The Option Value of Open Connectivity
In a January 26, 2000, Op-ed piece in the Wall Street Journal entitled "Business World: Let's Have a 'Closed Access' Free-for-All", Holdman W. Jenkins, Jr., took AT&T to task for considering opening its communications lines (especially cable) to content providers other than itself. He said:

AT&T is spending billions to buy cable networks and turn them into two-way systems to deliver voice, video, text and graphics to millions of subscribers. Everyone knows, though, that merely carrying digits from one place to another--the "dumb pipe" option--is doomed to become a commodity business. In the "information age," the value comes from information.

He ends with:

Dumb pipe equals poor shareholders, equals AT&T as patsy in an AOL world.

I've been reading some private emails reacting to his assertions, and got permission from David Reed to post some of it here.

David makes some interesting arguments about the value of open systems, especially the "option value" of unforeseen new things that will be created by others from which you will benefit. He backs it up with historic precedent.

Dvid Reed's reaction:
There's a straightforward business case for specializing in pipes. It's the same as the case for "open operating systems".

You may recall that back in the "bad old days" (pre-DOS and pre-Lattice/Borland C compilers), application vendors had to beg OS and compiler vendors for the privilege of offering applications on top of the OS or built using the languages (typically in the form of license structures that passed through some part of each application buyer's price back to the OS vendor or compiler vendor).

This was very typical in mainframe and even minicomputer situations. It was the death of the Xerox Star (Xerox refused to allow ISV's to develop software for the Star without hefty upfront payment), and was going to be the case with Oak, the old name of Java. The closed system licenses still apply in video game console markets (Sega, Nintendo, Sony) and so forth, and in the WAP phone market as well.

But it's incredibly clear, based on the experience with the Apple II and MSDOS/Windows, that by enabling anyone to develop new applications on the OS platform without upfront fees, that Apple and Microsoft were able to develop and capture dominant chunks of much larger markets much faster with much smaller investments of their own $.

It's the "stone soup" model of business growth and development.

It does not apply to mature markets where the applications/uses of the capability are well understood and a small team can write the basic market requirements with little risk of being wrong.

But where there is large uncertainty and risk, it is much smarter to diffuse the risk.

I'm reminded of a wonderful, but DEAD WRONG, technical report by Butler Lampson and Dave Tennenhouse in which they argue that the _only possible economic justification_ for HFC residential data networks was distributing 2 hour Hollywood movies to homes. They then went on to size that market and predict the rate of technology investment that such demand might justify.

What was wrong was that those authors discounted completely the "option value" (in strict economic terms) of enabling a whole class of unanticipated, and unpredictable uses yet to be discovered (such as e-commerce web sites with JPEG images, ...) would be able to justify the rollout in a way that would encourage venture capitalists to risk money on the theory that the economy would basically be restructured around the potential value of the platform.

This option value is real, and can be quite large. Option value is well established in economic analysis. The WSJ author, like many businessmen who live in "mature" industries where there is no option value, does not get it.

In a later email, he added:
Bob's main concern, and mine, can be summarized in one phrase.

"Connectivity needs to be subsidized by content".

That statement is demonstrably incorrect.

It serves the purpose of the would-be monopolist in confusing the issue.

Underlying that statement are two erroneous propositions.

1. [expensive connectivity] Connectivity is too expensive to build out and operate, so must be "subsidized".

2. [content is king] The idea that the only valuable (or the dominant valuable) item being delivered on a network is "content" - stuff that is rare and concentrated in the hands of a few, which is of interest to many, and which those many will pay dearly for.

It's sad, but when connectivity providers get out their accounting books, they seem to be able to make $600 toilet seats seem like a bargain. The actual facts are that the cost structure of connectivity is falling through the floor. But those who would question the cost figures are attacked vehemently.

The Internet proves that communication, commerce, and affiliation are where much value is, not proprietary content. Content is not proprietary to the communications carriers - it is largely sourced in a distributed way throughout the network. Only by schemes that block categories of communication can a communication provider make a claim to "providing" content. A better term would be "extorting content". The investment made by MCI or AT&T in creating the communications, commerce or affiliation assets of the Internet has been vanishingly small, yet they have been large and very profitable investors in connectivity to support those things. Given their lack of investment, why should they be rewarded for the efforts of millions of others? They can be rewarded for what they actually produce.

The discussion so far above completely discounts the value of innovations yet to be created in the areas of connectivity, commerce, affiliation, etc.  And there is some reason to believe that that's the largest value of all.

Why at this date are we trying to reinvent the sterile local telephone monopolies that discouraged AT&T from innovating in the service it provided for 50 years? Do we really believe that goverment-supported, monopolistic control of what customers can buy and who they can buy it from has ever led to innovation?
- David

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