte Carlo simulation of the model alluded to above
on that basis (SCHWARTZ & MOON, 2000). They show that the two sets of
parameters which have the largest impact on the value of the firm are costs
parameters and parameters affecting the future growth rate in revenues.
This is in line with standard expectations.
The authors of the article mentioned rely on expected utility theory, i.e.
use probabilities to form expectations of means and variances in play
(using risk neutral probabilities boils down to a special case). All we know
from experimental economics does not validate that rationality assumption.
Moreover, "business angels" and other investors in internet startups seem
110 COMMUNICATIONS & STRATEGIES
We recall here briefly the "rank dependent model", by now the most
popular of these models. In this risk appraisal model, financial prospects
are not evaluated as an expectation. Rather, the individual looks for the
minimal outcome first, and then add outcome increments weighted by non
linear transforms of the decumulative probability distribution attached to
them. As a result, the psychological volatility σ * is sensibly larger than the
volatility σ computed on the basis of straight probabilities.
Experiments show that the psychology of risk is more subtle and calls
for a representation which can be better approximated by:
µ1 + (µ2 - µ1).θ (p2 + p3) + (µ3 - µ2).θ (p3) [3]
where θ (.) is a non linear monotonically increasing function ((θ: R R),
with θ (0) = 0, θ (1) = 1, and, ∀p, θ '(p)> 0. The typical profile of an
"agressive" investor looks like the curve on figure 2.
The θ (.) function in this simple discrete case has as a graph the
piecewise linear curve OABO’. The standard probabilities are the three
segments on the abscissa (determined by the abscissa values of A and B).
B. MUNIER 111
The h1, h2, h3 segments which are the images through θ (.) of the p1, p2, p3
segments respectively have an immediate interpretation. It can indeed
immediately be seen that equation (3) above can be rewritten as:
µ1 [θ (1) - θ (p2 +p3)] + µ2 [θ (p2 +p3) - θ (p3)] + µ3 [θ (p3) - θ (0)] [4]
or:
µ1 .h1 + µ2 .h2 + µ3 .h3 [5]
3 3
with, ∀i,hi = θ ( ∑ pi) − θ (
i
∑ pi ).
i +1
0'
h1
h2
h3
0
p3 p2 p1
112 COMMUNICATIONS & STRATEGIES
Fig. 3 - Share price and share price volatility as functions of the volatility
of sales growth rate
(adapted from SCHWARTZ & MOON, 2000, pp.72-73)
US $
400
300
200 200
lity
volati
Price
ice
Pr
100 Price
100 volatility
Price observed
observed end 1999
end 1999
The observed share price had been around 100 US $ in the spring of
1999, and it went down to 27.7/8 US $ during the summer of the same year.
During the first part of 2000, it recovered and reached 40 US $. The share
price volatility seems also to have slightly decreased, while the σ ** (µ)
volatility might have increased (the relationships between share price and
σ ** (µ) have probably been slightly altered). Assuming nevertheless that
B. MUNIER 113
figure 3 has not undergone any too dramatic change in a few months, a
share price of 40 US $ implies a σ ** (µ) slightly above .05, which seems
only slightly outside the interval identified above.
We therefore would argue that, had the model taken economic risk
psychology into consideration, the overvaluation of the share might not
have completely disappeared, but at least would have looked much less
dramatic as in SCHWARTZ & M. MOON’s (2000) paper. Internet stocks might
not be as overvalued as analysts seem to believe, if account is taken of
investors psychology.
Some economists would of course claim that the investors pictured here
are "irrational". I do not want to take up this issue here, but no logically
compelling argument forces us to believe that it is so (MACHINA, 1995;
McCLENNEN, 1988; QUIGGIN, 1993; etc.) and most experimental results give
evidence that it isn’t so. Such investors are, indeed, consistent and thus
‘rational’ in the economic sense.
To take a few examples, let’s mention first the fact that employee
training and research and development are in standard GAAP "current
operating expenses". In a long term perspective, however, they also are
investments in Human capital as well as new technology development and
should be considered that way. Second, considering all the funds used one
way or the other to generate long term cash is a very strong incentive to
foster firm’s value. To consider cash brought in excess of the needed
compensation of those who brought the funds means taking care of the
interests of those persons. These are two of the reasons why "Economic
Value Added"-type of practices (or "Economic Profit" concepts) and thinking
114 COMMUNICATIONS & STRATEGIES
have pervaded the Internet economy and more generally high tech firms,
especially in the US (14).
(14) EVA was first defined and promoted by Stern Stewart & Co.
