The Internet and the revolution in distribution: a cross-industry examination

Technology in Society 21 (1999) 287–306
                                                                         www.elsevier.com/locate/techsoc

 The Internet and the revolution in distribution:
          a cross-industry examination
                                                              *
                                          Bharat Rao
      Institute for Technology and Enterprise, Polytechnic University, New York, NY 10004, USA

Abstract

   Distributors and channels of distribution have existed since time immemorial. Channels of
distribution have existed to get products to consumers cheaper, faster, and more effectively.
Distribution encompasses various types of activities, depending on the type of and point in
the supply chain where value is added. A supply chain constitutes a set of activities ranging
from production and manufacturing, to logistics, warehousing, transportation, and final delivery
of goods to the customer (Handfield RB, Nichols EL. Introduction to supply chain manage-
ment. Upper Saddle River, NJ: Prentice-Hall, 1999). Through their interactions with suppliers,
manufacturers, and end customers, distributors thus perform an important intermediary role in
matching supply with demand.
   In this paper, the impact of the Internet on the value chain is discussed. In order to explore
issues pertaining to this transformation in greater detail, three industries that have been either
radically altered by the Internet, or that are facing tremendous challenges as they head into
the future, are considered. They are (a) the retailing industry, (b) banking, brokerage and
financial services, and (c) the music industry. The objective is to elicit the underlying mana-
gerial implications and imperatives through this cross-industry examination.  1999 Elsevier
Science Ltd. All rights reserved.

Keywords: Internet; Supply chain; Value chain; Electronic retailing; e-commerce; Managerial transform-
ation

1. Introduction
   The Internet has emerged in the recent past as a dynamic medium for channeling
transactions between customers and firms in a virtual marketplace. In particular, the

  * Tel.: +1-718-260-3617; fax: +1-718-260-3874.
E-mail address: brao@poly.edu (B. Rao)

0160-791X/99/$ - see front matter.  1999 Elsevier Science Ltd. All rights reserved.
PII: S 0 1 6 0 - 7 9 1 X ( 9 9 ) 0 0 0 1 8 - 4

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World Wide has emerged as a powerful new channel for distribution, rendering many
intermediaries obsolete, and radically revamping the value chain in several industries.
The growth of the Web has been phenomenal, and there has been a corresponding
growth in commerce on this robust platform. Online shopping revenues are expected
to rise dramatically in the near future, from a projected $US11 billion in 1999 to
US$41 billion in 2002 [1]. While some firms and industries have rapidly absorbed
this new paradigm of competition, there are several others that have been slow to
respond to change. This has been partly due to structural reasons, but also in part
due to an inability and unwillingness by entrenched players to grasp the magnitude
and speed of change imposed by competition in such a networked economy.
   The Internet is challenging the traditional distribution structures that firms have
employed to get goods and services to market. In addition, it is forcing firms to re-
evaluate their value proposition to customers, and meet the challenges of more nim-
ble rivals. In this paper, we describe how the Internet has impacted channels of
distribution in three major industries: retailing, banking, brokerage and financial ser-
vices, and music distribution. Based on this analysis, we draw managerial lessons
for firms competing in the new marketspace [2–4].

1.1. Channels of distribution

   In the world of physical distribution, distributors provide the important functions
of “breaking bulk”, and “mixing” in channels. Breaking bulk enables reduced trans-
portation costs in the channel as it permits volume shipments from the manufacturer
to the distributor, which typically cost less on a per-unit basis. By doing so, manufac-
turers are free to concentrate on their core business strengths, and customers can
pick and choose the mix of products they need through such a channel intermediary.
Mixing also permits volume shipments to occur between manufacturers to original-
equipment manufacturers (OEMs) and downstream business customers even though
the quantity shipped between a specific manufacturer–OEM pair could be quite
low [5].
   Distributors also enable channels to operate with lower “safety stock”, as inventory
is centralized, leading to greater efficiencies. This is an important benefit as inven-
tory-carrying costs in some industries can range in the billions of dollars every year.
In many industries, distributors provide and reduce the role for inventory financing
in the channel by extending credit to customers, who would have otherwise been
unable to procure material directly from the upstream manufacturer. They also reduce
the need for numerous interactions between the final customer and manufacturer, as
they effectively become a clearing-house or portal for interaction with the final cus-
tomer. Finally, many distributors provide value-added services like extending credit,
technical and customer support, and training. This makes distributors an indispens-
able part of many industries.
   In the electronic world, corresponding network economies exist, and several inter-
mediaries have begun to exploit them to their advantage. However, the nature of
these economies are very different from those in vertical channels, and are based
more on the impact of speed, connectivity and critical mass. Many innovative market

