Love vs Lock In

Economists love to talk about “scarcity” and the fact that we live in a world of limited resources.

However, in the digital world this need not necessarily be the case.

Phil Libin of Evernote is of the view that if you’re in a traditional industry like minerals extraction or transportation, then customers will either go for your stuff or your competitors stuff, but almost certainly not both. And so it’s more or less a zero sum game.

However, Libin believes that in the world of technology it’s really not zero sum. There is room for people to use multiple products. It’s not a scarcity based economy. If anything, it’s a love based economy. It’s an economy where the affinity that people have towards your products and towards your brand controls how much money you make. If you’re in the technology industry it’s a mistake to think about the world in terms of scarcity.

Libin believes that while the tech world does lend itself towards having one business dominate in a particular segment (for example, Google in search), this is only because the tech world is becoming more of a meritocracy than it’s ever been. Libin asks, quite reasonably, why would you use the second best product when you can use the best?

The problem with Libin’s view about meritocracy (apart from the fact that it seemingly contradicts his view that there is room for everyone in Silicon Valley’s love based economy) is that it’s only a half truth. One of the strongest forces that enable (or inhibit) many technology companies are network effects. Companies that have lots of users can be extremely valuable because users benefit from each other rather than from anything that the company itself provides.

A case in point is Facebook. There is not a month that goes by that I don’t consider leaving the network, or don’t talk to a friend who is thinking about doing the same. But people typically return when they realise that, despite Facebook being a horrible and pointless waste of time, everybody else they know is on there too.

Network effects can protect incumbents long after their time has passed and this explains not only the persistence of Facebook but also that of other technology products including Microsoft Office and Whatsapp.

The technology industry may not be a zero sum game, but nor is it quite the meritocracy that Libin would have us believe.

Maintaining Market Power Online

In an age of rapid digital disruption, how can you retain market power and continue to prosper online?

There is a lot of misinformation and confusion about how to compete in the digital landscape, and one of the points of confusion is about the power and value of content.

There is a new company called The Grid, which you may have seen advertised on Facebook, which is planning to sell AI websites that design themselves. The company’s tagline is “content is power, power your content on The Grid.”

The company argues that if we each had our own unique personal corner of the web, then the Internet would be a better place. This is a compelling sales pitch but it also conveniently ignores the way that market dynamics work online.

As I highlighted yesterday, the Internet creates winner take all dynamics whereby companies that can establish brand recognition, sufficient scale and strong network effects will often be able to dominate their market segment online.

Consider also the fact that companies like Narrative Science have managed to produced natural language algorithms that can create high quality pieces of writing. This technology has the potential to put most journalists out of work and, perhaps a little bit further down the line, lawyers and technical writers too.

Content is not power, but if it can be used to connect with people and bring them together in a scaleable way then that would be powerful indeed.

Monopolies on the Internet

Monopolies on the Internet

(Source: Flickr)

When the Internet was still a toy a decade or so ago, many business leaders and strategists didn’t believe that it would be possible to create a profitable business online.

The reasons given to support this belief were many and various.

Some argued that business on the Internet would never work because it is impossible to establish trust online. However, businesses like eBay, Amazon, Paypal, and LinkedIn have all proven this argument wrong.

Others argued more persuasively that business on the Internet would never work because, since anyone can have a website, the large number of websites would lead to a kind of hyper-competition resulting in the destruction of profits online; a boon for consumers but not so great for Internet-based businesses.

As it happens, this second argument also turned out to be wrong. But why?

If everyone can have a website why is it possible for some Internet-based businesses to compete successfully?

The answer is an ancient one, and appears to have been discovered in the early days of civilisation by the priests and then later by the universities.

In short, it is possible to establish a monopoly online with the help of three simple concepts: brand, scale, and network effects.

Brand is your level of social recognition, or share of mind. Since websites are typically free (in whole or in part) they are uniquely well suited for brand building.

Scale is how many people you can reach, and since websites can be accessed anywhere in the world, instantly and free of charge, the Internet is the most effective tool ever devised for reaching people at scale.

Network effects is when you bring people together around a common interest or shared purpose. Amazon and eBay connect buyers and sellers, Facebook connects friends, LinkedIn connects colleagues, and so on. The Internet enables online businesses to build monopolies by connecting enough people in a particular market segment to establish strong network effects.

Brand, scale, and network effects are three powerful barriers to entry that every Internet-based business needs to be aware of, and which can be used to build monopolies online.

Barriers to Entry

You may want to launch a new product, start a new business or enter a new market. What’s stopping you?

