There’s a pattern to spotting economic revolutions: look for catalysts borne of changes in information, automation, or connectivity. The printing press produced masses of information that presaged the renaissance. The steam engine produced automation and the railroad connectivity that ushered in the industrial revolution. While the scale is smaller, there’s a revolution in connectivity underway now that is changing industry. As a result, pricing, supply chains, financial models, antitrust laws, and sources of competitive advantage are different.
Disruption is occurring based on a latent form of network effects. Ever-cheaper information and connectivity have revealed demand-interdependent or “two-sided” network effects that are turning old concepts upside down. For instance, we intuitively understand that a product with network effects gets more valuable as more users use it: Think about telephones, FAXes, and email gaining critical mass and creating S-shaped growth. But two-sided network effects are different. Here, a product or service gets more valuable to one group of users the more another group uses it. Consider that a single Internet searcher gets more value as others produce more web content, just as a single content producer gets more value as the audience of searchers grows.
Platform businesses match and benefit from these two-sided networks. AirBnB matches people with spare rooms to people with travel plans. YouTube matches content creators to content consumers. eBay matches buyers to sellers. oDesk matches tasks to talent, just as Apple iTunes matches users to apps and listeners to music. Connectivity-based network effects are as old as the railroads, but two-sided network effects became visible with the rise of the World Wide Web.
Before 1989 it might have been possible to do what these firms do, but it would have been difficult. That’s when researchers at the European Organization for Nuclear Research (CERN), proposed a way “to link and access information of various kinds as a web of nodes in which the user can browse at will.” Before the Web, you needed a printed directory to find a bed and breakfast, or a Kelly Services to hire temporary labor. Getting the music or video you wanted required trips to Tower Records or Blockbuster. If you didn’t want to pay, you might have borrowed from a local library. The best approximation for on-demand music was call-in radio.
New Rules, New Games
The Web has changed commerce forever. Beyond the hype that Internet boosters like Wired proclaim, the rules really are different. Prices below marginal cost can maximize profits. Linear supply chains fall to supply ecosystems. Classic antitrust tests of predation fail. Models of customer lifetime value leave MBAs scratching their heads when the services are free. The “resource-based” view of the firm holds that competitive advantage derives from control over novel resources, yet Google grows with each gmail account granted, each video posted, and each web page hosted–and it lacks even a copyright interest in any of this. Information technologies do not simply automate; they obliterate accepted business models.
The chief difference, again, is interdependent demand. Latent feedback dependence becomes visible as the costs of interaction and of universal “browsing at will” fall to zero. The more spare rooms AirBnB has, the more travelers it attracts and the more they list their own spare rooms. eBay buyers need sellers and vice versa. The more content YouTube hosts, the more eyeballs it attracts, the more users seek fame by creating content. Before the Web, high costs of interaction provided friction on this feedback. The traditional retail models of Tower Records and Blockbuster made sense. You needed to aggregate content or services from specialized producers then take it to markets where you could find the demand for the products you controlled.
Free universal browsing reveals interdependent demand. This means you can subsidize one side of a network, i.e. price below marginal cost, in order to charge more to the other side. The profits lost on subsidized users are swamped by profits gained on charged users. Classic antitrust tests fail because, despite devastating effects on competition, both sets of users are better off using a single market rather than a fragmented market to transact. The lifetime value of the free customer is measured by the change in elasticity and lifetime value of the matched customers. The resource-based view is undone! AirBnb, oDesk, eBay, iTunes, and YouTube do not own what they sell nor do they even control the assets used to produce what they sell. Instead, competitive advantage derives from the ability to consummate the match. The more matches, the more transactions, the more value they create. Platforms that perform matches efficiently have developed as a new ecosystem model of commerce.