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5. Why were Friis and Zennström successful with Kazaa and Skype?

This chapter contains a selection of theories to provide which address the question in the heading. My suggested answer to the research question is found in section 5.8.

5.1 Cause and Effect

5.1.a Success is Profit and Survival

The American economist and statician Armen Alchian wrote in 1950 about "Uncertainty, Evolution and Economic Theory" [Note 152].

Each economic actor for each action has a distribution of potential, overlapping outcomes.

"Each possible action has a distribution of potential outcomes, of which one will materialize if the action is taken – and that one outcome cannot be foreseen." [Note 153]

Alchian argued against the assumption that economic actors seek profit maximization, because that assumption implies perfect knowledge. He defined uncertainty to be the phenomenon that produces overlapping distributions of potential outcomes. If the distributions were not overlapping, there would be no uncertainty. And as all actors then would make the right choice every time, there would be no profits either. So, if one assumes perfect knowledge, profits disappear.

As the economic actors do not have the knowledge of how profit can be maximized, the motive of profit maximization can be neither a guide to action nor the reason for success. Hence motivation must depend on results:

  1. Successful and surviving firms are selected according to their realization of profits.
  2. "Realized positive profits, not maximum profits, are the mark of success and viability. ...
  3. Those who realize positive profits are the survivors; those who suffer losses disappear. ...
  4. Positive profits accrue to those who are better than their actual competitors ...
  5. The crucial element is one's aggregate position relative to actual competitors, ...
  6. The greater the uncertainties of the world, the greater is the possibility that profits would go to venturesome and lucky rather than to logical, careful, fact-gathering individuals." [Note 154]

Alchian employs a biological metaphor and refers to Darwin's evolutionary natural selection when he states that the firms that are nearest to the unknown optimum will grow quicker than other firms and become the dominant type.

"...the essential point is that individual motivation and foresight, while sufficient, are not necessary". [Note 155]

The lack of need for individual motivation is supported by Joseph Schumpeter:

"In the theory of the circular flow, the importance of examining motives is very much reduced by the fact that the equations of the system of equilibrium may be so interpreted as not to imply any psychic magnitudes at all, as shown by the analysis of Pareto and of Barone. This is the reason why even very defective psychology interferes much less with results than one would expect. There may be rational conduct even in the absence of rational motive." [Note 156]

5.1.b Correlations of Cause and Effect

Darrell Huff published in 1954 a clever and funny book called "How to Lie with Statistics".

Huff mentions three kinds of failings when analyzing causes and effects. He encourages putting any statement of relationship through a sharp inspection to avoid the post hoc fallacy. The error-prone correlations can be any of several types:

  1. Small samples: "One is the correlation produced by chance ... you simply throw away the results you don't want and publish widely those you do. Given a small sample, you are likely to find some substantial correlation between any pair of characteristics or events that you can think of."
  2. Unclear cause and effect: "A common kind of co-variation is one in which the relationship is real but it is not possible to be sure which of the variables is the cause and which the effect. In some of these instances cause and effect may change places from time to time or indeed both may be cause and effect at the same time."
  3. Correlation, but no effect on each other: "Perhaps the trickiest of them all is the very common instance in which neither of the variables has any effect at all on the other, yet there is a real correlation ... An instance of the nonsense or spurious correlation that is a real statistical fact. Which is the cause and which the effect? Watch out for subtle applications of post hoc logic." [Note 157]

Examples of these kinds of failures:

  1. Small samples: When tossing coins, "I have just tried ten tosses and got heads eight times, which proves that pennies come up heads eighty per cent of the time"
  2. Unclear cause and effect: Income by ownership of stocks, "The more money you make, the more stock you buy, and the more stock you buy, the more income you get; it is not accurate to say simply that one has produced the other."
  3. Correlation, but not effect on each other: "There are two clocks which keep perfect time. When A points to the hour B strikes. Did A cause B to strike?" [Note 158]

5.1.c Considerations of Cause and Effect for the Cases of Kazaa and Skype

I repeat the research questions:

1: Why were Friis and Zennström successful with Kazaa and Skype?

2: Will Friis and Zennström continue to have success in business life?

3: What are the requirements for other entrepreneurs to be equally successful?

It is worth considering the correlations between causes and effects before attempting to answer the research questions. Here are some considerations based on Alchian's and Huff's findings:

  1. Armen Alchian states that success is based on results, not motivation. By moving the concept of profit from the actor's (supposed) intension of profit maximization to his realized, positive profit, Alchian also moves the profit and the connected success from being a cause to being an effect.
  2. Friis and Zennström's success is visible because they realized a large profit. (Alchian's list no. 1); they realized a positive profit and are hence survivors (no. 3); they received a large profit, which shows that they were better than their actual competitors (no. 4); and as the world of Internet and telecoms is uncertain, the profit went to the venturesome and lucky ones (no. 6).
  3. The cases of Kazaa and Skype are interrelated. I think Kazaa's success was a cause for Skype's success. For this reason I will treat them together as a single case.
  4. Single-case bias (1): That the sample consists of just one case means that it falls within Huff's category of small samples. Firstly: Statistics for a population of one does not give sense. Secondly: There is a clear bias in my basic choice of studying the cases of Kazaa and Skype – they were interesting, because they had success. The bias is not a problem for research question 1, as the topic of that question is precisely Kazaa and Skype.
  5. Single-case bias (2): The main problem with bias is to consider answers to the research questions 2 and 3 and be aware of the single-case bias. [Note 159] There may be thousands of entrepreneurs with innovative projects ready for the market. Each of these projects may have prosperous potential performance, but not all projects will prosper, and nobody can predict with certainty which projects that will prove successful.

5.1.d Why Do We Hear About the Lucky Ones?

The problem with social science compared with other kinds of science is that it describes interactions between reflective individuals and organizations while other kinds of science describes un-reflective phenomenons. All of the individuals and organizations interact while at the same time pursuing their own goals.

