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The Platform Delusion

This is by far the most sophisticated book out there about both the nuts and bolts and big picture economics of "platform" businesses -- or those thought to be. The author effectively debunks the myth that all "platform:" companies have network effects (user value goes up as more users join), while explaining the sources of true competitive advantage in both on and offline economies.

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Highlights

The siren song of easy money is hard to resist. Its seductive strains lead us to replace what we know to be true with what we want to be true.

An understanding of the structural competitive advantages present or absent in a business is essential to assessing whether it is worth financing and at what price.

Although the economic concepts underlying competitive advantage are immutable, the ways in which such advantages are likely to present in digital environments are strikingly different.

Not just “platform” but also “artificial intelligence,” “winner-take-all,” “network effects,” “big data,” and other buzzwords are routinely invoked as a kind of “trigger” to inspire the belief that you clearly have a winner on your hands and that no further close examination is required.

The problem is that these concepts are inconsistently defined and applied. And when an effort is made to examine these characteristics systematically,

The problem is that these concepts are inconsistently defined and applied. And when an effort is made to examine these characteristics systematically, there is usually little correlation with success.

the defining characteristic of a platform is that its core value proposition flows from the connections it facilitates.

Many of the most iconic and valuable digital businesses fit this definition: the operating systems that connect software developers and users (Microsoft and Apple), the marketplaces that connect buyers and sellers (Amazon), the social networks that connect communities (Facebook), the search engines that connect advertisers and digital publishers with searchers (Google).

By lowering fixed-cost requirements and making switching easier, the internet has amped up the ferocity of competition among platforms to the detriment of their owners.

although the term platform has only relatively recently entered the vernacular, businesses with precisely this defining characteristic were around for decades before the invention of the internet.

No one called a local monopoly newspaper a platform, but it was: it connected advertisers to readers as well as buyers to sellers through the classifieds. The inability to support more than one such enterprise in most midsize cities is why it was a winner-take-all business that managed to generate 40 percent-plus margins long after readership and circulation began their inexorable declines.

consistent superior returns are only achievable through structural competitive advantage, and the resilience of the best platform businesses are the result of multiple mutually reinforcing advantages that are notable more for the differences than the commonalities in each specific case.

The problem with the Platform Delusion is that it does not generate systematically superior performance.

Rather, it actively undermines the ability to distinguish robust business models from weak ones.

the Platform Delusion signifies an entire class of loosely connected words and phrases used to imply supernatural powers on the part of the business described.

The tenacity with which the Platform Delusion has taken hold, not just in the public imagination but among institutional investors, reflects in part the sustained efforts of those who have a vested interest in its continued vitality. Technology executives, venture capitalists, private equity partners, and portfolio managers all have many millions of reasons to want the high and growing valuations of the platform businesses to which they have committed to persist.

There are echoes of the dynamics underlying the first internet boom in this unholy alliance of self-interested constituencies.

As for the businesses they underwrote—many had no realistic prospect of profit and in some cases no meaningful revenues but were routinely sponsored by these banks in the public markets in clear violation of what had been the firms’ long-established institutional standards. Research analysts cheered on acquisitions by more established companies that were simultaneously strategically incoherent and financially destructive. This time

Network effects have been touted as the dominant source of competitive advantage in the digital age. This phenomenon makes a product inherently better with the addition of every new user. But most businesses that exhibit network effects, either because of the structure of the particular industry or the absence of any reinforcing advantages, do not deliver exceptional results. What’s more, strong network effects are not, as commonly supposed, exhibited in all platform businesses. Of the group of digital goliaths that have come to be referred to as FAANG, only Facebook is a predominantly network effects driven franchise.

The acquisition sprees by many FAANG companies reveal vulnerabilities in their armor and the limits of their advantages. The ability of independent e-commerce players to establish durable leads over Amazon in diapers, footwear, fabric, pet supplies, and furniture and the ability of Instagram, WhatsApp, and TikTok to establish global online communities independent of Facebook reflect these structural constraints. Most of the specific companies noted have been acquired, but the regulatory environment will restrict future acquisitions (or even undo previous ones) and intensify future competitive challenges to FAANG. The power of network effects in the context of any given sector is significantly influenced by the complexity of the product or service being provided and the break-even economics for a given market.

This explains why Airbnb will always be a far better business than Uber and why Booking and Expedia make most of their money from selling hotel rooms and almost nothing from flights. Many of the most resilient network effects driven platforms, in sectors like travel and payments, predate the internet by decades.

In the areas of public policy and our culture more broadly, simplistic assumptions about the structure of digital industries and the path to riches have led to shortsighted and often self-defeating decision-making.

THE CORE TENETS OF THE PLATFORM DELUSION Platforms Are a Revolutionary New Business Model. Digital Platforms Are Structurally Superior to Analog Platforms. All Platforms Exhibit Powerful Network Effects. Network Effects Lead Inexorably to Winner-Take-All Markets.

what platforms have in common is that their core value proposition lies in the connections they enable and enhance. “They bring together individuals and organizations,” a recent review of platform businesses and research summarized, “so they can innovate or interact in ways not otherwise possible.”

As is often the case, when a moniker emerges that affords a premium valuation, all manner of enterprises twist themselves in knots to claim a credible association with the term.

Some of the platform businesses that predated the internet were primarily electronic, like credit cards.

Other long-established platform businesses are physical, like the iconic malls that connect retailers with shoppers throughout the country.

Operators face the same basic business issues—who and how to charge, encouraging platform loyalty, and “traffic” monetization strategies, for instance—in seeking to build and maintain successful multisided platforms.

Nobel Prize–winning economist Jean Tirole is the coauthor of an article from 2003 which, if not the absolute first to examine the phenomenon, is most widely cited and appears to have launched the avalanche of research and publications that have followed.

In many cases, these new digital models have proved devastating to long-established franchises. But bigger is not always better, and the ability to upend does not always signal a capability of creating lasting value.

The undeniable, sometimes shocking strength of the handful of the largest digital platforms established in recent decades—Google and Facebook in particular—has led to a broader assumption that digital platforms are consistently better businesses than the analog equivalents.

off-line business models have surprising relative resilience. It is not a coincidence that, despite the secular trends, right up until the COVID-19 crisis hit, struggling online retailers were increasingly looking to solve their structural woes by opening up mall outlets!

In theory, every new user increases the relative attractiveness of the business, simultaneously attracting still more new users and making the prospect of successful competitive attack ever more remote.

For instance, all ad-supported media businesses, from television broadcasters to internet content providers, serve as platforms to connect advertisers and consumers.

the economics of these businesses are primarily driven by traditional fixed-cost scale. It is the production of hit shows and compelling web content that power these businesses, not network effects either between or among viewers and advertisers. When the content succeeds, the significant fixed infrastructure costs can be spread across the heightened revenue base generated by attracting more viewers and better advertising rates.

Without any meaningful costs of switching or real challenges in coordinating among users, the value of any network effects is limited.

cities.21 Even Zoom, the video communications platform that is perhaps the most iconic success of the pandemic era, is not really a strong network effects business. By the end of 2020, the company was worth over $100 billion and its stock traded at around ten times its 2019 offering price. Zoom is a fabulous product, but its very success in eliminating any friction or complexity in adoption has severely limited how powerful its network effects can be. At this point, multiple competitive products also permit participation by simply clicking on a browser link, so obtaining access to the broadest possible pool of potential network participants is not a differentiator.

This is the classic indirect network effects business model—more buyers attract more sellers and vice versa.

the authors of The Business of Platforms 24 looked at two decades of performance, from 1995 to 2015, of platform businesses and noted that relatively few had survived.

The acceleration in the number of new large-cap internet companies in recent years stems in part from the structural incentives to wait longer before tapping the IPO market.34 With unprecedented levels of private capital willing to deliver liquidity and steadily increasing headline valuations—sometimes using questionable structural and accounting tools35—outside the glare of public scrutiny, former Uber CEO Travis Kalanick spoke for many peers when he said his company would go public “as late as humanly possible.”

The companies born in the original dot-com boom around the turn of the century had been in existence for three years on average when they went public. The more recent crop stayed private for a decade or more on average before looking to public investors.

As of late 2013, there were only 32 active unicorns, and with consistency each year investors in about a quarter of the outstanding companies were able to find an exit, whether through an IPO or otherwise.38 From 2015, however, when unicorns numbered over 100 for the first time, until the end of the decade, by which time there were 222, the percentage of exits has remained stubbornly at around 10 percent.39 This remained true even in 2020, with unprecedented opportunities—well beyond the previous record set during the 1999 dot-com boom—to tap the public markets.

That the losers significantly outnumber the winners should not be surprising or concerning in itself. What is alarming, however, is the extent to which the euphoria triggered by the Platform Delusion has led investors to forget that, ultimately, the existence of competitive advantage is what drives the ability of any business, digital or analog, to produce consistently superior returns. The basic concept of competitive advantage has been the subject of much needless confusion. This is partially the result of the sheer volume of scholarship that has been produced on the subject. But it is also a function of the practical difficulties encountered in applying the classic “five forces” framework for assessing competition developed by Harvard Business School professor Michael Porter over forty years ago.42 What I mean here by competitive advantage is disarmingly simple: the structural characteristics that allow a company to do what its rivals cannot.43 This simplicity does not detract, however, from its central importance. WHY UNDERSTANDING COMPETITIVE ADVANTAGE MATTERS Understanding competitive advantage is indispensable to pursuing successful long-term business or investing strategies in both the analog and digital worlds. A company can expect to deliver exceptional results in two ways. It can be a better operator or it can benefit from structural attributes that impede effective competitive attack. Such structural attributes are called competitive advantage.

That the losers significantly outnumber the winners should not be surprising or concerning in itself. What is alarming, however, is the extent to which the euphoria triggered by the Platform Delusion has led investors to forget that, ultimately, the existence of competitive advantage is what drives the ability of any business, digital or analog, to produce consistently superior returns.

What I mean here by competitive advantage is disarmingly simple: the structural characteristics that allow a company to do what its rivals cannot.

A company can expect to deliver exceptional results in two ways. It can be a better operator or it can benefit from structural attributes that impede effective competitive attack.

The fundamental difference between value creation deriving from operational and from structural sources is their respective durability.

Efficient operations can eventually be copied; great leaders can be poached. Process and culture do not have the resilience of a structural advantage. A natural monopoly, a patented critical proprietary technology, and an exclusive long-term government franchise are extreme examples of structural advantages that support persistent success.

