During the dot-com boom of the 1990s, Shane Greenstein routinely met entrepreneurs who believed that economic forces did not apply to their precious startups. As an economist, this bugged the hell out of him.
“I encountered two types,” says Greenstein, the MBA Class of 1957 professor of business administration at Harvard Business School. “One was the techy engineer sort who said, ‘I don’t have to know anything about business. Business will take care of itself.’ The other was the business type who said, ‘We don’t have to have a revenue model yet. Don’t worry about it. It will appear.’”
“E-mail and corn deployed much in the same way”
Greenstein dubs it “Internet exceptionalism”—this idea that the Internet is a technological innovation that defies economic logic, that there’s never been anything like it in business history, and that its impact supersedes everything. “It’s a pernicious myth,” he says.
His new book aims to replace Internet exceptionalism with a logical framework based on durable patterns of economic behavior. In How the Internet Became Commercial: Innovation, Privatization, and the Birth of a New Network, Greenstein looks at how the Internet evolved from a government-owned network (used primarily by military and university researchers) to a powerful profit engine (used by pretty much everybody). Marrying industry anecdotes and economic theory, the book examines the factors that created the Internet we know today.
The book is different from many other books on business history in that it focuses on innovation and commercialization rather than invention. Greenstein defines innovation as “the act of turning invention into something useful.” Commercial forces, he argues, turned the Internet into something useful.
While the government laid the groundwork for the information superhighway, pockets of industry outsiders were responsible for paving it. “A set of actors from outside the core played the instrumental role in commercializing the Internet,” Greenstein says. “This was innovation from the edges.”
What do corn and e-mail have in common?
Greenstein says the Internet follows economic archetypes—patterns of economic behavior that show up repeatedly throughout history. “Economic archetypes are not unique to the Internet and have appeared in other markets or time periods,” he writes in the book.
Greenstein compares the spread of the Internet in the 1990s to the spread of hybrid corn in the 1930s. (McCormick-Deering Ronning field ensilage corn harvester, 1930. Industrial Life Photograph Collection, Baker Library, Harvard Business School.)In one example, Greenstein equates the spread of the Internet in the 1990s to the spread of hybrid corn in the 1930s, citing the work of the late economist Zvi Griliches, who chaired the Harvard Department of Economics from 1980 to 1983. In the seminal 1957 paper “Hybrid Corn: An Exploration in the Economics of Technological Change, Griliches was the first scholar to argue that economic forces drive technological innovation. (Previously, economists had treated technology as an exogenous force, immune to the rules of economics.) In How the Internet Became Commercial, Greenstein reminds us that Griliches’ findings hold true in the Internet age, too.
“E-mail and corn deployed much in the same way, which is not an obvious connection,” Greenstein says.
In their infancy, Greenstein explains, both e-mail and hybrid corn faced an “adaptation conundrum.” To succeed on a large scale, they needed to spread into new applications and circumstances and to prove distinctively valuable to everyone who might use them.
In the case of corn, suppliers had to juggle the demands of buyers in different geographies (and therefore different agricultural needs), as well as keep up with the growing number of uses for corn. With e-mail, there were millions of customers subscribing to many Internet service providers operating under various standards. “You did not get the same kind of e-mail everywhere at the same time in 1996,” Greenstein says. “In fact, it had to be adapted in multiple ways, in multiple locations, in multiple circumstances.”
Fateful policy choices
Scholars and industry insiders sometimes debate whether the Internet achieved commercial success because of government policy or in spite of it. “For the most part, I’m on the because-of-it side,” Greenstein says.
That said, he believes that the commercialization of the Internet wasn’t a purposeful governmental orchestration but rather a matter of the government making decisions that enabled something huge, built up by a bunch of small players.
“The 30,000 foot lesson of the Internet is that it’s not designed by the government,” Greenstein says. “There’s no architect. There’s no one person who designed the whole thing. Part of what supported it was lack of concentration from the authority. The other big part was a modular architecture and open governance structure. That supported many so-called ‘innovative specialists,’ who really did much of the investing and building, which accumulated over time.”