  • By "interaction" I mean that if somebody finds luck by a certain action, all of the other individuals and organizations may try to find the same luck by doing similar or contrary actions
  • By "reflective" I mean that each of the individuals and organizations has a conscious, reflective approach to itself and the other parts of the community – as compared to an earthworm, who probably does not know that it is an earthworm

It is not an easy task to make any kind of objective description of the social world. I will make a try by employing two different approaches. In both of these approaches there are subjective choices among various methods to find the proper way to represent facts:

  • Statistics: "Statistics is as much an art as it is a science. A great many manipulations and even distortions are possible within the bounds of propriety. Often the statistician must choose among methods, a subjective process, and find the one that he will use to represent the facts." [Note 160]
  • Journalism: Journalists want to add to the reader's experience, using images to mediate the subject, and trying to show the experience rather than describing it. But the description is not necessarily true or objective. The gentlemen of the press treat it in a way so that we, the readers, want to read it. They mainly describe who won and who lost, not those who are running business as usual. They do so because we, the readers, as consumers of the news expect to learn about the untypical when we read the news.

On sampling and bias: Darrell Huff's statistical considerations for studies in economics:

"To be worth much, a report based on sampling must use a representative sample, which is one from which every source of bias has been removed."

One must expect a certain bias towards the well-to-do and well-informed:

"You have pretty fair evidence to go on if you suspect that polls in general are biased in one specific direction ... This bias is toward the person with more money, more education, more information and alertness, better appearance, more conventional behavior, and more settled habits than the average of the population he is chosen to represent." [Note 161]

How to lie with statistics

Newspaper reports tell an exiting and entertaining story – but using newspaper reports as the main source for the description raises several problems:

  • Bias 1: The press cannot predict who will have success. Journalists can describe what appeared to be a success: "This is a success, and the founders earned two billion dollars." Journalists can tell about potential performance, but they cannot judge what will be a success later, and what will not, for example "This is a success, and in two years the founders will earn two billion dollars."
  • Bias 2: "News" are unusual, not usual. The press likes to tell exiting and entertaining stories and stresses the deviating performance. This tends to be the opposite of the statistical "normality".
  • Bias 3: The winner takes it all, or nearly all. Those who lose in the fight for success will lose press coverage as well.
  • Bias 4: The road to celebrity is one-way only. The press and the readers love the fairytale of the ordinary guys who married the king's daughters and inherited half of the world market. For Friis and Zennström this means that they will never be ordinary guys anymore. The press will report on their successes and failures for the rest of their lives – even if they lose all of their money.

As this paper is based mainly on newspaper reports, it may be founded on problems with the sources and the press bias. According to Darrell Huff, statistics are employed to sensationalize, inflate, confuse, and oversimplify. This can be said about journalism as well. Huff comments on the combination of journalism and statistics:

"Public pressure and hasty journalism often launch a treatment that is unproved, particularly when the demand is great and the statistical background hazy." [Note 162]

But Armen Alchian brings us comfort. Circumstances may be troublesome, but economists only need to have their eyes wide open:

"All that is needed by economists is their own awareness of the survival conditions and criteria of the economic system and a group of participants who submit various combinations and organizations for the system's selection and adoption." [Note 163]

 

On normal distribution and average: Huff mentions that the word "average" has a very loose meaning. It can be the mean (the arithmetic average), the median, or the mode (the most frequent figure). If the distribution is close to normal, then you can employ any of the three. If the distribution of income etc. is markedly skewed, then the mean is far from the median and the mode. In this situation nearly everybody is below the mean.

"Consequently one kind of average is as good as another for describing the heights of men, but for describing their pocketbooks it is not." [Note 164]

An example: Comparing Skype's profits to that of any other Internet start-up takes place in a population with a markedly skewed distribution. For this reason it will be impossible to use the arithmetic average for any reasonable purpose.

5.2 Schumpeter on Entrepreneurs

Joseph A. Schumpeter was an Austrian economist born 1883. His analysis and written work was in the style of Karl Marx – but from an aristocratic viewpoint. In 1909, at the age of 26, he was appointed as a professor of economics at the University of Czernowitz (now Chervotsky, in Ukraine). Here he studied the development of the railway network throughout the Austrian empire, and he found that "... in general it is not the owner of stage-coaches who builds railways."

In 1912 Schumpeter published "The Theory of Economic Development. An Inquiry into Profits, Capital, Credit, Interest, and the Business Cycle" in German, translated to English in 1934. [Note 165] He later published other works and served as professor at the universities of Graz and Bonn. From 1932 till his death in 1950 he was professor at the Harvard University in the United States.

In "The Theory of Economic Development" Schumpeter explains growth in the economy as great waves of innovation caused by entrepreneurs. He distinguishes between two kinds of entrepreneurs:

  • The Walrasian entrepreneur: Schumpeter's theory has its starting point in the French economist Walras' very formal model, where the cast consists of a landowner, a worker, a capitalist and an entrepreneur. It is the task of the entrepreneur to combine the resources of the three other participants to produce goods or services. The Walrasian entrepreneur is not using any kind of new inventions – he is solely adapting to obtain equilibrium within the existing framework, as for example by running a stage-coach. [Note 166]
  • The Schumpeterian entrepreneur: There is an avant-garde of economic actors who is unsatisfied with the routines. They introduce innovations and try to persuade the customers to use the new goods or services. [Note 167] If the innovation proves a success, the entrepreneur will earn a "Schumpeterian rent", that derives from the new and innovative product or service. [Note 168] In his model, Schumpeter resolves all goods into labour and land so that all kinds of goods can be regarded as "bundles of the services of labor and land." [Note 169]

Adam Smith claimed that if anybody does the best for himself then the whole society will prosper. In the same train of thought Schumpeter claims that the single entrepreneur's actions may result in economic growth in the society as a whole:

It is the entrepreneur's innovative actions at micro level, originating from the single individual's own situation and creativity as the result of an inner process, which in special situations gives rise to a vast throng of followers who may in turn influence cyclical fluctuations. [Note 170]

Schumpeter criticised Adam Smith for flattening the theory of economic growth into a single, oversimplified cause: The division of labour. Schumpeter insisted that the entrepreneurship is a unique factor of production and at the same time the scarce social input that makes economic history unfold. [Note 171] One might propose that Schumpeter propagated entrepreneurship as Adam Smith propagated division of labour. It was his wish to describe the entrepreneurs' activities as a useful part of the business life. On the other hand any entrepreneur is working for his own self-interest and can in this way be regarded as a kind of robber baron. [Note 172]

Joseph Schumpeter noted that it is the producer who initiates developments and that the consumers must be taught about the new inventions:

"... innovations in the economic system do not as a rule take place in such a way that first new wants arise spontaneously in consumers and then the productive apparatus swings round through their pressure. We do not deny the presence of this nexus. It is, however, the producer who as a rule initiates economic change, and consumers are educated by him if necessary; they are, as it were, taught to want new things, or things which differ in some respect or other from those which they have been in the habit of using." [Note 173]

The innovations are not evenly distributed through time, but appear discontinuously in groups or swarms. They do so because the appearance of one or a few entrepreneurs facilitates the appearance of others, and these the appearance of more, in ever-increasing numbers:

"The swarm-like appearance of entrepreneurs, ... has a qualitatively different effect upon the economic system from that of a continuous appearance evenly distributed in time, ... it does not, ... mean a continuous, ... disturbance of the equilibrium position but a jerky disturbance, ... of a different order of magnitude." [Note 174]

The innovation has a disruptive effect for the economy, as it is exposed to what Schumpeter calls "creative destruction." The disruption may be a complete reorganisation of the industry with increased production, abandoning of obsolete businesses, dismissal of workers, etc. [Note 175]

Schumpeter tried to find out how the economic system generates the force which incessantly transforms it, for example explained in his 1942 book "Capitalism, Socialism and Democracy" where he notes that:

"The problem that is usually being visualized is how capitalism administers existing structures, whereas the relevant problem is how it creates and destroys them." [Note 176]

5.2.a Entrepreneurial Characteristics

Schumpeter offers three important characteristics for the relationship between innovations and entrepreneurs. In general an entrepreneur should meet all of the three requirements: [Note 177]

  1. The innovation is a discontinuous, irreversible change of the market supply: "It is spontaneous and discontinuous change in the channels of the flow, disturbance of equilibrium, which forever alters and displaces the equilibrium state previously existing. ... Add successively as many mail coaches as you please, you will never get a railway thereby." [Note 178]
  2. The innovation is the introduction to the market, not the preceding invention of the product or service: "As long as they are not carried into practice, inventions are economically irrelevant." [Note 179]
  3. It is carried through in a newly established firm "which generally do not arise out of the old ones but start producing beside them, to keep to the example already chosen, in general it is not the owner of stage-coaches who builds railways." [Note 180]

Less important characteristics:

  • It is carried through with borrowed money: "The possessor of wealth, ... must resort to credit if he wishes to carry out a new combination.", "... in carrying out new combinations, "financing" as a special act is fundamentally necessary." It may be Schumpeter's intention to equalize the cost of capital so that the cost per unit will be identical for all competitors in the market place, no matter how much the individual entrepreneur can provide by himself. [Note 181]
  • It is carried through with resources that so far have been used elsewhere - "we must never assume that the carrying out of new combinations takes place by employing means of production which happen to be unused." Schumpeter acknowledges that unemployed resources may be a favourable condition and an incentive for new combinations. The reason for the rule must be to equalize the cost of resources for all competitors if all resources have an alternative cost. [Note 182]

For Schumpeter, an innovative concept is one of the following five types:

  1. "The introduction of a new good – that is one with which consumers are not yet familiar – or of a new quality of a good.
  2. The introduction of a new method of production, that is one not yet tested by experience in the branch of manufacture concerned, which need by no means be founded upon a discovery scientifically new, and can also exist in a new way of handling a commodity commercially.
  3. The opening of a new market, that is a market into which the particular branch of manufacture of the country in question has not previously entered, whether or not this market has existed before.
  4. The conquest of a new source of supply of raw materials or half-manufactured goods, again irrespective of whether this source already exists or whether it has first to be created.
  5. The carrying out of the new organisation of any industry, like the creation of a monopoly position (for example through trustification) or the breaking up of a monopoly position." [Note 183]

The Origin of Schumpeter's Entrepreneur: Nicholas W. Balabkins has demonstrated that Schumpeter found the idea of the disruptive entrepreneur in a book by A.E.F. Schäffle (1831-1903), a source, that Schumpeter has never acknowledged by himself. Schäffle was a professor at the Universities in Tübingen and Vienna, Austrian minister of commerce, and author of 33 books. Balabkin found the Schumpeter-like entrepreneur described in a book published 1867 called "Die national-ökonomische Theorie der ausschliessenden Absatzverhältnisse, insbesondere des literarisch-artistischen Urhebberrechts, des Patent-, Muster-, u. Firmen-schutzes nebst Beiträgen zur Grundrentenlehre." (The Economic Theory of Restrictive Sales Conditions in Relation to Literary-Artistic Copyrights, Patents, Trademarks and the Firm's Goodwill, Together with Contributions to the Rent Theory). [Note 184]

5.2.b Friis and Zennström as Entrepreneurs

Kazaa  

Skype  

Entrepreneurial Characteristics – all three types:

   

A. The innovation is a discontinuous, irreversible change of the market supply:

Yes

Yes

B. The innovation is the introduction to the market, not the preceding invention of the product or service:

Yes

Yes

C. It is carried through in a newly established firm

Yes

Yes

Innovative Concept – at least one of the five types

   

1. The introduction of a new good

Yes

Yes

2. The introduction of a new method of production, ... or a new way of handling a commodity commercially

Yes

Yes

3. The opening of a new market

Yes

Yes

4. The conquest of a new source of supply of raw materials

Yes

Yes

5. New organisation - the breaking up of a monopoly position

Yes

Yes

Details for Kazaa:

  1. Napster introduced Internet file sharing for MP3 music files. Kazaa introduced peer-to-peer file sharing for music, film, etc. and was followed by a swarm of similar services. Friis and Zennström used the peer-to-peer technique to avoid costs – and maybe to avoid Napster's legal vulnerability.
  2. The founders invested in the development and introduced Kazaa to the market
  3. They established Kazaa's service through the new firm Kazaa BV
  1. Friis and Zennström offered file sharing with a huge number of all kinds of files, efficient and user-friendly
  2. They threatened the music industry's sales and earned a modest profit on advertisements
  3. The users liked the free access to all kinds of files, and later some files were offered for sale on this new marketplace
  4. The founders took advantage of the improved Internet connections and let the users pay the cost for broadband etc.
  5. They broke the music industry's monopoly, which was at least one of several causes for lower prices for digitally distributed music. Originally, the music industry demanded three dollars per song. When Apple and other firms later offered licensed music files for sale, they demanded only one dollar per song.

