#1/25: Information Rules

I want to try out a new format which you could call “book commentary”. I’ll quote some text passages and write a short comment about each passage.

Technology changes. Economic laws do not. If you are struggling to comprehend what the Internet means for you and your business, you can learn a great deal from the advent of the telephone system a hundred years ago.

This is a great advice and I can anybody recommend to read old books about business and economics especially case studies. I already covered some old business books myself here on the blog and I’m always receptive to recommendations.

We think that content owners tend to be too conservative with respect to the management of their intellectual property. The history of the video industry is a good example. Hollywood was petrified by the advent of videotape recorders. The TV industry filed suits to prevent home copying of TV programs, and Disney attempted to distinguish video sales and rentals through licensing arrangements. All of these attempts failed. Ironically, Hollywood now makes more from video than from theater presentations for most productions. The video sales and rental market, once so feared, has become a giant revenue source for Hollywood.

Interesting enough, Hollywood is still trying to fight against piracy. The next step would probably be to offer cheap versions as a stream (ala netflix). However, people don’t want to pay too much for a video stream.
I think it may be comparable with the automotive industry in the beginning of the 20th century. There were lots of car manufactures that produced really high quality cars which were really expensive. Most people couldn’t afford a car at this time. Then came the Ford Model T, which wasn’t as fancy at these other cars but it was cheap and good enough and people bought it.
Maybe Hollywood should think about producing movies which don’t cost $200m but instead only $20m.

In competing to become the standard, or at least to achieve critical mass, consumer expectations are critical. In a very real sense, the product that is expected to become the standard will become the standard. Self-fulfilling expectations are one manifestation of positive-feedback economics and bandwagon effects.

A very interesting observation with great effects. This makes PR much more important than I thought it would be. Especially, if you apply to to startups. Signals like founding and investors become stronger. And it isn’t so much about the product and more about connects, strategic networks, PR and marketing.

The dominant component of the fixed costs of producing information are sunk costs, costs that are not recoverable if production is halted. If you invest in a new office building and you decide you don’t need it, you can recover part of your costs by selling the building. But if your film flops, there isn’t much of a resale market for its script. […] Sunk costs generally have to be paid up front, before commencing production.

We’ve seen some movies which ran horribly in the cinema but great in DVD markets. So, there’s some recoverability. However, the movie can still suck. One method to cover the costs are upfront investments. Kickstarter is basically allowing this for a mass-market and some game studies took this approach to produce games which wouldn’t be backed by a publisher (see Doublefine Adventures).

The key to reducing average cost in information markets is to increase sales volume. Think of how a TV show is marketed. It’s sold once for prime time play in the United States. Then it’s sold again for reruns during the summer. If it is a hot product, it’s sold abroad and syndicated to local stations. The same good can be sold dozens of times.The most watched TV show in the world is Baywatch, which is available in 110 countries and has more than 1 billion viewers. […] The shows are cheap to produce, have universal appeal, and are highly reusable.

Basically the Hollywood argument I made above. Lower the production costs but produce more variety and stimulate more innovation.

With information you usually produce the high-quality version first, and then subtract value from it to get the low-quality version.

This is really important for the customer. You don’t want to feel that you paid the normal price for the inferior product. One example are some games which come with lesser content in the normal version but still costs $50-60. Don’t do that.

The coupons are worthwhile only if they segment the market. A coupon says “I’m a price-sensitive consumer. You know that’s true since I went to all this trouble to collect the coupons.” Economist say that a coupon is a credible signal of willingness to pay. […] What does this have to do with information pricing? Well, suppose that information technology lowers search costs so that everyone can “costlessly” find the lowest price. This means that sales are no longer a very good way to segment the market. Or suppose that software agents can costlessly search the net for cents-off coupons. In this case, the coupons serve no useful function.

I found this passage quite interesting. Basically sites like Groupon are too easy to use, so that people don’t segment themselves that good. Furthermore, there are lots of sites which offer coupon codes, so that today a sale for most online shops is probably more appropriate.

The rights management strategy is a twist on the versioning strategy described in Chapter 3. There we argued that you should offer a whole product line of information goods. The cheap versions (which can even be free) serve as advertisements for the high-priced versions.

Freemium described over 12 years ago. Interesting enough, McAfee used a freemium model since 1993 and before that they used a “pay what you think“-model, which was also quite revolutionary for that time.

