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This Blog Has Moved Temporarily to Thought Leader

Posted on October 7, 2007 
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I was recently invited to blog at Mail & Guardian Thought Leader at http://www.thoughtleader.co.za/llewclaasen. My new commitments at KeyJam.net are also keeping me more than fully occupied.

For the foreseeable future, I will not be blogging at corpv2.com, so if you’ve enjoyed my posts , want to follow posts along a similar vein and you want to see me get to the conclusion of this series (!), then please point your RSS reader to my Thought Leader feed.  Read more

The Impact of Network Effects on Online Technology Plays… Part 2

Posted on July 28, 2007 
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eBay has been a notoriously dominant property in the online auction/marketplaces space, where the market value of an item is uncertain. A significant element of this dominance is attributed to network effects (which I will refer to in the rest of this series using the correct economic terminology - network externalities). Elsewhere in this post, I ignore eBay’s Payments (Paypal) and Communications (Skype) businesses and focus the analysis on the business responsible for its most important past growth success - marketplaces.

In eBay’s business, the money side is the marketplace sellers and the subsidy side is the marketplace buyers.

Analysing the network externalities present in the marketplaces business, we find:

• moderate negative same-side network externality effects on the money side - the more sellers that enter the marketplace, the more difficult it is for a seller to get her items viewed by buyers and the lower the prices at which her auctions close (price is inversely related to supply for a given demand level), so sellers find listing their items on eBay becomes less effective.
• minimal positive to moderate negative same-side network externality effects on the subsidy side - increases in the number of buyers in the marketplace assists in creating platform credibility, but also discourage buyers from entering the marketplace as bidding becomes more competitive, pushing up the auction closing prices.
• strong cross-side network externality effects in either direction (from the subsidy to the money side and viceversa) - the more sellers that enter the marketplace, the more buyers that will enter the marketplace, because the more items that are listed, the more likely it is for buyers to find what they are searching for.

eBay’s cash engine is dissimilar from Google’s engine in that the former is driven by strong cross-side network effects in both directions, whereas the latter is driven by relevance and very strong cross-side network effects from the subsidy to the money side. eBay is much less likely to be unseated by a copycat in a marketplace category that it already dominates, because there are no naturally occurring positive same-side network effects on the subsidy side of similar platforms that could drive the cross-side network effects that increase the value of the new platform for marketplace participants. eBay has the crucial first-mover advantage. Consequently, buyers don’t have enough incentive to switch to a platform that provides less value and sellers won’t switch to a platform where there aren’t enough buyers.

Let’s consider this by way of example - if a new marketplace operator charged zero listing fees (eBay’s primary income), then almost all sellers would immediately move to the new platform, right? Wrong! Unless the majority of the sellers in a given category moved at the same time to the new platform and removed their listings on eBay, there would be no incentive for the buyers to change platforms, because they would still have a better chance of finding what they are looking for at the right price, on eBay. If the buyers didn’t move to the new platform, then neither would the sellers. Most likely, only the most proactive sellers would create listings on both platforms, the buyers would still get more value out of the eBay platform, will continue to use eBay more often than the competitor, and the competitor will wallow in obscurity or go out of business. I suggest that almost the only way for a new competitor to gain market share in established markets is to target those categories that are least competitive in a given eBay marketplace. This could enable the competitor to establish a beachhead, so that cross-side network effects have an opportunity to arise at the category level.

Unfortunately for eBay, its dominance has limits that stunt revenue growth - eBay suffers from same-side negative network externality effects on the subsidy side, not seen in Google’s case. These network effects will tend to reduce the rate of growth in the numbers of new buyers entering the marketplace, the bigger the marketplace becomes. A reduction in the rate of growth of buyers, will similarly result in a reduction in the rate of growth of sellers. In systems theory, this is referred to as a limits-to-growth systems archetype. In other words, there is a limit to the size of eBay’s individual marketplaces, whereas Google suffers from no such limit. eBay’s marketplace revenue growth would thus tend to come from one of 2 places:

• increased geographic coverage (in other words entering more markets)
• increased activity in less competitive product categories

I propose that the limit to the size of the eBay marketplaces will tend to be at a lower level of supply than that capable of meeting market demand in more developed marketplace categories. eBay’s market share thus has a diminishing tendency as market demand grows in a given product category.

