Pretend vs. Real Economy
6/8/1999
 
The Internet happened tD to Merrill Lynch last week, and it cost them a couple 
billion dollars -- when Merrill announced its plans to open an online brokerage after 
years of deriding the idea, its stock price promptly fell by a tenth, wiping out $2 
billion in its market capitalization. The internet's been happening like that to a lot 
of companies lately -- Barnes and Noble's internet stock is well below its recent 
launch price, Barry Diller's company had to drop its Lycos acquisition because of damage 
to the stock prices of both companies, and both Borders and Compaq dumped their CEOs 
after it became clear that they were losing internet market share. In all of these cases, 
those involved learned the hard way that the internet is a destroyer of net value for 
traditional businesses because the internet economy is fundamentally at odds with the 
market for internet stocks.

The internet that the stock market has been so in love with (call it the "Pretend 
Internet" for short) is all upside -- it enables companies to cut costs and compete 
without respect to geography. The internet that affects the way existing goods and 
services are sold, on the other hand (call it the "Real Internet"), forces companies to 
cut profit margins, and exposes them to competitors without respect to geography. On 
the Pretend Internet, new products will pave the way for enormous profitability arising 
from unspecified revenue streams. Meanwhile, on the Real Internet, prices have fallen 
and they can't get up. There is a rift here, and its fault line appears wherever offline 
companies like Merrill tie their stock to their internet offerings. Merrill currently 
pockets a hundred bucks every time it executes a trade, and when investors see that 
Merrill online is only charging $30 a trade, they see a serious loss of revenue. When 
they go on to notice that $30 is something like three times the going rate for an 
internet stock trade, they see more than loss of revenue, they see loss of value. When 
a company can cut its prices 70% and still be three times as expensive as its 
competitors, something has to give. Usually that is the company's stock price. 

The internet is the locus of the future economy, and its effect is the wholesale 
transfer of information and choice (read: power and leverage) from producer to consumer. 
Producers (and the stock market) prefer one-of-a-kind businesses who can force their 
customers to accept continual price increases for the same products. Consumers, on the 
other hand, prefer commodity businesses where prices start low and keep falling. On the 
internet, consumers have the upper hand, and as a result, anybody who profited from 
offline inefficiencies -- it used to be hard work to distribute new information to 
thousands of people every day, for example -- are going to see much of their revenue 
destroyed with no immediate replacement in sight. 

This is not to say that the internet produces no new value -- on the contrary, it 
produces enormous value every day. Its just that most of the value is concentrated in 
the hands of the consumer. Every time someone uses the net to shop on price (cars, plane 
tickets, computers, stock trades) the money they didn't spend is now available for other 
things. The economy grows even as profit margins shrink. In the end, this is what 
Merrill's missing market cap tells us -- the internet is now a necessity, but there's 
no way to use the internet without embracing consumer power, and any business which 
profits from inefficiency is going to find this embrace more constricting than 
comforting. The effects of easy price comparison and global reach are going to wring 
inefficiency (read: profits) out of the economy like a damp dishrag, and as the market 
comes to terms with this equation between consumer power and lower profit margins, $2 
billion of missing value is going to seem like a drop in the bucket.