Details for Skype:

  1. Friis and Zennström offered free Internet telephony distributed with their unique technology, user-friendly and in high quality ready for the grassroots' adoption
  2. They invested in the development and introduced Skype to the market
  3. They established Skype through the new firm Skype Technologies SA
  1. Friis and Zennström offered free Internet telephony
  2. They used the well-known peer-to-peer technology, but this time in the telephone business
  3. They opened a new market for free Internet telephony with a far better program than the competitors Free World Dial-Up (FWD), Deltathree, Packet8, and others
  4. Again, the founders took advantage of the improved Internet connections and let the users pay the cost for broadband etc.
  5. Their success threatens to disrupt the telecom industry worldwide

According to this account, Friis and Zennström are classical entrepreneurs in Schumpeter's definition.

5.3 Internet Strategy

5.3.a The Internet as a Brain

Gareth Morgan has in his book "Images of Organization" shown how to regard organizations with various metaphors. [Note 185] One of the metaphors that he uses is "Organizations as Brains".

Morgan states that there is a direct connection between artificial intelligence and the Internet when you regard both with the brain metaphor. The principles of artificial intelligence called "Cybernetics" were developed by Norbert Wiener during the 1940's. If a system shall be able to regulate itself, it must depend on exchange of information and negative feedback. [Note 186] The general rule of a simple cybernetic system is to avoid undesirable system states, "Thou shalt not", or what Morgan call

"avoiding noxiants defining a space of acceptable behavior within which individuals can act, innovate, or self-organize as they please." [Note 187]

The principle of avoidance operates in quite complex areas of social life such as legal rules, the Ten Commandments, or the Internet. According to Morgan, the Internet offers a perfect example of the problems of design in complex, open-ended systems:

  • No one can say what form the Internet should take
  • No one knows its true potential or what its future should look like
  • It cannot be predesigned in any authoritative way [Note 188]

This lack of rules is yet the reason for another rule, the rule of avoidance. We tell other users what they should not do, for example "Do not distribute junk mail". For Morgan, this confirms the brain-like, self-organizing organization of the Internet:

"As a result, the Internet is evolving within the space defined by key parameters. Experience and practice tests the limits thus defined, giving rise to a redefinition of limits when appropriate. In this way, the Internet is self-organizing in a way that is producing an emergent design. As in the developing intelligence of the brain, resonant innovations become embedded in the evolving 'architecture'" [Note 189]

Wise words – and stated in 1997, when the Internet was still young.

5.3.b Digital Strategies and the Value of Networks

In 1998 Larry Downes and Chunka Mui described the booming Internet business in their book "Unleashing the Killer App – Digital Strategies for Market Dominance." [Note 190]

Downes and Mui discuss killer applications throughout history, especially the stirrup, which made it possible for a mounted fighter to strike with a lance without falling off his horse. Around the year 740 the Franks' victory over the Saracens changed European military strategy and gave place for the specialized fighters of the cavalry, and with that a new class of landed gentry. The Franks were led by Charles Martel. [Note 191]

Charlemagne visits Pope Adrian I

Charles Martel's grandson Charlemagne visits Pope Adrian I. Note Charlemagne's stirrup. [Note 192]

It is the authors' view that the Internet is a killer application like the stirrup was 1250 years ago.

5.3.c Go for the Metcalfe Curve – Give Your Product Away

Downes and Mui are founding most of their recommendations on Moore's law [Note 193] and Metcalfe's law. Robert Metcalfe, the designer of the Ethernet protocol for computer networks, observed that new network technologies are valuable only if many people use them. Specifically, the usefulness of a network equals the square of the number of users, a function known as Metcalfe's Law. That is: If you have the double number of users compared to a competitor, then the usefulness of your network is four times higher.

An example: In section 4.4.c is a table describing the number of users in the various telephone and messenger networks. According to Metcalfe's formula, the customers' relative value of a network is the square of the number of users as shown in the figures below. Please note, that the networks are difficult to compare, as the various companies offer various kinds of service for their customers.

Square million users Square million users

The customers' relative value of the network as the square of the number of users. The left figure shows the curve – the right figure shows the value of the network as square areas.

Downes and Mui in 1998 described the effect this way:

"Developers of today's digital technology are conscious of Metcalfe's Law, and they are developing counterintuitive rules necessary to optimize and exploit it. The most dramatic demonstration of Metcalfe's Law during the digital age has been the explosion in the early 1990s of the Internet, a network of computers and a set of standards that makes it easy for computers to share data. ...

  • Computer hardware, software, and networking companies had been building up their user bases for decades with closed, proprietary networking standards like IBM's Systems Network Architecture and its PC token ring network, document interchange, and hundreds of subsidiary "IBM solutions"—solutions, that is, for IBM.

  • The Internet, on the other hand, has always been based on open, public standards, allowing it to grow faster despite its lack of a marketing function or, indeed, any organization whatsoever. The Internet became the dominant global computing network it now is by being the first to reach the knee in Metcalfe's curve, and the impact of that victory will be played out in the information technology industry for years to come." [Note 194]

Downes and Mui propose that open systems like the Internet browsers Mosaic and Netscape were killer applications like the stirrup was in the 740's. To get maximum exposure for Mosaic, the founder Marc Andreessen lowered the price of the software to zero. But how to earn money when you give your main product away? In Netscape's case the company derived revenues from advertisements and software tools for building and managing web sites.

"Netscape captured 80 percent of the browser market within months of its first product release in 1995 by giving away millions of copies of its software. ... giving away Navigator costs little in real dollars. Thanks to the Internet itself, users simply download the software, using their own phone connection, their own machines, and their own electricity. The marginal cost of each "copy" of Navigator that Netscape has given away is not effectively zero, it is actually zero. ... Navigator hit the Metcalfe curve at warp speed, with critical mass and the predictable explosion occurring not in years but in months. ... The Internet itself is their low-cost channel for advertising, product development, manufacturing, and distribution." [Note 195]

5.3.d Downes and Mui on Railways and Telephones

"Unleashing the Killer App" is in some ways quite outdated. The Internet had existed in various forms for many years, but reached critical mass in 1993. The Killer App book is published five years later in the middle of the Internet bubble. From 1998 until the time of writing this paper eight years has passed. Downes and Mui get it right on page 16 where they consider "telephone services over the Internet". But in all other parts of the book they use the telephone to describe a part of the predigital networks:

"Consider the telephone. How useful is it? Your answer depends entirely on how many other telephones there are and on how easily they can be interconnected. One phone is useless, a few phones have limited value. A million phones create a vast network, ...

