InternetEconomy

OlliMar1kainenAutumn2018

Whatweexpectyoutolearn•  Industrialrevolu1ons•  Produc1vity•  InternetEconomy

–  ICT-areasandtheirchangeasabasis–  Innova1onintensiveSchumpeteriancompe11on–  Dominantdesigns–  Switchingcosts–  Networkexternali1es–  Complementari1es–  Asymmetricinforma1on–  Newgrowththeory–  Systemicstructures–  Internetbusinessmodels

•  References

Industrialrevolu1onsaredisplayedasproduc1vityrateincreases

Industrialrevolu1ons

•  Ineconomicstechnologymeansarecipehowtomakeproductsfromrawmaterials(notonlyatechnicalartefact)

•  Theapplica1onofatechnologycomesintwophases–productinnova1onsandprocessinnova1ons(1stlecture)

•  ThesephasesarealsocalledasTechnologyPhaseandDiffusionPhase

•  Inthediffusionphasethetechnologyisappliedinindustriesandtheproduc8vityinorganiza1onsimproves

•  ThemajortechnologicalbreakthroughscanbeseenintheGDPgrowthrateofna1ons

•  TheincreaseofgrowthrateiscalledanIndustrialRevolu0onwhichmeansincreaseinproduc8vity:

GDP/popula1on=GDP/workhoursxworkhours/popula1on,i.e.Livingstandard=Labourproduc1vityxWorkamount

600182018301840185018601870188018901900191019201930194019501960197019801990200020102016

China

Finland

France

Germany

Japan

Sweden

UK

USA

USD50000400003000020000

10000500020001000

Source:MaddisonProjectDatabase,version2018.Bolt,Juda,RobertInklaar,HermandeJongandJanLuitenvanZanden(2018)

GDPpercapitagrowth1820-2016

10001820 1840 1860 1880 1900 1920 1940 1960 1980 2000 2016

USD5000040000300002000010000500020001000

AverageGDPpercapitagrowth

FirstIndustrialRevolu1on(diffusionphase)

SecondIndustrialRevolu1on

ThirdIndustrialRevolu1on

Whythegrowthrateisnotincreasing?Whatistheproblemindigitaliza1on?

IndustrialRevolu1ons

•  FirstIndustrialRevolu1on(diffusionphase)1830-1920–  Steam,industrialproduc1on,railway,telegraph

•  SecondIndustrialRevolu1on1920-1980–  Electricity,chemicalindustries–  Car,telephone,radio,television

•  ThirdIndustrialRevolu1on1980-–  Informa8onandCommunica8onTechnologies(ICT)–  Computer,digitalnetworks,PC,GSM,Internet,Apps–  Knowledgeasaninputinproduc1onthathasincreasingmarginalproduc1vity(PaulRomer,Nobelprice2018)

ThirdIndustrialRevolu1on

TechnologyphaseNooffirmsindex

Diffusionphase

1980199020002010

produc0vityincreasesherebyprocessinnova1onsstrongcomplementari1esbusinessstructureredefinedincrementaldevelopment

DominantDesigns

Sources: Abernathy and Utterback 1978 Christensen 1997, OECD 2003

ICTfocusshiisfromtechnologytoprocessesandservices:

Cf.Electricity1880-1929

ICTDiffusionPhase

Source:EUsta1s1cs

ICTDiffusionPhase

•  ICTisusedinallindustriestoincreaseproduc1vity•  InFinland2/3oftheICTgeneratedGrossDomes1cProduct

(GDP)hasbeenbasedonICT-industryproduc1on•  InUSA2/3oftheICTgeneratedGDPisbasedonICTusein

differentindustries•  ITincreasesproduc1vityanaverageof8-18%whenitis

combinedwithorganiza8onalandprocesschangesanddatacommunica8ons(ETLA2003,OECD2003).

•  Mobilecommunica1onscanincreaseproduc1vityanaverageof40%(ETLA2004)

Produc1vityeffectsofICTinfirms

-40 % -20 % 0 % 20 % 40 % 60 %

Computers

Internet

LAN

Services

Old

Middle

Young

Maliranta and Rouvinen 2003

Produc1vityeffectsofICTinfirms

-40 % -20 % 0 % 20 % 40 % 60 %

Computers

Internet

LAN

Manufacturing

Old

Middle

Young

Maliranta and Rouvinen 2003

Produc1vity•  Produc8vityismeasuredasthera1oofoutputvolumeto

inputvolume•  Differentproduc1vi1esareobtainedsuchasvalueadded

basedlabourproduc1vity=producedvalueadded/workhours

•  TotalFactorProduc8vityTFPismeasuredoverallinputs(work,capitalandotherinputs)andexplainsthegrowthpossibili1es