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mechanisms have emerged to match supply with demand, facilitated primarily by
the Internet. These range from pure info-mediaries that have negligible physical
infrastructure, to hybrid intermediaries who rely on both info-mediation and some
elements of physical distribution. In the former category, online auction sites eBay
(http://www.ebay.com/) and Onsale.com (http://www.onsale.com/) have created vir-
tual marketplaces that primarily match buyers and sellers without touching the mer-
chandise.
   Customers arrange for shipment through high-speed logistics intermediaries, who
in turn derive scale economies based on the traffic in their networks. In the latter
category of hybrid intermediaries, we find a majority of online retailers like Ama-
zon.com (http://www.amazon.com/), Eddie Bauer (http://www.eddiebauer.com/),
Gap Online (http://www.gap.com/), etc. who extend the info-mediation aspect onto
the physical world through online sales, catalog sales, and a store network if neces-
sary. The growth of direct marketing channels like online retailing and catalog sales
has also led to the emergence of world-class third party logistics intermediaries like
FedEx (http://www.fedex.com/), for example, who substitute “inventory for infor-
mation”, and provide superior abilities in moving shipments around the globe [6].
   The availability of instant information, and the connectivity offered by the Internet
are now challenging many aspects of distribution that were taken for granted. First,
information is pervasive and relatively easy to share and access across business
software platforms due to the open communication protocols of the Internet, and a
convergence in standards even in proprietary enterprise planning systems. Second,
firms around the globe are relying on just-in-time procurement, and deliveries, ther-
eby freeing the traditional channels of unwanted inventory. The emphasis has shifted
to inventory velocity (the speed at which inventory moves through the supply chain),
as opposed to the total amount of inventory available at any point in time. This
enables lower inventory holding costs, faster inventory turns, and an ability to
respond faster to sudden changes in demand. Finally, high-speed logistics intermedi-
aries (e.g. FedEx) are taking on the role of physical distribution, and further reducing
the need for inventory stockpiles in channels in the process. In doing so, they are
taking upon value-added functions like virtual warehousing, vendor-managed inven-
tory, and merge-in-transit.
   The growth and maturity of Web-related technologies has played a major role in
the new way companies are approaching the distribution process, both in the physical
and digital worlds. In the past, information gathering and processing was relatively
slow because of the limits imposed by human workers, and the vertical nature of
many industries. Today, information can be transferred, grouped, filed by various
categories and can be retrieved and shared in large volumes in a matter of seconds.
This has caused minor revolutions in many industries. In addition, the application
of technology-based supply chain management practices has begun to slowly under-
mine the traditional roles played by the numerous middlemen that are involved in
the supply chain. Unless middlemen identify and exploit their value-added capabili-
ties, they face increasing challenges from their technology-smart rivals.
   The Internet has been the driver for new types of value provision given its inherent
characteristics, and has led to the deconstruction of the value chain in many indus-

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tries. It has enabled new forms of businesses, and also different types of transition
from the physical world to the virtual world. In this paper, the discussion is centered
around the role of the Internet on distribution channels that deal with physical, hybrid
and purely informational goods, or “soft goods”. We describe each of these in the
following sections. In each section, we touch upon developments in the industry in
question, and seek to identify the underlying dynamics of managerial response to
this value chain deconstruction.

2. Online retailing

         We will never allow ourselves to be reduced to a role as a mere showroom for
      goods sold over the Internet by vendors or others …. Selling over the Internet
      can destroy years of investment retailers have made jointly with vendors building
      product brands. It can turn once desirable brands, unprofitable. The reality of the
      Internet today is this: sales are low; it’s an inferior channel for most merchandise
      and it can commoditize your brand. (Jerry Storch, President, Credit and New
      Businesses, Dayton Hudson Corp., 25 June 1998, PR Newswire.)

   The retailing industry is immense. Annual GAF1 retailing revenues in the US
amounted to US$685 billion in 1997 [1]. There are several characteristics that make
traditional retailing unique from the customer viewpoint. First and foremost, the retail
environment provides the sensory stimuli of touch and feel (and smell). For many
product categories (e.g. specialty apparel, furniture, or perfumes), this aspect provides
the customer with valuable data points before the purchase decision can be made.
In addition, the customer might interact with in-store personnel, who might assist
him or her in the purchase process, or provide additional information. In the case
of apparel, customers can also try out the product right at the store, while book-
lovers can browse through several pages of their favorite titles before making a
decision to buy the product.
   Once the product is selected and the purchase decision made, the customer can
walk out of the store with the merchandise in hand. In addition, the physical store
setting offers instant gratification to the customer. Given these obvious advantages
of physical in-store retailing, one might argue that it is difficult, if not impossible
for online retailers to make any headway. This is far from the truth. Online retailing
has taken off as a high-growth industry. In 1998, consumer retail spending on the
Internet reached US$7.8 billion, surpassing earlier projections of US$6 billion [1].
There has been a proliferation of shopping sites on the Internet. Although conven-

   1
     GAF represents those retail formats where the bulk of consumer goods shopping takes place. These
formats include general merchandise, department, apparel, furniture, and miscellaneous shopping goods
stores. It does not include automobile sales or restaurants [1].

B. Rao / Technology in Society 21 (1999) 287–306              291

tional retailers initially sought to resist the changes brought about by the Internet,
many of them have now plunged headlong into online retail.

2.1. Shopping online: key elements

   Characteristics of online consumers play an important role in their adoption of
the shopping model. Consumers on the Web are getting smarter in using e-tailers
(and online search engines and agents) for convenience and comparison-shopping.
Initial research suggests that they are also less likely to have qualms about not buying
from a physical retail outlet, and are opting for the more convenient alternative [7].
In addition to cost-conscious comparison shoppers, the e-tail model is also attracting
a growing segment of customers who are technologically competent, place a high
emphasis on convenience, and are willing to pay a premium price if they find the
product they are looking for.
   This suggests that there could be an ongoing migration of these “cash cows” from
retail shopping to e-tail. A study by Jupiter Communications suggests that the aver-
age household income of online consumers is much higher than that of a traditional
retail shopper. In 1998, the median age of an online shopper was 33 years, with an
average household income of US$59,000 [8]. It is therefore necessary to re-examine
the basic issues confronting e-tailers and traditional brick-and-mortar retailers as they
seek to innovate online.
   The main features of online retailing include:

앫 largely virtual interactions between buyer and seller;
앫 the provision of a range of services by the seller that seek to enhance the quality
  of interaction over conventional channels like in-store retailing;
앫 a set of complex networked linkages between various facets of the value chain;
  and
앫 the use of speed and content as key ingredients of competitive differentiation by
  online retailers.