B. MUNIER 115
Sales
Cost of Good Sold
Gross Profit
Sales, General and Administrative costs
Net Operating Profit
Taxes
Net Operating Profit After Tax
LIFO Reserve Increase
Interest expense, net of taxes
Loss on sales of assets, net of taxes
Net Adjusted Operating Profit After Tax
Training costs, R&D Costs, net of taxes
Less : Amortization of R&D
Readjusted NOPAT
Readjusted NOPAT
Capital Employed charge
Economic Profit
In any case, one can see that the impact on markets of the Internet
economy might be quite differentiated. The way markets function in the Net
economy deserves therefore some comments here before we can
conclude.
116 COMMUNICATIONS & STRATEGIES
sunk costs in total entry costs is here one real issue. The bulk of these sunk
costs mostly consists in advertising and marketing, which can be huge
when the incumbent is well-known. We have nevertheless argued in the
first part of this paper that a large part of such costs can be avoided,
notably through partnerships. Barriers to entry are thus not larger – to say
the least – on Internet than in the traditional economy.
Finally, the real issue here is a of a different kind: who will prove to react
quicker, sellers or buyers? If buyers are quicker, there will be a very strong
tendency for sellers to stick to low prices, for the sellers raising their prices
will be punished by losing immediately clients to their competitors. The
converse is true if sellers are quicker than buyers, and this might be a real
source of concern. Hope lies in the fact that not all sellers will be as quick
as the technology allows them to be online, be it only because some of the
physical economy sellers, will find it difficult to follow the game and will thus
temper online sellers to raise their prices too much or too often. Hope lies
also in the fact that buyers learn more quickly than many theorists believe
(even when they are smart buyers themselves).
• Price differentiation
Price differentiation or discrimination reaches unheard of possibilities
within the Internet economy. That might thus moves us far away from the
homogeneity-anonymity postulate of perfect markets.
The surprising answer is not only that such discrimination is not always
harmful in terms of common welfare, but also that it is often very useful to
increase consumers welfare – and hence global welfare, as the seller’s
surplus can only be higher. ARMSTRONG & VICKERS (1999) show that, as
long as markets are competitive enough and a few hypotheses can be
made, price discrimination increases welfare. The supply side is thus not
too much of concern on the whole. Clearly, however, more research on a
general methodology regarding price differentiation/discrimination would be
needed.
The consumption side of the Internet economy can only benefit of being
closer than ever to the perfect information postulate of idealized markets.
We have argued above that consumers would not be kept away from the
possibilities of information which the new technologies offer them. Attempts
to do so have failed, as the example of some online CD sellers in the US –
trying to lock out the shopbot Bargainfinder – has shown. And we may
argue that consumers look effectively for information. A recent poll
conducted in fifteen European countries by some of the major Internet
companies (Altavista, Microsoft, Real Media, Yahoo and maybe a few
others (EXERTIER, 2000) showed that many Internet users in these
countries (15) essentially look for information, and not look for physical
supply. This suggest that they use the old strategy of going to the best
shops (today the best sites online), asking for information and then look for
the good somewhere else. There is every likelihood that, once the majority
of European websurfers discover the shopbots, they will use them to see
where they can buy online the product in many cases.
(15) Austria, Belgium, Denmark, Finland, France, Germany, Ireland, Italy, Norway, Portugal,
Spain, Sweden, Switzerland, The Netherlands, The United Kingdom.
B. MUNIER 119
Occasionally:
Read the press 41% n.a.
Send greetings 34% 39%
Never:
Buy books or records (CDs, etc.) 66% 79%
Send greetings 45% n.a.
Read the press n.a. 43%
One may additionally count on learning by the consumers about the real
nature of their preferences, on their risk attitudes, on the the quality of the
suppliers, on the reliability of pure pilots. But what about prices?
As was said above, there is every reason to think that this will become
with learning a standard habit of European websurfers as it is becoming
slowly one of the American ones.
Concluding remarks
Like in all drastic changes in economic development, the way value has
begun to be created on the Internet has been awkward. Adaptations of
business plans to the new technological environment have not drawn all
necessary conclusions from this radical change. At the same time, illusions
120 COMMUNICATIONS & STRATEGIES
Yet, there are many reasons to believe that the new markets will
function if anything more stringently than the traditional ones. Life might be
more difficult to producers and to sellers in general. The consumers should
learn on their part and seize the opportunity to extend their welfare, without
necessarily having a larger share of the global surplus. This can happen
only when net value is finally being created.
B. MUNIER 121
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