•  Produc1vitygrowthrateisthemeasureoftechnicalchangeandcanbeusedtoiden1fytechnologycycles

•  Knowledgeandskillsareessen1alwhennewtechnologyisdevelopedandapplied

Newgrowthisbasedonknowledge

NewGrowthTheory•  IneconomicstheproducedoutputQismodeledas

produc8onfunc8onFasfollowsQ=F(L,C,H),whereL=labor,C=capitalandH=knowledgearefactorsofproduc8on

•  TechnologicalchangecreatesabederF•  WiththesametechnologyFsomefirmsmaybehavemuch

bederthanothers•  Thisisaresultofknowledgesuchaseduca1on,skillsand

patents•  Forinstance,ecosystemsareknowledgebasedindustrial

systemsthatmayimproveproduc1vitymuchoverna1onalaverages

•  Newgrowththeoryemergedfromthisobserva1onthatinforma1onandknowledgearefactorsofproduc1on

Nobelprice2018:PaulRomer

Source:Ilkka

Un1l1980’stheincreaseofproduc1vitywasbasedoninvestments,whichsubs8tutedlabourbymachines.Latertheincreaseoftotalfactorproduc8vity(TFP)hasbeenthemajordriverofgrowth,whichmeansthattheproduc1onfunc1on(“recipeofmaking”)hasbeenchanging.PaulRomerwasabletoexplainthesechangesbyaddingin1986theknowledgeasafactorintheproduc1onfunc1onmodel.Thiscreatedtheso-calledNewGrowthTheory,alsocalledasEmbeddedGrowthTheory(Romer1986).Innova1ons,patentsandknowledgegiveadvantagetotheirownersandcreatemarketfailuresinbusiness.ThesearetypicalinInternetEconomy.

NewGrowthTheory

PRODUCTIONFUNCTIONF(K,L,H)

CAPITALKsuchasmachines

LABOURLsuchaspeople

KNOWLEDGEHsuchaspatents,soiware,educa1on

Availableinanindustrialdistrict,industrialcluster,competenceblock,plaoormorecosystem,asasystemicfactor.Skillsincreasewithallpartnersandonthevaluechain.SeeAcemoglu2015anditsreferencesforins1tu1onalfactors.

FactorsofProduc1on:

Interneteconomyisbasedonmarketfailures

Characteris1csofInternetEconomyInternetEconomyisbasedonseveralmarketfailures.•  ICT-areasandtheirchangeasindustrybasis•  Innova1onintensiveSchumpeteriancompe11on•  Crea1vedestruc1onandproduc1vityimprovements•  Patentsas1melimitedmonopolies•  Dominantdesigns•  Switchingcosts•  Externali1es•  Complementari1es•  Asymmetricinforma1on•  Systemicstructures

–  Secondunbundling–  EcosystemsandPlaoorms–  Internetbusinessmodelsbypasstradi1onalmodels

Businessecosystemshaveoienthesefeatures,whichpreventcompe11on,andarehencemarketfailures!

.

.

.

ICT-areasandtheirchangeICT(Informa0onandCommunica0onTechnology)industriesarebasedonInforma1onpresentedandtransferredindigitalform:

•  ContentIndustry–  Mediabecomesdigital(E-media)

•  Consumerelectronics–  Audiovisualreplayandbroadcasttechnologies

•  ComputerIndustry–  PCtopersonal,consumerandmobile

•  TelecomIndustry–  Broadbandnetworks,mobileandinternetservices,digital

mul1media

ICT-areasandtheirchangeICTLawsofGrowth:

•  Moore’sLaws: MIPSx2every1.5years

TRs/Chipx2every2years

Chipsize-25%every2years

•  Guilder’sLaw:bpsx3eachyear

•  Shugart’sLaw: Diskcapacityx10every4years

Price/bit-50%every18months

•  Edholm’sLaw:Radiobw=fixedwith8yeardelay

•  Metcalfe’sLaw: NetworkValue=(NoofUsers)2

InternetProtocol(IP)asnetworkandWebasuserinterfacestandard

HighInternetandMobilePenetra1on

ICT-areasandtheirchange

0.1

1

10

100

1000

10000

100000

1000000

2000 2005 2010 2015 2020

CPU PC (GHz)CPU HandheldsMemory PC (GB)Memory HandheldsFixed network (Mbps)Wireless network