Competitive advantages are precisely those features of incumbency that shut down the process of relentless entry because potential new entrants know they will suffer from a relative structural handicap.

Strategy is all about actions that will allow a business to perform better than its peers over the long term.

The focus must accordingly be on establishing or reinforcing competitive advantage and will involve interrelated considerations of how to invest internally and how to interact with other constituents in the broader ecosystem. Efficiency, by contrast, has a relatively shorter-term horizon and is overwhelmingly focused

The focus must accordingly be on establishing or reinforcing competitive advantage and will involve interrelated considerations of how to invest internally and how to interact with other constituents in the broader ecosystem. Efficiency, by contrast, has a relatively shorter-term horizon and is overwhelmingly focused internally on optimizing operating performance.

Unfortunately, strong competitive advantage has a tendency to dull the senses when it comes to operating efficiency. If great results can be achieved without sweating, why sweat? Furthermore, it is convenient to imagine that solid results are the outcome of one’s own strategic brilliance or operating prowess rather than simply industry structure.

For investors, all profit is not created equally. Valuing a company correctly involves determining how high a multiple to apply to the profit in calculating the worth of the overall business.44 But to do this correctly requires an understanding of whether and to what extent there are competitive advantages. This is true for two reasons, one obvious and one less so.

On the obvious front, if the level of profitability is exclusively due to the superior execution by a stellar management team rather than structural entry barriers, an investor will likely have some skepticism regarding the longevity of these results.

A valuation multiple represents a mathematical calculation of the current value of anticipated future cash flows generated by a business discounted back to the present.

On the less obvious front, the existence of competitive advantage is a critical factor in deciding whether to place any value at all on growth.

To achieve growth, a business must make investments. Those investments create value only to the extent that they yield returns greater than what you were charged for the money used to invest. Said another way, there is an opportunity cost to using capital to generate growth—what economists call the “weighted average cost of capital,” or WACC.

If the business has no barriers to entry, those proposed growth investments will attract competitors until the returns are reduced to the WACC. As a result, growth in the absence of competitive advantage is worthless.

For those who have succumbed to the Platform Delusion or are simply immersed in the culture of internet investing, the notion that growth could ever lack value will likely come as a bit of a shock.

A reflection of the intensity of this belief is the prevalence of digital business models in which the gross margin is actually negative. In other words, even ignoring indirect overhead costs, the business loses more money every time it makes another sale.

On the one hand, it is certainly disruptive to sell product below cost and likely to spark plenty of consumer interest and thus growth. On the other hand, when you have unprofitable unit economics,

On the one hand, it is certainly disruptive to sell product below cost and likely to spark plenty of consumer interest and thus growth. On the other hand, when you have unprofitable unit economics, it is simply not possible to make it up on volume.

maybe their plan is to grow into sustainable competitive advantage: once they get big enough, unit costs could go down based on greater purchasing clout and they may be able to raise prices so that gross margins will become positive. The losses incurred along the way could be justified by the quality of the scale franchise ultimately established.

Wilson is highly skeptical of plans based on an ability to flip the economics once you scale up. Notably, “if there are other start-ups competing with you and offering a similar service, you aren’t going to be able to take prices up without losing customers to a similar competitor, unless your service truly has ‘lock in.’ ” That is highly unlikely, Wilson argues, “given the massive amount of start-up capital that is out there and the endless number of entrepreneurs starting businesses similar to each other these days.”

The emergence of the internet has enabled an intensification of network effects where they previously applied and a significant expansion of potential new applications. But even digitally enhanced network effects do not lead inexorably or even usually to either winner-take-all or winner-take-most markets.

Being digital, in fact, often lowers barriers to entry, not the opposite.

Without such structural barriers to entry, or a credible prospect of achieving them, investors cannot expect sustainable superior returns. Great management and efficient operations yield enormous benefits, but valuing these must reflect their inherently transitory nature.

The intuition of scale most often is associated with the idea of absolute size. But the advantages of scale are always relative.

Very large companies in very large markets that can support many similarly sized giants have no scale advantage vis-à-vis each other, whereas much smaller businesses in smaller markets that can only support a single profitable operator do.

The intuitive value of scale is that it offers an opportunity to spread costs across a larger user base. This results in a lower average cost and a higher profit potential per unit than smaller competitors can achieve. And this intuition is precisely correct.

The subtlety, however, is that the observation only applies to a certain kind of cost—namely, fixed costs.

The relative predominance of fixed costs drives the most important advantages associated with scale. Where costs are mostly variable, being the biggest simply doesn’t provide nearly as much of a leg up, and it can sometimes prove a hindrance as communication, management, and coordination become more complex.

And, of course, the less significant the fixed-cost requirements, the easier it is for a new competitor to enter in the first place.

Notable sectors that benefit from such advantages are consumer products with massive fixed marketing and distribution infrastructures (think Coke and P&G) and technology businesses with massive fixed R&D costs

(think Intel and Oracle).

The immediate financial impact of the internet was to lower many of the fixed costs of operations, particularly around marketing and distribution.

Arthur Sulzberger, the publisher of the New York Times, was hardly alone when he exulted, “it’s wonderful,”2 at the prospect of a future without printing presses, newsstands, and delivery trucks.

The trouble is that it is those very fixed costs that had served as a key barrier to entry against subscale players unable to afford them. Once the excitement over getting a bargain on their fixed-cost obligations subsided, these incumbents looked around and noticed some unexpected guests: new competitors.

while certain fixed costs decline, many other fixed and variable costs are likely to escalate as the new entrants bid up industry salaries and prices for key supplies.

The good news is that the internet facilitates the establishment of an entirely different breed of scale advantage that does not owe its existence to high fixed costs. As discussed, network effects have been repeatedly identified as the defining structural competitive advantage of the digital age and lie at the core of the Platform Delusion.

Rather than representing a supply advantage, network effects yield a benefit on the demand side of the equation: the bigger you are, the easier it is to attract new customers and incremental revenue.

In his book The Content Trap, Professor Anand argues that “chances are you win everything” in network effects markets in contrast to supply-side scale that he believes is more easily copied.4 Ironically, in the very market Professor Anand leads with—newspapers—the opposite was true. Local newspaper franchises were a winner-take-all market precisely because the fixed costs required made only a single paper economically feasible, whereas most online classified marketplaces, while benefiting from network effects, appear to support multiple competitors.

The minimum fixed-costs needs and gross margin profile of a business in a given industry determine break-even volume and the corresponding required minimum market share to achieve profitability.

Knowing the required market share to achieve commercial viability yields two significant insights with profound implications for the intensity of actual and potential competition to be anticipated in any domain.

First, it is possible to identify the maximum number of profitable competitors.

Second, it is possible to estimate how long it would take for a new entrant to achieve breakeven.

less movement there is in market shares in a given year. A good sign of high barriers is a normalized share shift within a sector

A good sign of high barriers is a normalized share shift within a sector of under 5 percent over a two-to-three-year period.

While valuable in theory, it could be argued that such data is simply not available for explosive new disruptive markets and digital business models.

these demonstrate how arbitrary such market definitions are and how challenging it is to identify a meaningful break-even market share.

Viable industries without meaningful fixed-cost requirements often allow competitors to operate at very low break-even market shares. And even industries where costs are predominantly fixed, but extremely low relative to the overall addressable market opportunity, can support many competitors.

Either circumstance implies a relatively short time to achieve a sustainable level of turnover and makes market entry relatively attractive.

TAM

While TAM is hard to put one’s finger on, gross margins and fixed-cost requirements are not.

It also makes the establishment of relative scale in the first place less likely and amplifies the vulnerability of an early mover who managed to secure it nonetheless.

The concept of break-even economics defines the maximum potential number of scale players in an industry. This is relevant for assessing either the demand- or supply-side advantages that could be available in a given business line.

Figure 2.2

how big a network needs to be to achieve product viability—and the extent and duration of incremental product enhancement from additional size—depends primarily on how complex the product or service being offered

how big a network needs to be to achieve product viability—and the extent and duration of incremental product enhancement from additional size—depends primarily on how complex the product or service being offered is.

In marketplace businesses, in which the importance of broad selection is negligible and the relevant product characteristics are few, the value of network size tends to have a cap. So, in ride sharing, where the ability to deliver a car within three to five minutes dominates all other customer considerations, adding drivers to the network beyond this point is of little value.

By contrast, in dating applications, where the breadth and variety of relevant human attributes is endless, the continuing value of additional network participants is more durable.

Second, where a single or relatively small group of users are responsible for disproportionate activity on the network, the ability of a network operator to retain the value created by scale is hindered.

In these instances, the users will have leverage to capture value whether through pricing, direct payments, or establishing their own network. In any of these cases, it is challenging for an independent operator to establish a compelling platform that is able

In these instances, the users will have leverage to capture value whether through pricing, direct payments, or establishing their own network. In any of these cases, it is challenging for an independent operator to establish a compelling platform that is able to secure the benefits from network effects for itself.

This ability of large users to capture value or establish their own platforms is also why smart private investors who look at “marketplace” businesses usually limit their search to so-called many-to-many markets, where the risk of disintermediation by customers is limited.9

This ability of large users to capture value or establish their own platforms is also why smart private investors who look at “marketplace” businesses usually limit their search to so-called many-to-many markets, where the risk of disintermediation by customers is limited.9

Figure 2.3

The internet-facilitated reduction of fixed-cost requirements undermines the extent of supply-side scale benefits available to incumbents. Conversely, the internet has enhanced the potential availability of demand-side benefits of scale through the power of network effects.

All network effects are not equal. Their inherent potential value at scale in a particular context is driven by the complexity of the product or service being offered, the diversity of network participants, and the break-even market share required given the market size and industry cost structure.

Demand-side and supply-side scale advantages are not in competition but, in many of the strongest digital franchises, mutually reinforcing. The importance of break-even market share in determining the likely intensity of competitive pressure in a sector highlights the continuing relevance of supply-side considerations even in assessing the attractiveness of network effects businesses.

if its only advantage is scale on the supply side, it is vulnerable to anyone with deep pockets and an interest in sharing the spoils.

This fate can be avoided, however, where a supply-side scale advantage is complemented by other competitive advantages that impede the ability of others with ready cash to easily copy and divide the market.