No entry

BARRIERS to entry are costs that must be paid by a new entrant but not by firms already in the industry.  Barriers to entry have the effect of making a market less contestable and allow existing firms to maintain higher prices than would otherwise be possible.

Here are seven (7) examples of barriers to entry:

1. Economies of Scale

The existence of economies of scale in an industry creates barriers to entry. Since existing firms are already producing they are often better position to exploit economies of scale than a new entrant and, as such, can often undercut on price. A new entrant is forced either to accept the cost disadvantage or enter the industry on a large scale (which increases the likely financial loss if they are later forced to exit the industry).

2. Product Differentiation

If there is a high level of product differentiation in the industry then this creates a barrier to entry since new entrants will not be able to compete merely on price, but will need to provide a unique value proposition.

Brand recognition: If existing firms and products have strong brand recognition that will deter new entrants. If customers perceive existing products as unique or high quality then a new entrant will need to spend money to educate customers about the unique qualities and benefits of its new products.  This will increase the cost of gaining market share and deter entry into the market.

Customer service: If existing firms have strong customer relationships formed through strong customer service and customer loyalty programs then it may be difficult for new entrants to gain market share.

Network Effects: The term “network effect” refers to the situation where a product or service becomes more valuable as more people use it. One example is eBay; as more buyers use the online auction site it becomes more valuable to each seller, and as more sellers use the site it becomes more valuable to each buyer.

If existing products or services in the industry benefit from network effects then it may be difficult for new firms to enter the industry.

Product differences: Existing products in the industry may be different due to differing design, quality, benefits, and other features.

3. Capital Requirements

High start-up costs: High fixed start-up costs will deter new firms from entering an industry. Examples of capital intensive industries with high fixed costs include the automotive and telecommunications industries.

High sunk costs: If a large portion of the start-up costs cannot be recovered (i.e. they are sunk costs) then the new entrant risks having to absorb the loss if it decides to exit the industry. Examples of sunk costs include:

  • Specialised assets: Highly specialised technology or equipment that cannot be used for other purposes and which cannot be sold (or can only be sold at a massive discount).
  • Industry specific expenditure: Industry specific expenditure, such as marketing or R&D, which cannot be used to benefit the firm’s operations in other industries.

4. Intangible Assets

Proprietary product technology: The existence of proprietary product technology represent a barrier to entry. If an existing product is protected by patent then it will not be possible for a new entrant to use the patented technology without permission from the patent owner.

Specialised knowledge: Incumbents may possess specialised knowledge, skills or qualifications which are difficult and costly to acquire: e.g. legal or medical skills.

5. Access to Suppliers and Buyers

Access to raw materials: If a new entrant cannot gain access to raw materials then this represents a barrier to entry. If existing firms have exclusive long term contracts with suppliers (or existing firms own key suppliers) this will make it difficult for a new entrant to obtain the raw materials it needs to operate effectively in the industry.

Access to distribution channels: If a new entrant cannot gain access to distribution channels then this represents a barrier to entry. If there are a limited number of wholesale or retail distribution channels, or existing firms have exclusive long term contracts with distributors then this will make it difficult for a new entrant to reach the customer. For example, McDonalds has stores in the best locations which makes it more difficult for new entrants to compete.

6. Government Regulation

The government may limit or restrict entry into a market by imposing licencing requirements or controlled access to raw materials.

Market participants may require a licence or other government approval in order to carry on its business; examples include taxi licenses, safety standard compliance certificates, mining permits, or investment approvals.

In extreme cases, the government may make competition illegal by establishing a statutory monopoly. For example, AT&T had a statutory monopoly in the telecommunications industry in the United States until the early 1980s.

Note that government regulations that limit or restrict the activity of all industry participants would not be considered as barriers to entry. For example, tariffs or quotas that apply equally to incumbents and new entrants would not be a barrier to entry.

7. Competitive Response

A potential entrant’s expectations about how existing firms will respond to market entry by a new player will affect their entry decision. If a potential entrant reasonably expects, or irrationally fears, that existing firms will competing aggressively then this may deter entry.

Expectations of a strong competitive response from incumbents will be higher where:

  1. Industry growth is slow, which means the industry will not be able to absorb a new entrant without incumbent firm profitability being hurt.
  2. Incumbents have a lot of fighting potential including large cash balance, strong cash flow, unused credit facilities, or clout with government, distribution channels and customers.
  3. Incumbents are likely to cut prices due to industry wide excess capacity or a desire to retain market share.