He also notes that many of these government policies only incidentally and retrospectively supported the Internet. “Ninety percent of the time it looks as if all these government actors were trying to support innovation from the edges,” Greenstein says. “It’s as if many government policy makers had a strategy to coordinate, but obviously that is not possible across so much time and so many decision makers. How did that happen? It’s one of the big puzzles of the book.”
Early in the book, for instance, he talks about how the 1982 government-ordered divestiture of AT&T created multiple Baby Bells, whose decisions would prove integral to developing the industry, although the Department of Justice couldn’t have known that at the time. “The divestiture was essential to the later growth of the Internet,” Greenstein says. “It eliminated the ability of one firm to veto what happened next with the Internet.”
He discusses the Federal Communications Commission’s decision to open up a particular swath of radio spectrum for unlicensed use. At the time, that spectrum, the 2.4-GHz band, was largely relegated to garage door openers, wireless handsets for landline telephones, and baby monitors. “Those three applications were regarded as ‘garbage’ by snobbish engineers because they were technically uninteresting,” Greenstein says. “They called the spectrum ‘garbage,’ too.”
That “garbage spectrum” eventually became home to Wi-Fi.
“By making it unlicensed, the FCC permitted the dominant use to migrate from the low value to a higher value,” Greenstein says. “To an economist, that’s a wonderful thing. They got rid of the Gordian knot that results from the hoarding of licensed spectrum, which you see quite a lot in the spectrum world.”
And he writes about the National Science Foundation grants that allowed Larry Page and Sergey Brin to conduct research at Stanford University, which eventually gave rise to Google. It wasn’t that the foundation guided the research, but rather that it granted the freedom for the researchers (and their academic advisers) to pursue new opportunities as they arose.
“Did the NSF intend to renew the market for ad-supported Web pages?” Greenstein writes. “No, that was not the direct intent of its funding. However, the flexibility of their funding process helped indirectly, because it raised the chances that the research would be relevant.”
Lessons learned
In addition to examining the factors that led to commercial success, the book also discusses several commercial flops—namely, companies that crashed and burned after falling prey to the idea of Internet exceptionalism.
Case in point: Webvan, the online grocer that went bankrupt in 2001, less than two years after a 1999 initial public offering in which it achieved a whopping $7.9 billion valuation in its first day of trading. Caught up in the dot-com bubble, the company stubbornly flouted basic economic tenets throughout its brief history. The company incurred high sunk costs upon entering the market, as well as high fixed costs during operations. Meanwhile, its margins were low, and its customer base was too small in too many geographic locations.
“How did the Webvan people convince themselves that somehow they could live by a different set of rules?” Greenstein asks. “The only thing that can explain this was that they believed and their investors believed that they didn’t have to play by the rules.”
Greenstein hopes How the Internet Became Commercial might serve as a cautionary tale for modern-day entrepreneurs who are too young to recall the booms and busts of the 1990s.
“The older I get, the more I realize that the kids just don’t get it,” he says. “I’ve been to too many tech conferences, sitting in the back, listening to business presentations and thinking, no, that’s a really bad idea. Don’t you remember what happened in 1996? We’ve been through this already. Don’t do that!”
WebVan impatiently launched in June 1999 after incorporating in 1997, and eventually lost more than $800 million. It proposed to revolutionize the grocery business by delivering groceries to households who ordered their groceries online. It recruited a well-known executive, George Sheehan, and gained financial backing from several big-name venture capitalists. It laid out an extensive plan to grow in major cities across the United States. It settled on a customer-friendly plan that would deliver groceries within thirty minutes of an order. It aspired to operate out of warehouses in less expensive locations, cutting out expensive retail space, so it could lower its costs enough to make it profitable to charge very low prices for groceries.