Of course, a new brand can emerge that is easy to learn, thus reducing switching costs. Indeed, one strategy for breaking into a market with significant brand-specific customer training is to imitate existing brands or otherwise develop a product that is easy to learn. Borland tried this with Quattro Pro, aimed at Lotus 1-2-3 users, and Microsoft World has built-in, specially designed help for (former!) WordPerfect users.

We’ve seen this in the online market quite recently, e.g. with WordPress and tumblr. I wonder if you see a better word processor in the future.

What happens when perfect competition meets lock-in? […] Think about the extreme case in which you face fierce competition from equally capable rivals to attract customers in the first place. Both you and your rivals know that each customer will be locked into whatever vendor he or she selects. The result is that competition indeed wrings excess profits out of the market, but only on a life-cycle basis. The inescapable conclusion: firms will lose money (invest) in attracting customers, and (just) recoup these investments from profitable sales to locked-in customers.

Normally, you would assume that lock-in leads to excessive profit in a market but it doesn’t. You can talk about quasi-profits, i.e. the lock-in needs negative investment at the start and if you locked-in a customer, he will return the investment costs over his life-time. That is, if you want to make excessive profit, you have to still rely on product differentiation and/or cost leadership.

If you give your product away, anticipating juicy follow-on sales based on consumer loyalty/switching costs, you are in for a rude surprise if those switching costs turn out to be modest.

That’s when freemium goes wrong. If you are in a market with low or non-existing lock-in costs, i.e. trash mail provider or image uploading sites, freemium probably won’t work.

An other approach is to rely on versioning by offering long-standing customers enhanced services or functionality. Extra information makes a great gift: it is cheap to offer, and long-standing customers are likely to place a relatively high value on enhancements.

I really like this idea. Often you see introductory offers, like 20% off of the subscription but after this period, you either don’t care about the price, feel ripped-off, because you have to pay more or cancel your current account and get another introductory offer.
However, if you reward long-term customers with some useful addons, they have no incentive to do the latter and probably will appreciate the extra addon. Varian and Shapiro talk about this in the book in greater length.

The beautiful if frightening implication: success and failure are driven as much by consumer expectations and luck as by the underlying value of the product. A nudge in the right direction, at the right time, can make all the difference. Marketing strategy designed to influence consumer expectations is critical in network markets.

See the quote above. Early adopters are really important and early press coverage can greatly introduce the probability of success.

The revolution strategy involves brute force: offer a product so much better than what people are using that enough users will bear the pain of switching to it. […] The revolution strategy is inherently risky. It cannot work on a small scale and usually requires powerful allies.

The authors quote Grove’s 10X as a revolutionary metric. I got two nice examples which fit to this quote.
Firstly, Google+ which hasn’t offered a 10X and wasn’t a evolution of Facebook either. Furthermore, the group in the beta phase was too small.
An other example, are open source clones of proprietary products. More often than not, free source code or enhanced privacy aren’t 10X.

In addition to launching your product early, you need to be aggressive early on to build an installed base of customers. Find the “pioneers” who ware most keen to try new technology and sign them up swiftly.

Really important, see Crossing the Chasm.

All in all, I really liked this book. I think it’s probably a must-read for internet entrepreneurs. What I personally found really interesting to see which people endorsed this book and one of them is Eric Schmidt (Google’s ex CEO). And he said in an interview about Google+ and its chance to beat Facebook: “It’s very hard to beat a fast-moving incumbent in exactly same game in technology because it changes so quickly.

If you are interested in more detail about the content of the book, its website offers free presentation material for college courses. Great book, great writing.

Economics of Angel Investing

After writing the last post I thought a bit about the further development of innovation. What would be if we could predict successful companies (ideas) with high probability? That would allow to reallocate human capital faster and thus leading to more successes.
And one idea is a prediction market for startups. You may think that sites like AngelList go in this direction. I’m not entirely sure about this. I will first take a view on Angel Investing from an economic standpoint.

Angle Investor and Entrepreneur
This is a typical Principal-agent problem. The Entrepreneur has more information than the Investor. Often happens exactly what you will expect and that is that the Investor will look for commitments of the Entrepreneur which reveal information about his private information. Examples for these commitments are quitting one’s job, using one’s own money for funding or buying an expensive domain. Furthermore, of course, they try to grasp personal attributes of the Entrepreneur and his team.

