Positively You

The Internet is only the latest example of the complex interconnections that govern modern life. Earlier such networks include the electricity grid, the telephone system, the rail lines, and the road system.

From an economic perspective, the defining feature of a network is that the value of membership increases as the network grows. Riding the rails became less expensive and more valuable as a growing number of riders pushed the railroads to provide more comprehensive service. Tele­phones became more valuable as more people bought the phones neces­sary to take each other’s calls. Large networks enhance the wealth and welfare of all of their members. Throughout much of human history, net­works were few and far between. They began to appear in significant numbers only after the industrial revolution. Each new network brought additional sectors of the overall economy into the network economy and created new wealth that all network members shared. The information age accelerated the emergence of new networks, thereby making us all richer.

Many people looked for a way to capture, direct, and privatize that newly created wealth. One common idea was that anyone who controls a network should be able to collect enough tolls to generate substantial profits. There were good reasons for this belief, but there were also some fundamental problems with it. Toll collection on the information super­highway is only lucrative if consumers are “locked in” to the toll road. If there’s a viable toll-free alternative, consumers will take it—leaving the toll collector with an unused new toll road and a mound of con­struction debt.

Therein lies one of the Internet’s many apparent paradoxes.

But alchemy and plunder may be set aside as artifacts of a gold rush. The key underlying question remains how to use the Internet to gener­ate profits—perhaps not the obscene profits for which we all once hoped—but comfortable profits comparable to those generated by other successful companies. That question, in turn, suggests thinking not like Internet entrepreneurs, but simply like run-of-the-mill, hoping-to- succeed, willing-to-work-hard entrepreneurs.

And so, let’s start with the obvious. If you want to build a profitable company, you’d better be able to answer three questions: What’s your product? What makes your product special? How are you going to use that “special quality” to generate profits? Every company in every indus­try faces these questions in some form or another. Management must consider them when allocating resources and devising business plans, and investors must consider them as the first steps of due diligence. Despite rumors to the contrary, which flared during the bubble, these questions are at least as important for Internet ventures as they are for conven­tional firms. In fact, they may be even more important on the Internet than they are elsewhere because it’s so easy to copy a Web site—not to mention the idea behind it.

The story of Tom Friedman, Jeff Bezos, Lyle Bowlin, and Scott Rosenberg provides an illustrative—and cautionary—tale.

Bezos’s story resonated among the book-buying public, the investment community, and beyond. At its peak, the story was so compelling that he was Time magazine’s 1999 “Person of the Year.” Months before Bezos earned that particular accolade, however, Friedman detected a flaw in the story. On February 26, 1999, Friedman’s column “Amazon.you,”⁶ asked: What’s so special about selling books over the Internet? He intro­duced Lyle Bowlin, a professor of small business at the University of Northern Iowa and founder of Positively-you.com, a bookselling Web site. Bowlin, his wife, and his daughter ran Positively-you out of their spare bedroom.

Not surprisingly, Friedman’s column was good for Bowlin’s business. Within ten days, Positively-you’s business had grown by a factor of about thirty. Bowlin moved its operations out of the spare bedroom and into the formal dining room. Friedman responded with a follow-up column, “KillingGoliath.com,”⁸ in which he summarized Positively-you’s success in a two-word reply directed at the skeptical readers who’d questioned “Amazon.you.” No, not those two words. This was, after all, the op-ed page of the New York Times. Friedman’s response was a fully capital­ized “YOU’RE WRONG.”⁹

That’s where Scott Rosenberg entered the story. Rosenberg, the man­aging editor of Salon.com, was one of the skeptical experts to whom Friedman had directed his reply. In “Amazon vs. the Ants,”¹⁰ Rosenberg explained that Friedman had captured only half the logic of the online marketplace. That half, the low cost of getting started, certainly allowed hobbyists like Bowlin to launch commercial ventures. The other half, in Rosenberg’s view, was what set Amazon apart from Positively-you. He cited two fatal flaws with Positively-you’s business model. The first flaw stemmed from scalability. Positively-you’s overhead was lower than Amazon’s precisely because it was a smaller operation. As business grew, Bowlin would have to relocate yet again, likely to a warehouse for which he might actually have to pay rent. He would also eventually run out of unpaid family members and need to hire employees. These costs would drive his overhead up and narrow if not eliminate any cost advantage that he maintained over Amazon. The second flaw dealt with the chal­lenges and the expense of generating traffic comparable to Amazon’s.

