Web 2.0 Doesn't Does Exist, eBay + Skype, and Network Scale Economies

OK. What is Web 2.0? Is there such a thing? Is it just FUD that non-geeks fall for? All questions that have been asked lately. Good ones, too - I think it's important to define this.

My answer is (you guessed it) about economics, not technology. I mention it below, in my Skype posting. Here it is: Web 2.0 is a shift to from tight, hierarchical architectures which realize exponential network FX, to loosely structured architecture which realize combinatorial network FX.

Hopefully, you can pretty simply see from the graphs what I'm talking about - that combinatorial gains (seriously) dominate exponential gains (seriously) dominate linear gains. If I can get a bit geeky for a sec, from a world of x^n, to a world of n^x, where n is network size, and x is utility/value/etc. This is Metcalfe vs Reed, if you like, although I think several economists were first to these ideas.

More simply, Web 2.0 is about the shift from network search economies, which realize mild exponential gains - your utility is bounded by the number of things (people, etc) you can find on the network - to network coordination economies, which realize combinatorial gains: your utility is bounded by the number of things (transactions, etc) you can do on the network.

The point is that this shift is combinatorial - each person can do X activities in a combinatorial network, and it's combinations of these activities that make value explode. Contrast with a exponential network, where it's the number of people on a network that create value. That is, a relationship between any two people is 1:1 in an exponential network, but many to many in a combinatorial network. It should be intuitive to you that the former kind of network has more potential for value creation.

The graphs make this pretty clear. They're meant to show what the sources of value for these three players are. Pretty clearly, eBay's main value driver is it's user base - the regression between revenues and users is almost perfect. It's not a combinatorial network; eBay is not creating value by letting activities scale faster than users. That means eBay is realizing almost no network scale economies.

Check out what Reed notes as a constraint to network FX:

"...each user typically has a fixed, small set of friends and family that they call all of the time. Since the value of these services to a particular user does not depend on the number of other users of the network, the total value of these services grows more slowly�proportional to N, not N�."

Does this sound familiar? It should - it's the eBay problem, in a nutshell.

Now, for Yahoo, and especially for Google, things get more interesting. They're deriving more and more revenue relative to users; there's not a simple linear relationship between users and value like there is for eBay. They are realizing network scale economies.

Clearly, users are not the primary value driver here - it's the transactions they engage in; that is, Google is creating (and capturing) more and more value from users as the user base grows, and Yahoo is trying, but only marginally succeeding.

The implication is that Google and Yahoo are mediating many to many relationships between users - transactions, if you like. Yahoo's deriving mild exponential gains from weak network economies, and Google is (almost) deriving combinatorial gains from strong network economies.

Why is Google realizing stronger economies? Well, pretty intuitively, it's done a much better job at both search and coordination. At least as far as online advertising goes, it's made it easy to find buyers and sellers, and to then close the deal relatively costlessly. Yahoo's still trying to find it's feet as a real maker of network markets, versus a simple aggregator/distributor, which is pretty clearly demonstrated by the graph (and should be intuitive).

This is an old theme of mine - from search to coordination. I hope this makes things a bit more concrete for those of you who I haven't chatted with.

I also hope it helps you see why so many people are getting excited about the value creation potential of Web 2.0. If the theory's right, it's going to be a very valuable market. And since the theory for Web 1.0 was pretty much on the money (despite the crash, evil ibankers, silly analysts, etc), I'd say fasten your seatbelts - note that I've used revenues in the graphs; in fact, I should've used a cap-based measure, which would have exaggerated scale effects (but didn't have time). In short, this is very real value creation we're talking about.

Technical notes: I should've used a cap-based measure; didn't have time. My user numbers are probably off, since they're based on Googled public data, but hopefully close to get the idea across. I'm also comparing global Yahoo to US Google. The scale effects should stay similar regardless. Oh yeah, and this post is really badly written, but again, no time to edit...sorry.

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