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Originally published Monday, July 7, 2008 at 12:00 AM

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Analysis

Google era reshaping business dynamics

Bill Gates, who ended full-time work at Microsoft last month, was perhaps the foremost applied economist of the second half of the 20th...

The New York Times

Bill Gates, who ended full-time work at Microsoft last month, was perhaps the foremost applied economist of the second half of the 20th century.

Gates and Microsoft fundamentally shaped how people think about the behavior of modern markets in which technology plays a central role. Under Gates, Microsoft also challenged the conventional wisdom about competition, business strategy and even antitrust law.

Now, in the early 21st century, Google is the company prompting a rethinking of assumptions.

Microsoft was a master at "network effects," the economics precept that the value of a product or service often rises as more people use it. That's not new. It was true of railways, telephones and fax machines, for example.

Microsoft, however, applied the power of network effects more lucratively than any company before it.

It attracted consumers and software developers to use its software that controls the basic operations of a personal computer. The more that people used Microsoft's operating system, the more that third-party developers built products to run on it, which attracted more users.

Microsoft's success snowballed, and the company owned the essential technology, making it harder for users and developers to switch to alternatives.

But the Internet has changed the rules of networked competition, partly because Internet software standards are more open than those in the PC industry. That helps explain why Microsoft has struggled to catch up with Google in the market for Internet search advertising.

Google's huge, widening lead in that business suggests that while some weapons of competition have changed, the market dynamics are similar, say economists and industry experts. At this stage, they note, Internet search appears a market that is winner take most, if not all.

Google, it seems, is the emerging dominant company in the Internet era, much as Microsoft was in the PC era. The study of networked businesses, market competition and antitrust law is being reconsidered in a new context, shaped by Google.

Google's explanation for its large share of the Internet search market — more than 60 percent — is simply that it is a finely honed learning machine. Its scientists constantly improve the relevance of search results for users and the efficiency of its advertising system for advertisers and publishers.

"The source of Google's competitive advantage is learning by doing," said Hal R. Varian, Google's chief economist.

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In the Internet marketplace, Varian notes, users can easily switch to another search engine by typing in another Web address, so there is no tight technology control, as there is with proprietary PC software. Similarly, Varian says, advertisers and publishers can switch fairly easily to rival ad networks.

But economists and analysts point out Google does have network advantages that present formidable obstacles to rivals. The "experience effects," they say, of users and advertisers familiar with Google's services make them less likely to switch.

There is, for example, a sizable cottage industry of experts who tailor Web sites to get higher rankings on search engines, which drive user traffic and thus ad revenues. These experts understandably focus their efforts on Google — another network effect, analysts say.

Google points out that personal data in its services like Web e-mail is not held in proprietary document formats, as it is in PC software. Formats aside, however, a person with a year or so of e-mail housed in Gmail is highly unlikely to switch as a practical matter, analysts say.

Taken together, these networked advantages enjoyed by Google are significant, most analysts agree. "It certainly does have an impact on whether other companies can be competitive threats to Google," said Michael Katz, an economist at New York University.

"But it's a very different way to lock people in than it was for Microsoft. It would be a lot easier for people to walk away from Google."

Michael Cusumano, a professor at the Sloan School of Management at Massachusetts Institute of Technology, sees the difference in terms of what he calls "direct network effects" and "indirect network effects."

The direct effects, he says, include software document formats and technology standards that are owned by one company and that are incompatible with a rival's technology. The indirect effects, he adds, include large numbers of users, the ability to learn from those users, the power of a well-known brand and user inertia.

"For Google," Cusumano said, "the indirect network effects are very powerful."

The implications for antitrust law are just beginning to be considered. The Justice Department is reviewing Google's planned partnership with Yahoo. Under the agreement, Yahoo, the No. 2 company in search, would farm out some of its search advertising to Google, the leader.

Google has said the deal is a voluntary outsourcing arrangement, while foes say it will reduce competition in search advertising even further.

Google's market share alone invites global scrutiny. In the U.S., antitrust law defines a dominant firm with potentially monopolistic power as one with 70 percent market share or more. In Europe, the definition of a dominant firm is one that has as little as 35 percent of a market, legal experts say.

Still, dominance alone is not an antitrust problem. The issue is the powerful company's behavior, says Andrew I. Gavil, a professor at the Howard University School of Law. "You have to be big and bad, not just big," he said.

The telltale signs of bad behavior include raising prices, hindering innovation and excluding competitors. There is no evidence Google is doing that, but it could be hard to see. Its ad auction system, for example, is essentially a private marketplace run by Google, without much disclosure to advertisers or Web publishers.

Google's Varian acknowledges the company has been criticized for its lack of transparency. But he says the Google approach is a byproduct of its virtue as a fast-moving learning machine. "The system is constantly evolving to optimize efficiency, improve ad quality and make the pricing smarter, so you don't want set rules that say, 'We do X, and we don't do Y,' " Varian said.

Whether that kind of "trust us" explanation will satisfy government regulators, if Google's market power continues to grow, remains to be seen. But Google seems to have learned a lesson from Microsoft. Varian said antitrust training is mandatory now for Google managers.

"Google looks at what happened to Microsoft, and we're going to follow the rules," he said. "If you're really successful, you need to know about antitrust. That goes with the territory."

Copyright © 2008 The Seattle Times Company

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