There were a few problems with this proposal, but the biggest was most apparent to anyone who had studied the business years earlier, when online grocery ordering and delivering had been tried on a small scale and had not yielded dramatic success. The logistics of delivering perishable products imposed large costs on operations. The prior experiences had not been flawed in any obvious way, and the previous generation of entrepreneurs had executed reasonably well. Try as they might, WebVan’s business was going to be more similar to prior attempts than different from them, despite being shinier, newer, and better publicized. WebVan could improve on the past in only incremental ways at most, but delivering the service at high scale in new facilities.
The economics could be stated in simple terms. WebVan incurred a large sunk cost to entering and incurred high fixed costs during operations. To justify the costs of those facilities and operations, WebVan had to generate large revenue over operating expense. Since the delivered groceries were generally priced at competitive levels and did not generate high margins, and delivery costs were high and did not command high prices, large revenue could be achieved only one way, through a high volume of orders. WebVan’s viability, therefore, came down to a simple economic question in every locale: how many households in a geographic area wanted groceries delivered, and could it become very large?
There were good reasons to be skeptical. The experience of one of the earlier entrants, Peapod, was well known and illustrated the constraints. Peapod started a small-scale version of the grocery delivery business in the Chicago area by partnering with existing grocery stores. They had operated this entrepreneurial business since 1989, improving it constantly, and had showed it was viable. Peapod’s experience also illustrated the challenges. No amount of operational cleverness could reduce the delivery costs—gasoline, vehicle maintenance, a driver’s time. It was expensive to send a van from a warehouse to a customer. No amount of clever marketing—online, in magazines, flyers on door posts, and even from the grocery store partner—could convince most users to pay much money for a delivery service, or use it at all.
The problem did not appear to be the software. It went to something for which no technical solution existed, to something innate in human behavior. Stated simply, users changed their shopping habits with reluctance.
That was so of even the savviest online users in the early 1990s. It was quite sensible, therefore, to expect later users to be more reluctant. After all, these were the most inexperienced online users. No amount of website genius could induce a new online user to break with old habits and do their shopping for groceries on a web page. No clever marketing tool could convince many shoppers to trust the selection of bananas to someone else. Many shoppers wanted to examine the day’s daily specials in person. Many wanted a tactile grocery experience, merely as a way to stretch their legs. Many parents with young children wanted an excuse to get out of a claustrophobic house to roam the aisles. All those simple factors prevented many households from making use of the online service.
None of WebVan’s senior management had extensive experience in the grocery business, or in the online grocery business. It is not surprising, therefore, that WebVan’s management convinced itself that it had something that had eluded previous pioneers. They proposed to build brand new warehouses to gain efficiencies from scale and reduce costs as low as they could go. They believed that the newer features of their well-funded web-based grocery would generate high demand.
The financial vulnerability of the proposal was plain to see: it only could be viable if it achieved a scale of use that no prior pioneer in online groceries had ever come close to achieving. Expensive warehouses and fancy operations would be too expensive if not employed at full capacity. The costs of delivery trucks and drivers would be too high unless demand grew to a point that spread those costs over many customers. The entire cost structure for the business would not be—could not be—low enough unless the business generated a large set of customers to use the capacity at or near its maximum.
In normal times that type of vulnerability would have led investors to call for a cautious expansion plan, reigning in the aspirations of the management. Investors might have asked for less cavalier uses of their money, requiring WebVan to, say, first experiment with different mixes of marketing and operational novelties in a friendly location, such as San Francisco, which had a technically sophisticated population spread around a dense urban location. Yet following the prevailing view, WebVan’s management eschewed caution. It avoided the cautious exploratory practices. WebVan’s management opened in several cities without first testing the concept in one city for an extended period of time.
What happened? Soon after starting it became obvious that WebVan did not differ that much from any of the pioneers. The online grocery business could generate some interest, but not nearly enough to gain the advantages of scale. WebVan could not make any of its financial goals.
Excerpted from How the Internet Became Commercial: Innovation, Privatization, and the Birth of a New Network by Shane Greenstein. Copyright 2015 by Princeton University Press. Reprinted by permission.