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.

Balancing the Scale

Scale improves productivity but also increases bureaucracy

Scale can help a company to produce more output at lower average costs.

However, production at scale also leads to unhelpful bureaucracy. As production rises, more employees are needed and executives implement more rules to keep things under control. Increasing production tends to lead to higher cash flows, and managers who were previously focused on production, innovation and bottom line results start to shift their focus towards turf battles and extreme careerism.

If this reminds you of a certain tech company (Microsoft) then you would be right. Ballmer announced this month plans to restructure the company with the aim of overcoming its slow moving and bureaucratic culture.

Economies of Scope

Economies of scope exist where a firm can produce two products at a lower per unit cost than would be possible if it produced only the one

ECONOMIES OF SCOPE is an idea that was first explored by John Panzar and Robert Willig in an article published in 1977 in the Quarterly Journal of Economics entitled “Economies of Scale in Multi-Output Production”.

1. Relevance

The title of that landmark article may not sound very appealing, but it does make clear that economies of scope and economies of scale are closely related concepts.

Economies of scale is a fairly well known concept relevant to big producers like Intel, Boeing and Toyota.

In contrast, economies of scope is a lesser known concept particularly relevant to small and medium sized enterprises (SMEs) that may not have access to large markets or the ability to produce at scale. SMEs represent the overwhelming majority of global business activity, and are the world’s main source of job creation and economic growth. For example, SMEs currently account for more than 99% of businesses in Europe (Economist Intelligence Unit 2011).

With the Euro-zone at the brink of collapse, governments and business leaders may be well advised to revisit basic concepts like ‘economies of scope’.  If properly understood, economies of scope could be used by SMEs to drive profit growth and reduce the risk associated with product failure.

2. Importance

Economies of scope provide firms with two key benefits:

  1. Lower average costs: If a company diversifies its product offering it may be able to lower the average cost of production. For example, McDonalds offers a range of different products (e.g. burgers, fries, sundaes and salads). As a result, it can achieve lower per unit costs by spreading its large overhead costs across a broad range of products. Lower per unit costs allow a company to do one of three things: (1) enjoy higher profit margin on each unit sold; (2) lower the price it charges customers and thereby increase market share; or (3) a combination of 1 and 2.
  2. Diversified revenue streams: By producing multiple products, a firm can diversify its revenue sources, which reduces the risk associated with product failure.

3. Economies of Scope

Economies of scope exist where a firm can produce two products together (joint production) at a lower average per unit cost of production than would be possible if it produced only one of those products (OECD glossary). Economies of scope have been found to exist in a range of industries including banking, publishing, distribution, and telecommunications.

Economies of scope and economies of scale are related concepts. The distinction is that ‘economies of scale’ refers to where the average cost of producing a unit of output decreases as output increases, whereas ‘economies of scope’ refers to where the average cost of producing a unit of output decreases as the number of different products increases.

3.1 Sources of economies of scope

There are 7 potential sources of economies of scope:

  1. Common inputs – Using more of the same inputs will increase bargaining power with suppliers. For example, Kleenex manufactures a range of products which use the same raw materials: tissues, napkins, paper towels, facial tissues, incontinence products and Huggies nappies.
  2. Joint production facilities – Plant and equipment can be more fully utilised. For example, a dairy manufacturer may be able to use its existing dairy production facilities to produce a range of different dairy based products: e.g. milk, butter, cheese and yoghurt.
  3. Shared overhead costs –The cost of certain fixed overhead costs can be shared across products. For example, McDonalds can produce hamburgers, French fries and salads at a lower average cost than it would cost to produce any of these goods separately. Each product shares overhead costs such as food storage, preparation facilities, restaurant space, toilets, car parks and play equipment.
  4. Marketing – The cost of advertising can be shared across products. For example, Proctor & Gamble produces hundreds of products from Gillette razors to Old Spice aftershave, and can therefore afford to hire expensive graphic designers and marketing experts and spread that cost across a broad range of products.
  5. Sales – Selling products is easier when salesmen can provide customers with a range of value options, as well as upsell and cross promote … “Would you like fries with that?”
  6. Distribution – Shipping a range of products is more efficient than shipping a single product. For example, Amazon sells an extremely broad range of products. As a result, it can negotiate favourable deals with freight companies.
  7. Diversified revenue streams – A firm that sells multiple products will have lower revenue risk because it is less dependent on any one product to sustain sales. More stable cash flows are attractive for three reasons. Firstly, they can be used to negotiate more favourable credit terms with banks. Secondly, a strong cash position can also be used to extend credit to customers and thereby increase sales. Thirdly, more stable cash flows can allow a firm to be more innovative with new product launches because the failure of any one product will have less impact on total revenues.

4. Diseconomies of scope

A firm that offers too many products may actually incur an increase in average per unit costs when it offers additional products. Reasons for diseconomies of scope may include:

  1. diluted competitive focus;
  2. lack of management expertise;
  3. higher raw material costs due to bottlenecks or shortages; or
  4. increased overhead costs.

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.