I believe that eBay’s very strong cross-side network effects will maintain its dominance (in online auctions for items with uncertain value) and profitability for many years to come - it is very difficult to disrupt or compete against. Unfortunately for eBay, it can’t fully exploit this dominance in its primary business - it’s size is limited by network effects that I believe make it incapable of earnings growth from new marketplaces or underdeveloped categories in line with expectations associated with the Price/Earnings multiple of close on 36 that is currently trades on.

Moving house

Posted on July 23, 2007 
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I realise that things have been a little slow around here since my first post. I’m in the process of moving back to Cape Town after spending a few months in the Eastern Cape, so setting aside time to put together thoughtful posts has been an issue.

Please bear with me.

The Impact of Network Effects on Online Technology Plays… Part 1

Posted on July 15, 2007 
Filed Under Online Tech, Economics | 6 Comments

This being my first post on this new blog, I thought I’d look at one of the fundamentals upon which the major online players have built their revenue models - network effects. It is also a significant reason for the rapid growth of the social networks Myspace and Facebook and explains a lot about Google and eBay, which we will explore further.

Barriers to entry have typically been used by traditional offline plays to deter entry into an industry. This has the effect of creating a business environment where healthy profits and sometimes even monopolistic (economic) profits are possible. In the online space, there are few of these barriers to entry, but there is something else that often works just as well called network effects.

Network effects arise when a good is more valuable to a user the more users adopt the same good or compatible ones. Economists refer to this phenomenon as a network externality because when additional consumers join the network of current consumers they have a beneficial “external” impact on the consumers who are already part of the network.
European Commission’s Directorate-General for Competition

Network effects occur around a platform and there are 2 significant types - same-side & cross-side. Network effects can also be either positive or negative as I will explain. Platforms, in turn, have what are called the “money” side and the “subsidy” side. For example, in Google’s case, the subsidy-side is comprised of the people that perform the searches and the money-side is the merchants that buy the paid-placements from Google. A user doesn’t pay to perform searches on Google, but that doesn’t mean that there are no costs associated with it - in effect, the merchants subsidise the users that perform the searches.

Same-side network effects increase the value of the good/service the more people join on the same side of the platform , whereas cross-side network effects increase the value of the good/service the more people join on the other side of the platform (and viceversa for either if the network effect is negative).
Continuing with the analysis of the impact of network effects on Google’s business model, we find that Google has:

• weak positive same-side network effects on the subsidy side - you using Google does not make their search service much more valuable to your friends, except that your word-of-mouth references will urge them to consider it in the absence of a better alternative;
• strong negative same-side network effects on the money side - as more merchants have joined the Adwords program, they have found that the click-through history of the incumbents has made it more difficult to unseat the incumbents from prime position, unless the entrants are prepared to suffer initial losses. This discourages new merchants from entering the Adwords programs in the competitive areas (financial services, travel, etc), or at least restricts them to small budgets and low positions on the SERP.
• very strong positive cross-side network effects from the subsidy to the money side - as the number of users and searches performed on Google has increased dramatically, so too has the number of merchants that are keen to buy Adwords inventory from Google to enable them to reach those potential customers .

What we really want to know though, is how do these networks effects impact on Google’s earnings capabilities, or sustainability? What are its weaknesses brought on by network effects?

Google’s cash machine is a combination of the scarcity of Adwords inventory (which can only grow at the rate of growth in new searches) and the very strong positive cross-side network effects, which pushes up the cost of Adwords inventory. The positive cross-side network effects are very strong, because Google’s users are BUYERS on a scale that exists nowhere else on the web. Why are they buyers? Because of the RELEVANCE of the search results.

Google’s most fundamental weakness is that it hasn’t created strong network effects on the subsidy side (explained above) or significant traditional barriers to entry in search, and so its very existence as the premier search player hinges almost entirely on the relevance of its search results, compared to that of its competitors. If another startup comes along that provides a better search experience, offers more relevant results and generates grass roots buzz, Google has only its brand and past success to protect itself. And in our current disruptive innovation business paradigm, that’s not much protection.

In part 2 and the rest of this series, I will explore the impact of network effects on eBay, MySpace and Facebook and I will explore why Facebook is in the strongest position for earnings growth of all the most significant web properties today. This is not more Facebook fluff, so I hope you’ll continue reading.

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  In this blog I will attempt to apply recent research findings and my own ideas on the management of technology and innovation to online technology startup environments. I hope that I will bring new strategic and tactical alternatives to the attention of both corporates and two-man startups.

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