There are several unique elements that make online shopping different from tra-
ditional retailing. Online retailing offers convenience and expanded product variety,
and makes it easier for consumers to access and compare data from multiple sources.
Visiting three online retailers, for example, would take less time than driving up to
one physical store. Search capabilities within online stores replace physical browsing
through endless aisles at a traditional retailer, especially if the product is hard-to-
find or out-of-stock. Further, electronic shopping malls like the Yahoo! Visa Shop-
ping Guide (http://shopping.yahoo.com/) or Shop-the-Web at Amazon.com
(http://shoptheweb.amazon.com/) now provide comparative data at the customer’s
fingertips, either through proprietary or external search agent software [9]. The
immediate challenges of such capabilities for the retail and online retail environments
include: (a) the erosion of brand equity and customer loyalty, (b) cannibalization of
in-store retail sales, and (c) price competition.
   These challenges have already being experienced by a number of business, ranging

292                     B. Rao / Technology in Society 21 (1999) 287–306

from specialty retailers who deal exclusively in hard goods, to full-service stock
brokerages who deal mainly in info-mediation and knowledge transfer. Such threats
might be countered to some extent by investments in marketing and brand equity
building, and extracting a premium based on customer service capabilities. Online
guides and recommendations could also play a role in reaching selective customers
[witness the transformation of Zagat Restaurant (http://www.zagat.com) from a pap-
erbound publication, to cross-marketing alliances with city guides like Sidewalk.com
(http://www.sidewalk.com/)]. At Amazon.com, for example, advertising and
expenses are around 50% of its revenues, with an acquisition cost of US$12 per new
customer [10].
   On top of developments like the profusion of well branded retailers that could
command enhanced margins once they establish market share, the Internet has also
given rise to a number of retailers that stretch conventional revenue models to the
limit by selling products at extremely low prices. Buy.com, for example, offers all
products at or below cost. By relying on massive infusion of capital and minimal
operating expenses, and a revenue stream bolstered by advertising dollars, Buy.com
has established a strong presence in product categories like hardware, software and
peripherals. Several other companies have followed suit. Egghead, for example,
closed down its physical store operations in 1998, and began to offer its products
through Egghead.com, its online avatar. These trends present clear threats to undiffer-
entiated players, and, ironically, players in the physical domain that lack or are con-
templating a significant e-tail presence.
   Traditional retailers might cry foul, but this might very well be the new shopping
paradigm they have to face as premium customers begin to accept the e-tail alterna-
tive in larger numbers [11]. The good news to pure retailers is that most pure online
retailers and their hybrid counterparts (with both retail and e-tail operations) face
challenges in offering deep discounts over a sustained period of time, which could
undermine their financial viability. However, some online retailers seem to be willing
to wait for a long time before their businesses turn in a profit. Some studies have
shown that Web shopping might be convenient, but, on the average, pricier than the
physical alternative [12]; as discussed earlier, newer models that are based on adver-
tising derived revenues often sell products at or below cost (e.g. Buy.com). As
pointed out earlier, in-store retailing has traditional strengths that are harder to imitate
in the online world (like merchandising or assortment planning, for example, which
are discussed later in the paper). But the retailing industry could do well to change
its game plan to adjust to these new challenges posed by online businesses [13].

2.2. Implications for traditional retailers

   There are several ways in which they can respond to the challenges posed by the
Internet. First, retailers need to make a Go/No-Go decision on whether they should
have an e-tail “storefront”. If they go ahead with establishing an online presence,
the main challenges will be on the operational and marketing fronts. Initial research
suggests that the addition of an e-tail channel might be relatively easy if the company
has cataloging experience. For example, traditional catalogers like L.L. Bean

B. Rao / Technology in Society 21 (1999) 287–306             293

(http://www.llbean.com/) have had tremendous success in adding an online channel.
Such businesses also have well established and integrated linkages with third-party
logistics intermediaries like FedEx, a factor which is critical to e-tail success [14].
Fig. 1 shows some examples of firms that have had successful transitions into e-tail-
ing.
    Second, they can use their e-tail storefronts to capture valuable customer demand
data, and conduct pricing and promotional experiments. Consumers are often willing
to spend significant time in personalizing their experience, and this is a clear opport-
unity to “hear the voice” of the customer. This is greatly facilitated by several off-
the-shelf tools that capture and analyze data from online visits. These tools are also
being provided by services like Yahoo! Store (http://store.yahoo.com/) and iCAT
(http://www.icat.com/). It has been pointed out that matching supply with demand
remains one of the critical strategic imperatives for retailing [15]. Online retailing
is no exception, and e-tailers should use the tools at their disposal to sharpen their
performance on this dimension.
    Finally, when executed properly, retailing can be a market for the imagination. A
number of innovative retailers have created unique shopping experiences within the
walls of the store. Retail chains like REI (http://www.rei.com/), for example, have
excelled in creating a truly unique shopping experience that leverages their knowl-
edge of the customer, and the contextual setting of consumption. REI, a merchandiser
of outdoor recreation equipment and goods, boasts a 100,000 square-foot flagship
store that includes an indoor mountain-bike track, a full-scale standalone climbing
wall, and a rain room to test raincoats and outdoor apparel. Its customers are also
members of a cooperative, and share profits generated at the store. In the case of an
upscale retailer like Saks Fifth Avenue, customers are provided custom tailoring and
fitting of quality apparel, and such value-added services can become a key driver of
repeat business. Such services are extremely hard to imitate, not only by competing
store chains in the physical world, but hardly at all in the emerging world of online

                          Fig. 1.   Possible transitions to e-tailing.