For the phone system, or the power system, the initial investment in network infrastructure was high, which kept the price of access high. In the case of railroads and telephones, initial developers failed to appreciate the value of interconnection (in essence, the power of the Metcalfe curve). ... In the predigital age, Metcalfe's Law could take decades to unleash network power." [Note 196]

Downes and Mui's description of telephone systems sounds like Schumpeter's railways in the Austrian Empire, a world that was largely protected from global and digital competition.

5.3.e The Lock-in Effect

The lock-in effect is an expression used to describe a customer's reluctance to change between suppliers. If the customer chooses another supplier, he may have to change procedures, buy additional equipment, etc. Microsoft Corp. is known as a vendor that is very clever in using the lock-in mechanism so that its customers are reluctant to change to other suppliers, and here are two examples concerning operative systems:

  • If a firm wants to change to an operative system from another vendor for performance or cost issues, then there may be a need for costly changes in the company's files, programs, servers, etc. After the change a lot of the organization's traditional computer skills will be superfluous.
  • As Windows is a dominant operative system, it is an advantage for any Windows user that everybody is using the same standard. Files and programs are compatible across company borders, etc. That is an advantage for each firm in question, and certainly for Microsoft. [Note 197]

The lock-in effect is important in networks like telephone systems. It is an advantage to be the first mover, as most customers stay with their first choice. Even if telehony is free, any firm will create costs and loose revenue if it changes to another supplier of telephony. In this way the lock-in effect is working both for Microsoft and for Skype – even when most of Skype's offers are free.

5.3.f Friis, Zennström, and the Internet Strategy

Friis and Zennström have learned the lesson well. Twice they have created worldwide networks with the characteristics that Downes and Mui emphasize:

  • Both for Kazaa and Skype the advantage for the single user is that many others are connected to the network. Janus Friis told News.com in September 2003: "Before we launched, we thought that Skype would be even more viral than Kazaa. When you've got it, you want your friends to get it as well, so you can talk for free" [Note 198]
  • Friis and Zennström took advantage of the open and public standards of the Internet. They employed the peer-to-peer technology and made the customers install their (proprietary) program.
  • They gave away millions of copies of the Kazaa and Skype software. That was an offer with very limited costs, as they let the users bear the expenses for network connections, PCs, and electricity.
  • As Downes and Mui tell about Netscape, one could say about Friis and Zennström's projects as well: "The Internet itself is their low-cost channel for advertising, product development, manufacturing, and distribution."

As a result Friis and Zennström twice reached the "knee" in the Metcalfe curve at an astonishing speed. Kazaa is the world's most downloaded software yet, and Skype developed to be a worldwide telephone service in only two years after the launch.

Further, they went for the lock-in effect when they followed Tim Draper's advise from section 4.3.b: "viral adoption and minutes of voice traffic rather than a false economy of early profit"

Finally, Morgan's three dicta from section 5.3.a yield nearly unlimited space for Friis and Zennström to define profitable business plans:

  • No one can say what form the Internet should take
  • No one knows its true potential or what its future should look like
  • It cannot be predesigned in any authoritative way

5.4 Preparing for the Lucky Strike

In December 2002, Janus Friis told Politiken:

"... There is a lot of luck in Kazaa's success, a kind of snowball effect. Our starting point was that the program should be super-easy to use ..." [Note 199]

How come, that some businessmen seem luckier than other? I am not going to discuss luck and bad luck in the superstitious sense of anything "unnatural" happening, but here are two approaches from Armen Alchian and Jakob Nielsen.

5.4.a Sheer Chance and Conscious Adapting

Armen Alchian shows how chance or luck is one way to achieve success, as he distinguishes between sheer chance and conscious adapting:

  1. "Sheer chance is a substantial element in determining the situation selected and also in determining its appropriateness or viability."
  2. "A second element is the ability to adapt one's self by various methods to an appropriate situation." [Note 200]

To describe the role of sheer chance, or luck, Alchian proposes an unrealistic, but useful, approach to distinguish between the two criterions. In the example the individuals are barred from acting with conscious foresight:

"Assume that thousands of travelers set out from Chicago, selecting their roads completely at random and without foresight. Only our "economist" knows that on but one road are there any gasoline stations. He can state categorically that travelers will soon run out of gas. Even though each one selected his route at random, we might have called those travelers that were so fortunate as to have picked the right road wise, efficient, foresighted, etc. Of course, we would consider them the lucky ones.

If gasoline supplies were now moved to a new road, some formerly luckless travelers again would be able to move; and a new pattern of travel would be observed, although none of the travelers had changed his particular path. ... All that is needed is a set of varied, risk-taking (adoptable) travelers." [Note 201]

It will be possible for an economist to tell which participants that will now become successful, and in this way Alchian shows that the system is able to direct resources even if the individual travellers are ignorant of their self-interest.

"With a knowledge of the economy's realized requisites for survival and by a comparison of alternative conditions, [the economist] can state what types of firms or behavior relative to other possible types will be more viable, even though the firms themselves may not know the conditions or even try to achieve them by readjusting to the changed situation if they do know the conditions. It is sufficient if all firms are slightly different so that in the new environmental situation those who have their fixed internal conditions closer to the new, but unknown, optimum position now have a greater probability of survival and growth." [Note 202]

5.4.b Good Luck and Bad Luck on the Internet

Jakob Nielsen is a Silicon Valley expert on Internet usability. since 1995 he has been the author of a widely read newsletter. Here are three examples of conscious adapting for the good luck:

1. Here's an example of good luck from a test with disabled users trying to use the website of the U.S. tax authorities (IRS):

  • "One blind user wanted to find out whether she could deduct money donated to a high school band. Because the IRS page was long and overwhelming, the user decided to have her screen reader device read out the list of links on the page.

  • Further, because the user was looking for tax rules about "donations" she commanded the screen reader to read links that started with a "D." As it turns out, the IRS uses the term "deduction" rather than "donation" – something the user would never discover from a simple page or site search using the word "donation."

  • However, because both words start with "D" and the person was using a screen reader, she easily happened upon "deduction" as the correct link.

  • A joyful outcome, but one that's purely due to good luck."