ICT-areasandtheirchange

VR=VirtualrealityOTT=Over-the-topcontentsuchasNeoix(alsoVOD=VideoonDemand)

Innova1onintensivecompe11on•  Innova8onisanideawithcommercialpoten1al•  Innova1onsdriveindustrialdynamicsandproduc8vity•  Schumpeter(1911)Thetheoryofeconomicdevelopmentand

(1942)Capitalism,Socialism,Democracy•  SchumpeterintroducedtheconceptCrea8veDestruc8on,

whichmeansthatnewinnova1vefirmstakeoverbusinessfromoldandlessinnova1vecompanies

•  Crea1vedestruc1onexplains30-50%ofproduc1vitygrowth•  Successfulinnova1onsanddominantdesignsgiveashort

1memonopolytotheirowners(e.g.iPhone)•  Similarly,plaoormsandecosystemsmaygivestrongbusiness

advantagestotheircreators(e.g.Apple,Google,Amazonetc.)•  Patentedinnova8ongivesamonopolyfor20years

Example:Innova1onecosystems•  AppleiPhoneandGoogleAndroidphonescreatedstrong

ecosystemswithAppsmarkets•  InterviewofRistoSiilasmaa,theChairmanofBoardof

Nokia,YLE15.10.2018:”Wesold300000Lumiaphones(withtouchscreenandWindows)permonthin2012butAppleiPhoneandAndroidsold300000perday.Itwasthenimpossibletocatchupbecausetheapplica1ondeveloperspreferredthesetwofastestgrowingopera1ngsystems(iOSandAndroid).”“WefinallydecidedtosellNokiaMobilePhonestoMicrosoifor5,5billionUSDin2013.”

Source:TekniikkajatalousSeealsoExternali1es

Produc1vity

Defini1onofProduc1vity:

Produc1vity=Y/X,where

Y=output(ineuros,tons..)X=input(hours,labourcosts,..)

Usuallyonlyrela1vechangesarecompared(%).Thedefini1ondependsonwhoisdoingtheanalysis:

Na1onaleconomy:Y=industryvalueadded,X=labourhoursFirm:Y=profit+labourcosts,X=labourcostsTechnicalprogress(technologicalinnova1ons):87%ofthegrowthinUSofthegrossoutputperperson-yearwasadributabletotechnicalprogressin1909-1949(Solow,1957).

•  Amajorproduc1vityimprovementinindustriesresultsfromtheCrea8veDestruc8on(Schumpeter1942),whereenterpriseswhichhavenewandbederwaystocombinefactorstoproductsorservices(i.e.whichhaveabeHerproduc8onfunc8on)winmoremarketsharefromtheoldfashionedfirms(withanoldproduc1onfunc1on),andasaresultpartoftheoldfirmsgofinallyoutofthemarket

•  Compe88onbetweenfirmsisessen1alhere,firmswithbederproduc1onfunc1ongetlimited1meadvantage

•  TheCrea8veDestruc8onexplainsmorethan30-50%oftheproduc8vityimprovements.Therest(lessthan70-50%)followfromdevelopmentac1vi1esinsidetheorganiza1ons(BöckermannandMaliranta,2007)

•  Thesefeaturescreateindustrialdynamics

Produc1vity

Crea1veDestruc1on

Produc1vityindex

Time

NewProduc1onFunc1ons(howfactorsarecombinedas(b)(c)productsorservices)

Produc1onFunc1on(a,blue)withorganiza1onsthatusethisoldmodelvanish.NewProduc1onFunc1ons(b,green)andlater(c,red)comeintouse.

Theproduc1vityimprovementinphase(b)byorganiza8onaldevelopment

Theproduc1vityimprovementfromCrea8veDestruc8on

(a) FIRM

DominantDesigns

•  DominantDesign(DD)isthewinningstandardacceptedbythemarket–  Notnecessarilythebestpossibleavailable–  Sufficientlywellperforming–  Oiensimpleorelegant

•  Publica1onandpatentamountshaveoienmaximumsomeyearsbeforetheDD(Ehrnberg)(TechnologyPhase)

•  ThenumberoffirmsinvolveddecreasesstronglysomeyearsaiertheDD(AbernathyandUderback)

•  Applica1onofthenewDDcon1nuesinfirmswithincrementalandprocessinnova1ons(DiffusionPhase)

Example

•  Mobilephonedominantdesigns–seethe1stlecture– Keyboardandscreenonthephone– Shellphone– Touchscreenphone– Applica1onmarketsforservices

•  Todaythedominantdesignsareoienbundledwithecosystems

Switchingcosts•  Switchingcostsincurwhencustomersswitchfromone

suppliertoanother.•  Examplesofswitchingcosts:

–  Theeffortneededtoinformcolleaguesaboutanewtelephonenumber

–  Thecostsfromlearningtheinterfaceofanewmobilephonefromadifferentbrand

•  Switchingcostsinclude–  Exitfees–  Searchlearningandemo1onalcosts–  Equipment,installa1onandstart-upcosts–  Financial,psychologicalandsocialrisk.

