Chapter 2: The New Economics

I don't know who discovered water, but it probably wasn't a fish—Marshall McLuhan

What is it about the digital killer apps that makes them so deadly? If Moore's and Metcalfe's Laws are improving the power and speed with which technology enters the marketplace, shouldn't that be cause for celebration and not anxiety? Why does the Law of Disruption apply to commerce at all, when conventional wisdom holds that technological innovations improve productivity and create new wealth?

Moore and Metcalfe explain how digital technology spawns so many killer apps, but we need to look elsewhere to understand why business executives now see technology as their main competitor instead of their chief weapon. The answer comes from the remarkable work of economist Ronald Coase. Coase's breakthrough work on transaction costs, as well as the peculiar economics of information provide a powerful framework for thinking about the new economics of cyberspace.

2.2: Ronald Coase’s Journey

Ronald Coase was in his twenties when he made the most important discovery of his life. He had finished his course work in industrial management at the London School of Economics and decided to spend his last year doing field research. Coase, who was ideologically a socialist, wanted to show that the state could be a more efficient manager of the economy than the free market. To prove it, he came to the United States to study the closest thing he could find to a nonmarket economy—the growing American phenomenon of the firm, exemplified by companies like Standard Oil, General Motors, and U.S. Steel. Inside these increasingly large organizations, the full range of market functions—purchasing, marketing, sales, manufacturing, distribution—were performed internally. Traveling around the country in 1931, at the height of the Great Depression, Coase was struck by the failure of economists to answer a few basic questions: Why did firms form at all? Why were they the size they were and not larger or smaller? How did entrepreneurs decide which functions to bring inside and which to leave to the open market?

It was an eventful trip, and by its end Coase had begun to question his faith in socialism and government regulation. In the process, he made a discovery about market behavior that he published in a 1937 article entitled "The Nature of the Firm." Coase's discovery was of such importance that it was one of only two achievements singled out by the Nobel Committee that awarded Coase their prize for economics over fifty years later. Ronald Coase had discovered transaction costs. As we'll see, it is this discovery sixty years ago that explains the new economics of cyberspace. First, though, you need to understand how it is that Coasean economics operates in traditional industrial markets.

2.3: Transaction Costs, or The Unnatural Nature of the Firm

To understand the concept of transaction costs, let's take a simple example. Let's say you work for an average-sized firm and you've run out of paper clips. Almost assuredly, you will get your paper clips not by going out on the open market but by going down the hall to the supplies department of your office, which has purchased and maintains an inventory of paper clips in your building. Your company will, in fact, keep such basic supplies on hand as a matter of course, without giving much thought to the cost of carrying such inventory, even if buying and distributing office supplies is not the core activity of your business. Your company is likely to keep paper clips on hand even if there was no discount for buying in bulk.

The reason? Even if you could get paper clips on your own for the same price, you still have to get them. This means finding out where the stores that carry them are located and how much they charge, deciding between the closest store and the one with the best price, making sure that you are really charged what the store advertises, and, if the clips are somehow defective, taking them back and demanding replacements or some other remedy.

And that's just for a simple transaction. Imagine instead that you were buying raw materials needed to manufacture your product. There is the additional effort of negotiating a price, writing a contract, inspecting the goods, and, potentially, invoking the legal system to enforce the contract. Better, you say, to own the supplier or at least to buy in bulk and avoid all that trouble.

That "trouble" is transaction costs, a set of inefficiencies in the market that add—or, as Coase argued, should be added—to the price of a good or service in order to measure the performance of the market relative to the nonmarket behavior in firms (or in weighing the costs and benefits of government regulation). There are six basic types of transaction costs:

• Search costs: buyers and sellers finding each other inside the increasingly broad and disorganized open market.
• Information costs: for buyers, learning about the products and services of sellers and the basis for their cost, profit margins, and quality; for sellers, learning about the legitimacy, financial condition, and need (which may lead to a higher or lower price) of the buyer.
• Bargaining costs: buyers and sellers setting the terms of a sale or contract for services, which might include meetings, phone calls, letters, faxes, E-mails, exchanges of technical data, brochures, entertainment, and the legal costs of contract negotiations.
• Decision costs: for buyers, evaluating the terms of the seller compared with other potential sellers, and internal processes, such as purchasing approval, designed to ensure that purchases meet the policies of the organization; for sellers, evaluating whether to sell to one buyer instead of another buyer or not at all.
• Policing costs: buyers and sellers taking steps to ensure that the goods or services and the terms under which the sale was made, which may have been ambiguous or even unstated, are in fact translated into the real goods and services exchanged. This might include inspecting the goods and any negotiations having to do with late or inadequate delivery or payment.
• Enforcement costs: buyers and sellers ensuring that unsatisfied terms are remedied. This could range from mutual agreement on a discount or other penalties to the often high cost of litigation, that is, using an external tribunal to settle disputes associated with the transaction.

