I read an interesting article in the latest issue of The Review of Network Economics, “The Economics of Digital Business Models” by Eric Brousseau and Thierry Penard. The authors discuss how ‘digital’ businesses like Internet-related companies or software firms create economic value and how specific factors lead to different types of business model emerging. They talk about many things, so I just wanted to highlight their insights into how Internet-related businesses create economic value.

First of all, how is economic value created by businesses in general? There are basically two ways: by creating something new that people want, or by producing an existing thing more efficiently and cheaply than existing producers. The Internet enables both of these things. At its most fundamental level, the Internet is a technology for transmitting information in digital form. This enables both new products and services like blogs, and more efficient production of existing things, like online auctions (it’s cheaper to facilitate auctions online via a website than to do them in real life).

Brousseau and Penard go into this idea in more detail. They talk about three specific things that digital or Internet-related businesses can do to create value, that I’m going to summarise and discuss here.

1. Making markets / reducing transaction costs

Market makers stand in between buyers and sellers of goods and mediate transactions between them. A few specific examples are stockmarkets, wholesale food markets, and auction houses. Making markets is a very information intensive business. You have to know who wants to buy what, who wants to sell what, and the prices that people are willing to pay to buy or want to receive in order to sell. Information technology obviously helps to make these kinds of activities more efficient and cheaper.

In addition, buyers and sellers often face ‘transaction costs’ to do business with each other. For example, finding the person who sells the product most similar to what you want to buy can be time consuming and costly. The process of trading can be costly too. For example, running an auction in the ‘real world’ is an expensive process. You need an auctioneer, a room, a way for people to view the things being sold, and so on. Reducing these transaction costs explains much of the success of eBay. It creates value by allowing people to run auctions at much lower cost than they otherwise would. This results in cheaper trades, and opens up many more opportunities for trading that would not otherwise exist.

On top of this, making a market is a costly activity, regardless of whether it’s done online or in the ‘real world’. There needs to be a place (physical or virtual) for the market transactions to take place in, and the market maker has to supervise the trading that takes place. However, Internet-based market makers probably have more opportunities to exploit economies of scale compared to traditional market makers. Economies of scale occur when the average cost of producing something increases the more of it that you produce. Setting up a website is costly, and you need to spend more as your traffic grows, but the costs of supporting, say, an online auction market with 100 million members are almost certainly less than doing the same thing in the real world.

2. Packaging information goods together / customisation

‘Information goods’ are things that people consume that consist primarily of ‘information’ in some form. Examples include news, books, music, movies, and software. The Internet enables the transmission of these goods in digital form. Typically, information goods are highly modular. This means that they can be broken down into discrete pieces and combined in different ways. I’m not talking about bits and bytes. What I mean is that, say, a newspaper is composed of a number of discrete articles, each of which could stand on its own. A newspaper is valuable because it puts these discrete pieces together. However, newspapers are not very flexible — it’s too expensive to print customised newspapers for everyone.

With digital information goods, customisation is much easier and cheaper. A news website can easily offer the ability for readers to customise the categories of news that they see. This brings the product closer to what people want, and it’s valuable for that reason. The possibilities for customisation also explain some of the success of Apple’s iTunes service. By breaking albums down into individual songs and offering them for sale separately, iTunes allows music listeners to construct a customised bundle of their favourite songs. This is one way that iTunes creates economic value.

3. Knowledge management

Finally, knowledge is a valuable thing for several reasons. Without getting too philosophical, people value knowledge because it allows them to do things and understand how the world works. Knowledge can be represented in digital form, as words or other data, and can be transmitted between people via the Internet. Sites like Wikipedia are valuable because they collect and disseminate knowledge.

From a business point of view, knowledge about customers is also often valuable. Firms can make more money if they have better knowledge about what their customers want and what they are willing to pay. In a traditional retail business, say, the retailer has very little knowledge about their customers. If you go into a bookstore and buy a book, the shop doesn’t know who you are and probably won’t remember what you bought previously when you next come to the shop. An online retailer such as Amazon has much more information about its customers. Since you have to log in to the site to make purchases, they know your purchase history when you visit the site. They also probably know your address and some other personal information. They can use this information to improve the products and services that they offer.

Summary: Where the value comes from

Brousseau and Penard describe how Internet businesses create economic value through these channels:

• Improving efficiency in information-intensive activities like making markets and knowledge management.
• The modularity of digital products means they can be easily customised to suit people’s preferences.
• Reducing the costs of transacting and exploiting economies of scale in online market-making.
• Reduced costs and improved efficiency in knowledge management.
• Greater opportunities to gain knowledge about customers and their behaviour.