Historically, the strongest analog supply-side-driven scale franchises have been paired with a variety of demand-side advantages. What all these fortifying advantages have in common is that they encourage existing customers to stay put in the face of an identical, or even somewhat better, offer by a new entrant.

Network effects—the key demand-side advantage potentially enabled by relative scale—by themselves can be similarly fragile. What’s more, in digital environments, the ability to secure complimentary “customer captivity” advantages is often compromised. Beyond simple habit, the most typical forms of customer captivity are switching costs and search costs. What makes the internet such a revolutionary medium for consumers is the ease with which it allows switching and searching. These advantages for the consumer are usually not so good for the producer.

A simple historic example demonstrates the point. In the 1990s, the SEC introduced rules that allowed alternative trading systems to emerge, enabling market participants to inexpensively trade equities outside of the established exchanges. The resulting Electronic Communications Networks (ECNs) were classic network effects businesses: buyers attracted sellers and market liquidity attracted more market liquidity. And the sector experienced huge growth as new technology platforms emerged to wrest trading volume away from the high-cost incumbent platforms where most activity had previously occurred. But the hedge funds and professional traders who participated in these networks had no more loyalty to one ECN over another than they had had for the predecessor exchanges that they had quickly abandoned. Each new ECN would invariably offer lower transaction fees. The impact of even a fraction of a cent reduction in the rate charged often resulted in immediate and massive shifts in liquidity pools among ECNs. Traders cared only about “best execution”—the net price available for a given security after commissions—resulting in wild shifts in market share among new low-cost competitors and a race to the bottom in commissions. As far as network effects are concerned, a virtuous circle can quickly become a vicious one.

There are some unique benefits available to producers operating in digital environments relative to analog ones. Specifically, businesses interacting with their users digitally are able to learn more about and develop a direct relationship with their customers in ways that their analog counterparts cannot.

This closer digital customer connection can translate into a number of other competitive advantages. Continuous interactions facilitate continuous product improvement and could accentuate the slope of the learning curve. Existing digital customers can more easily be a source of new customer referrals, potentially reducing customer acquisition costs.

Although truly foundational proprietary technology that alone creates a sustainable competitive advantage—think of Qualcomm’s wireless technology patents—remains exceedingly rare, the combination of cutting-edge technology with unique data sets can yield distinctive insights that provide real operational advantages. Google Search’s greatest advantage over Bing derives not from how much better its secret search algorithm is but how many previous searches by the same user it has already undertaken.

So, if strong analog fixed-cost-scale businesses are most often paired with customer captivity, digital network effects businesses seem to lend themselves to reinforcing advantages on the supply side, whether from learning, data and artificial intelligence, fixed-cost scale itself, or a combination of cost advantages.

This is not to suggest that such network effects can only be buttressed in this way. For instance, the ability to personalize the product experience can mitigate the tendency of internet applications to undermine customer captivity. The point is simply that the structural commonalities of the underlying industrial organization of each of these categories of advantage supports a directional shift in likely sources of competitive advantage.

Figure 3.1

Even when platforms do generate network effects, this by itself should not be convincing to investors and they should certainly not be counting on dominating a winner-take-all, or even winner-take-most, market. The existence of network effects should represent the beginning rather than the end of the analysis.

Even when platforms do generate network effects, this by itself should not be convincing to investors and they should certainly not be counting on dominating a winner-take-all, or even winner-take-most, market. The existence of network effects should represent the beginning rather than the end of the analysis.

the very structure of digital environments makes it harder, not easier, for network effects businesses to secure many of these potential complementary advantages like customer captivity or scale advantages that flow from high fixed costs.

Some combination of high break-even market share, an ability to establish entrenched customer relationships, and a use case that can take advantage of the availability of large quantities of transactional data when paired with network effects can indeed result in remarkably powerful business franchises. What is most notable, though, is not only how unusual such businesses are but also the fact that most of the largest internet businesses do not rest primarily on network effects at all.

Strategy has always been and always will be about establishing and reinforcing barriers to entry. Even the core categories of competitive advantage

It is popular among adherents to the Platform Delusion to assert that the digital revolution necessitates a fundamentally new approach to business strategy.2 Nothing could be further from the truth. Strategy has always been and always will be about establishing and reinforcing barriers to entry. Even the core categories of competitive advantage have not changed: scale, demand, and supply.

Digital environments have changed the precise form these entry barriers usually take, what combination of them is achievable, and how difficult it is to establish great companies—and generally not for the better as far as investors are concerned. Investors should not look for fundamentally new strategic paradigms or fall prey to the Platform Delusion but rather remember fundamental principles

Figure 3.2

content creation businesses, whether digital or analog, do not typically lend themselves to network effects. Indeed, the print Times once had a modest but highly profitable classified advertising segment, which did benefit from network effects. The digital Times, by contrast, has no significant classified business, so arguably it exhibits fewer network effects.

On the supply side, the benefits of scale at the Times are enhanced in its digital form because of the increase in the percentage of its cost structure that is fixed.

On the supply side, the benefits of scale at the Times are enhanced in its digital form because of the increase in the percentage of its cost structure that is fixed. Because of the elimination of raw materials and other variable elements that underpin the cost of producing a newspaper, a digital news product is overwhelmingly a fixed-cost affair.

the potential for customer churn has increased dramatically in the digital realm as both signing up and signing off have never been so easy.

Customers now demand that they be able to cancel online without confronting endless hold music and a not-so-friendly customer service agent. The New York Times only began enabling online cancellations in 2020.

As impressive a job as the company has done in this area, subscribers are simply not as captive as the advertisers who previously could only reach the rarefied Times readership through its print edition.

In the context of platform businesses, this ability to easily shift among or support the simultaneous use of multiple platforms is often given a fancy digital moniker: multi-homing. There is nothing objectionable in this term, but it is sometimes treated as an entirely novel category of phenomenon rather than simply a manifestation of weaker demand-side barriers to entry.

A final potential upside from data is that by observing engagement, it may finally be theoretically possible to fill in the demand curve—some subscribers will pay a lot for access, some will pay a little, and better data means that it’s increasingly possible to identify the clearing price for each subscriber.

Publishers have been slow to pursue such data-driven revenue-maximization strategies, although it is not clear whether this is because of a lack of sophistication or a nervousness about irritating customers who realize they are paying more than their friends.

its shareholders will likely still see a more modest bottom line. While the New York Times will undoubtedly remain one of the largest scale English-language news providers in the world, and may also boast the highest paid subscription base, the structural limits on the degree of competitive advantage available to a news content producer in a digital world impose constraints on potential size and returns.

The availability of one other significant form of competitive advantage has not changed in any basic way by virtue of the internet: the government. Structural benefits bestowed or reinforced by the government are rarely highlighted by companies, which instead tend to cast the government more usefully as an obstacle to the unfettered functioning of capitalism in the service of shareholders.

The steadily increasing investment in lobbying by the internet giants, however, implicitly reflects the importance of government munificence to their respective franchises.

government regulation—often, with no small irony, directives supposedly developed to encourage “fair” competition and new entrants—imposes significant fixed costs that benefit the largest incumbents.

When Congress punished the ratings agencies for their lapses in the lead up to the 2008 market meltdown, the result was actually a benefit to these firms. By imposing new burdensome requirements on any ratings provider, Congress ensured that only the largest existing players could afford to comply.

In the digital realm, there is evidence of a very similar dynamic at play in the case of the European Union’s imposition of strict General Data Protection Regulation, or GDPR. These rules went into effect in 2018. The ability of Google and Facebook to quickly and effectively comply with regulations appears to have given the companies an additional advantage in the battle for advertisers. GDPR has “entrenched the interests of the incumbent,” according to the CEO of the world’s largest advertising agency, WPP, by handing “power to the big platforms because they have the ability to collect and process the data.”

Government-bestowed advantages can be on the supply/cost side, as in the case of regulatory regimes imposing significant fixed costs, or on the demand/revenue side, as where a public entity provides an exclusive long-term contract or designated “approved” vendors.

Relying exclusively on structural protections that are subject to changes in the political winds is a dangerous game.

What almost all of these benefits have in common—and as the example of the elimination of onetime protections that spawned the proliferation of ECNs demonstrates—is that they can be fleeting.

Amazon is an example of a company that worked to protect its regulatory advantage even as it prepared for its eventual loss. For the first twenty-plus years of Amazon’s rise, it benefited from not having to charge the same sales taxes that its analog competitors did.24 The loophole the company exploited was a requirement that in-state operations were required to impose state taxes on sales. Amazon limited operations to a handful of states with few sales to maximize the benefits of this advantage.

Even as it fought to preserve this anachronistic benefit while it gained scale in key categories, Amazon prepared to radically expand its sales and distribution infrastructure so that the cost savings from optimizing its logistics networks would mitigate the need to charge sales tax.

The government’s overall attitude toward the technology industry has undergone something of a sea change. Until recently, the global dominance of US tech—at least outside of China—has been a source of pride and a symbol of our innovative spirit. Until very recently, the result has been, with few exceptions,

The government’s overall attitude toward the technology industry has undergone something of a sea change. Until recently, the global dominance of US tech—at least outside of China—has been a source of pride and a symbol of our innovative spirit. Until very recently, the result has been, with few exceptions, a surprisingly hands-off approach to the entire sector.

Part of this oversight was structural, not merely cultural. As many significant technology businesses have few assets and little revenues, a number of competitively questionable transactions have slipped under the financial thresholds for the required government antitrust notification of the Hart-Scott-Rodino (HSR) Antitrust Improvements Act.26 Google had even found a loophole to avoid giving regulators a heads-up on its billion-dollar acquisition of Waze.

Even as the Justice Department had closely scrutinized or even blocked deals in secularly challenged analog industries seeking to rationalize operations to survive, hundreds of acquisitions by the digital giants have been consummated largely unperturbed.

The shift in perspective from big tech being given a pass on principle to now being subject to heightened scrutiny on principle reflects one consistency: the misguided notion that these businesses have so much in common that they deserve a singular approach to enforcement.29 This conceit is a regulatory manifestation of the Platform Delusion. In both instances, the assumption is that their size and strength are not only comparable, but flow from the same sources. A deep dive into the elements of advantage enjoyed by each of the largest digital leaders is the best route to disabusing investors and regulators of this deeply flawed supposition.

though the digital environment creates opportunities for new advantages where none could have existed before, the overarching impact of lower break-even market shares and weaker customer captivity suggests that digital franchises are generally not as strong as the analog ones they replace.

