Our secret sauce

Posted by Hal Varian, Chief Economist

I was recently a guest columnist on the Freakonomics Blog. There were several interesting questions from the readers, but one was quite striking:

"How can we explain the fairly entrenched position of Google, even though the differences in search algorithms are now only recognizable at the margins? Is there some hidden network effect that makes it better for all of us to use the same search engine?"

It seems that a lot of people are trying to figure out why Google has done so well. The difficulty is that the typical economic forces at work in many technology businesses that lead to entrenchment don't seem to explain our success. Let's take a look at the usual culprits.

Supply side economies of scale. This refers to the fact that a larger business may enjoy a cost advantage. The problem is that though there probably are some scale advantages, they get played out at a reasonably small scale. There are plenty of data centers out there and plenty of people that know how to run them efficiently.

Lock-in. The idea here is that when users have a high cost of switching to an alternative provider, they can be charged high prices that reflect the fact that they are effectively locked in to a single provider. But if you look at Google's business, the competition is only a click away. Users can trivially switch search engines. Most of our large customers also advertise on other search engines. And most publishers get their ads from a variety of providers, including their own sales force. So there are very small costs of switching to an alternative search engine for users, advertisers, and publishers.

Network effects. This refers to a phenomenon where the amount that people are willing to pay for a service depends on the number of people that have already adopted a service. The classic example is a fax machine: the amount that I am willing to pay for a fax machine depends on how many of my correspondents already have one. But this doesn't fit the Google case either: my decision to use Google is irrelevant to other users. It's true that advertisers want to advertise where there are lot of users but that doesn't affect the amount that they are willing to pay on a per user basis. The value of a user to an advertiser depends on how likely he or she is to buy, not how many users there are. A small website about knitting could be a great place to advertise yarn and could charge rates far higher for such ads than a much larger site.

If it isn't economies of scale, lock-in, or network effects, what is it that explains Google's success?

The answer, at least in my opinion, is a much older economic concept called "learning by doing" that was first formalized by Nobel Laureate Kenneth Arrow back in 1962. It refers to the widely-observed phenomenon that the longer a company has been doing something, the better it gets at doing it.

Google has been searching the web for nearly 10 years, which is far longer than our major competitors. It's not surprising that we've learned a lot about how to do this well. We're constantly experimenting with new algorithms. Those that offer an improvement get rolled into the production version; the others go back to the drawing board for refinement.

So I would argue that Google really does have a better product than the competition -- not because we have more or better ingredients, but because we have better recipes. And we are continuously improving those recipes precisely because we know the competition is only a click away. We can't fall back on economies of scale, or switching costs, or network effects, to isolate us from the competition. The only thing we can do is work as hard as we can to keep our search quality better than that of the other engines.