As this list suggests, transaction costs range from the trivial (turning over the box to see what the price is) to amounts greatly in excess of the transaction itself (imagine if you were seriously injured by a defective paper clip). In any case, transaction costs add a layer of complexity to market transactions, and Coase thought they would be studied carefully. Yet we know little more today about their nature, size, and avoidability than we did when Coase published his findings in 1937. His fellow economists simply assume their way around him and now study markets and prices under the fiction of a "frictionless" economy (an economy, that is, in which transaction costs don't exist).

Firms are created, Coase concluded, because the additional cost of organizing and maintaining them is cheaper than the transaction costs involved when individuals conduct business with each other using the market. What functions should a firm perform internally? The answer is only those activities that can not be performed more cheaply in the market or by another firm. In fact, as Coase says, a firm will tend to expand precisely to the point where "the costs of organizing an extra transaction within the firm becomes equal to the costs of carrying out the same transaction by means of an exchange on the open market." For some activities, say plumbing, the open market works relatively well, and the need for plumbers to form large firms to avoid transaction costs has never arisen. For the large-scale operations of General Motors and U.S. Steel, which require coordination, heavy capital investment, and complex distribution systems, the firm is the only economically viable solution.

Viable, but not perfect. As anyone who has ever worked for an organization knows, the cost of performing a function inside a firm is the creation of communications and coordination functions, activities known collectively as bureaucracy. Bureaucracy increases as the size and complexity of the firm increases, sometimes approaching or surpassing the alternative transaction costs of the market. We have seen employees using their own travel agents rather than hassling with corporate travel departments, or computing at home where they can avoid the needless oversight of the corporate I/S group. In regulated industries or cartels, where there is no market alternative, customers may simply forgo the transaction—adding a second phone line or changing an airline reservation—rather than fight the inside costs.

2.4: Blown to Bits

Even before the digital revolution, technology played a central role in the development of firms. Coase noted in 1937 the enabling role of communications technologies like the telegraph and telephone, which reduced the cost of maintaining a large-scale organization across wide distances and thus made possible the creation of larger firms. Up until now, the role played by digital technology has been consistent with that history. Computers, networks, and large-scale data storage capabilities have made it possible for bigger and more complicated firms to emerge, internalizing more and more market functions and casting their shadow over a wider range of activities in an increasingly global market. According to the Bureau of Economic Analysis, U.S. companies spent $212 billion on information technology in 1996 alone, or roughly 5 percent of the GDP. Think of the global financial markets and their dependence on such technology. They couldn't exist without technology, and they didn't.

Large-scale industrial companies are also in some sense creations of digital technology. One example is British Petroleum, a major oil producer, which coordinates exploration, refining, and retail distribution on a worldwide basis, with major operations in such out-of-the-way spots as Alaska and Vietnam. BP relies on digital technology for everything from selling its products in the commodities markets, to storing and processing enormous quantities of geological data, to hosting regular videoconferences for its experts, senior executives, and exploration teams around the world. New applications, following Moore and Metcalfe, quickly become normal features of daily life. Only a few months after BP launched an experiment in virtual teamworking with videoconferencing and other software that enabled teams to share and simultaneously edit documents, diagrams, and other work products, the combined technology became an accepted part of how BP operates.

So it is ironic that the long-standing servant of such firms has now become their worst nightmare. Just as technology reduces the costs of operating a firm, it reduces the costs of the market itself. It's not only firms that get more efficient, in other words; the market is also getting more efficient. Moore's Law and Metcalfe's Law are working to create a new marketplace where transaction costs are reduced not incrementally (as they are in today's firms with reengineering and similar cost-cutting activities) but exponentially. As Harvard Business School professors Jeffrey Rayport and John Sviokla point out, in this evolving "marketspace," it is not only the infrastructure that is different, but the content and context of transactions as well.