Figure 3.7

Digital models undermine the ability to sustain certain entry barriers but potentially facilitate the establishment of others. Overall, however, the level of competitive intensity faced has generally increased because of these structural changes.

The ability of a business or an entire sector to demonstrate consistently superior profit margins is an indicator of structural competitive advantage.

More fundamentally, the underlying sources of success for each of these businesses are quite diverse. Only one of the five platforms—Facebook—exhibits characteristics broadly consistent with the narrative of the Platform Delusion.

And even Facebook’s primary reliance on network effects and its commanding global market share does not tell the full story—either about the complementary competitive advantages that have been central to reinforcing the company’s position or its continuing vulnerabilities.

Taking a deeper dive into the foundation for the remarkable accomplishments of these five businesses serves two purposes. First,

Figure II.5

Just as the media moguls of yore worked tirelessly to convince the outside world of their magical abilities to create hits and manage talent, the tech elite—not just the executives, but the private and public investors who back them—want us to believe that they have the gift of creating unassailable franchises.

Of course, it would be far too crass—and a dangerous red flag to antitrust regulators—to directly make these claims publicly. But there are subtler means to express these sentiments, whether by informal communications to gullible research analysts, journalists, and “thought leaders” or simply by not contradicting statements of others that reaffirm the delusion.

solution to this parade of horribles is proposed by one FAANG CFO: “We need a simpler ‘platform’ story.”

Based on the strength and breadth of their respective competitive advantages, the two strongest franchises among them are Facebook and Google. It is notable that both of these, unlike the other three, operate in essentially new business sectors made possible by the internet. Neither was a “first mover,” but social networking and search had not been consumer business lines for very many years before they were established. And although each of these businesses displaced an “incumbent” for leadership, the nascence of the industry meant that the earlier players enjoyed only modest scale and limited customer captivity.

Specialization can be geographic but even when geographic distinctions are less relevant, product market specialization can be equally or more powerful. Google does indeed dominate search in the US and most other countries, but Amazon now has a majority of product searches. Although product search is a small part of overall search, given the psychic proximity of this subset of searches to spending money, it is among the most valuable.

One can look at the rollout of the Facebook product road map as a relentless digging of the customer captivity moat around the citadel of scale.

From day one, founder Mark Zuckerberg was maniacally driven by the need to invest in reinforcing customer captivity in all its forms—switching, habit, and search.

For successful network effects businesses, there are two primary threats.

First, it is well established that there are diminishing returns to scale.

There comes a time when a network is plenty big for its purposes and incremental participants don’t add much incremental value.

What’s more, dominant mass scale usually hides relative scale vulnerabilities within particular geographies, demographics, or interest groups.

Often scale in the niche is more relevant to endemic advertisers and targeted users than sheer absolute size.

Facebook has always been well aware of this inherent risk and has aggressively tried to stay ahead of it both by continuous product development and by quickly copying the functionality of new entrants who seem to gain traction.

Until recently at least, Facebook had one additional critical tool in its kit to push back against ongoing threats to its relative position: mergers and acquisitions.

Justice Department announced its broad review of Facebook and other tech giants in 2019,26 the company had decided to abandon

It seems fanciful, for instance, that an independent WhatsApp would have been inclined or able to launch a successful traditional social network that competes directly with Facebook. Indeed, given that WhatsApp has generated almost no revenues in the seven years since Zuckerberg parted with $19 billion to own it—even as Facebook invested generously to build the messaging service’s functionality and user base—the alternative narrative that consumers are far better off as a result of Facebook’s improvements seems pretty credible. The emails reveal a frantic and frightened Facebook CEO scrambling to own and optimize as many alternative social mechanics as possible to ensure his company’s continued relevance in a changing landscape, far more than an effort to suffocate an emerging competitor in the cradle.

The second primary threat to network effects businesses stems from the inherent challenges to securing customer captivity in the digital realm.

For a business, the problem with all the remarkable attributes of the internet is that they are available to every other business. The speed with which competitors can replicate your best new feature or collect enough data to be able to entice your customers can be startling.

The structural fragility of even the largest social networks demands that protecting trust requires a vastly broader and more nuanced set of corporate aims than optimizing customer engagement and short-term monetization. The range of issues that have threatened Facebook actually highlight the need for greater, not relaxed, operating discipline. As a user or an advertiser, I love the idea of a cult committed to protecting the integrity of the network in the face of everything from hostile governments, scam ads, and fake profiles. The problem has not been that Facebook is a cult. The problem is the end to which that cult has been dedicated.

although the public and regulators see Facebook with some justification as the biggest part of the problem, it also has the potential to be the biggest part of the solution. This is not to imply that anyone should feel sorry for Facebook or that they are without fault. To borrow from a superhero movie,50 with great power comes great responsibility, and the bar for Facebook should be significantly higher. But in designing optimal regulatory solutions, both the advantages and dangers of scale must be considered.

Timing of Facebook’s growth was propitious based on the establishment of widely accepted social media use cases and the availability of technologies and connectivity that supported a satisfying user experience.

The success of Facebook’s developer platform also reinforced its direct network effects with indirect effects. In addition, Facebook’s initial focus on serving already established networks and continuously investing in tools to demonstrate the value of the platform ensured a significantly stronger level of customer captivity once scale was reached.

On the supply side, those R&D investments, which represent a higher percentage of overall costs than any of its FAANG brethren, provide another important entry barrier. This scale advantage is reinforced by the learning advantages that allow Facebook to deliver uniquely effective advertising opportunities. It is this powerful combination of supply and demand advantages that make the barrier formed by Facebook’s core network effects so solid.

It would be almost a decade after Amazon’s founding in 1994 before it launched the “marketplace” business that does indeed benefit from network effects. Amazon Marketplace serves as a platform connecting independent vendors with buyers in these transactions rather than as the actual retailer.

Today Amazon transacts more so-called third-party sales on its platform—around double the volume—than direct sales. But because the revenues resulting from third-party sales are simply a 15 percent commission3—unlike direct sales for which the full purchase price counts as revenues—as an accounting matter this still represents a tiny portion of the company’s overall business.

The one new business that has unambiguously moved the needle at Amazon since the 2005 Prime launch has essentially nothing to do with its core business. Amazon Web Services (AWS), the B2B cloud computing infrastructure business that launched in 2006,15 has represented a majority of Amazon’s profits since 2014 and is anticipated to continue to do so for the indefinite future.

This more recent competitive onslaught has resulted in significant pricing pressure. But the combination of fixed-cost scale and customer stickiness—rather than primarily network effects—that characterizes the industry allows Amazon to remain well positioned and well ahead. What’s more, the increasing adoption by large corporations and governments of both basic cloud infrastructure outsourcing and higher value-added services “up the stack” suggests an opportunity to create significant incremental shareholder value here for some time to come.

The fact that AWS has little to do with the rest of Amazon does not diminish Bezos’s visionary daring in financing and supporting the project. Microsoft, Google, IBM, Oracle, Alibaba, and others wouldn’t enter the market for years after AWS launched.

All one needs to do, however, is look at the company’s cash-flow statements to see what competitive advantage it has placed its bets on: old-fashioned fixed-cost scale. As noted earlier in Figure II.6, Amazon frequently spends more on R&D in absolute dollars than any other company in the US,21 and its largesse extends to capital expenditures more generally. Although much of this spending is directed toward the largely unrelated AWS buildout, Amazon has continuously invested in raising the table stakes in fulfillment and distribution.

Using Amazon as the poster child, as many do, for the case of a company for which “almost every human interaction is removed from the actual critical path in service delivery”23 is a stretch in light of the company’s one-million-plus employees.

It is the local density, not the overall size of operation, that overwhelmingly drives the economics.

Offering free two-day shipping required a huge investment by Amazon. The company spent almost $40 billion on shipping in 2019.

The fact that Amazon profit margins fell in its core North American market in 2020 (as they had as well in 2019) even as the pandemic boosted sales by almost 40 percent is suggestive of the modest nature of Amazon’s scale benefits in retail. We have described why scale by itself is a fragile advantage. Weak scale is obviously even more fragile. Scale begs for customer captivity as reinforcement. In retail, many methods have been tried to instill captivity, with varying degrees of success: loyalty programs, personal shoppers, ancillary services, referral programs, contests and challenges, and creating a sense of community.

there are two problems with customer captivity initiatives in highly price-competitive largely commodity retail sectors. They are very expensive and your competitors, both online and off-line, soon copy them.

That is, they become little more than a fancy discount program. This makes them a boon for consumers, but not so much for the enterprises offering them.

The fact that Amazon feels a need to give away a service that is not only costly to provide but also exhibits notoriously high customer churn reflects how thin Amazon’s customer captivity is even after all the hard work.

The single most confounding and increasingly expensive Prime benefit is Prime Video, a poor-man’s version of Netflix that is free for Prime subscribers but costs Amazon an escalating king’s ransom. Amazon disclosed that it had increased 2020 spending on entertainment content for Prime members by 41 percent to $11 billion.37 And that was before paying 40 percent more than anyone else was willing—$8.5 billion—for MGM in 2021.

In the online commerce business, the analysts point to two primary areas of growth—new product categories and new international geographies.

The product category that has attracted the most attention in recent years is grocery.58 For those in search of growth, the good news is that grocery is the biggest category in which Amazon does not have a meaningful historic share and represents the largest retail category overall after motor vehicles and parts dealers.59 For those in search of value, the bad news is that it has the thinnest margins and boasts the carcasses of an unusual number of high-profile online failures. Webvan raised almost $1 billion before crashing. Other has-beens include Kozmo, HomeGrocer, and ShopLink.

As the pandemic has convinced investors that “grocery shopping is forever changed,”62 Ocado

is not anticipated to break even for many years despite its attractive hybrid business model and sky-high valuation.63

After the purchase of Whole Foods, Amazon announced it would suspend its Amazon Fresh grocery delivery service in many suburban zones across the country that were remote from any of the acquired stores. This move, along with the recent launch of Amazon Fresh stores, suggests a realization that an off-line presence is required to make an online grocery business viable.

touted internationally as a “home delivery success story,”

The necessity of a multi-local rather than international strategy is driven by the often stark differences in market structure, consumer demand, and regulation across geographies.75 This is particularly true in sectors, like retail, where the costs incurred in providing the product or service are predominantly local.

