March 22, 2009

Internet Economics -part III

Computers stripped down:

I do not see hardware companies with exclusive consumer offerings doing very well in the long term. End user computers will be so stripped down of any horse power or might as most of its computing power shift to the Internet, as I have discussed in my earlier post. Look at some of the strategic actions of the following companies:

  • IBM divested from all things consumer hardware.
  • HP have boosted its data centre management with the purchase of EDS.
  • Dell is struggling to regain market share.

Remember Sun's "the network is the computer" tag line; it makes a lot of sense now. Moreover the computing infrastructure is ready for it. I see computer makers designing and selling for utility providers, to the Google and Amazons of the world. Consumers will use Net-books to access their computing power. Those thin terminals have not taken off before because the utility model was not mature. Now I think it is a better environment. Currently I do most of my applications from online providers, whether business or personal. I hardly use any application from my hard drive. Once my laptop kicks the bucket I am in for a net-book that will cost me $200 or so.

So my conclusion here is to stay away from computer makers who are making heavy investment in distribution channels and goods geared to consumers and look for those with good distribution network with utility businesses.

Free Labour:

The Internet has introduced free labour to many industries like media and software. Think of the contribution of bloggers and content on YouTube. Also, think the volume of applications being used thanks to open source code and other free software used on the Internet like Google Docs...etc. Many have created profitable businesses using this model whether by supplying the infrastructure like YouTube and Blogger applications or by providing the content like blog posts. Participants are benefiting mainly by attracting advertising revenue. I am arguing that this model is unsustainable.

The Internet and computing power over the years have lead to two hard trends:

  1. globalization: the shifting of manufacturing jobs to low cost producing countries, and
  2. automation: the replacement of routine task by machines

Both trends have resulted and continue to result in jobs displacement. Job displacement will have to reach a limit where it will affect people who supply the free labour to the Internet eco-system. This will have two outcomes:
  1. loss of advertising dollars as advertisers do not want to advertise to unemployed people who can't purchase their goods, and
  2. the labourer will be so occupied about their livelihood that will consume most of their time to prevent them from being a participant in the Internet free labour force.

The idea that you can give things away online, and hope that advertising revenue will somehow materialise later on, undoubtedly appeals to users, who enjoy free services as a result. There is business logic to it, too. The nature of the internet means that the barrier to entry for new companies is very low—indeed, thanks to technological improvements, it is even lower in the Web 2.0 era than it was in the dotcom era. The internet also allows companies to exploit network effects to attract and retain users very quickly and cheaply. So it is not surprising that rival search engines, social networks or video-sharing sites give their services away in order to attract users, and put the difficult question of how to make money to one side. If you worry too much about a revenue model early on, you risk being left behind.Ultimately, though, every business needs revenues—and advertising, it transpires, is not going to provide enough.

Free content and services were a beguiling idea. But the lesson of two internet bubbles is that somebody somewhere is going to have to pick up the tab for lunch.
Source: Economist 2009

Today it is a new phenomena that it will take time to play out but the economics of the Internet will impact us and soon it will force us to change our social behaviour yet again.


Anonymous said...

I'm afraid that I totally disagree with your conclusions. First, you mention that the internet and increased computing power has been increasing the amount of automation and globalization in economies. I would point out that these forces have been around MUCH longer than the internet has. They've been around for centuries, and I would argue that the internet is simply a continuation of that trend. Next, you argue that this will result in increased unemployment, and through that decreased advertising dollars that internet companies rely on so that they can provide free services. Given that these forces have been around for so long, and that unemployment rates have not had a historical up trend, I can only conclude that your conclusion has no factual backing at all.

Finally, the Economist article you use in support of your claim that ad revenues cannot make an internet company profitable neglects to mention (in your quote, anyway) a very large exception to that claim. Google profits amazingly from ad revenues... by providing free services. So when they say "every business needs revenues—and advertising, it transpires, is not going to provide enough", they are wrong in general, because it can be done.

Sami said...

I would expect a lot of people to disagree since we are talking about the future.

The internet has accelerated both trends I talk about. Before the internet and broadband technologies thanks to the internet bust, support centres were largely in the US now they are mostly in India. research and development centres are being shift to where talent is relatively cheaper and it made possible due to infrastructure that is conducive for collaboration by internet technologies.

As for manufacturing jobs, yes I agree it has been occurring well before the internet but with it the trend has accelerated due to abilities to manage document flow better and supply chain technologies that use the openness of the internet to exchange and collaborate faster on documentation making trade flow much easier and faster.

Look at the composition of employment in the US it is mainly entry level jobs. The talented few will always find job but that is the reserved for the very best at what they do not for the average or marginal employee, and that trend will intensify sadly. you better be good at what you do or your standard of living will sadly deteriorate and if that happen you will be hard pressed to find time to participate in the free labour structure that is happening now, and eventually the pullout of people due to economic reasons will weaken that system and make it unsustainable.