294                       B. Rao / Technology in Society 21 (1999) 287–306

retailing. In the case of Norwalk Furniture, a manufacturer and retailer of custom
upholstered furniture, physical stores are equipped with computers that enable cus-
tomers to design their piece of furniture, based on their selection of styles, fabrics
and other accessories. This is fed back into Norwalk’s made-to-order manufacturing
capability for over a million different combinations of styles, firmness, and fabrics
[16].
   In addition to the online retailing models discussed earlier, there have also emerged
a number of innovative businesses that capitalize on their role as info-mediaries in
a fragmenting distribution environment. These include online auctions like eBay and
Onsale.com, aggregators like Priceline.com (http://www.priceline.com/) and
iShip.com (http://www.iship.com/), and a number of virtual business to business mar-
ketplace models like PlasticsNet (http://www.plasticsnet.com/) and CommerceNet
(http://www.commercenet.com/). Online auctions bring together geographically dis-
persed buyers and sellers who trade in thousands of products. As info-mediaries,
eBay and Onsale do not physically touch the merchandise, but make money off
every transaction. Priceline.com, on the other hand, allows customers to decide the
maximum price they would be willing to pay for airline tickets, car reservations,
hotel rooms, vacations, etc.; based on these bids, the orders are fulfilled if they are
attractive enough to the seller. Although Priceline lost US$90.7 million in revenues
from its inception in April 98, to December 98, its revenues grew dramatically to
US$35.2 million during the same period. When Priceline went public in early 1999,
its IPO put its market capitalization at around US$80 billion, which is more than
the combined market capitalization of three of the major airlines whose tickets Price-
line sells through its service.
   The valuations might seem unreasonable, but on closer analysis, such companies
are radically altering the way supply is matched with demand in a competitive mar-
ketplace. Finally, virtual marketplaces like PlasticsNet and CommerceNet enable
business to business commerce transactions online, and speed the flow of products
and services through the supply chain. This has accelerated the move towards dedi-
cated trading partner networks, which are real-time and highly integrated into the
business processes of collaborating firms, and suppliers and other intermediaries. As
major players in many industries move away from legacy systems, and onto stan-
dardized, open technology platforms, it is likely that business-to-business virtual mar-
ketplaces will represent a substantial growth area in the future.

3. Banking, brokerage and financial services

         The do-it-yourself model, centered around Internet trading, I think should be
      regarded as a serious threat to American financial lives. This approach to financial
      decision making doesn’t serve clients particularly well. As far as we’re concerned,
      it’s not likely to create long-lasting value. (Launny Steffans, Vice-Chariman, Mer-
      rill Lynch, speaking at the PC Expo, 1998.)

B. Rao / Technology in Society 21 (1999) 287–306             295

   An industry that has been radically altered by the advent of electronic commerce
is the arena of banking, brokerage and financial services. In addition to the spectacu-
lar growth of the Internet, analysts point to the strong bull market since the early
1990s, and a growing customer appetite for investment related information and ser-
vices that has aided the growth of this industry. Traditional players have been forced
to rethink their business models and uncover true measures of value they provide
to customers. While some have been successful at handling the competition, others
are facing immediate and long-term threats that could lead to a major consolidation
in the event of a market downturn.
   The Securities Brokerage Industry comprised of nearly 7800 firms at the end of
1997, with a total capital of US$92.5 billion. Some of the leaders in this arena
include Merrill Lynch, Goldman Sachs & Co., Morgan Stanley, Dean Witter & Co.,
and Salomon Smith Barney. In the past, these firms earned fixed fees based on the
number of securities traded for their clients, based on a schedule set forth by the
Securities and Exchange Commission. After the SEC eliminated the fixed free sched-
ule in 1975, intense competition in the commission structure of many brokerages
ensued, leading to lower commissions on transactions, and an unbundling of services
offered. However, the big players still continued to maintain and grow their client
bases, which were characterized by institutional and corporate accounts, and high
net-worth individuals, who relied on the knowledge, advice, and availability of the
firms’ expertise, and paid them a hefty commission for it.
   With the advent of the Internet, the level of competition has increased, given the
widespread availability of information, and the separation of many components of
services (e.g. research, mutual funds, personal advice, transaction execution, and
commissions), as well as the creation of a grass roots individual investor market.
Firms like e-Trade (http://www.etrade.com), Ameritrade (http://ww.ameritrade.com/)
and Charles Schwab (http://www.schwab.com/) offer investors a range of products
and services that would have been unimaginable a few years ago. The value chain
has been disassembled to accommodate various classes of brokerage services,
depending on the depth of service customers are looking for, and the price they are
willing to pay for these services. An informed investor can now get research from
disparate sources for a small fee, and use this research to execute trades through a
low-commission online brokerage. A number of different business models have
emerged to serve this changing market. The four common categories of brokerages
today include: (a) full service brokers, (b) discount brokers, (c) deep discount brok-
ers, and (d) electronic deep discount brokers.
   Full service brokers provide a wide range of services including proprietary
research and analysis, a professionally managed investment strategy, superior cus-
tomer service, and trading in a variety of financial instruments. This umbrella of
services comes with a hefty price tag, and certain restrictions like a minimum account
balance. Discount brokers, on the other hand, provide a watered down version of
the above offerings, but are getting increasingly sophisticated through their use of
technology. They typically offer syndicated and in some cases, in-house investment
research, portfolio management, and online and telephone customer service. The
trading commissions are a fraction of those charged by full service brokerages. Deep