Think of the Internet not as a network of connected computers but as the testbed for a new market economy, one that is global, continuously operating, and increasingly automating the processes of buying, selling, producing, and distributing. To return to the paper clip example, instead of leaving the building, you can now simply point yourself to Office Depot's Web site, click on the product you want, give them your credit card number, and get the paper clips the next day via UPS. Soon, that process will be enhanced by intelligent software "agents," such as those being developed by start-up software companies like Firefly, which use sophisticated pattern—matching algorithms to make recommendations based on your past behavior and the behavior of their growing databases of other shoppers.

Buying paper clips on the World Wide Web today is hardly a frictionless transaction, but it's an awful lot closer to it than shopping in the real world. Maybe it's already cheaper than engaging your office bureaucracy.

In the move to the marketspace, dramatic results are already visible. Whole industries, particularly those—like banking, insurance, publishing, and entertainment—that are the most information-intensive are simply being blown to bits. The Law of Disruption is relentlessly opening closed markets, exposing corporate waste, and laughing in the face of government intervention. In the insurance industry, startups like Quickquote are already offering agentless sales for such basic products as term life. Large insurers, at the same time, are constrained by the leverage of more than 650,000 insurance agents in the United States alone. As the CEO of one midsize insurer told us recently, "The industry is so dominated today by distribution that every time management tries to change something, the system of independent agents promptly kicks management in the groin. We feel under siege, and yet we think there's real opportunity here. It's a great time to be a schizophrenic."

The economic disruption caused by today's digital killer apps is twofold, the first a function of Moore's Law and Metcalfe's Law and the second a function of the Law of Disruption:

1. Killer apps are reducing transaction costs, in many cases dramatically, for nearly all goods and services.
2. They are doing so much faster in the open market than they are for firms.

That the market itself could become more efficient by reducing transaction costs is not something Coase has considered, but the result, when the market does, is entirely predictable given the "nature" of firms. If firms increase in size until they reach the point where the next transaction would be just as cheap if done outside the firm, what happens when the outside world gets cheaper? The natural corollary is that the firm shrinks. If Coase is right about the relationship between firms and transaction costs, there is this even more shocking implication, which we call the Law of Diminishing Firms: As transaction costs in the open market approach zero, so does the size of the firm.

A truly frictionless economy needs no permanent firms. We don't mean to suggest that such a future is imminent or even possible. For most complex transactions, even the most perfect information flow would still leave considerable transaction costs. The nature of the firm will change, however, and indeed, it is already changing. The concept of a firm as a physical entity, defined by its permanent employees and fixed assets, is giving way to what some have called a "virtual organization," where employees may be part-time or contract workers, where assets may be jointly owned by many organizations, and where the separation between what is inside and what is outside the firm becomes increasingly hazy. Venture capital firms, like Silicon Valley's Kleiner Perkins Caufield & Byers, link the companies they fund into a network, borrowing the Japanese concept of keiretsu. Individuals will be participants in many enterprises, like today's entrepreneurs, and those enterprises will be formed around events much closer to transactions than to a sense of corporate immortality.

2.5: The Law in Operation Today

Economists have done little to quantify the impact of transaction costs in traditional markets, but you don't have to look far to see the Law of Diminishing Firms turning the marketplace into the marketspace. Information and service businesses, such as dealers, agents, and brokers, are the first victims of reduced transaction costs, since they face head-on the improvements in information exchange. The start-up company Auto-by-Tel, for example, uses the Web to remove many of the expensive and unpleasant transaction costs of buying a car. Visitors to its site review extensive databases to make a selection and are then routed directly to qualified dealers who provide a binding quote within 24 hours. Auto-by-Tel can also provide loans and insurance. The activities of today's car dealer are greatly reduced, and in the end may be eliminated.

There's another group of early victims. Mature industries, regulated industries, and monopolies and cartels, which by definition avoid competition from the open market, have done little to reduce their basic costs. Consequently, they are proving to be not only vulnerable but downright fragile when even a little ray of competition or deregulation sheds light on their operating models. Investment in digital technology is a key feature of competitiveness. These organizations, which include most of the utilities and transportation sectors as well as a large chunk of the retail supply chain, have grossly underinvested and misinvested in technology, making them extremely tempting targets. In Japan, the "Big Bang" deregulation of financial markets that will take place over the next few years has led to a mad rush to upgrade uncompetitive technology infrastructures, with banks, insurers, and securities firms spending more than $11 billion in 1997 alone.

