The Net: A Market Too Perfect For Profits

Prophets of electronic commerce trumpet the Internet as the realization of a holy grail--a perfectly free, "frictionless" market. But practical businesspeople have noticed that Netrapreneurs often fail to turn a profit. The two observations are related.

Consider: The Internet is a nearly perfect market because information is instantaneous and buyers can compare the offerings of sellers worldwide. The result is fierce price competition, dwindling product differentiation, and vanishing brand loyalty. Imitators, especially those with deep pockets, can steal innovations as fast as they are invented and marketed.

For instance, Inc. invents a virtual bookstore. But Amazon knows that much larger Barnes & Noble Inc. will soon be nipping at its heels. So Amazon plows its earnings back into the one plausible defense, branding. Amazon tries to make its service unique, charming, and user-friendly and spends a fortune advertising the name, deferring profitability.

But in Net commerce, the whole premise is that consumers will be, and should be, fickle. So the comparison shopper can use Amazon's delightful book reviews and other nifty features and then disloyally buy the product from Barnes & Noble if the price is lower. And you can bet Barnes & Noble will use its market power to selectively underprice and otherwise undercut the upstart bookseller. It has already cut a $40 million deal with America Online Inc. to be AOL's exclusive electronic bookstore partner. So in cyberspace, economic "rents," the temporary, above- normal profits that reward innovation, are quickly competed away. The more perfectly competitive the market, the scarcer the rents.

STRONG SOLVENT. Bill Gates, meet Joseph Schumpeter. It was Schumpeter, the great mid-century economist, who offered the paradox that imperfect competition is necessary for efficient capitalism. Schumpeter wrote, in his classic, Capitalism, Socialism and Democracy, that "every grocer, every filling station, every manufacturer of gloves or handsaws" depended on a degree of market power to assure profits--a miniature monopoly in a product perceived by consumers to be unique. Historically, those minimonopolies have depended on imperfect consumer information, limited time for comparison shopping, and a lot of brand loyalty. The Internet, of course, acts like a solvent on all of these three.

Moreover, Internet consumers are spoiled. They are accustomed to getting a great deal for free. A lot of Net enthusiasts put out information and software at no charge, just for the visibility and sense of community. Both traditional media companies and publishers of Net magazines have tried to charge for their wares, and most keep pulling back. Microsoft's Slate is a loss-leader. Entertainment companies have seen the Net as a money sinkhole.

To be sure, some people nonetheless make money from the Internet--designing software for it, using it as a supplemental catalog, mining it for information, building a client base, and so on. The Net is perfect for financial transactions, the sale of high-value-added data, business-to-business commerce, inventory tracking, and wholesale distribution. But except in rare niches, the Net produces speedy imitation and thin margins.

CONSUMER REVENGE. Moreover, the more price information is diffused on the Net, the more adroit consumers become at haggling, and the less sellers can defend posted prices. This wreaks consumer revenge on industries such as airlines that have restored profitability by counting on consumer ignorance to sell the same product at different prices. Likewise autos. Within two years, according to J.D. Power & Associates, half of all new-car buyers will use the Internet for price information, cutting into dealers' already thin margins. (BW-Mar. 9).

So electronic commerce means that the consuming public will gradually trade one set of intermediaries for another. Retail sales forces, insurance agents, financial brokers, and auto dealers, who often add little value, will be squeezed. Net consultants will arise to try to lengthen the shrinking half-lives of Net branding, product cycles, and market power.

In one sense, the development is good news, for it revives the often-breached ideal of consumer sovereignty. But it makes life less rewarding for the innovator. It is no accident that Bill Gates, champion of the frictionless electronic market, is also aggressively pursuing market power. For the latter is irresistibly attractive as a defense against the former. Even missionaries for perfect markets can't stand too much perfection. Schumpeter would have understood.

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