Monday, April 04, 2005
Consumer Surplus in the Digital Economy: Estimating the Value of Increased Product Variety at Online Booksellers
Looked at this very interesting, if somewhat old, paper once again after a long while over the weekend as I have been wondering about the profitability of Long Tail business models. This paper was the first one to start putting a value of increased variety of offerings at online bookstores, and it embeds some of the ideas of all things Long Tail as we know today. It addresses a key point : economic value is created by more choice, which results in creation of consumer and producer surplus. Profitability is determined by how such surplus is split between the producers and consumers. But how sustainable is such profitability?
The question I am specifically wondering about is the impact of competition on a Long Tail business. What will happen when the inevitable supplier rivalry starts into the Long Tail space? Suppose you are someone like Uglydolls (from this post on Long Tail) , what will happen to your profitability if a number of rivals spring up to compete for your piece of the Tail? Let's think this through.
First of all, what will be nature of such competition? Basic strategy premise is that it can be based on cost or differentiation. Given that the niche that an LT business operates in is very specific and the customers are loyal only to their very narrow taste, such users would actually be more likely to switch to a rival that offers price competition. However, from the viewpoint of such a competitor, cost-competition may be the only option as the opportunities for differentiation in a very narrowly defined niche are likely to be very limited. If you think about it, the niche itself is the differentiator but that applies only at the overall "industry" level, if you will.
Secondly, let's think about the buyers' switching costs. Given that the niche is narrow, the addresseble market size and the number of potential consumers is small. It means that creating high switching costs based on network FX will be harder too.
So, does this mean that an LT business can only be based on a low-cost strategy? The small size of addressible market and number of potential consumers makes it difficult for a player to drive costs down on the basis of economies of scale or scope. Where else can low costs come from?
This leaves me with only one possibility : a weak competitive advantage based on a first mover advantage. This advantage is primarily based on quickly spotting a niche and setting up a business to serve it. But just as Umair points out in the del.icio.us debate, the question of creating entry barriers and/or buyer switching costs will continue to nag such businesses.
This leads to my aha moment : LT businesses fundamentally belong to two cateogries. One is those that accumulate huge customer base, and then create a number of micro-niches. Classic example is, of course, Google and its advertising revenue model. The other category is businesses like Uglydolls, which actually find a micro-niche to serve and then aggregate a customer base around it. These two businesse models are mirror images of each other : aggregate customers and then create micro-niches or create micro-niches and then aggregate a customer base.
Hmmm....so, what next?
How wierd, I was just reading a ton of papers that referenced this paper and thinking about this topic this wknd.
My intuition is that microniches within the LT will be winner-take-all markets. But I have yet to explain why!!!