Example•  Numberportabilityinsmartphones

–  SeveralEuropeanmobileoperatorsleasedthemobilephonetogetherwiththemobileconnec1on(withmobilenumber),itwascalledbundlingthephoneandnumber

–  Itwaspossibletoswitchtoanothermobileoperatorbutyouhadtopaythepreviousleasingperiodbill,too

–  Thispreventeduserstoswitchoperatorstoooien–  InFinlandthenumberandphonewereseparate,andwhennumberportabilitybecomecompulsoryinEUin2003,theFinnishusersswitchedtothecheapestoperatormany1mes,andmobileservicesturnoveralmosthalvedinoneyear

Externali1es•  Externali8esareconsequencesofeconomicac1vi1esto

unrelatedthirdpar1es,e.g.pollu1on,educa1onleveletc.•  Networkrelatedexternali1esarecallednetworkeffects•  Networkeffectcreatesvaluetoapoten1alcustomer

dependentonthenumberofcustomersalreadyowningthatgoodorservice

•  Examples:soiware,telecomservices,web•  Metcalfe'slaw:thetotalvalueofagoodorserviceis

roughlypropor1onaltothesquareofthenumberofcustomersalreadyowningthatgoodorusingthatservice

•  Cri8calmass:networkeffectbecomessignificantaieracertainamountofcustomers

•  Sideeffect:thepurchaseofaservicebyonecustomerindirectlybenefitsotherserviceusers

Externali1esThesuccessofiPhonesandAndroidphoneswasspedupbytheApplica1onmarketexternali1es:

Source:hdps://play.google.com/storeSource:hdps://www.apple.com/ios/app-store/

SeealsoComplementari1es

Complementari1es•  Thecommercializa1onofaninnova1onissystemic,itmust

bedoneinconjunc1onwithComplementaryassets,suchas–  Manufacturing–  Marke1ng–  Distribu1on–  Services

•  Complementaryassetscanbegeneric,specialized(withdependencebetweenpar1es)orcospecialized(mutualdependencebetweeninnova1onandasset)

•  Missingcomplementari1esoienexplainwhysomanyinnova1onsfail

•  Tightappropriabilityregimessuchaspaten1ngortradesecretsprotectinnovatoragainstimita1onandcompe11on

Complementari1es•  Underwhichcondi1onshouldfirmscollaboratetoaccess

complementaryassets?Incorporatesdynamicsoftechnologicalchange.

•  Twokeydimensions:(i)  Appropriabilitycondi1ons=thepossibili1estoprotectR&Dand

innova1ons(e.g.patents,copyright,complexity,lead1mes)(ii)  Natureofcomplementaryassets=externalassetsthatinnovators

needtocommercializetechnologies–  Genericassets–  Specializedassets(unilateraldependency)–  Co-specialisedassets(bilateraldependency)

•  R&Dalliancesareviableifappropriabilitycondi1onsareweakandcomplementaryassetsarenon-generic–thisistypicallythecaseintheearlyphaseofatechnologylifecycle

Complementari1esStart: you have new innovation

Innovation requires

complemenatry assets?

Commercialiseimmediately

Complementary assets specialized?

Specializedasset critical?

Weakappropriability?

Cash position OK?

Competitors better positioned?

CollaborateYes

Yes

Yes

Yes

Yes

No

No

No

No

No

Yes

Collaborate

Collaborate

Collaborate

CollaborateDevelop assets

yourselvesNo

(Source: adapted from Teece 1986)

AsymmetricInforma1on

•  Asymmetricinforma1onoccurswhenonepartyoftransac1onhasmoreorbederinforma1onthantheotherparty.

•  Exampleswithseller:used-carsalespeople,stockbrokers,realestateagents

•  Examplesofbuyer:lifeinsuranceforabuyerwithheavysmokinghabits

•  Interneteconomyhasaneffectoninforma1onasymmetrybyallowingtheuserstoacquirepreviouslyunavailableinforma1onsuchaspricesofrecentsalesortransac1ons,foreignprices,selec1onofavailableusedcars,etc.