Amazon’s offering. Although strict state dealership laws limit new car buying online, in addition to advertising a number of these businesses have thriving peer-to-peer marketplaces for buying and selling used cars. But the very number of players in these markets, and continuing ability of more to enter, demonstrates the difficult economics of the space even as it has grown. The hugely disappointing performance of Cars.com since it spun off as an independent company several years ago is reflective of this structural sectoral infirmity—as is the inability of the company to find a willing buyer even after it put itself up for sale.74 More recently, purely digital used car retailers have emerged with the successful IPOs of Carvana (2017) and Vroom (2020). Others appear poised to follow. Amazon’s warehouse infrastructure, however, cannot practically accommodate car retailing and it has no apparent plans to enter this part of the market. Turning to the sources of potential international growth, it is worth remembering that for the most successful truly global companies, what is captured under the generic label “international” is really a series of tailored approaches to very different markets. The necessity of a multi-local rather than international strategy is driven by the often stark differences in market structure, consumer demand, and regulation across geographies.75 This is particularly true in sectors, like retail, where the costs incurred in providing the product or service are predominantly local. These dramatic market-to-market distinctions are reflected in the fact that even among businesses with truly international operations, it is typical that a majority of profits are found in a very small number of countries or regions and may even require the adoption of distinct local branding to succeed. Amazon

The necessity of a multi-local rather than international strategy is driven by the often stark differences in market structure, consumer demand, and regulation across geographies.75 This is particularly true in sectors, like retail, where the costs incurred in providing the product or service are predominantly local. These dramatic market-to-market distinctions are reflected in the fact that even among businesses with truly international operations, it is typical that a majority of profits are found in a very small number of countries or regions and may even require the adoption of distinct local branding to succeed.

Many companies accept lower profitability from their international operations in return for a higher growth rate once the domestic market starts to become saturated. What has distinguished Amazon’s international operations in recent years, however, is that they have grown significantly slower than the US business even while hemorrhaging money. For the entire decade between 2010 and 2020, international retail grew slower than its US counterpart and, until the pandemic hit in 2020, did not show a profit in any year since 2013.76 When the international division posted its first quarterly profit in years during the height of a pandemic-fueled boom in online sales, even Bezos warned that it was a “highly unusual quarter” rather than a reliable trend.

If every number one player in a market could easily become the number one player in every other market, all the markets would have a lot of number one players! The clear leader in the UK, Tesco, learned this the hard way only after it poured 1 billion pounds into its efforts to dominate the US before retreating entirely.

Digital investors often obsess more about the total size of the potentially addressable market—to plug in corresponding potential growth rates—rather than how much of it is worth addressing.

In chapter 9, we examine a number of e-commerce businesses that have managed to dig far deeper moats than Amazon by targeting narrower markets that lend themselves to stronger entry barriers.

In its early years of growth, Amazon was a pure retail model, with no network effects and little customer captivity. It would be almost a decade before the Amazon Marketplace, which is a classic indirect network effects model, would be made broadly available.

Amazon’s formidable franchise has emerged from a combination of “relentlessness and ruthlessness” on the one hand and “a rope of many small advantages” on the other. Its aura of invincibility, however, is not justified and the potency of this mixture of attributes varies widely across markets. The overall return on investment of its future e-commerce growth trajectory is likely to remain modest.

The question of whether an asset is valuable is completely distinct from the question of whether the investment required to build the asset is likely to yield superior returns. As we will examine in detail in our discussion of content businesses in the next chapter, just because a hit movie is a valuable asset doesn’t mean going into the business of trying to make a hit movie is a wise investment decision.

The point is not that brand doesn’t matter. It is that industry structure will determine whether brand can serve as a sustainable competitive differentiator. Customer captivity and scale are the relevant structural barriers to entry. Brand can powerfully reinforce these barriers in sectors where the key supply and demand attributes lend themselves to such support. So, for instance, in consumer packaged goods categories where there is high usage frequency and marketing and distribution dominate the cost structure, brand really matters.

The introduction of the iPhone and iPad transformed the economics of Apple not simply because they were both wildly successful products. Rather, for the first time, the rapid adoption in both instances allowed Apple to benefit from deep network effects, which had previously eluded the company.

Operating systems are classic network effect businesses. The more users, the more developers develop software applications, which in turn attract more users.

Apple’s long-standing refusal to license its operating systems to third-party manufacturers, in contrast to the ubiquitous Microsoft system that powered IBM and its clone army, ensured that it would be at a significant

Apple’s long-standing refusal to license its operating systems to third-party manufacturers, in contrast to the ubiquitous Microsoft system that powered IBM and its clone army, ensured that it would be at a significant competitive disadvantage in attracting developers.

The iPhone finally allowed Apple to benefit from network effects.

In addition to the core indirect network effects of the two-sided iOS marketplace connecting developers and users, Apple established a layer of direct network effects among users through communication tools available only through Apple products. Video chat software FaceTime, launched in 2010, and messaging service iMessage, launched in 2011, have both become ubiquitous tools for Apple users and are only accessible to other owners of Apple products.

The fallacy of the first-mover advantage is that the real advantage—scale—is only achievable once the profile of consumer demand and core technology has stabilized enough to allow an aggressive entrant to quickly secure significant share.

During the year that the original iPhone was on the market, Apple was able to learn enough about both to place a huge bet on the integrated iPhone 3G and App Store. The company had upgraded its operating system and speed, improved compatibility with Microsoft Outlook, developed a core catalog of powerful apps that highlighted the unique utility of the iPhone, and, most important, dramatically dropped the price. The result was a sustained acceleration of iPhone adoption, third-party app development, and user downloads.

It would be 2012, though, before Google would consolidate Android Markets and its various content stores into Google Play,32 and another two years after that before

it would catch up and exceed the number of apps on the Apple App Store.33 But all market share and all apps are not equal, and many of the structural distinctions between the Apple and Google ecosystems spawned persistent economic differences.

So, for instance, in the early days of Android Market, the failure to have seamless payment mechanisms reinforced the tendency for apps to be free. But even after the technical issues were resolved, Google Play continued to host apps that were overwhelmingly free.

Even the paid apps on Google Play generate less revenue than those in the Apple App Store, despite the increasing divergence in respective global market shares.

Both operating systems retain around 90 percent of users within their respective ecosystems when they buy a new phone.

The intense loyalty of Apple users is well established. And Apple has constructed a complex web of addictive features and services, not to mention the seductive trade-in program started in 2013,35 to reinforce customer captivity. What has changed in recent years, however, is the extent to which loyalty to the Android OS has come to match or exceed this.

Apple announced in November 2018 that it would no longer report iPhone unit sales.48 The following quarter, Apple for the first time began reporting the relative profitability of the product and services businesses, which highlighted both how much more inherently profitable the services business was and how much faster it was growing.

Given the relative growth and profitability of services, they could account for a majority of Apple’s revenues by 2030 if current trends persist. This shift should in theory strengthen the overall Apple franchise. But as the company stakes its future on services, investors should pause before going all in for at least three reasons.

network.57 Second, although Apple services do indeed maintain a higher margin overall than their physical products, under the hood of what the company hopes will be a $50 billion business category in 2020 is a wide range of very different services with very different financial profiles.

many of the service categories that are anticipated to drive a disproportionate share of Apple’s growth in services are much lower-margin businesses.

is also a global luxury brand, and the only one on this scale in the technology industry. This has reinforced the other structural advantages highlighted and helps explain how the company has been able to consistently extract a disproportionate share of industry profits.

Third and finally, we return to the nature and value of the Apple brand. Apple is not just any kind of brand. Yes, as Larry Ellison pointed out, it is a lifestyle brand. But it is also a global luxury brand, and the only one on this scale in the technology industry. This has reinforced the other structural advantages highlighted and helps explain how the company has been able to consistently extract a disproportionate share of industry profits.

While the high-end segment represents a small minority of overall smartphone units sold, by dominating this market, Apple has been able to consistently command an average phone price more than triple that of Android phones.

brands of the content producers historically have had little to do with the success of the product. With the possible exception of Disney or Pixar within the narrow children’s niche, neither the brand of the movie studio nor the overarching holding company that it may be a part of has been predictive of box office success.

Less benign is the interpretation that within the media and, increasingly, the technology industry value chain, the business of creating compelling content is responsible for a disproportionate share of value. This could not be further from the truth.

Redstone was right that you need a “hot” movie to get butts in seats. But his ability to get the most anticipated films, and the terms on which he was able to secure those for his theaters, was a function of his leverage with the studios. And like his leverage with local concession distributors, commercial realtors, and even employees, that came from being the only game in town.

What modest profit the largest content players do eke out has typically come from the ability to monetize ancillary businesses in marketing and distribution that do scale.

Enterprises, however, whose success relies on the regular production of fresh hits—“hot” blockbusters that draw the lion’s share of attention in any given season—share a common characteristic: they generate anemic financial returns over time. The fundamental problem is a lack of entry barriers to financing the prospect of the next runaway success.

Netflix should not be as successful and as highly valued as it is. But the animating force of the original Netflix Paradox was a disbelief that a media company like Netflix that produced no original content could thrive while the media content giants, on whose output Netflix feeds, faced a secular tailspin.

In a media culture committed to the proposition that “content is king,” the robust success of a mere redistributor is something incomprehensible and, frankly, a little unnerving, especially while those responsible for the creative lifeblood that flows through its veins struggle for profitability.

In fact, the dirty little secret of the media industry is that content aggregators, not content creators, are the overwhelming source of value creation.

It had long been the case that the cash flows generated by the aggregation and distribution businesses of the media conglomerates dwarfed those of their content creation activities, despite the film and television studios’ outsized place in the public imagination.

The most prevalent sources of industrial strength have been the mutually reinforcing competitive advantages of supply-side scale and customer captivity. Content creation simply does not lend itself to either, while aggregation is amenable to both.

The economic structure of the media business is not fundamentally different from that of business in general.

Aggregation, on the other hand, by its nature requires a large fixed-cost infrastructure to collect, manage, market, and redistribute content. This is why a cable channel with 20 million subscribers loses money but an identical one with 100 million subscribers might generate 50 percent margins.

