Winner Take All: Competition, Strategy, and the Structure of Returns in the Internet Economy

ABSTRACT: In this paper, we develop an economic rationale for a the following stylized facts: Web-based firms command high (and highly-volatile) valuations relative to earnings, spend profligately on advertising and marketing, and usually lose money. Our rationale is based on the winner-take-all structure of high-fixed-cost, low-marginal-cost, markets for information goods. This market structure ensures that market participation and the investment strategy are highly stochastic. Moreover, if a firm chooses to participate in a web market, it is optimal to act very aggressively through saturation advertising. While increases in advertising costs reduce the probability of entry, once the decision to enter is made, firm strategies are insensitive to advertising price. These competitive strategies generate returns that are highly positively skewed, following a Pareto-like distribution. Thus, firms have a small chance of huge gains combined with a large probability of ruin. In dynamic competition, firms weakened by early rounds are is less likely to challenge in subsequent rounds. However, when a challenge is attempted, it is always aggressive. In addition, since large expenditures in the first period produce valuable strategic real options in later periods, which are treated as expenses using traditional accounting methodology, the financial valuation of internet firms may actually be negatively related to performance using standard accounting measures of profitability that fail to capitalize these strategic real options.

ACKNOWLEDGMENTS: We would like to thank seminar participants at the Boston College, New York University, the University of Alabama, and the 2000 Workshop on Information Systems and Economics for helpful comments. The usual disclaimer applies.