296                    B. Rao / Technology in Society 21 (1999) 287–306

discount brokerages are in the business of reducing transaction costs, i.e. trading
commissions. As pointed out earlier, many sophisticated investors and traders prefer
this option, as they are capable enough to do their own research and analysis, and
use the brokerage mainly for speedy execution. Electronic deep discount brokerages
reduce these transaction costs even further. Through the use of the Internet, they
also offer a range of research and industry and securities information, at a fraction
of the price of the full service brokerage.
   American consumers now routinely conduct banking and investment transactions
through the Internet, check their account balances and portfolios online, seek out
investment research and advice, and participate in online communities that enhance
their knowledge of the financial and investing environment. In the early stages of
evolution of this digital financial model, a number of banks began offering pro-
prietary software through which customers could access their account information
and conduct transactions online. A key driver of this phenomenon was the radically
reduced cost of conducting such transactions. A trip by a customer to a retail bank
location costs the bank approximately US$5 per transaction, and a phone call costs
US$1 per transaction, while an online transaction costs a mere 10 cents.
   Financial online intermediaries like e-banks or e-brokerages can also offer in-
depth and tailored information matching their clients’ investment needs and financial
profile to specific investment products or services they have to offer. Over time, one
would expect this to lead to customer loyalty, increased switching costs, and a unique
branding opportunity that would enable the bank (or brokerage) to provide a host
of services and products in various categories. In fact, a number of players in this
industry have gone in that direction, and moved into complementary (and not-so-
complementary) areas including insurance, mortgages, online retailing, travel infor-
mation reservations, and entertainment services.
   Banks like Wells Fargo (http://www.wellsfargo.com/) have been able to innovate
both online and in physical space [17]. Physical branches of Wells Fargo boast of
piped music and fresh Starbucks coffee, while the online version has links to the
Museum Store, where customers can buy memorabilia. Wells Fargo boasts a total
of 620,000 customers for its home banking service, followed closely by NationsBank
with 500,000 customers, and Citibank with 350,000 customers [18]. Contrary to the
expectation that competition would come from established players like Bank of
America, banks like Wells Fargo will find the main challenges coming from finance
portals     like     Yahoo     Finance     (http://quote.yahoo.com/),    Quicken.com
(http://www.quicken.com/)             and            Microsoft          MoneyCentral
(http://www.moneycentral.com/). These trends attest to the rapidly changing dynam-
ics of both the banking and financial services industry.

3.1. Industry response

   The mainstream American banking and financial services industry has been slow
in responding to the impact of the Internet. It is only recently that the industry woke
up to both the threats and opportunities that have been created by the Internet. This
is an industry where costs and pricing structures matter, and have a direct and

B. Rao / Technology in Society 21 (1999) 287–306              297

measurable connection to the ultimate growth in revenues and customer base. Never-
theless, full service firms are not threatened as much by the fall in transaction prices
engendered by the Internet. They may be simply missing out on a growth area of
the market, and of reaching new customer segments with vastly different needs over
their lifetimes.
   This may be due in part to the fact that several of the major investment firms and
brokerages operate on a strictly hierarchical model that rewards individual perform-
ance. Some observers posit that this could prove a serious threat to product and
process innovation within these firms, and to meet the challenges imposed by more
nimble competitors. Others point to the entrenched connections between many of
these financial organizations and the leading firms in most industries. They typically
provide underwriting services to many of these firms, as well as analysis of these
firms to investors who are their clients. It is unlikely that either their organizational
or reward structures will change in the near future, and it remains to be seen if this
organizational model will survive further competition in the financial services mar-
ketplace.
   The big investment and brokerage firms cannot take the status quo for granted
anymore. Online brokers are taking a closer look at lucrative areas like underwriting,
and any success they have in this area will be at the expense of the entrenched
players [18]. It is a matter of time before they begin to make forays into areas like
insurance, mortgages, and other financial products and derivatives. At the present
time, however, the multitude of e-brokerages that has sprung up need to look into
the prospects of shifting their focus from pricing to customer service, and increase
their reach to other segments of the market. Over time, it is quite likely that electronic
brokerages will draw in traditional clients that see the advantages inherent in their
models, but are willing to rely on their own or outsourced research. One of the oft-
repeated challenges for Internet brokerages is their ability to sustain high levels of
traffic on their servers, in a reliable and time-sensitive fashion. Several of them need
to invest more in technology that is fail-safe and robust, and has the ability to grow
with the needs of their changing business models.
   Several common functions and services associated with banks, brokerages, finan-
cial underwriting and IPOs, venture capital, financial research and analysis, and the
distribution of a vast array of financial products and services including mutual funds
and retirement plans, will find the Internet the next major areas for expansion. Innov-
ative firms like Wells Fargo, Bloomberg (http://www.bloomberg.com/), TheS-
treet.com (http://www.thestreet.com/), Wit Capital (http://www.witcapital.com/), and
Garage.com (http://www.garage.com/), are merely the first wave of the dramatic
changes buffeting this industry.

4. Online music distribution
  “Gotta li’l rhyme but we barely get a dime”
     - (Lyrics from Public Enemy’s album Swindler’s Lust. (Chuck D, a member
   of this group, is one of the most vocal advocates of online music distribution,
   and recently released a new album in the MP3 format.)

