“Information Rules” is a competitive strategy framework articulated by economists Carl Shapiro and Hal Varian in their book of the same title released in 1999. The framework concerns companies in the knowledge industry that produce information products like software, recorded music and proprietary networks. The following aspects help to evaluate a knowledge company’s competitive advantage:
- High up-front, low incremental costs
- Network effects
- Customer lock-in
High up-front, low incremental costs
Many knowledge products are costly to come up with for the first time but once in digital form, they are rather inexpensive to replicate and distribute. For example, Microsoft’s costs to create a new Windows disk is high but replicating and distributing that disk is extremely cheap. Windows 2000 cost Microsoft $2 billion to create but subsequently, mass reproducing them was actually inexpensive. Therefore, knowledge-based companies enjoy increasing, and not diminishing, returns.
Network effects occur when the value of a product or services increases as more members use that product or service. Think of eBay. More sellers there are, more buyers there will be and vice versa. It’s a self-fulfilling cycle.
Once customers develop user skills with a certain product, they often hesitate to switch to a competing offering. Customers are “locked in” and they will be more open to purchasing highly profitable product upgrades than purchasing products from other sources. Lock-in includes brand-specific training and loyalty programs. Examples of lock-in are Adobe and Microsoft.
Giving away products (or heavily discounting them) in the short-term is often the best way for a company to build a long-term value. Established users will be valuable to the company as a source of future revenues through product upgrades.
Once customers are used to a certain interface or technology, link-and-leverage becomes a great way to create value. An example is Microsoft’s product evolution from operating systems to applications to internet access.
Thus, there are five ways to evaluate the competitive advantage of knowledge companies as shown above.