2. People are sometimes lucky on a website and get exactly what they want in fewer clicks than expected:

"Maybe, for example, they're looking to buy something that happens to be the homepage's featured promotion that day.

In other cases, some users happily skirt gross usability mistakes that cause other people grave difficulties and much frustration."

3. Or they may be unlucky because of small, but real defects in the design's usability:

"What qualifies these flaws as bad luck is that, under rare circumstances, they condemn users to terrible misfortune. If things had gone a tiny bit differently – say, a user had scrolled down one line further – he or she might have had good luck and a very pleasant user experience.

Although the data shows that most users will avoid bad luck in their next online task, you can't just say "better luck next time"; if you do, their next user experience will likely be on somebody else's website.

People leave websites that hurt them – they don't know that it's just bad luck, and that next time will be better. It's therefore incumbent on you to hunt down the root causes of bad luck and eradicate them from your site." [Note 203]

5.4.c Survival and Risk

The risk thermostat

The risk thermostat

When we consider the importance of luck, it must also be noted, that in courting luck you may also court disaster and bankruptcy. For example Henry Mintzberg in his 1983 book "Power In and Around Organizations" noted that there are two principal goals for a Chief Executive Officer, which are the survival and the growth of the firm, and that the two may contradict each other. [Note 204] Any CEO may feel forced to investments that threaten the firms's survival if they go wrong, and as Alchian stated:

"Each possible action has a distribution of potential outcomes, of which one will materialize if the action is taken – and that one outcome cannot be foreseen." [Note 205]

To treat the question of risk I will include a theory that originally stems from a British researcher in traffic accidents. John Adams writes in his book "Risk":

"How to stay out of trouble? ... It appears to be a skill that we do not want to master completely."

John Adams proposes a theory of risk compensation called the risk "thermostat". The model postulates that:

  1. "Everyone has a propensity to take risks
  2. This propensity varies from one individual to another
  3. The propensity is influenced by the potential rewards of risk-taking
  4. Perceptions of risk are influenced by experience of accident losses – one's own and others'
  5. Individual risk-taking decisions represent a balancing act in which perceptions of risk are weighed against propensity to take risk
  6. Accident losses are, by definition, a consequence of taking risks; the more risks an individual takes, the greater, on average, will be both the rewards and losses he or she incurs." [Note 206]

5.4.d Friis and Zennström Prepared for the Lucky Strike

It is obvious that luck has smiled upon Friis and Zennström, but was it by sheer chance or by conscious adaptation to the situation? My opinion is that they may have prepared themselves very well by consciously adaptating, but sheer chance may have played a role as well.

  • They were well prepared from the beginning, where Politiken's journalist wrote: "It is easy to see why Fasttrack has gained its popularity. It works, it is quick, and it is easy to use, even for beginners and those scared by technology." [Note 207]
  • They developed a new Internet technology which (in extension of Alchian's example) works like a car that consumes no gas and hence can go where all other cars run out of gas
  • Surely they have been risking the future of their company. The whole idea of two entrepreneurs with limited means that want to disrupt all telecom companies of the world is a very risky business plan. Alchian wrote in section 5.1.a: "The greater the uncertainties of the world, the greater is the possibility that profits would go to venturesome and lucky rather"

5.5 Being on the Edge of Craziness?

In section 4.4.i I asked: How come that Friis and Zennström could come up with the ideas of Kazaa and Skype and realize them? In Berlingske Tidende, Morten Lund told of his impression:

"Janus Friis is visionary like a madman and Niklas Zennström is fabulous to execute the ideas and to organize their employees. ... They are always on the edge of craziness amounting to genius."

"Being on the edge of craziness" – that doesn't sound well. Or does it? We have a queer respect for the crazy ones. In a way it is like none of us in earnest want to be completely sane.

Adam Phillips is a British psychoanalyst who in 2005 published the book "Going Sane". He describes our strange relationship to the wish of being sane – but not too sane. In his book he is wondering what we in reality want to do, and how we tell others about it:

"Imagining possibilities for ourselves involves telling stories about what we think we are like, what we think we want, and what we think we are capable of."

He finds that as nobody seems to care about being a bit mad, and that we are risking our sanity by heading narrow-minded for our goals:

"It is possible that in losing heart about our sanity – in not describing or addressing it – we are losing more than we realize. It means, even at its most minimal, that we are becoming extremely narrowminded about what we want, about imagining possibilities for ourselves." [Note 208]

And sheer madness is a dangerous property. We only accept it if connected to genius:

"Madness requires genius to make it viable. Indeed that may, ultimately, be what genius is, what sanity has to be: a talent for transforming madness into something other than itself." [Note 209]

Adam Phillips is supported by Darrell Huff who is in doubt what is normal, and mentions that "normal" is not always the desirable state:

"Hardly anybody is exactly normal in any way, just as one hundred tossed pennies will rarely come up exactly fifty heads and fifty tails. Confusing "normal" with "desirable" makes it all the worse." [Note 210]

I agree with Darrell Huff in that it is dangerous to mention a subject with a high emotional content without hastily saying whether you are for or against it. [Note 211] So I will simply say that I do consider neither Friis nor Zennström mad.

5.6 A Digression into Biology

Economics can be difficult to understand, and it is quite usual for economists to borrow images or metaphors from the natural sciences. For example Schumpeter gives an account of the terms "static" and "dynamic":

"The terms static and dynamic were, although in a different sense, introduced into economics by John Stuart Mill. Mill probably had them from Comte, who, in turn, tells us that he borrowed them from the zoologist de Blainville." [Note 212]

Later in the book Schumpeter discusses whether economic systems develop continually like natural systems do. His answer is that they do not:

"Our question is: does this whole development which we have been describing proceed in unbroken continuity, is it similar to the gradual organic growth of a tree? Experience answers in the negative. It is a fact that the economic system does not move along continually and smoothly. Counter-movements, setbacks, incidents of the most various kinds, occur which obstruct the path of development; there are breakdowns in the economic value system which interrupt it." [Note 213]

But... "hier irrt Schumpeter". This is a false discrepancy; as such interruptions exist in natural systems as well. Economists use biology to explain economy, and biologists do vice versa!