Take scale. Because making a blockbuster movie is expensive, people assume that it is a scale business. But the benefits of relative bigness flow from the ability of the largest players to spread high fixed costs most efficiently. Moviemaking is not this kind of business. The cost of a blockbuster does not vary based on the size of the studio producing it. Creating hit-driven content in any medium does not typically require significant fixed costs.

Time was when the content giants in the movie, music, and book industries could earn superior returns. But their ability to do so had nothing to do with content being king. It was a function of the scale and captivity inherent in their aggregation business: the massive marketing and distribution networks that they rented out to smaller, independent content producers, often at usurious rates.

The decline of these enterprises does not reflect any change in the nature of content generation—it was as unattractive a business then as it is now. Instead, their decline reflects the loss of their advantages in aggregation—a loss resulting from a combination of external forces and self-inflicted wounds. The obvious external force has been advances in technology.

Customer captivity—the “stickiness” of the company-to-consumer relationship—is similar. If Universal had a successful slate of movies last year, customers aren’t more likely to seek out Universal films this year.

Contrast the lack of customer captivity among pure content companies with the leverage cable channels and TV networks still enjoy to a surprising extent when they threaten to pull their signal from a distributor.

In industries like media, where a few large players share the same advantages of scale, the key to long-term success is avoiding destructive competition in pricing, costs, and capacity. In the mostly forgotten era of the MCA/Universal chief Lew Wasserman, being a media mogul meant enforcing a culture of informal cooperation, where the bottom line mattered more than one-upping your peers. Wasserman was not literally “the Last Mogul,” as multiple biographers have dubbed him, but he may have been the last one who didn’t think the defining genius of moguldom was outbidding all the other moguls for the hottest talent, technology, or property of the moment. Similarly, a culture that rewards “stealing” established authors or musicians from competitors the old-fashioned way—by overpaying—will never earn its shareholders a decent return, regardless of the technological environment. As we discuss shortly, the industry culture that seems to be emerging in connection with the new streaming wars looks much more like this than that enforced by Lew Wasserman. Interestingly, in the book industry, the culture appears to have moved in a more shareholder-friendly direction. Netflix’s early success in streaming video was therefore hardly paradoxical. The company sits squarely in the tradition of the most-successful media businesses: aggregators with economies of scale and customer captivity. Netflix used its leading position in its legacy DVD subscription business to quickly develop scale in the streaming business. The company had fewer than 9 million subscribers in 2008, when it began offering video streaming directly to the TV for its existing customers. That move accelerated subscriber growth and supported the introduction of a streaming-only service in 2010. Netflix’s ability to spread the fixed costs of content, marketing, and technology across a subscriber base vastly larger than any other competitor’s is continually reinforced by superior customer service, a powerful recommendation engine, and a great, habit-forming product.

In industries like media, where a few large players share the same advantages of scale, the key to long-term success is avoiding destructive competition in pricing, costs, and capacity.

Netflix’s early success in streaming video was therefore hardly paradoxical. The company sits squarely in the tradition of the most-successful media businesses: aggregators with economies of scale and customer captivity. Netflix used its leading position in its legacy DVD subscription business to quickly develop scale in the streaming business.

Netflix’s ability to spread the fixed costs of content, marketing, and technology across a subscriber base vastly larger than any other competitor’s is continually reinforced by superior customer service, a powerful recommendation engine, and a great, habit-forming product.

most media aggregators, such as cable channels, structurally act as wholesalers, whose customers are not the individual consumers but the distributors who manage the physical pipe (or satellite feed) to the home.

Netflix is the rare aggregator that manages the direct customer relationship itself, which allows it both to excel in customer service and to perfect the product by harnessing customer feedback.

There is only one reason for a successful content aggregator of scale to go into the content production business: heightened competition leaves it no choice. Cable channel owners’ collective recognition of the need to amp up investment in original content reflected a commercial necessity in the face of growing over-the-top (OTT) streaming alternatives and diminishing clout with distributors. Corresponding declines in profitability and, more precipitously, valuation multiples have been the predictable result. Taking on creative risk may be the right strategic choice compared to the alternative. But it doesn’t make Netflix a better business than it was before.

Rather, it highlights that it has become a worse one.

The winners from this rapid expansion in creative output have been the viewers and the talent, but not the shareholders.

A look at the bleak economics of Netflix’s established streaming competitors is suggestive both of why, despite Netflix’s structural advantages, the accelerating need to compete aggressively in content creation is bad news and what a hard slog the newer services piling into the market face.

With the exception of Apple TV+, these new competitors are owned by important historical sources of exclusive material for Netflix, meaning that the service’s need to develop its own original content and the cost of developing it will increase further.

Notwithstanding high-profile global rights deals like the one Netflix recently secured for Seinfeld,43 most content rights are licensed locally. As Netflix has gone global, the increasing number of international competitors looking to lock up local streaming rights for themselves44 also justifies the shift toward fully-owned content.

To date, Netflix has been remarkably adept at rising to whatever new challenges it faces. In content production, however, efficiency has historically been optimized through specialization within genre and audience, not total absolute production volume.

It is worth noting that Netflix itself has largely eschewed claims of network effects.

Reed Hastings contrasts companies like Netflix that have “normal scale economies” with “those rare businesses like LinkedIn and Facebook where there are network effects.”

“Over the years,” Netflix conceded in frustration, “we have tried various ways to make Netflix more social.”

Network effects aside, the competitive advantages Netflix is supposed to generate from its unique repository of “big data” fall into two broad buckets. The first relates to how it manages the customer experience, primarily based on how and what it recommends that subscribers should view. The second relates to the company’s ability to consistently produce hit shows. The first of these is very real, although not new. The second is largely nonsense.

Estimates of Netflix annual churn mostly have ranged from 20 percent to over 35 percent.65 Some research suggests that even with churn toward the higher end of this range, it is meaningfully lower than rates for many other SVOD services.

But this still means that, even using an assumption of 25 percent, with a global membership base of over 200 million by 2021, just to keep flat Netflix needs to attract more than 50 million new subscribers annually—well

So how does big data change the ability of Netflix to deliver more compelling content at a lower cost, particularly in an environment where Netflix needs to produce an increasing proportion of that content itself? Contrary to conventional wisdom, the answer is almost not at

So how does big data change the ability of Netflix to deliver more compelling content at a lower cost, particularly in an environment where Netflix needs to produce an increasing proportion of that content itself? Contrary to conventional wisdom, the answer is almost not at

all.

The service has claimed that it renews series it produces 93 percent of the time as compared to traditional networks’ mere 33 percent of the time.75 This difference, at least historically, is real, but it reflects that Netflix is a different business, solving for different economic outcomes. Television networks need a certain level of national ratings to generate adequate advertising revenue for themselves and their broadcast affiliates.

many of the best-funded competitors are entirely new exacerbates this challenge, despite Netflix upping the ante on the fixed cost required to play this expensive game competitively.

The fact that this has been financially disastrous for the onslaught of newer SVOD entrants does not make it less bad news for Netflix, particularly given that those challenging results do not appear to have limited availability of competitor funding for the foreseeable future.

service. And by virtue of its large installed base and unique combination

by virtue of its large installed base and unique combination of skills in online customer management and marketing and negotiating with content owners, Netflix benefited from a much-invoked but rarely experienced phenomenon: a first-mover advantage.

The advantage is not in going first but in gaining scale. And the ability to quickly gain scale by going first requires relatively stable product/market fit and technology.

If either is in significant flux, customers are likely to hedge their bets before signing up, making gaining critical mass challenging for the brave first mover. That is why the winner in most markets is someone who let others undertake what is effectively free R&D for them and only invests big once greater visibility emerges as to the shape of demand and technology requirements.

the fate of the New York Times, the leading general interest national newspaper, in the face of digital disruption has been quite different for three primary reasons. First, the New York Times’s content, much like Netflix but unlike local newspaper content, had a significant untapped market that supported online subscriptions. Second, the larger addressable market supports further investment in content, upping the fixed cost price of entry for a credible subscription competitor. Third, the New York Times was never as reliant on advertising as local papers and relatively even less on the classified advertising that drove local paper profitability. So the digital ecosystem has allowed the Times to radically expand its reach and improve its economic performance relative to the local newspapers whose profitability once dwarfed theirs. The sources of the Times’s historic competitive advantages—scale and captivity—have been enhanced in some ways.

but as we saw, compared to the New York Times of 2000, the New York Times of 2020 was still less profitable and less valuable.

What does this say for Netflix’s prospects? Like the Times, it is the scale leader in a global content market that is unlikely to ultimately support more than a very few broad-based subscription services despite the digital medium’s significant expansion of the overall market potential.

In SVOD, Disney appears to have committed itself to this strategy and has the assets required to achieve scale, even if the financial returns realized on the road to getting there seem bleak. Amazon also has the financial wherewithal to keep its implicit pledge to Prime members to deliver expensive content along with fast free shipping indefinitely regardless of the economics.

psychographic, or demographic product niche. That would represent a market structure in which Netflix should be able to thrive for the long term much like the New York Times. But in the short or maybe even medium term, Netflix faces a long list of mind-bogglingly deep-pocketed and possibly not fully economically rational competitors who have decided that they want to be in this business.

Netflix’s decision to invest aggressively in original content creation reflected both the intensity of new competition and the decision by many of the largest established content creators to no longer license to Netflix.

While it was strategically sensible for Netflix, the business of taking creative risk has always yielded paltry long-term financial returns.

The combination of Netflix’s structural advantages and commitment to operational excellence suggests a market equilibrium in streaming in which it and no more than a very few broad-based global players will ultimately survive.

roughly 85 percent of Google’s over $150 billion in revenues still persistently comes from advertising.

Like Netflix, Google started life as a pure aggregator—as its corporate mission “to organize the world’s information” makes clear. Unlike Netflix, however, the depth of Google’s structural advantages ensured that it never needed to go into the content creation business in any serious way.

Google is the rare company that seems to have strong elements of all three of the most important sources of competitive advantage identified—economies of scale plus reinforcing demand and supply advantages.

More remarkable is that Google displays multiple manifestations of each of these categories of advantage: the advantages of Google’s scale flow from both the relative size of its fixed-cost base and network effects; it retains customer captivity of both consumers and advertisers because of habit, switching and search costs; and it secures major cost advantages through proprietary technology enhanced continuously by learning and data.