In the United States and Europe telecommunications deregulation is bringing in surprising new competitors for the traditional telcos—cable companies, foreign companies, as well as start-up companies without fixed assets. In Europe, alliances of electric utilities and companies that own large private networks (like the Union Bank of Switzerland, the Swiss railway, and Migros, the country's largest retail chain, which pooled their assets to form Newtelco) are forming to take on the national carriers. At the same time, technology and content-rich companies like Microsoft and Disney are buying up the technology poor, like Comcast, TCI, and Capital Cities/ABC.

Sudden mergers in formerly stable industries are just one of the most visible trends in today's business environment that can be explained by the Law of Diminishing Firms. Add to that list the disintermediation of wholesalers, the craze for outsourcing, and even much of the downsizing seen in the last ten years. Each of these is, at its core, a response to decreasing transaction costs in the open market.

2.5.1: Mergers and Acquisitions

As transaction costs fall, one of the remaining advantages a firm has over market transactions is the advantage of scale—the ability to outperform the market by saving money through repetition. Most of the interesting recent merger activity has been in industries experiencing sudden changes because of significant deregulation or changing market conditions, as in the defense industry. (As one Brigadier General of the British Army described the end of the Cold War to us: "Our market changed.") It is no coincidence that frenzied consolidation is taking place in banking, telecommunications, and insurance, all of which are responding to the new pressures of a competitive market that has absorbed new technologies more quickly than they did during their regulated slumber.

When banks had a monopoly on certain financial activities, there wasn't much pressure to perform, and branches proliferated. Now that anybody can be a bank for most purposes and can do so cheaply by using ATMs and the Internet, those branches are a significant drain (see Figure 2.1). A merged bank can close redundant branches, which is exactly what Wells Fargo did as part of its hostile takeover of First Interstate in 1995. And Wells Fargo, as we'll see, is also leading the banking industry in new technology investments that may ultimately redefine the concept of banking

2.5.2: Disintermediation and Disaggregation

A second effect of reduced transaction costs in the market is that they force the participants in stable industries to reconsider who is capturing the margins. Nearly every distribution activity, from commodities to consumer goods, includes a range of intermediate players such as wholesalers, financers, insurers, transporters, and warehousers. These middlemen reduce transaction costs for functions that are outside the firm; that is, they mediate between the firm and the customer. Middlemen are valuable to the transaction only if they are cheaper than the equivalent functions found on the open market. Consequently, it's no surprise that as technology reduces transaction costs in the open market, the role of middleman is coming under attack and the power dynamic among the players is changing rapidly. If buyers and sellers can find each other cheaply over the Internet, who needs agents (for instance, insurance) and distributors (for instance, home computers)? Complex transactions are becoming disaggregated, and middlemen who are not adding sufficient value relative to the open market are being disintermediated, which is to say they're being cut out.

If Auto-by-Tel can leverage itself into a large-scale operation, think of the disruption it will cause to the industry model of the new and used car markets. Manufacturers, dealers, newspapers, insurers, and financers will all find themselves wondering what happened. Even renegade middlemen like Charles Schwab & Co., a leader in the disintermediation of high-price investment firms for small investors, now find themselves threatened by even cheaper technology solutions over the Web (e.g., E*Trade, which operates solely in cyberspace). A cartel of optometrists that controlled the lucrative market for contact lenses is being broken up by the superior technology of drugstores, mail order companies, and Web businesses such as Lens 4 Me Web.

2.5.3: Outsourcing and Downsizing

As transaction costs fall, many organizations have already farmed out functions like purchasing, travel, data processing, and accounting to outsource partners that can operate, thanks in large part to new digital technology, on scale. Despite admonitions to focus on the organization's "core competence" (those activities the firm does particularly better inside than outside), firms today don't usually decide on their own to outsource a function that's no longer efficiently performed inside; rather, the outsourcer comes to them with the economics already worked out. To return to our paper clip example, many firms have already adopted an intermediate solution of turning supplies, copying, and other purely administrative activities over to outsource partners, who often actually reemploy the firm's employees who formerly performed the function but now operate it as a profitable business.

