The Two Faces of The Internet Economy
By J. Bradford Delong

(FORTUNE Magazine) – Determining a company's worth in today's schizophrenic market is, well, difficult, to say the least. Is the fundamental value of Amazon.com the $40 billion-plus the stock market gave it last December? The $15 billion the stock market gives it today? Or something much, much smaller? Is JDS Uniphase worth today's $90 billion? Or last summer's $20 billion? How about Kana Communications? Today's $3 billion, last April's $21 billion, or next to nothing at all? The wide fluctuations in stock market valuations reflect Wall Street's oscillation between two radically--and seemingly inconsistent--views of the new economy.

The first view is that technology has been a boon to competition. For instance, a decade ago making price comparisons was a lengthy process that probably involved many trips to stores and a stack of Consumer Reports; now swift search engines have made the process more efficient and quicker. They've also all but nullified reputations based on brand loyalty and advertising. As these advantages fade, profit margins fall. In this scenario, new-economy technologies are valuable to create wealth for consumers, but they're not foundations for highly profitable companies.

The second view is that the new economy creates a host of winner-takes-all markets. In the old days big producers had small cost advantages, but today they can reap huge savings. After all, companies designing software or online entertainment have essentially fixed costs; once a program is written, it can be copied for pennies. The version with the largest market share becomes the standard since it is the easiest to use, to support, and to accessorize. Unless competitors take extraordinary steps--as Microsoft did when it poured a fortune into creating and distributing a competing browser--the first firm to establish a dominant market position gains a license to print money. That is why Microsoft Windows dominates the desktop (Apple sought higher margins), why Cisco is a de facto standard for Internet hardware, and why JDS Uniphase dominates the production of optical components.

According to this second view, new-economy technologies are immensely valuable as creators of wealth and utility. The companies that are smart enough to make large up-front investments in market share also will reap a large share of the wealth creation. The new-economy stocks of these firms are, if anything, still undervalued.

Both of these arguments are reflected in the market, and stocks rise and fall depending on which one is in vogue. This duality obviously makes investors wonder, Are these things dogs or gold mines?

Both, actually. Like the fable about the blind philosophers studying the elephant--one thought the object was a wall, another thought it was a snake--the new economy is different depending on what part of it you touch. Generalizations across all sectors are inappropriate.

In industries like software, a product is made once and sold everywhere: Ten times the sales means one-tenth the costs. In each software market there's room for a leader to make lots of money and maybe an also-ran to break even; others are out of luck. Other winner-takes-all businesses are microprocessors (Intel), routers (Cisco), and even retail goods (Wal-Mart). In those industries, the new economy is a source of massive wealth for consumers and shareholders.

But there are a host of other industries in which economies of scale are not salient. Is it really possible for anyone to acquire significant economies of scale by distributing information about groceries over the Internet? Doubtful. Here, margins sink and profits are hard to earn and keep. This is exactly what is happening with Amazon.com. Shipping books products that are specific and have no value-added opportunities--is not a high-margin business. Amazon can't make the money it needs to justify its market valuation; other online booksellers and price-comparison shopping sites cut into its profits. Amazon's executives seem to realize this, and as the company evolves, it is branching into other products and positioning itself as a single-stop shopping destination.

The lessons for businesses are clear: Internet companies can generate high margins only if computing and communications enable the creation of economies of scale. The lessons for investors are also clear: Internet hype is justified if the value of a company's product increases as it is widely distributed. The lesson for the economy as a whole--the effect of wild valuations on our economic health--is up for grabs.

J. BRADFORD DELONG is a professor of economics at the University of California at Berkeley and co-editor of the Journal of Economic Perspectives. E-mail: delong@ econ.berkeley.edu; Website: www.j-bradford-delong.net.