The greatest benefits of scale in search are of the old-fashioned supply-side variety and stem from the ability to spread the huge fixed-cost requirements over the larger user base.

there is little question that Google’s greater familiarity with prior search behavior drives a scale advantage on the demand side by facilitating the effective customization of the selection and presentation of search results for individual users. But all prior experience is not equal. The incremental value of a new search query by one user for the results of another user is trivial. On the other hand, Google learns a lot about how to optimize results by looking at the same user’s previous queries and clicks. So to the extent that there is a direct network effect on the user side of search, it is overwhelmingly driven by the number of one’s own prior searches rather than the number of other searchers.

Much of the Justice Department’s recent investigation of Google originally focused on whether this loyalty has been fairly earned or coerced by Google integrating software tools that dominate “every link in the complex chain between online publishers and advertisers.”

Ironically, regulators’ focus on Google’s central role in the placement of digital display advertising has corresponded to the dramatic decrease in importance of this category of advertising generally and of these services to Google’s profits specifically.

the Justice Department’s 2020 antitrust suit ultimately decided to target an entirely different aspect of the business for the time being. Even if the federal government decides to revisit this topic later, or if the state lawsuit that focuses on it is successful, it will have little impact on the overall customer stickiness of Google’s franchise or of its ability to invest more than anyone else to make the experience even better.

Apart from Google’s clever government and public relations efforts, the federal government’s decision to tailor its challenge narrowly to Google’s commercial deals with Apple and others to serve as the default search engine is likely driven by one primary consideration: it’s a winner. Having recently suffered serial humiliations in court in its efforts to block AT&T’s purchase of Time Warner,32 the Justice Department “essentially copied the successful antitrust complaint it filed against Microsoft in 1998.”

Low commissions for sellers in the absence of enough interested buyers does not deliver value—and attracting a critical mass of buyers to a new, unintuitively named start-up like Etsy can be a prohibitively expensive proposition. But in the world of artisans, it turns out that there is a significant overlap between buyers and sellers—more than 50 percent in the early years.18 This in turn facilitated—and still facilitates to a degree—both even growth and a remarkably low level of marketing expense for the company.19 At the time of its IPO a decade later, almost 90 percent of Etsy’s traffic was still secured organically rather than through search or paid channels.

Neither Amazon nor eBay has much chance of ever attracting a critical mass of dealers or other purveyors of truly luxury items to their platforms because of the negative halo that emanates from the distinctly un-luxurious nature of the bulk of what they sell.

Etsy confronted a much more direct attack with the launch of Amazon Handmade in 2015, just months after its IPO. Its shares struggled for years as it took incremental hits with every new announcement from Amazon—for instance, establishing the “Amazon Handmade Gift Shop”44 and the availability of Handmade product for immediate Prime Now delivery in certain cities.45 Performance only turned around when investors noticed that Etsy’s organic growth was actually accelerating in the face of the Amazon onslaught.46 This suggested the surprising possibility that Amazon’s marketing efforts served mostly to draw attention to the category, benefiting Etsy as the category leader!

The success of Etsy and 1stDibs highlights the relevance of two particularly important attributes in establishing durable marketplace franchises: the extent to which the market lends itself to specialization and the degree of product complexity. Specialization facilitates the establishment of relative scale as well as customer captivity and learning. Product complexity enhances the increasing strength of network effects at scale, drives higher required break-even market shares, and improves the usefulness of applying technology to data.

On the other hand, the largest online travel company—Booking Holdings—is worth more than the equity value of Delta, United, and American Airlines combined. What’s more, multiple other substantial and profitable digital travel companies with diverse business models have regularly gone public during the last twenty-plus years, from Expedia (1999) and Trivago

(2016) to TripAdvisor (2011) and Ctrip (2003), now just Trip.

The economics of the industry revolve mostly around a fee per flight segment per booking that the airlines pay the GDS and that the GDS shares with the travel agents.

Online travel agencies don’t actually compete with either GDSs or airlines—they compete with off-line travel agencies. But their introduction into the ecosystem had significant implications for both. By potentially aggregating substantial demand, OTAs could gain leverage in negotiating the share of the airline fee the GDS gets to keep for itself. And airlines’ preference is for the online opportunity to be captured by the online direct channel rather than a strengthened online indirect one. As a result, at least initially, both GDSs and airlines sought to themselves play a role in the emerging OTA sector. For instance, Travelocity was founded as a joint venture with Sabre, and two major OTAs were founded by consortia

Online travel agencies don’t actually compete with either GDSs or airlines—they compete with off-line travel agencies. But their introduction into the ecosystem had significant implications for both. By potentially aggregating substantial demand, OTAs could gain leverage in negotiating the share of the airline fee the GDS gets to keep for itself. And airlines’ preference is for the online opportunity to be captured by the online direct channel rather than a strengthened online indirect one. As a result, at least initially, both GDSs and airlines sought to themselves play a role in the emerging OTA sector. For instance, Travelocity was founded as a joint venture with Sabre, and two major OTAs were founded by consortia

Online travel agencies don’t actually compete with either GDSs or airlines—they compete with off-line travel agencies. But their introduction into the ecosystem had significant implications for both. By potentially aggregating substantial demand, OTAs could gain leverage in negotiating the share of the airline fee the GDS gets to keep for itself. And airlines’ preference is for the online opportunity to be captured by the online direct channel rather than a strengthened online indirect one. As a result, at least initially, both GDSs and airlines sought to themselves play a role in the emerging OTA sector. For instance, Travelocity was founded as a joint venture with Sabre, and two major OTAs were founded by consortia of airlines—Orbitz in the US and Opodo in Europe.

because of the more generous splits, leisure air bookings from an OTA are half as profitable to a GDS as a booking from an off-line agent.

But where the airlines make their money, and where the GDSs are an indispensable partner, is business travel.

The corporate market relies primarily on off-line travel agents known as travel management companies (TMCs)—American Express Global Business, BCD, and CWT are the biggest—and make little use of either the direct channel or OTAs.

The first major frontal assault on the GDS incumbents from a major carrier came from Lufthansa, which in 2015 began imposing a surcharge on bookings made through the indirect channel.28 More significantly, the establishment of a new industry-wide XML-based communication standard (called NDC)29 to facilitate airlines’ content distribution to agents around the GDSs allowed Lufthansa to establish direct connections through which it offered preferential rates and availability.

Google sits squarely at the top of the funnel where travel dreams begin and has used that enviable position to take a bigger and bigger slice of the pie over time. Google has not taken the step of moving up the value chain and directly attacking the OTAs for two reasons. First, it is always worth thinking twice before killing the golden goose. Booking and Expedia each spent around $5 billion in marketing in 2019—most of which went to Google.54 Second, and more important, being a travel agent, even an online one, requires undertaking a variety of functions—customer service notably among them—that are not Google’s business. Google’s entire model is built on leveraging scalable technology rather than managed services.

monopoly.”59 But neither reviewers nor travelers pay for the privilege to participate on the platform. TripAdvisor remains a metasearch company and it relies on advertisers (of whom Booking and Expedia are by far the largest) who want access to the users planning to take a trip. And although the strength of its unique network effects driven review content helps its position in organic search results, nothing provides a long-term solution to sitting between Google60 and your two biggest customers,61 all of whom have their own competing metasearch capabilities.

TripAdvisor shares ended 2019—before the coronavirus pandemic hit—at almost the exact same price at which they began their journey eight years earlier.

But neither reviewers nor travelers pay for the privilege to participate on the platform. TripAdvisor remains a metasearch company and it relies on advertisers (of whom Booking and Expedia are by far the largest) who want access to the users planning to take a trip. And although the strength of its unique network effects driven review content helps its position in organic search results, nothing provides a long-term solution to sitting between Google60 and your two biggest customers,61 all of whom have their own competing metasearch capabilities.

The overwhelming traffic demonstrated the network effects of the model—travelers want the most recent relevant reviews of properties they are considering and reviewers want to share with the widest possible audience.

The failure of TripAdvisor as a network effects driven digital platform to deliver the kind of performance predicted by the Platform Delusion highlights the critical importance of other structural attributes—here the lack of diversity of key network participants and low switching costs—in determining success.

Figure 12.1 Although Uber had consistently been valued at a multiple of Airbnb, the key

Figure 12.1

Template for Assessing Competitive Advantage

it is far from clear that the ride-sharing market—unlike the space-sharing market—is really global. As a result, in any given market, Airbnb is likely to face the same handful of players while Uber is more likely to also confront significant local or regional champions.

extent to which the relevant market and product characteristics turn scale into tangible economic benefits. It is here that the differences between the two companies are most stark.

Although Uber had consistently been valued at a multiple of Airbnb, the key market and product attributes that drive sustainable franchise value suggest that it is Airbnb that has always been the better business. When the company finally did go public in December 2020, the valuation surged past $100 billion.7 By the end of the year, Airbnb’s value exceeded Uber’s despite earning less than half its revenues.

Two primary attributes are responsible for the superiority of Airbnb over Uber: product/service complexity on the demand side and the fixed-cost requirements on the supply side.

Two primary attributes are responsible for the superiority of Airbnb over Uber: product/service complexity on the demand side and the fixed-cost requirements on the supply side. The former determines how many network participants are needed

Two primary attributes are responsible for the superiority of Airbnb over Uber: product/service complexity on the demand side and the fixed-cost requirements on the supply side. The former determines how many network participants are needed for a viable product and the extent to which additional network participants continue to enhance the product. The latter determines basic break-even economics and the relative financial advantage of being larger than competitors.

In any given city, the product viability of both companies is a function of local density—of drivers on the platform on the one hand and property inventory on the other. A key distinction between Uber’s and Airbnb’s respective marketplaces, however, is how the level of intrinsic product complexity drives the marketplace liquidity required to establish a viable service in a locality. In ride hailing, other than price, the ability to deliver a car within three to five minutes dominates all other customer considerations. How many drivers it takes to satisfy this level of service will depend on both the geography and activity level in a given market. But any service that can attract enough drivers to achieve this threshold, if priced correctly, would be competitive with any other. In the short-term lodging market, by contrast, there are many more salient product characteristics and market segments. An acceptable service would need to secure an adequate pool of alternative accommodations across these dimensions to attract broad interest. Although it is again impossible to know in the abstract how many providers could meet this minimum level, the need to satisfy such a nuanced profile of demand suggests that it would be fewer than for a more homogeneous product or service.