Even when the former employees aren't retained, the rush to outsource explains why, despite continual and massive downsizing in nearly every industry, the unemployment rate in the United States is near record lows (it is high in much of Europe, but this seems more a function of overregulation and the upheavals being caused by the collapse of Communism in Eastern Europe and the shift to European Union than to downsizing). It's not that people are losing their jobs, it's that they are increasingly shifting from large firms to smaller ones. Just as the Law of Diminishing Firms suggests, the U.S. Department of Labor is already predicting that by the year 2005 the largest employer in the country will be "self."

Outsourcing and downsizing are part of the transition to the new digital economy, in effect replacing monolithic, General Motors-style firms with smaller, more specialized players who, as we'll see, are tied together not by ownership (and bureaucracy) but by high bandwidth data and communication links. How far will this go? Consider two examples. Mastercard, which processes millions of credit card transactions a day, has only 1,000 employees, 800 of them in data processing; Sara Lee recently announced plans to sell off most of its manufacturing assets, leaving it free to concentrate on managing its brands.

2.6: Bits as Public Goods

A second critical feature of the old economics that takes on new meaning in the world of killer apps has to do with the properties of information as a good. Computer hackers chant that "information should be free." The notion that we should give away our valuable property sounds at best irrational, and yet, when that "property" is information, economists have understood the value of doing so at least since the time of Adam Smith. Information is part of a special class of commodities that economists refer to as public goods. Where traditional goods like crops, minerals, and cars can be owned and used by only one person at a time, public goods (e.g., national defense and lighthouses) can be owned and used by everyone simultaneously. Since sharing them with as many people as possible spreads their value without adding to their production costs, the goal for a producer is to find a way to pay for their development without invoking the pricing system of supply and demand, which works best for traditional goods.

Laws that grant copyrights and patents to writers and inventors for their work are aimed at exploiting the public goods nature of information and suggest how an economy for bits might best operate. These laws grant a monopoly the author can use to maximize the value of his or her investment. While copyright and patent might be thought of as contrary to the idea of a public good, remember that the monopoly granted is a limited one—in the United States the owner of a copyright holds it only for his or her lifetime plus fifty years, and patents are good only for seventeen years. After this period, the work or the invention (including the information necessary to re-create it) goes into the public domain, where it stays forever. Moreover, copyright applies only to the author's actual words—the ideas in a work, like this book, go into the public domain immediately. Motorola recently won a case in which the National Basketball Association claimed that Motorola's sports paging device violated the association's copyright in the broadcast of basketball games. Not so, said the court. Scores—even interim scores—are public information. Everyone can use them, any way they like.

Intellectual property rights are granted solely to encourage the creation of useful information ("To promote the Progress of Science and the useful Arts," as the U.S. Constitution puts it), and the trick has always been to strike the right balance between incentives for creators and the value the public derives from unlimited access and use. It's a balance that is being actively reconsidered in light of the ease with which information in the form of bits can be spread over public networks like the Internet. Many observers (including the authors), believe that large entertainment and publishing companies are trying to shift it in precisely the wrong direction.

Information, like other public goods, is inexhaustible, but information has an additional property that is unique. Information actually increases in value the more people use it, one reason why we think less, not more, protection would benefit everyone, including the owners of copyrights. The latest John Grisham novel—the content, not the actual physical copy we call a book—is a public good in this sense. Everyone can read it at the same time, and the fact that everyone is reading it means that everyone knows what Grisham thinks about the practice of law or the criminal justice system. This collective knowledge creates a context for discussion about these ideas and about Grisham's skills as a storyteller, a phenomenon that becomes increasingly powerful once a critical mass of people have read the novel.

If and when novels can be distributed with little cost over the Internet, a new author might be well served to give away his or her first book to as many people as possible. This would create a ready market for the next book. The cost of the give-away would be much less than in today's publishing business, where the price of a book reflects the author's and publisher's intellectual investment only to a small degree, while the majority of the cost reflects the creation, transportation, and retailing of the physical artifact. Giving away the bits creates a network, and networks, as we noted in Chapter 1, are powerful generators of value. Information increases in value as it is used, the economic expression of Metcalfe's Law. As the Electronic Frontier Foundation's John Perry Barlow said insightfully in rewriting the hacker motto, "Information wants to be free."