5.6.a Forks on the Road

Gareth Morgan explains changes in organizations by employing the image of forks on the road: They usually arise around key paradoxes or contradictions that block the way to the future. Systems seldom change gradually – they either choose the old road or a new road. Systems that move away from the influence of a dominant attractor pattern towards a potential new configuration encounter forks on the road (bifurcation points), at which energies for change shift the system into a new form or dissipate and dissolve in a way that allows the old attractor to reassert itself. [Note 214]

Ball rolling downhill

The ball will find its way, but which way?

The image of the ball rolling downhill stems from the Scottish biologist C.H. Waddington. He used it as an illustration of how embryo mammals canalize their DNA into their full-grown forms. Just a little change in the landscape may change the choice so that the ball will end somewhere else than in the usual, expected place. [Note 215]

The emergence of new species: The Danish biologist Jesper Hoffmeyer has suggested a set of conditions for new species to arise: Normally, aberrant types will be wiped out by the Darwinian selection. But the selection will not be as strong in the outer fringe of the species' area as in the centre. Here, distinctive characters may be allowed to spread, and with them also secondary modifications. Under favourable circumstances some of these secondary modifications could happen to stabilize the new, distinctive characters. If the new species is discretely stabilized, it may later be able to compete with the original species in the centre as well. [Note 216] The biological species will experience counter-movements, setbacks, and incidents of the most various kinds – just like Schumpeter's economic systems above.

5.6.b Changes in the World Description

Jesper Hoffmeyer proposes that one may regard the social world as a homeostatic system connecting technology, consciousness, organization, and world description. Like Leavitt's diamond, one cannot change one part of the system without changing at least one of the other parts as well.

Hoffmeyer employs the image of a train with a locomotive (technology and consciousness) and a heavy wagon (organization and world description) to illustrate the possibilities for societal development.

Mostly, the train will pass through wide valleys, but sometimes it must cross a mountain ridge. Uphill the locomotive (technology and consciousness) are doing the hard work incited by vague ideas about the wonderful possibilities in the next, faraway valley - while the wagon (organization and world description) resist with all of its weight.

From the top of the ridge there is a clear view of the new valley. The old world description cannot explain the new valley and will quickly transform into a new world description. The technological possibilities of the new valley will be legalized, and the train can enter the new valley.

After passing the ridge, the heavy wagon will push the train downhill. Because of the speed, the new organization and world description may even create problems and instability for the technology and consciousness. Later there will be a new, stable homeostasis between the four parts of the system. [Note 217]

5.6.c Friis, Zennström, and the Biological Development

Forks in the road: A little change in the input may create a huge change in the outcome. A sudden change in Alchian's luck (section 5.4.a) will be enough, and the customers will prefer Internet telephony instead of ordinary telephony. If you combine that with the lock-in effect (section 5.3.e) you will see, that the little change may have permanent consequences.

The emergence of new species translated into economics: Skype was allowed to emerge in the fringe of the telephone market, and the others laughed at it, as when AT&T's officer Hossein Eslambolchi said: "What Skype is doing is like a toy, they will realize they can't scale it, they..." (section 4.3.a). But Skype had some of Alchian's two kinds of luck and managed to attract millions of customers. The members of the ordinary POTS species had to recognize that here was a dangerous, new species that grew quickly extremely low costs.

Changes in the world description: Right now we experience an unknown world description, an enormous technical development, and in the middle of the unknown is the Internet:

  • "No one can say what form the Internet should take
  • No one knows its true potential or what its future should look like
  • It cannot be predesigned in any authoritative way" [Note 218]

Klaus Riskær Pedersen's words from section 4.4.i may be a warning that a completely new world description is ahead:

"Their message is that the development will be stronger than the rules, so that if the development is right, the rules will be changed."

5.7 Opportunities and Strengths

Here is an overview of the opportunities and strengths at the moments when Friis and Zennström founded Kazaa in 2000 and when they founded Skype in 2003.

During this analysis I will take into regard what are causes and what are effects. For example I consider all marketing efforts as instances of Huff's unclear cause and effect – they may be cause and effect at the same time.

5.7.a Kazaa's Opportunities and Strengths

External Opportunities:

  • The music industry had changed to digital media. That improved the quality for the customers and made the distribution for the industry easier. (3.1)
  • Napster had shown the possibilities of file sharing, but was threatened by legal claims (3.1)
  • Broadband penetration was growing in 2000 (3.1.a)
  • The peer-to-peer technology was well suited for the purpose (3.1.c)

Internal Strengths (1) – The Business Plan:

  • Friis: "We quit our jobs because we wanted to find out which kind of project." (3.2)
  • Zennström: "We knew we'd come up with something. ... Or at least we hoped we would." (3.2)
  • Originally they hoped to sign deals with European Internet service providers and to offer a pay-for-share music service. Morten Lund: "When he presented the business plan for Kazaa I simply could not believe it." (3.3.a, 4.4.i)
  • When the first plan did not work, the second business plan was to let the customers have the basic service for free and let the network grow. Friis and Zennström's source of income were reduced to advertisement fees and license fees. (3.1.a, 3.6.a)
  • Friis and Zennström provided Kazaa with a user-friendly interface, an advanced search facility, etc. (3.2.b)
  • The peer-to-peer principle for file sharing was a well-known principle exploited for a new purpose. (4.3.a)
  • The advantages of the peer-to-peer principle are that the popular files are the most accessible, that Kazaa's growth required no infrastructure, and that there were no central control (which was a legal protection) (3.1.c, 4.3.c)
  • The effect was that with limited means they created a business model that disrupted business worldwide in the music and film industries. Friis: "It is fun to be ahead (cause) and that we can provoke the huge organizations and their lobbyists." (effect) (4.4.j)

Internal Strengths (2) – Cooperation with Venture Capital:

  • None, as when the two started Kazaa, they couldn't get a call returned (4.3.a)

Internal strengths (3) – The Internal Cooperation:

  • Friis and Zennström had worked together developing business ideas for the Internet since 1997. Friis: "We have always had a queer faith in what we were doing." ..." we had to keep the goal in mind. It cost a lot of toil and long workdays." (4.4.j)
  • Morten Lund: "Janus Friis is visionary like a madman and Niklas Zennström is fabulous to execute the ideas and to organize their employees. ... They are always on the edge of craziness amounting to genius." ... "There is a lot of work behind the success ... Janus is uncompromisingly persistent when it is time to realize the ideas." (4.4.i)

Internal strengths (4) – Technical Questions:

