Winner takes all in the networked economy

Ferocious competition is the norm in most of the networked economy, but a single supplier has dominated the markets for desktop software, internet search and online auctions almost from the outset. How did winners like Microsoft, Google and eBay manage not just to take virtually all the prizes but to hold on to them?

The winners' explanation would be that they are immensely innovative organisations that came up with vastly better products and services than their competitors and made them the standard. There is some truth in this, but much the same could be said of all entrepreneurs who create new markets: they start with a radical idea, deploy or develop capabilities that nobody else has and make propositions to customers so compelling that the market explodes.

Their reward is enormous competitive advantage, something close to a monopoly for a while. But this is nearly always shortlived as others start to acquire once unique capabilities. More often than not the pioneer is displaced as industry leader, as happened to Apple and IBM in personal computers, and Netscape in internet browsers.

There are two ways to avoid this fate. One is to keep capabilities so distinctive and customer propositions so compelling that competitors cannot match them. The other is to cultivate strategic assets that act as barriers.

The two are not of course mutually exclusive – the safest strategy combines both. Google's innovativeness accounts for much of its competitive advantage but, like Microsoft and eBay, it has also benefited from a strategic asset that even now few people understand – network effects. The more customers they acquire, the more attractive they become to others, and the tighter their grip on them. A network generally becomes more valuable to its members the bigger it is, and the more members or nodes there are.

This is true whether it is a telephone system, the members of a stock exchange or the subscribers to a dating agency: they have more people to speak to, trade with, fall in love with.

A virtual network can include those who use the same equipment, listen to the same music or belong to the same community.

Once a network gets to a certain size it becomes difficult to tempt members away – they face significant switching costs if they leave. Bob Metcalf, the creator of ethernet and of the 'law' that bears his name, suggested that the value of a network is proportional to the square of the number of its members.

eBAY WAS AN ACCIDENT

Facebook is the most striking recent example but this has yet to prove its business model and staying power. eBay, though it only became a business by accident, was profitable from the start. Pierre Omidyar started the site in 1995 so that computer buffs like him could trade bits of old equipment with each other, with no idea of making money from it. Anyone could post items for sale and anyone else could bid for them.

When his internet service provider told him it was getting too much traffic and he'd have to pay the business rate of $250 a month, Omidyar asked the virtual community to contribute a percentage of the value of each sale they made. In the first month, March 1996, he was amazed to receive more than $1,000, in May $5,000, and in June, $10,000. Every month traffic and revenues kept growing. It wasn't so much computer paraphernalia – now toys and dolls were selling like hot cakes. Then antiques, stamps and coins took over.

There was apparently no end to the imperfect markets eBay could make work better. It would continue to grow exponentially for years to come, like a giant snowball rolling down a mountain, gathering more and more buyers and sellers.

Total sales reached $95 million in 1997 and hordes of competitors tried to move in. A few eBay traders were tempted away but most came back: there was more stuff to buy and more people to sell to on eBay than anywhere else. Above all, it was the size of its virtual network that made it so attractive to traders. Sales hit $5 billion in 1999 and $50 billion by 2006.

POSITIVE FEEDBACK LOOPS

What fuelled eBay's extraordinary growth was another distinctive feature of the networked economy – positive feedback loops that amplify small changes to produce a bandwagon effect: success breeds success, and failure, failure; the strong tend to get stronger and the weak weaker. Positive feedback accelerates the growth of all new markets and is critical to the development of networks, producing virtuous circles like the growth of eBay or vicious ones, as when Netscape's market started slipping away from it. When it became clear that Microsoft's Explorer would win the battle of the browsers, nobody wanted to be stuck with the loser.

The importance of feedback has long been recognised in physical systems. It is only recently that its role in social networks has been understood. (Though Shakespeare got it 400 years ago: 'There is a tide in the affairs of men, which taken at the flood leads on to fortune. Omitted all the voyage of their life is bound in shallows and in misery.')

In a much more complex, networked economy, feedback loops explain how ideas, and the adoption of new products such as the iPod, can suddenly become social epidemics. The growth of a network typically follows an S-curve. In its early days, it is too small for its size to attract other members, and it grows slowly, accelerating sharply if and when positive feedback kicks in, slowing down as the network approaches maturity.

Some networks have long gestation periods. Fax was technically possible early in the 20th century but only really caught on in the early 1980s, when cheap machines came on to the market and there were robust, automated telephone networks in most rich countries. By the end of the 1980s just about every business was using fax every day.

Fax was soon eclipsed when email became even more ubiquitous. The original email systems were closed – proprietary ones, used mainly for internal communications. When the internet emerged as the common standard and big companies switched over, there were suddenly hundreds of thousands of email users on the net. Very quickly, every business and most individuals could see a reason for joining the internet, which more than doubled in size every year in the 1990s.

Nobody owned these customers, and proprietary online systems often lost theirs. AOL, though, convinced many people, notably Time Warner, that 'owning' so many eyeballs made it the most valuable company in cyberspace. This particular network proved to be a perishable asset and Time Warner paid dearly for its naivety.

Very few businesses enjoy network effects to the extent that eBay has. The biggest beneficiary has been Microsoft, which achieved its domination of the desktop long before the internet became a mass medium.