298                    B. Rao / Technology in Society 21 (1999) 287–306

   Several threats in late 1998 and early 1999 looked significant enough to undermine
the very foundations of the music industry, and the way business was done. First,
consumers routinely purchased their music online, through online retailers like
CDNow (http://www.cdnow.com/), and Amazon.com (http://www.amazon.com/).
This had led to increased price competition in general, and the undermining of the
traditional retail channels like Tower Records and Virgin Megastores. Many retailers
had to rethink their revenue model either due to the advent of pure online retailers
or their own migration to the hybrid physical-online model [19]. Second, the Internet
had brought a more immediate and perhaps more serious threat: the online, and in
a majority of cases, illegal distribution of music through compressed audio formats,
accessible to anyone with a connection to the Internet.

4.1. Standards (or lack thereof)

   Streaming audio and compression technologies have made spectacular progress
since their inception in late 1995 and early 1996. The earliest signs that near CD-
quality music could be transmitted on the Internet came from RealAudio 5.0, a pro-
gram developed by Real Networks (http://www.real.com/). With this program files
could be stored and streamed relatively efficiently across on a 28.8K modem.
Although the quality of sound transmitted in this manner was not perfect by any
means, this was just a hint of the developments to follow. In a few months the
spectacularly successful MP3 format had emerged. Under this format, files were
compressed in compliance with the standards established by the Moving Picture
Experts Group (http://www.tnt.uni-hanover.de/project/mp3/audio). Established in
January 1998 by the International Organization for Standardization (ISO), MPEG
had grown to include some 350 experts, hailing from academia and 200 companies
and organizations around the world.
   The MP3 format allowed for an almost tenfold reduction in file size from previous
methods of compression, without a discernible loss in quality. Most commercial
music singles could now be stored and transmitted in file sizes of less than 5 MB.
The rapid acceptance of MP3, and the proliferation of the so-called ripper-programs
that enabled audiophiles to copy tracks from CD-ROMs and post them online, had
turned the music trickle into a flood. Extensive libraries of music were soon available
online, and music buffs could locate and retrieve files of their favorite music in a
matter of minutes. In late 1998, the MP3 phenomenon had gone “mainstream” on
the Internet, when the Internet portal Lycos.com began to offer a unique MP3 search
engine (http://mp3.lycos.com). Soon, other search engines with more features began
to emerge: some, for example, offered search capabilities based on lyrics someone
might remember from a music single they had heard. Such unprecedented access to
music content meant that Internet users with relatively fast connections could set up
extensive play-lists of their favorite music in a matter of days, if not hours.
   The growing traffic in MP3s was clearly illegal and violated copyright laws. MP3
had proliferated virus-like in a networked environment where legislation and policing
were not forthcoming, efforts that would have been almost impossible to enforce.
MP3 also gained widespread attention when Michael Robertson, a pioneer and evan-

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gelist of the format, established a web-site dedicated to resources for MP3 buffs
(http://www.mp3.com/). In addition to the illegal traffic in MP3, the ease of generat-
ing new music in this format encouraged artists to post their tracks online, in a matter
of minutes after recording it, if necessary. With 500,000 music files available for
free download (and growing exponentially) on the Internet by February 1998, it was
clear that MP3 had arrived in a big way.
   By April 1999, MP3.com had logged more than 21 million legal downloads of
files posted on its web site. Insofar as final distribution was concerned, the trend
was towards the ubiquitous availability of music. Rio, a portable MP3 player (a
Walkman sized device) that retailed for US$199, would enable users to download
their own play lists as and when required. The “empeg-car” player was geared toward
the car user. A future version promised the ready availability of 500 albums (or over
7000 singles) for the road at CD quality (http://www.empeg.com/). Further advances
in storage technology (like flash memory sticks developed by Sony, for example)
were just around the corner. As recently as May 1999, Real Networks began the
free distribution of Real JukeBox, a piece of software that would allow consumers
to digitize and store their entire music collections on their computers, and, if neces-
sary, transmit them with great ease over the Internet. Although Real Networks
expected consumers to abide by the honor system and not make additional copies,
it was quite probable that this program would result in further trade in illegal MP3s
files over the Web.
   In addition to the revolution in the distribution of music, the new online medium
was beginning to alter the way content was created and promoted. A number of
bands had gravitated toward the MP3 format, creating and promoting new singles
online, due to cost and reach considerations. This enabled even small bands to make
their presence felt in a competitive landscape. Some bands like Widespread Panic
complemented this type of promotion with online marketing efforts, often aided by
a loyal group of fans who managed web sites, arranged for mass mailings, helped
out at live events, and spread the word online to existing and prospective fans [20].
   This type of grassroots enthusiasm and viral marketing tactics had also led to
impressive turnouts at live musical events later held by the same band, and others
who had embraced the online medium. It is very likely that small to medium sized
bands could easily migrate to the online distribution format in the future, in order
to attract and gain an initial audience, and ultimately build their identity. By initially
promoting their music with free MP3 files, and distributing subsequent content using
a copy protected format, they could establish a presence in a relatively short time
span. The arrival of a safe, secure standard for distribution would be vital for moving
toward being recognized and earning deserved financial rewards.