  • From Tele2 they had experience in distributing communications software via Internet in a technical quality so that it could be employed by all kinds of computers in all kinds of configurations. Friis: "We are trying to make our product more user friendly than Napster, which definitely is geeky. For example Kazaa has an advanced search facility."(3.2.b)
  • The peer-to-peer technology appeared to stand up to millions of simultaneous users (4.3.a)

Internal Strengths (5) – Marketing, which may be both cause and effect at the same time:

  • They offered a free, simple, easy-to-use product that easily could be adopted by the customers (3.2.b)
  • They employed viral marketing, but it is not clear whether they do so because of lack of money, or on purpose. The viral marketing was possible because the product was viral in itself, and because it was easy to install and to use. Friis: "We uploaded the programs to a web server and entered links on http://download.com and other shareware sites. Then we just sat down and waited for something to happen" (3.2.b)

5.7.b Skype's Opportunities and Strengths

External Opportunities:

  • The established telecoms had the customer relations, but could not compete technically with Skype's peer-to-peer technology (4.3.a)
  • The other Internet telephone start-ups had neither the customer relations nor the peer-to-peer technology (4.2.a)
  • The broadband penetration increased dramatically in 2003. This was partly an external, partly an internal cause, as Kazaa's success was one of several causes for the improved broadband penetration. Zennström: "P2P file sharing has been driving broadband adoption." (4.2.e)
  • As with Kazaa, The peer-to-peer technology was well suited for the purpose (3.1.c)

Internal Strengths (1) - The Business Plan:

  • Friis and Zennström's business plan for Skype depended on economy of scale by letting the customers have the basic service for free and wait for the network to grow. Later Friis and Zennström could exploit the value of the network without depriving their customers of the free service. (4.2.e, 4.4.d)
  • The use of peer-to-peer technology for Internet telephony was a well-known principle exploited for a new purpose: Daniel Roth: "Like most of Zennstrom and Friis's ideas, this one wasn't original" (4.3.a)
  • They offered instant messaging from day one and were well prepared for offering more services (4.2.c)
  • Skype's growth required no infrastructure and only minimal capital investment compared to the established telecoms (cause). For this reason they were able to offer it for free without losing money (effect, 4.3.a)
  • They were well prepared for public rules and regulations - as well as they unintentionally had a lot of legal experience (4.2.c)
  • With limited means (cause) they created a business model that disrupted business worldwide in the telecom industry (effect). Ian Clarke: "When you are doing something disruptive, it typically means there is a business opportunity there." (4.4.h)

Internal Strengths (2) – Cooperation with Venture Capital:

  • They engaged with the venture partners in October 2002. That the venture partners agreed meant that somebody believed in the idea (cause) and that Friis and Zennström had somebody to discuss with (effect). Friis: "The investors hardly believed us". Morten Lund: "Later, I could not believe in Skype either." (4.4.i)
  • They had patient investors like Tim Draper, and for a very long time they sticked to his advice: "viral adoption and minutes of voice traffic rather than a false economy of early profit" (4.3.b)
  • Because of their achievements with Kazaa (cause) they had venture investors in the Skype project (effect). Daniel Roth: "Without Kazaa, they would likely be just two European entrepreneurs trying to get some attention." (4.3.a)

Internal strengths (3) – The Internal Cooperation (as with Kazaa, see above)

Internal strengths (4) - Technical Questions:

  • Experience from Tele2 and Kazaa (3.2.b)
  • They were experienced in user-friendly technology and offered a sound quality better than the ordinary telephones network did (4.2.c)
  • The peer-to-peer technology appeared to stand up to millions of simultaneous users, to register the users in the distributed database, to manage encryption, etc. (4.3.a, 4.3.d)
  • The Estonian programmers were able to penetrate nearly all firewalls (4.2.e)

Internal Strengths (5) - Marketing:

  • Friis and Zennström had star power - they were well known among Internet users and in the press (both cause and effect) (4.2.b)
  • They offered a free, simple, easy-to-use product that easily could be adopted by customers – the glad tidings of telephony free of charge for everybody all over the world (4.2.c)
  • They employed viral marketing on purpose. This was possible because the product was viral in itself, and because it was easy to install and to use. (4.2.c, 4.2.e, 4.2.f)
  • They targeted private users with the plain message of free telephony (4.2.e)
  • They marketed Skype directly to the consumers, not depending on collaboration with various distributors throughout the world (4.2.e)

5.8 Answering Research Question 1

Here is an abstract of all of the theories and methodologies dealt with in the sections 5.1 – 5.6 combined with the cases as referred in section 5.7.

Why were Friis and Zennström successful with Kazaa and Skype?

Causes in the case of Kazaa:

  1. Friis and Zennström started in 2000 with an idea that could disrupt business in the music and film industries to create an Internet business for themselves
  2. They chose to work with the peer-to-peer technology that they knew from Tele2
  3. In the beginning nobody else believed in their business plan. They financed the venture by themselves and created Kazaa as a free, user-friendly file sharing program.
  4. They spent no money on marketing, maybe because they did not have the money

Effects:

  • They experienced an enormous success measured in number of downloads
  • They were chosen as the main target of the music industry and decided to leave Kazaa

Causes in the case of Skype:

1. Friis and Zennström started again in 2003 with a disrupting idea, this time in the telecom industry

2. They chose again to exploit the well-known peer-to-peer technology

3. They declared that from now on telephony was free for all. They offered a user-friendly program with good sound quality and an ability to penetrate firewalls.

4. They used viral marketing only, and let their customers do the marketing work

5. Their technology appeared to stand up to millions of simultaneous users

Effects:

  • They experienced again an enormous success in number of downloads and customers, partly because of the "star power" from their Kazaa project
  • In 2005 they chose to sell Skype to eBay for 2.6 billion dollars

Summary

Friis and Zennström have a unique cooperation. They generate ideas and turn them into big business.

They are classical entrepreneurs in Schumpeter's understanding. They create valuable networks and are well prepared to be lucky in Alchian's understanding.

They founded Kazaa and learned a lot, but did not earn much.

When they founded Skype, they chose to use viral marketing only – a demanding principle, as the distributed product must be viral in itself.

In both cases they have created their own market by letting their customers have the basic service for free and then wait for the network to grow. In both cases they could later sell the network without depriving the customers of their advantages.

With limited means they have created a business model that affect the whole world. They created an enormous profit for themselves and disrupted the music, film, and telecom industries.

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