{"id":1185,"date":"2008-10-27T14:37:40","date_gmt":"2008-10-27T20:37:40","guid":{"rendered":"https:\/\/www.roughtype.com\/wp\/?p=1185"},"modified":"2008-10-27T14:37:40","modified_gmt":"2008-10-27T20:37:40","slug":"further_thought","status":"publish","type":"post","link":"https:\/\/www.roughtype.com\/?p=1185","title":{"rendered":"Further musings on the network effect and the cloud"},"content":{"rendered":"

Tim O’Reilly, in a comment on my earlier post<\/a> about how he overstates the importance of the network effect, writes: “… you failed to address my main point, namely that cloud computing is likely to be a low-margin business, with the high margin applications found elsewhere.”<\/p>\n

Let me try to correct that oversight.<\/p>\n

O’Reilly is here using “cloud computing” in the narrow sense of offering for-fee access to utility data centers for basic computing “infrastructure” encompassing compute cycles, data storage, and network bandwidth (a la Amazon Web Services or Windows Azure). I would definitely agree that this will be – and should be! – a low-margin business, as is generally the case with utility industries. (O’Reilly seems to dislike big low-margin businesses. Personally, I’m fond of them.) Success in a capital-intensive utility industry often hinges on maximizing usage in order to utilize your capital equipment as productively as possible; seeking high margins, by keeping prices high, can actually be self-defeating in that it can constrain usage and lead to suboptimal capacity utilization. I would also argue that the infrastructure side of cloud computing will likely come to be dominated by a relatively small number of firms that will tend to be quite large, which is quite different from the fragmented hosting business that O’Reilly believes will be the model for the infrastructure cloud.<\/p>\n

Where I have a real problem with O’Reilly’s argument, though, is when he goes on to suggest that the low-margin characteristics of the cloud infrastructure business can be best explained by the lack of a strong network effect in that business. That’s balderdash. If you were to list the determinants of the profitability of the cloud infrastructure business, the lack of a strong network effect would be way down the list. O’Reilly appears to be suffering from a touch of tunnel vision here. The network effect is his hammer, and he’s looking for nails.<\/p>\n

As to O’Reilly’s belief that at least some cloud applications will be relatively high-margin businesses (in comparison with running the infrastructure), I have no beef with that view. I would even be happy to agree that in some cases the network effect will be a source of those high margins. I would strongly disagree with O’Reilly’s idea that a strong network effect will be the only source, or the primary source, of high margins in the web app business. (“Ultimately, on the network, applications win if they get better the more people use them<\/i>,” he declared. “As I pointed out back in 2005, Google, Amazon, ebay, craigslist, wikipedia, and all other Web 2.0 superstar applications have this in common.”*) There will be plenty of other potential paths to high margins: like creating a good, useful, distinctive software tool, for instance, or creating a strong brand, or achieving some form of lock-in (as horrible as that may sound).<\/p>\n

Digression: <\/i><\/p>\n

I note that today O’Reilly is expanding<\/a> his definition of “network effect” far beyond his original definition of “applications that get better the more people use them.” He now dismisses his earlier definition as a “simplistic” definition, even though it’s the generally accepted definition. (As Liebowitz and Margolis explain<\/a>, the network effect “has been defined as a change in the benefit, or surplus, that an agent derives from a good when the number of other agents consuming the same kind of good changes. As fax machines increase in popularity, for example, your fax machine becomes increasingly valuable since you will have greater use for it.”) If I were O’Reilly, I would also expand the definition of the term. After all, the broader you define “network effect,” the more phenomena you can cram under its rubric.<\/p>\n

But, since O’Reilly continues to reject my contention that Google’s success cannot be explained by the network effect, let me defer to a higher authority: Hal Varian. Professor Varian is not only one of the smartest explicators of the network effect and its implications but is now a top strategist with Google. The following is an excerpt from a Q&A<\/a> with Varian from earlier this year:<\/p>\n

\n

Q: How can we explain the fairly entrenched position of Google, even though the differences in search algorithms are now only recognizable at the margins? Is there some hidden network effect that makes it better for all of us to use the same search engine?<\/p>\n

A: The traditional forces that support market entrenchment, such as network effects<\/b>, scale economies, and switching costs, don\u2019t really apply to Google. To explain Google\u2019s success, you have to go back to a much older economics concept: learning by doing. Google has been doing Web search for nearly 10 years, so it\u2019s not surprising that we do it better than our competitors. And we\u2019re working very hard to keep it that way!<\/p><\/blockquote>\n

Yes, Google is adept at mining valuable information from the Net, and the value of that information tends to go up as more people use the Net. Yes, Google runs auctions that become more valuable as more traders join. Yes, web activity in general is a complement<\/a> to Google’s core profit-making business. But that doesn’t change the fact that there’s little or no network effect in the use of Google’s search engine. The benefit I derive from Google’s search engine does not increase as more people use it. Period.<\/p>\n