Once the minimum product-viability requirements have been met, complexity also impacts the value to users of increasing available supply beyond this point. Having so many drivers that cars arrive sooner than the optimal three to five minutes is not useful. Riders often can’t get to the car that fast. In the short-term lodging market, however, the wide range of relevant product characteristics ensures that the value of higher incremental density in local listings does not top out in the same way. Indeed, evidence suggests that more listings not only attract more travelers but also drive higher occupancy rates. This dynamic reinforces the value of relative network scale on the demand side for Airbnb that is far greater than for Uber.

On the supply side, the biggest distinction between Uber and Airbnb is that ride-hailing service customers primarily use them in a single city. In contrast, customers of short-term lodging services use those services in and hail from many different locales. As a result, people choosing platforms on which to list their primary residences are not just concerned about the density of listings in their home cities—density of listings as well as awareness of the platform in multiple popular destination cities is also important to attracting travelers to a platform.

Thus, the collective fixed costs associated with a national or global network of local market leadership positions, which in turn benefit from spreading the central fixed overhead, become a significant obstacle to new entrants.

?

As Expedia belatedly realized, the ability to attract international demand from vacationers for a local listing placed on a service unknown outside of its home country is limited.

Uber competitors don’t need to be global in order to offer a compelling alternative.

It may be that in some markets, the level of fixed operating costs won’t sustain more than one or two ride-hailing services. But in larger metropolitan areas, multiple robust offerings are always available, and viability sometimes can be achievable at market shares of less than 20 percent.

This effectively translates to a permanent pool of four or more Uber competitors, severely limiting returns.

Ironically, in some larger markets, like New York City, costly local regulations designed to cripple the ride-sharing sector have raised the minimum viable market share so that the level of competition beyond the two market leaders is artificially low.13 Indeed, by being a fast follower, Lyft historically has been able to free-ride on Uber’s investments to clear the regulatory way for the service.

Despite such high-profile victories as in California, Uber has painfully seen in London that regulation is a double-edged sword. The number and speed of competitors ready to take advantage of Uber’s legal challenges in London reflect the generally low entry barriers in the sector.

More recently, the services have worked together to successfully pass a California ballot initiative allowing them to use gig workers.14 But what regulation gives it can take away; it is unlikely to support a broad-based sustainable advantage.

Despite such high-profile victories as in California, Uber has painfully seen in London that regulation is a double-edged sword. The number and speed of competitors ready to take advantage of Uber’s legal challenges in London reflect the generally low entry barriers in the sector.15 Conversely, the greater fixed-cost needs in short-term lodging mean that Airbnb competitors can break even only at far higher market shares.

It is not a coincidence that while Uber may face competition from dozens of local and regional ride-hailing services, Airbnb has far fewer direct competitors of size in any given market—and the serious ones have generally attempted a more global footprint.

To help spread the fixed-cost requirements, Airbnb’s primary competitors have become part of larger international travel companies. For example, HomeAway Inc. (which has half as many listing as Airbnb) was acquired by Expedia Inc., and FlipKey Inc. (with one third as many listings as Airbnb) was purchased by TripAdvisor Inc. Booking, Airbnb’s largest alternative accommodations competitor, as noted, used its global footprint to build its business organically.

The nature and durability of customer relationships is a key determinant of the speed at which share can move in a particular marketplace.

When combined with minimum viable market share, the level of customer captivity enables a potential new entrant to quickly calculate how long it can expect to lose money before achieving a break-even market share.

So, for instance, in an industry where customer loyalty limits annual share movement to a couple of points and break-even market share is 20 percent, an insurgent can expect at least a decade of losses before establishing financial viability.

Customer captivity is an attribute of incumbents and by definition only applies to existing customers. As a result, the structural advantage is far greater in well-penetrated businesses where the number of new customers annually represents a relatively small portion of the overall opportunity. In a market that is doubling in size every year, even where existing customers are entirely captive, if an insurgent is able to split new customers evenly it could achieve a 25 percent share in the first year—well in excess of the 20 percent break-even market share that would take a decade to achieve in the previous example.

in emerging industries, strong customer captivity is rarely available because users look to keep their options open until a sector finds its footing. Over time, however, as legacy customers represent an increasing percentage of annual industry revenues, the ability to retain users in the face of potentially competitive offerings becomes both more essential and more valuable.

By enhancing the ability to easily search out, compare, and switch between sellers, the internet has set the bar far higher for businesses to articulate truly compelling reasons for customers to stay put.

What’s more, customers and business partners operating in an environment characterized by swift technological change, even in well-established markets, are generally wary of long-term commitments. Nonetheless, robust captivity is still achievable when service quality, breadth of offerings, the verification of nuanced counterparty credentials, and seamless buying processes are central to the ultimate decision to transact.

Unfortunately, even the best-run ride-hailing company will struggle to encourage loyalty among drivers and riders. Over 80 percent of drivers overall work with two or more services, and this percentage has been increasing.18 Moreover, although a small minority of riders overall currently use multiple ride-hailing apps, that percentage is growing fast and varies widely by geography and demographic.

There is a difference between an individual’s willingness to entrust short-term rentals of his or her home to multiple companies and a professional driver’s willingness to drive for multiple ride services. And, as we’ve discussed, for the customer, price and speed are the overwhelming factors influencing the decision about which ride service to use for a short trip, but many other factors play a large role in the decision to stay in a stranger’s house.

And the downside of making a mistake in connection with your only vacation is much greater

And the downside of making a mistake in connection with your only vacation is much greater than in connection with one of many crosstown journeys.

More broadly, the importance of trust and thus a platform’s verification capabilities—that is, its ability to reassure both parties in a transaction by providing detailed information about with whom they are doing business and what they are getting into—is a much more critical factor in reaching a decision about a short-term rental than it is in choosing which service to use for a brief ride.

When Airbnb establishes a leadership position in a market, competitors are at a disadvantage in terms of inventory availability. Many of Airbnb’s listings are exclusive and as long as adequate occupancy rates are achieved, it is not worth listing a property on multiple sites.

However, the same is not true for Uber’s competitors in the ride-hailing market, because most drivers use multiple apps. Drivers engage in a regular ritual in which they review the weekly promotional offers available from competing services before deciding which app to favor in the subsequent days.

Furthermore, while a driver can easily manage multiple apps in real time, a homeowner (and the vast majority of Airbnb listings come from primary homeowners rather than professionals) most likely will need to enlist a “channel manager” service to do the same.

The observance of ride-hailing market-share shifts of greater than 5 percent over a matter of months nationally (and of even more in some localities) suggests a future filled with a steady stream of new competitors for Uber.

Uber’s decision to begin to offer a broader range of services, notably Uber Eats food delivery,21 and a subscription service, Uber Pass,22 reflects attempts to build customer loyalty in a category without much.

When the pandemic lowered ride-hailing activity by as much as 85 percent, the explosion in food delivery certainly mitigated Uber’s revenue losses. But food delivery is even more competitive and unprofitable with lower break-even market shares than ride hailing.

As a result, the business lost hundreds of millions of dollars more despite the superior top-line performance. The

As a result, the business lost hundreds of millions of dollars more despite the superior top-line performance.

Neither Pink nor Pass has gotten much traction or fundamentally changed the low loyalty exhibited toward these services.

Zillow Inc.’s continued dominance in the online real estate marketplace, for instance, is in part a function of its ability to use its unique access to data to continually improve its automated valuation models and its home search and recommendation engines.

peer-to-peer (P2P) lenders discovered that, for most borrowers, their proprietary data yielded little more insight than was readily available elsewhere from sources such as credit scores.

The structural attributes discussed, however, suggest that ride sharing will always be intensely competitive in large local markets. In many international markets, Uber is the insurgent and its US market position provides limited advantage elsewhere. More broadly, the resilience of its position hinges on a relentless aggressiveness rather than an inexorable tendency toward a global winner-take-all or -most equilibrium.

because visitors looking for rooms come from all over, while ride sharing is a predominantly local business, effective competitors to Airbnb need to establish global operations whereas Uber faces hundreds of local competitors.

The existence of network effects should represent the beginning rather than the end of the analysis of overall potential franchise value.

increased investor trust.”12 The problem with Goldman’s prognosis was that, for most borrowers, readily available information like credit scores provide perfectly adequate predictive capabilities. The incremental proprietary borrower data, even when massaged by painstakingly developed proprietary technology,

The problem with Goldman’s prognosis was that, for most borrowers, readily available information like credit scores provide perfectly adequate predictive capabilities. The incremental proprietary borrower data, even when massaged by painstakingly developed proprietary technology, simply does not yield significant incremental value.

Goldman’s confidence was based on the belief that the proprietary data elicited from a greater number of loan originations had allowed LendingClub to develop superior dynamic credit models. As a result, “more high-quality borrowers are attracted to LendingClub’s platform due to the lower interest rates [due to the lower risk premium required by lenders], creating a positive-feedback loop of better loan performance and increased investor trust.”

But in place of disparate lenders and borrowers, LendingClub and its peers found themselves wedged between enormous institutional private wealth managers like Goldman Sachs itself and giant consumer finance portals like LendingTree and Credit Karma as well as Google. Much as the metasearch travel companies are limited by their reliance on Expedia and Booking for demand and Google for supply, in the absence of significant supply advantages from learning, this was never going to be a very good business.

Interestingly, in one segment of the market, it appears that there is meaningful incremental value from data beyond simple credit scores. For borrowers with lower credit scores, additional data analysis can yield significant insight into the probability of repayment.

appreciable value—borrowers with credit scores above 640.14 A number of other businesses have emerged targeting this niche of borrowers

A number of other businesses have emerged targeting this niche of borrowers with low credit scores—LendUp and Applied Data Finance—using a variety of business models but all emphasizing the role of data analytics. These face their own challenges, but at least there is a case to be made for being able to develop a supply-side advantage.

It does highlight, however, the importance of determining whether the particular use case at issue lends itself to such benefits and whether those same dynamics allow others to catch up quickly.

Where the predictive relevance of the data or its applicability to product improvement or customer management is limited, the mere existence of big data is not a differentiator.

Similarly, the very power of machine learning to draw useful conclusions from relatively small data sets means that any advantage will come only when significant incremental pertinent knowledge can be gleaned from much larger data sets.

Yet, ironically, LendingClub sought to distinguish itself by

Yet, ironically, LendingClub sought to distinguish itself by operating exclusively in that portion of the market where big data add no appreciable value—borrowers with credit scores above 640.