Angel Investor and other Angel Investors
This stage is more interesting. Let’s say that our Entrepreneur got his first funding from one Angel Investor. Depending on the status of the first Angel Investor there are two different scenarios.
Firstly, assume the first Angel Investor isn’t famous. The next Angel Investor will probably see that this investment could possible be profitable but he will with a high probability go to stage one again and use his own judgment.
Secondly, now assume that the first Angel Investor is famous, a top notch one. The second Angel Investor will probably trust the judgment of the first Angel Investor so much that he will skip the first stage or neglect some flaws that he found. This is herding and leads to incorrect pricing and maybe a bubble.

We could either try to make these investments anonymously but this would be impractical. However, we could at least correct the pricing allowing short selling.
This all sounds like a stock exchange and they have a similar function, i.e. funding companies.

However, I think there’s one problem of stock exchanges for Angel Investment and that is that the expectations of the participants are different. Some Investors want 2x exists, some 5x exists, some want it in the next two years other in the next five. This is totally OK if we use these mechanisms for allocating capital.

Yet, the goal is to predict future successes and here I think prediction markets are more suitable because there are clear goals. E.g. “Company X will reach 5m in sales by 31 December, 2016.” Prediction markets do these things really good. One of the biggest problems will be liquidity which can be partially solved using aggregation or even better attracting more people to the market.

Best of 111in2011

Yes, one of this content free summaries about previous read books – but I think it would be nice if you had a small reading lists with some great books.

Best of Marketing
Ice to the Eskimos

Probably to most creative marketing ideas I’ve ever read about. Jon Spoelstra has excellent writing skills, it’s so much fun to read this book even if you’re not into basketball. He’s probably what you think a marketing guy should be. Creative, uncommon and full of power. If you want to read about marketing that stands out of common marketing then this is the book for you!

The Referral Engine

Not as loud as Ice to the Eskimos but filled with love and thought about your customers. Show love to your customer and he will probably learn to love you. I think this book is ideal if you work in some sort of service industry where you have direct contact to your customers. But even if you build some product, you can learn a lot about how to please your customer and why pens as advertising gifts probably won’t work.

Best of Organization
The E-Myth

Probably one of the most important books if you got more than one employee. Micheal E. Gerber shows you how you can organize your company so that you don’t have to work in the company but you can work on the company. This book is so full of useful ideas and their implementations that you probably won’t be disappointed.

Built to Sell

One could say that Built To Sell is a unofficial sequel to The E-Myth. John Warrillow tells this excellent story in this book about a guy who has a advertising company and he wants to sell it. Like The E-Myth this book shows how to make yourself dispensable in your company – and so got more time for other important things. Awesome book, even if you never will sell your company.

Best of Entrepreneurship
Running Lean

The best book, I read, about customer development. Ash Maurya explains demonstrates colorful how to find markets, test your ideas and track your objectives. Furthermore, the book is neatly organized and quite short. If you want to start a company then Running Lean should be on your reading list.

Best of Management
Rework

A book for people how value quality over quantity. The guys from 37signals explain their business philosophy in Rework and it’s excellent. It’s a down to earth approach on running a business – work less, but better – stay simple – hire reasonably. A magnificent book for small and medium sized business owners or new entrepreneurs.

#36/111: The Knack

What is it about?

What should you know before starting a business? Norm Brodsky and Bo Burlingham try to answer this question. They focus on some topics from money management to hiring. The Knack is especially targeted at former sales persons.

Key points?

Know your metrics: Most sales people focus on the sales volume only. This doesn’t work for your business is your profit margin is too low. Brodsky recommends to calculate your profit margins by hand to get a feeling for the numbers.

Search a niche in an old market: You should focus on an old market because you don’t have to generate demand and often the leading companies are pretty rigid. If you can find a niche which undermines these companies, you can earn a fortune.

Keep your old customers: You already know that it’s easier to sell to your existing customers than to new ones. So try to generate more profit from them.

Build a culture:  You will reach a point where it is impossible to do everything by yourself. If you hire people try to hire for cultural fit. This way you will trust them more and they will know what’s important for your business.

Conclusion

The first quarter was extremely good. He told a story from two friends of him who wanted to start a business and he explained lots of steps and how they developed their company. Sadly, stories of other people decreased and it become more and more egocentric. The name of the book is a bit misleading, maybe it would be better if it was named “My Business Life by Norm Brodsky”.