End of digression.<\/i><\/p>\n

I think O’Reilly did a nice job of identifying the different layers of the cloud computing business – infrastructure, development platform, applications – and I think he’s right that they’ll have different economic and competitive characteristics. One thing we don’t know yet, though, is whether those layers will in the long run exist as separate industry sectors or whether they’ll collapse into a single supply model. In other words, will the infrastructure suppliers also come to dominate the supply of apps? Google and Microsoft are obviously trying to play across all three layers, while Amazon so far seems content to focus on the infrastructure business and Salesforce is expanding from the apps layer to the development platform layer. The degree to which the layers remain, or don’t remain, discrete business sectors will play a huge role in determining the ultimate shape, economics, and degree of consolidation in cloud computing.<\/p>\n

Let me end on a speculative note: There’s one layer in the cloud that O’Reilly failed to mention, and that layer is actually on top of the application layer. It’s what I’ll call the device layer – encompassing all the various appliances people will use to tap the cloud – and it may ultimately come to be the most interesting layer. A hundred years ago, when Tesla, Westinghouse, Insull, and others were building the cloud of that time – the electric grid – companies viewed the effort in terms of the inputs<\/i> to their business: in particular, the power they needed to run the machines that produced the goods they sold. But the real revolutionary aspect of the electric grid was not the way it changed business inputs – though that was indeed dramatic – but the way it changed business outputs<\/i>. After the grid was built, we saw an avalanche of new products outfitted with electric cords, many of which were inconceivable before the grid’s arrival. The real fortunes were made by those companies that thought most creatively about the devices that consumers would plug into the grid. Today, we’re already seeing hints of the device layer – of the cloud as output rather than input. Look at the way, for instance, that the little old iPod has shaped the digital music cloud.<\/p>\n

Today, we tend to look at the cloud through the eyes of the geek. In the long run, the most successful companies will likely be those that look at the cloud through the eyes of the consumer.<\/p>\n

*UPDATE: I just realized that O’Reilly tempered this statement in his comment on my earlier post, writing, “I agree that I probably am overstating the case when I say that this is the only source of business advantage. Of course it isn’t.” Clarification accepted.<\/p>\n

UPDATE: Meanwhile, Tim Bray warns against<\/a> jumping to conclusions about the ultimate shape of the cloud based on what we’ve seen to date. Everything could change in an Internet minute: “Amazon Web Services smells like Altavista to me; a huge step in a good direction. But there are some very good Big Ideas waiting out there to launch, probably incubating right now in a garage or grad school.” The spreadsheet is to the PC as the _______ is to the cloud. Fill in the blank, and win a big prize.<\/p>\n","protected":false},"excerpt":{"rendered":"

Tim O’Reilly, in a comment on my earlier post about how he overstates the importance of the network effect, writes: “… you failed to address my main point, namely that cloud computing is likely to be a low-margin business, with the high margin applications found elsewhere.” Let me try to correct that oversight. O’Reilly is […]<\/p>\n","protected":false},"author":1,"featured_media":0,"comment_status":"open","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_jetpack_newsletter_access":"","_jetpack_dont_email_post_to_subs":false,"_jetpack_newsletter_tier_id":0,"_jetpack_memberships_contains_paywalled_content":false,"_jetpack_feature_clip_id":0,"_jetpack_memberships_contains_paid_content":false,"footnotes":"","jetpack_publicize_message":"","jetpack_publicize_feature_enabled":true,"jetpack_social_post_already_shared":false,"jetpack_social_options":{"image_generator_settings":{"template":"highway","default_image_id":0,"font":"","enabled":false},"version":2},"jetpack_post_was_ever_published":false},"categories":[1],"tags":[],"class_list":["post-1185","post","type-post","status-publish","format-standard","hentry","category-uncategorized"],"jetpack_publicize_connections":[],"jetpack_sharing_enabled":true,"jetpack_featured_media_url":"","_links":{"self":[{"href":"https:\/\/www.roughtype.com\/index.php?rest_route=\/wp\/v2\/posts\/1185","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/www.roughtype.com\/index.php?rest_route=\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/www.roughtype.com\/index.php?rest_route=\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/www.roughtype.com\/index.php?rest_route=\/wp\/v2\/users\/1"}],"replies":[{"embeddable":true,"href":"https:\/\/www.roughtype.com\/index.php?rest_route=%2Fwp%2Fv2%2Fcomments&post=1185"}],"version-history":[{"count":0,"href":"https:\/\/www.roughtype.com\/index.php?rest_route=\/wp\/v2\/posts\/1185\/revisions"}],"wp:attachment":[{"href":"https:\/\/www.roughtype.com\/index.php?rest_route=%2Fwp%2Fv2%2Fmedia&parent=1185"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.roughtype.com\/index.php?rest_route=%2Fwp%2Fv2%2Fcategories&post=1185"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.roughtype.com\/index.php?rest_route=%2Fwp%2Fv2%2Ftags&post=1185"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}