Lyle Bowlin and Positively-you then proceeded to fall from public view for about a year. They reappeared March 3, 2000, in columns writ­ten by Friedman and by Rosenberg. Friedman’s “Saga of an Online Pioneer”¹² told of Bowlin’s attempt to leverage his early publicity into a real business. He raised $90,000, took a leave from his teaching posi­tion, rented office space, hired employees—and went out of business. Friedman considered Positively-you’s failure instructive. He cited a number of lessons that he had learned about e-commerce. The two most significant of them were the difficulty of scaling costs and the challenge of driving traffic to a Web site.¹³ Rosenberg’s column basically said “I told you so,” which, of course, he had.¹⁴

The Positively-you.com saga illustrates the Internet’s tantalizing allure. It’s so easy to open an Internet company, yet so difficult to succeed with one. So what’s the secret? The “secret” lies in truly understanding the three key questions: What’s your product? What makes your product special? How are you going to use that “special quality” to generate profits? Amazon’s answers may sound deceptively simple. But that appar­ent simplicity masks some subtle insights.

All Internet companies start as software-development ventures. The bare minimum required for doing business on the Internet is a working Web site. A fully functioning and launched site, however, is little more than an idea, and ideas travel quickly. Any Web site based on a good idea is likely to be copied many times over. The only way to convert such an idea into a profit is to ensure that everyone attracted to your idea works through your site, rather than through a rival’s knock-off. These needs all pose complex challenges.

In the Internet’s early days, pioneers believed that they could meet these challenges with little deep thought, and a few may have been right. Most of them proved to be horribly wrong; the once-vibrant Internet economy was decimated by failure. The main lesson from that failure is that deeper thought is required. In order to deepen our thought, however, we must first identify what we’re to think about. Once again, the three key questions of business development point us in the right direction. It’s hardly a coincidence that the single company best poised to capitalize on the Internet is Microsoft, who delivered a product (Internet Explorer) in a special way (integrated into the Windows platform) as part of a strat­egy to generate profits (by maintaining and extending its monopoly of the platform market). Nor, for that matter, is it a coincidence that Napster, who delivered a popular product (digital music files) in a special way (shared freely among fans), but without a legitimate business strat­egy (it neither paid for the music files nor charged for its services), has already met its demise.

A profitable Internet company must develop software that embodies a powerful idea and then leverages it in an appropriate direction. Entre­preneurs maximize their prospects for success by building their compa­nies around products that are well-defined, in some way special, and distributed in a manner designed to generate profits. Computer scientists study the first of these requirements, software development. The second, the protection of ideas, is the purview of intellectual-property (IP) lawyers. The third, leveraging, lies at the intersection of applied indus­trial economics and antitrust law. Deep thought about either Internet success or the future of the information sector translates into deep thought about all three sets of issues.

Technology, economics, law, and public policy interact cyclically in the information sector. Technology comes first: Innovations in information technology make it easier and cheaper for producers and consumers to exchange information. Economics takes over: Information innovations drive down the cost of transactions, save consumers money, and often suggest new business models that increase producer profits. Law enters the picture: Some of the new business models might be illegal, either because they leverage competitors out of business inappropriately or because they infringe on someone else’s property rights. Policy resolves the dilemma: Government must decide which laws to tighten and which to liberalize—and thus which business models to encourage and which to prohibit. The cycle then repeats itself with a new set of incentives in place. Technologists move yet another industry into the information sector, consumers and producers benefit, aggrieved parties litigate, and governments legislate.

There’s nothing new about this story; it predates digitization, com­puters, information products, and bit strings by at least several centuries. The influential Peruvian economist Hernando de Soto has spent more than twenty years investigating why capitalism has created so much wealth in the West while working only sporadically elsewhere. He’s con­cluded that reasonable records and databases of property rights are a prerequisite for a viable capitalist economy. Physical “real property” like land and buildings is tough to convert into cash that can then be rein­vested elsewhere. But titles to land and buildings, recognized by gov­ernments and enforceable by trustworthy courts, are widely accepted as collateral. Thus, for example, would-be entrepreneurs can mortgage their homes and receive investment capital with which to begin new busi­nesses. De Soto has shown how, throughout the history of both the Western and developing worlds, entrenched interests have worked to prevent new, rising classes from converting their property into information—and from information into capital. He has also shown how the development of each new information system unleashed a new wave of entrepreneurs whose hard work catapulted society to its next, richer, level.¹⁵

In other words, development—and its consequent enrichment of each of society’s members—first became possible when real estate morphed into a “property information sector.” What de Soto didn’t explain, though, is that what worked for real property has also worked for other property. Whenever we develop a new informational analog to an exist­ing industry, the folks who are already successful in that industry fight the change. When they lose, as they eventually do, the information sector grows and we all become richer. But sometimes that eventuality can take a long time. Our challenge is to ensure that market dynamics prevail and that good ideas chase bad, so that the Internet and its consequent changes to the economics of information can enrich us all. To meet that public­policy challenge, we need to understand the basics of technology, economics, and law that underpin our marvelous new information infra­structure.