The digital economy and network effects: value chains and multilateral platforms.

aparelhos-conectados

Introduction

“Airbnb’s market value: $ 30 billion, higher than the traditional Hyatt and Wyndham hotel chains.”

“Uber’s market value: $ 60 billion, higher than Ford or General Motors.” (Source: NYT, March 2016)

The information above shows two industries that suffered drastic structural movements. However, the changes that occurred in the mobile segment were even more dramatic. In 2007, the year Apple launched its iPhone, the top five handset manufacturers (Nokia, Samsung, Motorola, Sony Ericsson and LG) controlled the global market of the handset, but a few years later Apple gained the industry’s lead. Meanwhile, Motorola left the mobile segment after selling its manufacturing mobile device unit to China’s Lenovo and Nokia followed suit by selling its handset division to Microsoft.

How has the iPhone dramatically changed the structure of the mobile phone industry? Although Motorola, Samsung, and other manufacturers have classic strategic advantages such as first-mover advantages, economies of scale, proprietary technology, strong supply chain and established distribution channels, Apple outperformed its existing competitors by using the multi-platform business model, which will be explained bellow.

smartphones

What are multilateral platforms?

Business models based on multilateral platforms are the ones that connect producers and consumers to exchange goods, services, money of information. In the platform model, information and interactions between the participants are the main assets. With the increase in the number of participants, the value of the platform also increases, a phenomenon known as “network effect”. This fact is not new because it occurs with old-fashioned telephone lines, newspapers (each time the number of subscribers grows, circulation increases, more advertisers are attracted and consequently more subscribers join the newspaper) and shopping centers. Thus, a definition of the business model based on multilateral platforms is introduced below:

“[Platform] is a business model that creates value for multiple sides in a given market, by attracting both customers and suppliers, simplifying the purchase and remuneration processes of each network agent.”

Thus, a platform is a structure that creates value by allowing direct interaction between at least two distinct types of actors. With this definition, one can see that platforms have existed for a long time and do not necessarily have to be based on high technology: Barbie dolls serve as platforms for companies that sell plastic accessories for the doll, shopping centers unite consumers and merchants, and credit card companies connect consumers and retailers. The phenomenon that changed the concept of platforms was information technology (IT), which simplified and reduced the intrinsic cost of building multilateral platforms because it accelerated the entry of producers and users and annihilated the need for physical infrastructure and traditional assets. Uber and Airbnb are classic examples of multi-sided platforms because they unite car owners to passengers and apartment owners to travelers, even though both companies have no tangible assets (vehicles and apartments). Apple also understood the platform phenomenon because the company conceived the iPhone to connect participants on both sides of the ecosystem: developers of applications and end users.

Multilateral platforms are ecosystems

Marshal Alstyne, Geoffrey Parker and Sangeet Choudary, in their article “Pipelines, Platforms, and the New Rules of Strategy,” published in the April 2016 issue of the Harvard Business Review, present the idea that platforms are ecosystems formed by four actors: (i) owners (in charge of the governance of the platform), (ii) suppliers (setters of the platform interface with its participants), (iii) producers (suppliers of product or service in the platform) and (iv) consumers (users of the products or services offered by ecosystem).

It is interesting to note that actors can change roles. For example, passengers of Uber can work as drivers, travelers can offer their residences on Airbnb, job seekers look for jobs via LinkedIn but can also recruit potential candidates for their firms, and merchants who sell through credit cards can buy supplies through the same payment tool.

mundo-conectado

Economics 101: supply-side versus demand-side models

Exxon, Shell, American Airlines, Delta, Airbus, Boeing, General Motors, General Electric, Ford, Fiat, Siemens, Philips, hospitals and universities are examples of firms that base their business models on economies of scale; their high fixed costs mean that companies must increase sales to increase profitability, which will allow reducing prices, which will further improve sales. In supply-based business models, the rule of thumb is asset control (resources) and the ruthless pursuit of efficiency is a critical success factor.

On the other hand, the driving force behind demand-based models is the network effect, a phenomenon that is strengthened by technologies that enable network socialization, demand aggregation, and application development. In demand-driven business models, successful organizations are those that attract more participants to their platforms. This fact occurs because the more participants are in the ecosystem, the greater the possibilities of a combination of buyers and supplier. Companies like eBay, LinkedIn, Facebook, Google+, Tinder, Twitter and Instagram follow, to a greater or a lesser degree, to the demand-based model. Table I shows some differences between the first model, typical of the Industrial Economy, and the second model, paradigm of the Digital Economy. Some points presented in the table will be discussed in the following topics.