4.2. Industry response

  Reacting to the changes brought on by the new technologies, the music industry
has been scrambling to react to the far-reaching effect these developments have on
their business and revenue models. By early 1999, IBM had developed a new com-
pression technology that would compete with MP3. IBM had launched the Electronic

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Music Management System (EMMS) that would enable entire albums to be distrib-
uted online. Developed in collaboration with Warner Music, Universal, EMI, Sony
and BMG (the Madison Project) it will take some time before the success of this
initiative can be assessed. IBM has already indicated that this format would not be
compatible with current MP3 devices like the Rio, which makes the acceptance of
this format extremely unattractive to existing MP3 consumers.
   One of the assumptions of this plan was that the delivery of music would increas-
ingly move to broadband. At the end of 1998, broadband technologies penetrated
around 1.3% of on-line households in the US. It was projected that this figure would
swell to 30% of on-line households by 2002 [21]. It was likely that time and infras-
tructural hurdles would test this assumption across a broad spectrum of the market.
The other assumption, that the security of this method of digital delivery would be
foolproof, was yet to be tested as EMMS was still in a developmental phase. Also,
any method that relied purely on software encryption was vulnerable to future
break-ins.
   Industry groups were also echoing these concerns. Noting that the music business
and its artists were the “biggest victims” of MP3 and the “Internet culture of
unlicensed use”, the Recording Industry Association of America (RIIA), was
vehemently fighting the illegal use of MP3 for music distribution. Further, the RIAA
had launched the Secure Digital Music Initiative in December 1998, with a view to
developing a secure audio format that would prevent illegal copying. The success
of this project was questioned by industry analysts, given the proliferation of formats
like MP3 and the difficulties in enforcement. Other competing formats that had
emerged on the horizon were Liquid Audio (http://www.liquidaudio.com/) and AT&
T’s a2b platform.
   The music industry has been caught unawares by the revolution in online distri-
bution. They have not realized that the technological changes affecting their industry
are of a fundamental and revolutionary nature. These developments threaten to
change the relationships between artists, labels, distributors, retailers, and consumers.
The Internet is fast shifting power away from the big labels to artists, and to the
info-mediaries who keep tabs on changing consumer tastes, and influence music
selection and consumption. These intermediaries — labeled for convenience as music
portals — will evolve to play a combination of roles, including online retailing,
online labels, and informational and community resources (Rao, et al, 1999b.).
   In the future, it is quite likely that the emphasis will shift from passive and top-
down music sales to active, and interactive music experiences that encompass activi-
ties like custom music delivery, live events, and subscription based models of music
consumption using the Internet. Alliances and partnerships will emerge between
major online music retailers, music portals and other content providers like Rolling
Stone Magazine and MTV Networks. Radio will continue to play a major role in
popularizing music, and consumers will be able to download (and purchase) music
in a matter of seconds in their homes or cars. Retailers operating in the physical
space, like Virgin Megastores, for example, will need to move more aggressively
into live in-store concerts and events and offer more music sampling stations with

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even deeper selections of music. They might consider fusing such sampling stations
with portable music devices, and custom CD capabilities.

5. Lessons learned

   The industries described in this paper are just three in number, but the Internet is
changing the business dynamic in almost every industry. Several small, innovative
firms have shown that they “understand” the Internet and have learned to compete
in and exploit the advantages of a networked economy. At the same time a number
of established firms are finding it very hard to assess the changes affecting their
businesses, to answer fundamental questions about if and how they should embrace
the change, and to develop new and appropriate strategies. Given the radical nature
of these trends, it becomes important to discern the key managerial implications
dictated by this technological change. That is what we will focus on in this section.
   What type of organizational structure, culture, and skills do firms need to thrive
in a networked economy? First, a firm that seeks to operate on “Internet time” needs
an organizational structure that is dynamic and flexible. Product development cycles
need to be compressed whether in developing a new piece of software, or a new
generation of airplanes. In fact, the Boeing Company is one of the biggest users of
the Internet in integrating disparate aspects of the business, and of the product devel-
opment process. Given the speed of change that a networked model of competition
engenders, managers not only need to identify market opportunities carefully, but
must also be willing and able to make speedy transitions once they have identified
the niche they would like to compete in. Using technological excellence and know-
how, they can leverage their position by partnering with more established players
to extend their market reach and impact. Being first to market, or a close follower,
enables Internet firms to specialize initially in a few market segments, and then
rapidly expand market share through economies of scale and partnering. This effec-
tively raises the barriers to entry for future competition (Fig. 2).

5.1. Co-creation with the customer: understanding “Internet time”

   Time is of the essence in Internet competition. The ability to rapidly innovate in
the marketplace ahead of competitors will be a key skill to acquire and nurture. On
the Internet, establishing a technological or market lead of a few months can be very
detrimental to the future moves by a competitor. The rate of innovation diffusion
through this electronic medium is much faster than through traditional channels, and
requires that firms be acutely aware of their “time to market”, and the “time to
market response”. In addition, many web-based businesses have discovered that
Internet customers make their views and opinions known, and are extremely involved
with their experience as consumers. The feedback loops between buyers and sellers
are shrinking fast, and so are the boundaries between production and consumption.
Firms that seek to compete in this domain need to understand the dynamics of “viral”
digital marketing, and the formation of extremely loyal customer communities. By

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             Fig. 2.   Deconstruction of the value chain: sample constituents and linkages.

constantly listening to what customers have to say, observing their purchase and
consumption behavior, and interacting with them in a dynamic environment, they
will be able to fine-tune the products or services they offer.
  “Customer feedback on the Web makes old methods of customer response the
equivalent of putting a note in a bottle and hoping someone will find it, let alone
read it”

        (Alan Weber, Founding Editor, Fast Company, speaking at a Roundtable on
      New Media; Institute for Technology and Enterprise, 1998.)