•  Butalso–fakenews

Secondunbundling•  Thefirstunbundlingallowedthespa1alsepara1onof

factoriesandconsumers•  Thesecondunbundlingspa1allyunpackedthefactoriesand

officesthemselves.Theoldparadigm–essen1allytradi1onaltradeeconomics–wasusefulforunderstandingtheimpactofthefirstunbundling(Baldwin2006)

•  Understandingthesecondunbundling(whichhasvariouslybeencalledfragmenta1on,offshoring,ver1calspecializa1onandslicingupthevalue-addedchain)mayrequireanewparadigm,especiallywhenitcomestotheoffshoringofservices

•  Secondunbundlingdistributesna1onalvaluechainsandclusterstointerna1onalvaluenetworks(Pajarinenetal.2010),someofwhichdeveloptoecosystems

NokiaN95phoneretailprice€546decomposedtohardware,soiwareandothervalueaddedin2007:

ThevaluebreakdownofNokiaN95bysupplychainpar1cipant(%):

Systemicstructures•  Industrialclusterisageographicallyproximategroup

ofinterconnectedcompaniesororganiza1onsinapar1cularfieldlinkedbycommonali1esandcomplementari1es–  Innova1on,produc1vitygrowthandnewbusinessforma1oncanbeexplainedbyawellworkingcluster

–  Increasingsophis1ca1onofcompe11ongrowstheimportanceofcluster

•  Competenceblock(Eliasson)explainswhichsystemicactorsareneededtocarryanideathroughaninnova1ontosuccessfulbusiness

•  Ecosystemisaglobalindustrialsystembasedondominantdesigns,plaPormsandIPRs

CompetenceBlock

•  CompetenceBlockcreatesasystemicviewoffirmsandexplainstheselec1onofwinnersandlosers

•  Actorsrepresen1ngdifferentlevelsofknowledgearenecessaryinthecompetencebloc:1.Competentandac1vecustomers2.Innovatorswhointegratetechnologiesinnewways3.Entrepreneurswhoiden1fyprofitableinnova1ons4.Competentventurecapitalistswhorecognizeandfinancetheentrepreneurs

5.Exitmarketsthatfacilitateownershipchange6.Industrialistswhotakesuccessfulinnova1onstoindustrialscaleproduc1on

Source:Carlsson&Eliasson2003

Ecosystems•  Ecosystemisaninterna1onalvaluenetworkwith

commonali1esandcomplementari1esprovidedbyitsactorsandmanagedbyaleadingorganiza1on

•  Ecosystemsarecharacterizedby(Moore1993,2006,GawerandCusumano2002,Gawer2009,KenneyandPon2011,Adner2017)–  Commonvisionsharedbytheactors–  Commonplaoormandstandardsusedbytheactors,alsocalledasthe”solu1onstack”

–  IPRdevelopedbytheplaoormowner(ifcommercialecosystem)–  Highinterdependencebetweentheactors–  Highpoten1alforinnova1onbyeachactor–  Valuecapturebasedone.g.dominantdesignsandcustomerlockin(ifcommercial)

–  Entrybarriersbasedone.g.proprietaryelementsandIPR(ifcommercial)

–  Customerlockup

InternetBusinessModels•  ThegrowthofInternetisnotthesamephenomenonasthedevelopmentofInternetEconomy

•  TheInternetopenedseveralsectorsforbusinessentrantsbypassingtradi1onalchannels:–  PortalsservingConsumertoConsumer(C2C)–  E-commerceasBusinesstoConsumer(B2C)–  Brokeringbetweenbusinesses(B2B)–  Subs1tu1onofpreviouselectronicsupplychainmanagementsystemsinsideandbetweencorpora1ons(B2B)

•  85%ofInternetbusinessvaluegloballyliesinB2Bandbackofficesystems(Kogut2003)

Summary

•  NewGrowthTheoryexplainsthefastproduc1vityincreaseandgrowtheffectsinnewindustrialsystemssuchasplaoormsandecosystemsbytheapplica1onanddistribu1onofknowledgeintheformofinnova1ons,patents,industrialstandards,competenciesandskills

•  Theplaoormorecosystemownersusuallyhave1ghtappropriabilitycondi1ons(industrialstandardownerships,patents,trademarksetc.)

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−  DatafromSta1s1csFinlandandOECD,2002-2017