Industrial Economy Digital Economy
Focus Product Platform
Structure Value Chain Ecosystem
Source of Power Monitoring and control of the value chain Governance and architecture of the platform
Economic Model Economies of scale on the supply side Economies of scale on the demand side
Strategic assets Physical assets Ecosystem capacity, platform attractiveness
Market value Return on assets Return on transactions within the ecosystem
Source of growth Organic growth or acquisitions Network effects
Table 1 – Differences between models from the industrial and digital economies (Source: Techvision 2016, Accenture, adapted by the author)

From Value Chains to Multilateral Platforms

The value chain business model was the classic industrial paradigm for a few decades. Successful organizations were those who controlled a linear series of activities that began with product/service design, procurement of inputs, manufacturing, and marketing. Automobiles, electronic devices, clothing, refrigerators, locomotives, airplanes, and MBA courses are examples of products and services generated by value chains. The platform business model arises when companies create and govern environments (physical or virtual) in which content providers (such as Netflix) or applications (such as digital games) deal with their end users.

With the change of business models, from a value chain to that of a platform, the skills required for a company to succeed also change. First, rather than controlling resources (or assets), organizations must manage communities, made up of suppliers and consumers. Second, instead of seeking to maximize the value of an individual consumer, the ruler of a platform must maximize the value of a network of transactions. Finally, rather than monitoring a value chain, the governor of a platform must expand the ecosystem by attracting more consumers and producers. Table 2 shows how each model depends on the different types of assets.

Structure Economic Model Company and example if its platform Use of traditional assets Use of traditional and non-traditional assets Use of non-traditional assets
Traditional organizations, focusing on value chains and physical assets Industrial Economy, economies of scale on the supply side General Electric (Predix),
General Motors (connected vehicle)
High Low Low
Hybrid organizations, which use a combination of value chains and platforms Hybrid economic model that pursue economies of scale both on supply and demand sides Nintendo, Sony, Microsoft (digital gaming consoles such as PlayStation, Xbox, Wii) Average Average Average
Non-traditional organizations focused on platforms Digital Economy, economy of scale by demand side Google (Android), Airbnb, LinkedIn, Twitter (respective applications) Low Low High
Table 2 – Different organizational structures, economic models and asset types (Source: Techvision 2016, Accenture, adapted by the author)

Strategy, value chains, and platforms

The value chains used in the Porter´s 5-forces model are stable and the boundaries between consumers, suppliers and competitors are well defined; however, in multilateral platforms, the contours can change rapidly. Netflix is a content provider for digital platforms, however, it can become a competitor in case the firm starts to attract suppliers and content providers to a brand-new platform.

The development of strategies in the case of value chains is synonymous of building barriers, but in the case of digital platforms, the focus should be on the elimination of barriers for producers and consumers, to allow them to interact with each other. For digital platforms, however, the name of the game is about governance, that is, controlling what consumers, producers, and even competitors can do within the platform. Therefore, governance must address the openness of the network. In conclusion, digital platforms consist of rules and architectures. For example, in the digital games segment, Apple opted for a closed platform while Google (Android) offers an open platform.

It’s important to note that businesses based on platforms may fail due to a variety of reasons. First, the leadership requirements of a value chain are very different from those of an ecosystem. Second, decisions about the types of consumer and producer may be inadequate, Third, the platform may be very slow in acquiring consumers and producers. Fourth, the platform may be insufficiently convenient for one side, with Twitter being an example of this problem. Fifth, execution may imperfect. Finally, entry barriers are small for platforms and many companies can build ecosystems for the same industry. For example, Groupon and its numerous competitors in the collective purchasing segment show that too many platforms decrease the value of each of them. In this case, many ecosystems compete for the same commercial space (aggregation of purchases) without a dominant ecosystem. Like any model prior to it, platforms are not immune to the wrong business decisions

Conclusion

Multilateral platforms are: (i) business models suited to an evolving, double-sided digital economy; (ii) are based on economies of scale on the demand side; (iii) offer an alternative value proposition to the traditional value chain model because ecosystems do not require traditional resources, and (iv) require specific skills from the platform governor. However, like any business model, multilateral platforms are no guarantee of success and will certainly be surpassed by another paradigm in the future.

Recommended Literature:

1. Ph.D. thesis from Luiz Ojima Sakuda, Universidade de São Paulo.  www.teses.usp.br/teses/disponiveis/…/LuizOjimaSakudaCorr16.pdf
2. Van Alstyne MW, Parker, GG, Choudary, SP Pipelines, Platforms, and the New Rules of Strategy. Harvard Business Review, April 2016 (pp.54 – 60, 62)
3. Techvision 201 6, Accenture
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