2.7: The New Firm: Rebuilding with Bits

If the Law of Diminishing Firms explains the disruption to current business, the public goods aspect of information accounts for the phenomenal opportunities for growth that are emerging at the same time. Because information wants to be free, the sudden creation of cyberspace, a viable home for free-moving bits, is driving a massive information migration. During 1997, InterNIC, the company responsible for registering site names on the World Wide Web, reported that new sites were being added at the rate of one every minute. Libraries, publishers, financial service firms, and buyers and sellers of every kind have been flooding cyberspace with their information archives. Some of Wall Street's hottest technology stocks are for companies like Yahoo!, Excite, and Alta Vista, all of which simply help users to navigate through this amazing wealth of knowledge.

Just as cheap bits are shrinking the traditional firm, their public goods features are building firms back up again, using bits for the bricks and mortar. The new forms, however, look little like their predecessors. As information flow increases, organizations are less able to hide their costs and pass along inefficiencies to customers. So they must focus, as authors Gary Hamel and C. K. Prahalad argue in Competing for the Future, on those activities that truly add value; that is, activities they can perform, owing to their expertise, scale, and other special properties, more efficiently than everyone else. Companies already struggling with these changes have found that the first wave of displacement involves employees. But people can be retrained. The next phase of restructuring is more difficult. Fixed assets—the trucks, pieces of manufacturing equipment, factories, and warehouses that were a necessary evil of running an integrated firm—are not so flexible.

New entrants and early adopters of new technologies do not have fixed assets, and in the new economy, what was an advantage will quickly become a disadvantage. Digital publishers don't have or need printing presses, a distribution network, and retailer contracts. Digital insurance firms and banks don't have or need agents and branches. And digital shopping malls don't need any of the three key assets of traditional retailers: location, location, and location. New digital competitors can still reach an exploding, global, unregulated market overnight, and at very little start-up cost. The barriers to competition are falling fast, falling at the speed of a bit. Software giant Microsoft is already offering services as varied as event ticket sales, travel reservations, home and car shopping, and investment advice.

In effect, someone has just turned your balance sheet upside down. As the CEO of a leading durable goods manufacturer told us, "The leverage has shifted to the consumer. They know when they're getting value and when they're not getting value and will pay for service where there is quality service. If there is no value added to high-cost distribution systems, they aren't going to pay for them." Utilities, used to passing along cost overruns from plants they didn't need to build directly to consumers, have a new term to describe these items in a deregulated environment. They call them "stranded assets."

Getting caught with stranded assets, even ones that you considered just the other day to be the source of your competitive advantage, isn't hard. It can happen with remarkable speed, even in markets that aren't highly regulated. In the early 1990s, Microsoft's Bill Gates approached Encyclopedia Britannica about creating a digital version of its leading encyclopedia, to be delivered on the increasingly cheap medium of CD-ROM. Britannica, concerned that licensing content would jeopardize the high margin market for their printed books, turned him down. So Gates created his own encyclopedia, Encarta, using content from Funk and Wagnalls and public domain audio and visuals. From the beginning, Encarta was published exclusively in digital form. Not only is the multimedia product more engaging than the cold text, it is cheaper to produce and distribute ($1.50 to press the CD-ROM versus $250 to print the book), and easily updated as well.

Within eighteen months, Microsoft Encarta became the best-selling encyclopedia in the world. Britannica saw its own market collapse. Britannica approached Gates about reconsidering his deal. The meeting ended, according to Gates, when he informed the company that his market research showed that the Britannica brand name now had negative value in the new interactive encyclopedia market and that the company would need to pay him to use its name on his product. Since then, Britannica has changed hands several times, eliminated its direct sales force, and struggled to gain market share with a competing CD-ROM product, initially priced at $1,000

2.8: Information Assets

The good news is that there's a new item in the asset column, one you're probably not even accounting for: your information assets. These include everything from expertise, trademarks, market intelligence, goodwill, and processes to corporate culture and identity, most of which are today considered too soft to include in a company balance sheet (accountants are likely to suffer from the Law of Disruption). Information assets will for many organizations become goods and services themselves, subject to the economic rules of public goods.

Many organizations have already recognized the power of information assets. Some are even willing to put a value on them. Jewel grocery stores give their customers a "Preferred Card" that allows the stores to capture and market perfect sales data, connecting customers with the complete details of what and when they buy. Jewel compensates the customers for cooperating in the collection of this information by providing discounts on various products only to customers who use their Preferred Card.