Anonymous said...

Hello again. I'm afraid I disagree with a bit of your response as well! I think I agree that the internet has accelerated the changes in the economy. However, I'd have to see some numbers to convince me that the US labor market is composed of mainly entry level jobs (and comparisons with previous years, to convince me that this is different than before).

You argue that only the most talented people will be the only ones to find decent jobs in the future, and that the rest of us will (presumably) have to work our asses off in crappy entry level jobs (and so can't work for free by making internet content). I don't think that will be the case. It is true that there is a trend for more skilled people to get higher and higher wages, especially when compared with unskilled people. But I don't see this causing a decrease in the amount of free stuff on the internet.

Providing free stuff on the internet can only exist (as a business model, anyway) if it is supporting some other service. For example, if it draws people's eyeballs to the site, and so advertising space can be sold. Or if a popular website sells memorabilia (like xkcd t-shirts). Or if an anti-virus provider gives a basic version away for free to make it more well known, but sells an extensive version for businesses or extra-paranoid people (like AVG does). The business model that consists of giving away stuff for free won't work unless it is able to drive more demand to that other service. I don't see anything making this effect go away any time soon.

Anyway, that's my 2 cents. Only time will tell who is right!

Sami said...

thanks for the input.

i agree with the point you making to give basic elements for free and charge for more services that is a pricing strategy and it will be I think the main model for many.

Anonymous said...

I recently came accross your blog and have been reading along. I thought I would leave my first comment. I dont know what to say except that I have enjoyed reading. Nice blog. I will keep visiting this blog very often.


Sivaram Velauthapillai said...

Interesting series you have goine here :)

I think your first point (i.e. computer hardware companies going bankrupt) may take a long time (I'm thinking 10 to 30 years.) People are doing more and more online, and with "thin" devices but there are a couple of reasons why things may not change rapidly.

The consensus in the late 90's was for everyone to do everything through the Internet, yet it turned into a bust. It's not that it didn't happen; it's just that it was very slow. For instance, instead of online retail sales being 50% of the total within a decade, they are just barely approaching 10% in 2008, if I recall the numbers correctly. I think what you are suggesting may follow a similar path. Namely, it could happen but it will be very slow.

I think the main reason it will be slow is because, although it is never clear what drives the computer industry, many, including me, believe it is driven by business spending. This was clearly the case in the 80's (business is what made PCs popular) but it's debatable now. Nevertheless, I would argue that information technology spending by businesses probably drive the market. Even if they don't drive it, they play a major role.

If we go with the view that business spending plays a big role, then it is difficult for me to see how the computer market will change much, even on the consumer side. One of the problems with an Internet-oriented, thin PC-type, solution is that they will be very general and limited. Desktop computers became popular because they were general purpose and could perform many tasks. A machine can run accounting software as well as it can run a word processor or a computer game. Perhaps some common software such as a word processor or a spreadsheet can be offered online at a low cost right now. But a lot of businesses depend on specialized accounting software, databases, engineering software, and so on. At some point those software may be available in an online platform but it will take a long time. I just don't see any start-up or an online-only software company outspending an established desktop software company.


Regarding your second point, I agree with what you are saying for the most part. I also view many of the current online companies as having no viable business model. I hate to say it, because all of us benefit from free and low-cost stuff, but some of it is going to come tumbling down any minute now. I really feel like venture capital has been financing many of these projects and many don't seem to have any way of generating profit.

For example, consider Twitter. I have nothing against the company and don't really use their product but how are they ever going to make any money? I guess they can insert some ads into the tweets but will the consumer ever put up with that? I really wonder.

The consensus, including Wall Street, seems to view advertising as being sufficient for many of these free projects but I don't think it's going to work. Some companies, like Google, can survive because they are simply stealing advertising dollars from traditional companies (e.g. newspapers, yellow pages, etc) because that is what Google is replicating (to a large degree.) But advertising is unlikely to work or be sufficient for many others who are not really displacing traditional companies.

John said...


I have worked in the Internet advertising business for many years. Companies like Google have an excellent business model and generate significant free cash flow.

The next Internet bubble will be caused by the fact that investors do not yet see that Goggle and others should be valued just like any other company. Take the earnings, project the growth and work it back to EPS and PE.

Google was never worth $600 a share. Even at today’s price of $350 it is at least 2X to 3X too high.

The bottom line is that Google and others are great companies – but they are still over priced by far. When the market figures this out – the next bubble will burst.


Sami said...

yes I agree with you Google and amazon valuation are still unreasonable. great business model but valuation is still high.

hardware companies with consumer focus I doubt that they will be in making any money from consumer hardware, as it is their margins right now are razor thin. Off course the timeline can be longer but as a business model is not viable.