The key step was holding on to the rights to the DOS operating system it obtained for IBM's first PC. But it was far from obvious, even in the late 1980s, that DOS's successor, Windows, would become the universal standard.

IBM had a new operating system for business customers and Apple's Mac was easier for consumers to use. However, when it became clear that Windows 3.0 would have the largest market share, a bandwagon started: most businesses and consumers wanted the same system that everybody else was going for, and Microsoft sold 10 million licences between 1990–92.

MICROSOFT'S DOMINANCE

By now it was extending its dominion to other desktop markets, edging out Lotus and WordPerfect, the previous leaders in spreadsheets and word processing. The new vogue for connecting computers over local area networks encouraged standardisation in these programs as well as operating systems.

Once people started exchanging files, it was infinitely easier if they all used the same software. Naturally they standardised on the products that had emerged as the new market leaders, and which worked so conveniently well with the new standard in PC operating systems. By 1994 Microsoft had 70 per cent of the markets for spreadsheets and word processing and more than 90 per cent in operating systems.

This was not entirely planned. Bill Gates acknowledged that he had been slow to spot the significance of computer networking in general and the internet in particular, but he benefited enormously. Microsoft went on to pulverise Netscape and to extend its hegemony to the browser market. It really did look for a while as if one winner was going to scoop up all the prizes.

ENTER GOOGLE

In fact, far from dominating as many feared, Microsoft's brand was seriously damaged by its ruthless exploitation of its strategic assets. The company that later emerged as the most powerful on the web was Google, which was soon challenging Microsoft for leadership of the software industry.

Like eBay, Google is a business whose most valuable assets are networks. The physical one is an enormous pyramid of computers and server farms. Equally important are two virtual networks of consumers and advertisers which only emerged, like the business itself, serendipitously.

For its first two years, the founders did not know how they were going to make money. They hated the idea of funding Google through advertising, which they thought could only bias search results towards advertisers. They concentrated on building the biggest and best computer network – and on 'organising the world's information and making it universally available'.

Google attracted such an enormous public following that when it discovered a form of advertising it could live with, it was like striking oil. Until it launched AdWords in October 2000, revenues were negligible – then they rocketed. In 2001 they hit $86 million, two years later $1.5 billion, and by 2008 $22 billion.

Google wasn't the first to offer contextual advertising, but it had the strongest brand in search and the largest possible audience for advertisers. The growth of that consumer audience fed its advertising revenues – these were feedback loops and networks on the scale of eBay's. What made Google's proposition for advertisers so compelling was the exponential growth in the number of searches being made. And the quality of those search results was the product of another virtuous circle – that scalable network of computers that got better as it got bigger.

All fast-growing businesses benefit from virtuous circles but very few from network effects. One market creator understood them from the outset: PayPal deliberately set out to attract a critical mass of users as quickly as possible, offering $10 to all new members and another $10 for introductions. It soon found itself in a race with eBay, which tried and failed to marginalise its rival. In 2002, however, eBay had to bow to another network with unstoppable momentum, and paid $1.5 billion to acquire PayPal. It now enjoys near monopolies in both auctions and payments.

WHAT LESSONS CAN BE LEARNED?

Most businesses cannot hope to emulate these winners, but they can learn lessons from their stories.

• The first is only to go head-to-head with the owners of enormous strategic assets if you have powerful weapons of your own and a smart strategy. Monopolists capable of crushing challengers tend to exercise their power.
• The most powerful strategic assets for incumbents are switching costs. If it's expensive for customers to leave a supplier, only an immensely compelling proposition will tempt them away. Strong networks have high switching costs but they are not their only source. Companies that make their technology the standard in a market enjoy equally effective customer lock-in. Gillette's razors and blades business model is still working well after more than a hundred years.
• Excessive reliance on strategic assets can lead to complacency and customer resentment, as both Microsoft and eBay discovered. This can leave incumbents painfully exposed when the rules of engagement change. Former monopolists such as telephone companies and many national airlines have found competing in a deregulated market uncomfortable. Technological revolutions can have a similar effect on those with previous advantage.
• Most leaders in the networked economy rely primarily on their distinctive capabilities for competitive advantage. Capabilities are what gave Google, Apple, Amazon and Nokia their original leads, and burnishing and extending them have been crucial to their enduring success. All these companies acquired strategic assets, notably brilliant brands, but used them mainly to support their superiority.
• Finally, these cases demonstrate that first-mover advantage is far from being universally true. It may help in building a lead but is no guarantee of holding on to it. Microsoft has scarcely ever been first into a new market. It made itself master of the universe to a considerable extent by painstakingly copying other people's ideas and occupying their markets. Google likewise benefited from improving on what pioneers had done.

Sometimes, a single supplier can tie up the lion's share of a new market, generally because of developing capabilities that competitors cannot match, forming binding relationships with customers or building other barriers to entry.

Being first is nearly always a means of achieving one of these. It was critical in the cases of eBay and PayPal, as feedback loops helped their networks to reach a size that no one could match. But this strategy only works if you have a very strong hand.

ABOUT THE AUTHOR

Kieran Levis is principal of Cortona Consulting and the author of Winners and Losers, Creators and Casualties of the Age of the Internet (Atlantic Books, 2009).

[email protected]