One start-up company is at work developing tools specifically for consolidating and distributing information assets. The company, Digital Knowledge Assets, works with business school professors to translate as much of their classroom experience as possible into digital form, hoping to distribute it more widely to a corporate audience that can't physically attend classes. But the toolset they are developing, which includes virtual "tours" of case study companies and software that sorts and selects news items of interest based on a set of common criteria, is equally useful inside a company. DKA's first customer was a large electronics manufacturer that was more interested in the tools and DKA's expertise in information design than outside content. Their second customer was a consulting firm.

Our clients frequently challenge us to find information assets hiding in their organization. Doing so never takes long. Distributors have logistics, manufacturers have engineering, retailers have customers. Valuable information surrounds each of these functions. Invariably, the information assets we find aren't in a usable form, since they're spread over numerous departments and information systems, many of them not even automated. As Moore's Law makes processing power and data storage unspeakably cheap, the cost of collecting and consolidating these disparate data becomes less of an obstacle. Still, learning to exploit these assets will take imagination. Already, media companies including publishers Simon & Schuster and Time Warner are hurrying to produce "corporate digital archives" of their text, photo, and promotional materials. These organizations are first because they have to be—their businesses depend on the reusability of content. But so do yours, sooner or later.

To identify your own information assets, start with activities that already contain components of public goods, such as marketing and advertising. The goal of advertising is to spread knowledge about the company's goods and services to as wide an audience as possible, an example of a current practice of giving information away to increase its value. Once a critical mass of people know about the product, they act as a source of credibility, which can be expressed in shorthand as a brand or product name and communicated in the form of trademarks. The logos for Coca-Cola, McDonald's, and Nike are valuable because they are universally recognized and because the associations with them are consistent and predictable.

Everything you move from the world of atoms to the world of bits will be a kind of public good, behaving the way brands and trademarks do today. Today your logo may be your primary public good, but tomorrow it may be supplemented by your inventory, your money, your business partnerships, and your production schedule. As technologies for large-scale collaboration that creates a virtual workspace for scattered project teams become cost effective, the information assets of development projects shift into public goods. Instead of involving customers and suppliers in the design and testing of new goods and services as you may do today, you may find yourself following the lead of product innovation specialist Hewlett-Packard, which, in effect, outsources much of this work to its business partners. By doing so you start to build a network for developing new products before the current products are even finished.

The more functions you can express as information and translate into bits, the more you can take advantage of the Metcalfe effect. As the information elements of manufacturing, distribution, and other processes become digital, in fact, the bright lines between these activities turn out to be largely a function of their physical nature. Marketing, recruiting, training, investor relations, and even manufacturing are already merging for strong international brands like McDonald's, where a computer game to optimize the production of hamburgers, given away as a premium, might serve all five activities. We believe that in the new economy many traditional functions merge into one overall activity. For the moment, let's call that one activity what it is today: brand management.

Part 2 describes some strategies for profiting from this feature of the new economy. But consider for now that brand management today is more than likely a separate and highly specialized activity in your organization, usually managed by experts. Tomorrow, it may be a skill that everyone will need.

2.9: Old Coase, New Coase; Old Public Goods, New Public Goods

Today's killer apps, operating under Moore's Law and Metcalfe's Law, are expressing their disruption potential on today's business models by changing the economic rules of the game. As it turns out, the principles that animate this new economy—Coase's theory of transaction costs and the concept of public goods—have been known for decades or longer. Now they take center stage.

In the new economy, the balance of activity between firms and the market, between middlemen and the buyers and suppliers they sit between, changes dramatically. Early exploiters of new technology disrupt value chains, cartels, industry structures, and the delicate balances between sellers and customers, between regulators and the regulated, and partners and competitors. New rules and new structures will rise and fall with increasing velocity, new operating models and new competitors will come and go, and activities will morph into others or disappear altogether.

The rapid reduction in transaction costs in the open market has caught traditional industrial-age organizations by surprise, especially those sheltered from market competitors by regulation or cartel. These firms must now find new ways to offer and communicate their value. The power of information as a public good, both its inexhaustibility and its ability to increase in value through use, has launched a massive shift of information, much of it once considered proprietary, to cyberspace. Those who are first to embrace and exploit the powerful but unfamiliar features of public goods can gain significant advantage over organizations that still treat their information assets as they would gold bars or manufacturing processes; that is, by hoarding them.

This is a brave new world—one that requires a new strategy. In the age of digital killer apps, it requires a digital strategy.