   Creating products and services with active and continuous involvement of the
customer thus becomes one of the keys to competitive success. Firms like Yahoo
and Microsoft, for example, actively use customers in every stage of product devel-
opment [22]. The “beta-test” mentality has been poorly understood by businesses
seeking to make the transition from the physical to the online world. Comprehensive
testing, constant fine-tuning of products and services, and churning new generations
of products and services over time is characteristic of businesses thriving in Internet
time. Managers should take full advantage of the opportunities offered by involving
end-users as they shape their final offering. “Co-creation” with the final customer
reduces product development costs, and also helps create something that the market
really     wants.     James     Cramer,     the    chairman      of     TheStreet.com
(http://www.thestreet.com/), an online financial site specializing in news and analy-
sis, sums it up concisely,
   “In the online world, everything is turned upside down. The reader is the client.
I say it again, because it is astonishing: The reader is the client. When I get my

B. Rao / Technology in Society 21 (1999) 287–306               303

1,000 emails a day, I know who the client is. When we get bombarded by input
every time we put an inquiry up, when we get told what to do and how to do it by
paying readers, the client is the only way to describe it.”

     (James Cramer, Chairman of TheStreet.com, an online provider of financial
   news, research and analysis, speaking at the Jupiter Financial Services Forum;
   Source Media, 1998.)

5.2. Unrelenting market focus

   Marketing is crucial to the growth of a company, from developing customer
relations to promoting a successful brand. Senior executives must adapt to the ever-
changing demand of the market. Extremely low switching costs for online customers
challenges managers to accept the mantra of customer-orientation. Internet-based
competition operates on a very accelerated timeframe where customers have the
power to create market leader status in a very short span of time. The entire organiza-
tion, from senior management to salespeople, must constantly pool knowledge in
order to recognize new market demand and create goods and services to fulfill that
unique demand. Success in increasing-returns primarily depends on recognizing
trends and developing products accordingly. The advantage of direct customer links
enables companies to conduct electronic surveys to forecast trends for their goods
and services. Dynamism, responsiveness, the ability to listen to the customer, and
relationship management skills are valued competencies in a networked economy.
A personal e-mail message from Jeff Bezos, CEO of Amazon.com to its customers
best summarizes this orientation,
   “In everything we do, we’ll try to be the best, the most innovative, and the most
customer-obsessed. That’s as true as ever for books; it’s true for music and videos;
it’s true for auctions; and it’ll be true for everything new we do.”

     (Jeff Bezos, CEO, Amazon.com, in a personal e-mail to Amazon.com cus-
   tomers, announcing the launch of auction services, April 1999.)

   Information technology enables firms to market one-to-one. Historically, compa-
nies have acknowledged that the retention of customers is of strategic value, given
the stream of revenues such customers can bring over their lifetimes. Internet-based
companies have the unique potential to reach a global audience with highly tailored
marketing messages. Web sites are tools not only to sell goods and services, but
also to acquire detailed customer information. Such “granular” information, when
correctly warehoused, mined, and utilized, enables managers to be responsive to
customers’ needs by creating new products and services, as well as augmenting exist-
ing ones. Also, customer loyalty increases as companies build a more detailed profile
of individual needs and values. The advantage of creating such profiles (including
transaction history, gift transactions, custom lists, etc.) for online retailers, financial
services, or music clubs, is that they can be used to call the attention of customers

304                    B. Rao / Technology in Society 21 (1999) 287–306

to related products and services and targeted promotions, that increase the chances
of response and retention. By treating customers as partners, respecting their privacy,
and explicitly valuing their contributions, successful firms in the online world have
been able to create a superior purchasing experience.
   “Happy Birthday, Your Team Won, Your Stock Crashed.”

        (Headline of a newspaper article on personalization on the Web, New York
      Times, 1998.)

6. Conclusions

   The advent of the Internet has transformed industries and redefined the rules of
competition. The old rules of distribution still exist, but they have also given way
to new channels and info-mediaries, and changed the nature of relationships between
businesses and consumers. Given current trends the Internet’s influence will continue
to grow into the foreseeable future as businesses collaborate with suppliers and part-
ners; source, produce and distribute products and services globally, and leverage the
inherent advantages of networked competition. Consumers will be the driving force
of this change by purchasing physical and knowledge goods, communicating glo-
bally, and participating in dynamic virtual marketplaces enabled by the growth of
the Internet.
   Public policy implications of these developments have to be addressed with care
and determination as commerce moves online in a big way. These include the role
of regulation, the protection of intellectual property, taxation, security and privacy,
and the changing nature of global trade. Wise decisions will support a continued
robust growth in electronic commerce.
   In summary, we offer the following guidelines to firms competing in the net-
worked economy:

앫 Firms should work with their customers to create and improve new products and
  services. Customers should be treated with respect, and their privacy and intellec-
  tual contributions valued throughout the organization.
앫 Firms should work cooperatively with their suppliers, partners, and customers and
  find the best way to create high-quality products and services, pattern them to
  individual customer needs and deliver them in a timely fashion. As boundaries
  between these traditional constituents blur, it is important for firms to continuously
  evaluate their position in, and contribution to, the segment of the value chain they
  compete in.
앫 Firms must constantly scan the environment and the competitive landscape to
  look for opportunities and be willing to change and deliver products and services
  in new ways.
앫 Firms must build in a set of unique brand attributes, and strive to deliver superior
  consumption experiences using the Internet as the means to that end.

B. Rao / Technology in Society 21 (1999) 287–306                          305

앫 Firms must allocate substantial resources to recruiting the best talent, nurture a
  culture of continuous product and process innovation, and encourage creativity.
  In addition to an excellent working environment, the willingness to change and
  to anticipate their competitors’ strategies will be critical to a firm’s success.

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Bharat Rao is an Assistant Professor of Management at the Polytechnic University in New York City. He