Economies of scale

1. Importance of economies of scale

IN THE early 20th century, by using assembly lines to mass produce the Model T Ford, Henry Ford became one of the richest and best-known men in the entire world.

Economies of scale provide a company with two main benefits:

  1. Increased market share: Lower per unit costs allow a company to reduce prices and increase market share. Economies of scale allow larger companies to be more competitive and to undercut smaller firms.
  2. Higher profit margins: If a company is able to maintain current prices, then lowering the average cost per unit will result in higher profit margins. For example, a drinks manufacturer which can produce 100,000 cans of soft drink at $0.50 each might expand production to 500,000 cans of soft drinks at a cost of $0.20 each. Assuming it can sell cans for $1 each in either situation its profit margin per can has increased from $0.50 to $0.80, which represents a 60% increase.

2. Relevance of economies of scale

There are many times when, for a firm to make a good strategy decision or for a government to engage in sound policy making, an understanding of ‘economies of scale’ is useful.

2.1 Barriers to entry

The existence of economies of scale in an industry creates barriers to entry. This is relevant if you are trying to determine the competitive intensity and attractiveness of an industry (see Porter’s 5 Forces analysis).

Where economies of scale exist, they represent a barrier which inhibit new firms from entering the industry. A large incumbent firm is in a better position to exploit economies of scale than a new entrant and, as such, may be able to force a new entrant out of the market by undercutting on price.

2.2 Natural monopoly

An industry is a natural monopoly if one firm can produce a desired output at a lower social cost than two or more firms. That is, a natural monopoly exhibits economies of scale in social costs.

In a natural monopoly, since it is always more efficient for one firm to expand than for a new firm to be established, the dominant firm often has significant market power. Therefore, it makes sense that a natural monopoly is usually highly regulated or publicly-owned. Examples of natural monopolies include railways, water, electricity, telecommunications, and postal services.

2.3 Free trade

Economies of scale provide a justification for free trade policies since some economies of scale may require a larger market than is possible within a particular country. For example, it is unlikely that Airbus, based in Toulouse, would be able to operate profitably if it could only sell aeroplanes within France.

3. Economies of scale explained

‘Economies of scale’ refers to the situation where the average cost of producing one unit of a good or service decreases as the quantity of output increases. One reason economies of scale are possible is that large overheads and other fixed costs can be spread over more units of output. Reduced average costs may result from increased output by an individual firm (internal economies of scale) or due to the growth in the size of the industry as a whole (external economies of scale). The situation where the average cost of production increases as output increases is known as diseconomies of scale.

Economies of scale 2

3.1 Internal economies of scale

Internal economies of scale are the cost savings that accrue to a firm as output increases. Seven (7) reasons that internal economies of scale may occur are:

  1. Lower input costs: A larger company will have more bargaining power with suppliers and will be able to negotiate lower prices for raw materials by bulk buying and through entering long term agreements.
  2. Efficient technology: A company that uses more efficient production technology will be able to produce higher output at a lower average cost.
  3. Research and development: Research and development is a large fixed cost for many firms. As a company increases output, R&D can be spread over a larger number of products.
  4. Access to finance: A large company will typically find it easier to borrow money, to access a larger range of financial instruments, and may also be able to borrow at lower interest rates.
  5. Marketing: Many marketing costs are fixed costs, such as the cost of advertising. A larger company is able to spread the cost of marketing over a larger number of products, thus reducing the average marketing cost per unit produced.
  6. Specialisation of labour: In a large company, managers and workers are able to specialise in particular tasks. Management specialisations include operations, marketing, human resources, and finance. Specialist managers are likely to be more effective and efficient in carrying out their roles because they will have a higher level of expertise and experience, and can obtain role specific training and qualifications.
  7. Learning by doing: Workers can improve their productivity by regularly repeating the same type of action. The increased productivity may be achieved through practice, self-perfection and the introduction of minor innovations.

3.2 External economies of scale

External economies of scale occur outside of a firm, within an industry, and arise when firms benefit from the way in which their industry is organised. Three (3) reasons that external economies of scale may occur are:

  1. Improved transport and communication links: As an industry becomes established and grows in a particular location, the government is likely to provide better transport and communication links to the region. This benefits firms as they will need to spend less money on transport and communication. Improved transport also allows firms to attract more customers, and recruit from a broader pool of employees.
  2. More focused training and education: As an industry becomes more dominant, universities will offer more courses suitable for a career in that industry. For example, the rise of the IT industry led to a proliferation of IT courses. Firms benefit from being able to recruit from a larger pool of appropriately skilled employees.
  3. Growth of support industries: If a network of suppliers or support industries becomes established and grows alongside the main industry then a firm will be able to purchase higher quality inputs at lower cost.

3.3 Diseconomies of scale

‘Diseconomies of scale’ refers to the situation where the average cost of production increases as output increases. As a firm benefits from economies of scale and grows in size it also becomes more complex to manage and run. Diseconomies may result as the increasing bureaucracy of a larger firm leads to inefficiency, as well as from problems of motivating a larger work force, greater barriers to innovation and entrepreneurial activity, and an increased principle-agent problem.