eBusiness and the Network Effect

This paper was written the Information Management/Infomation Strategy Module of my MBA with the University of Westminster. It is a pretty academic piece that I plan to use as the basis for a more digestable white paper. I think there are some valueble ideas here though so dive in if your interested.
Feel free to email me if you have any questions

go back to the experienceCurve blog

Table of Contents

Introduction

eBusiness Literature review

What is eBusiness

Definitions of eBusiness

What are eBusiness models

Areas undervalued that change the economics of doing eBusiness

Network effects

Literature review

Examples of eBusiness benefiting from network effects

Parallel theories of potential key enablers

Communities

Knowledge management

Conclusion

References

Bibliography

Table of Figures

Figure 1 Relationship Between Elements of eBusiness Framework

Figure 2 Sarnoff Broadcast Network

Figure 3 Metcalfe's Law

Figure 4 Reed Group Forming Network

Figure 5 Network value gain over time

Figure 6 Amazon: Reviews

Figure 7 Amazon: Customers who bought

Figure 8 Amazon: Lists

Figure 9 Amazon: Guides

Table 1 Business Models on the Web (Rappa, 2001)

Table 2 eBusiness frameworks compared

eBusiness and the network effect

We will elaborate at a later portion of the paper but initially we'll define eBusiness as business mediated by the internet or network related technologies (Gartner, 2000) and we will define network effect as members of a network having an affect on other members or potential members of a network (liebowitz and Margolis, 1998).

Doing business on the web is a very recent phenomenon, and has led to much speculation about "new" economies and "new" rules (Liebowitz, 2002, Shapiro and Varian, 1999). The speed at which companies have been created and have failed has been unprecedented. What was last year's boom is this year's bust. It is clear for instance that many companies that were going to rely on on-line advertising, and measured their wealth potential with eyeballs and hits, have had to look for other sources of revenue.

Companies in this new paradigm have to create businesses that provide value, make money, scale and are competitive, to achieve those ends many companies have created new business models and some have even tried to patent them (priceline.com, Amazon.com).

So we have a proliferation of new business models and as they are on-line, eBusiness models, the challenge then is to be able to look at these business models and understand not only how they work but how they compete.

Some notable business writers have created several frameworks to help analyze eBusiness but it is seems that some of these have been written without consideration of some of the realities or oddities of the internet.

In this paper I will review existing frameworks for eBusiness models and then introduce areas undervalued in current models and suggest areas that companies can increase their competitiveness.

eBusiness Literature review

What is eBusiness

What is eBusiness? In this section we shall look at several definitions of eBusiness, highlight some eBusiness models and archetypes

Definitions of eBusiness

When representing the internet on a network diagram it is customary to use a cloud, because it has no edge, it is ever changing and it has many forms, eBusiness is also hard to define. When we look at some of the definitions of eBusiness we start to see how broad a topic it really is and how hard to define it is also.

eBusiness  and e-commerce  are net related business activities that transform internal and external relationships to create value and exploit market opportunities driven by new rules of the connected economy.
(Damanpour,  2001)

This could be a good start although the author neglects to illuminate the broad statement on what the "new rules of the connected economy" actually are. The portion of the statement: "eBusiness and E-Commerce are net related activities that transform internal and external relationships to create value and exploit market opportunities", does describe any eBusiness without being exclusive to a particular type of business, business model or whether it is a portion of a companies total business.

The Gartner group asserts that the internet or the web are essential components of eBusiness. Therefore companies must participate in external business relationships by using computer-to-computer interactions (transactions, support, marketing, communications, and collaboration) by either business to business (B2B) or business to consumer (B2C), if it is to be considered an eBusiness . Gartner also acknowledges that eBusiness is not a pure state and might be categorized based upon the proportion eBusiness related activities a company might participate in (Gartner advisory 2000).

eBusiness has also been described as just another channel as part of the multi channel marketing strategy. We might not call the gap, banana republic or best buy eBusinesses despite the fact that they all have .com portions of their business.

For the purpose of this paper then I will use a the first part of Damanpour's (2001) defenition:

"eBusiness/E-Commerce is  any "net" related activity that transforms internal and external relationships to create value and exploit market opportunities."
(Damanpour,  2001)

What are eBusiness models

In this section I will discuss the various concept s of eBusiness models, different revenue models for eBusiness and effect of network externalities on eBusiness. A business model in the context of this paper will not be description of the entire social system with all its relationships and processes. In this paper business model will be a description of the logic of a business system for creating value underlying the actual business processes  (Peterovic et al 2001).

eBusiness models/archetypes

eBusiness models are treated in several different ways in literature. In fact it is quite explicitly stated that there is, at this time, no single, comprehensive and cogent taxonomy of web (eBusiness) business models (Rappa, 2001). In that case I will list some of the ways eBusiness models have been categorized here and attempt to set a common frame for this discussion, I will then define the subset of eBusiness models that I will use in the remainder of this paper. The business model concepts I have listed here are defined in different fashions and from different perspectives. The first model is defined by markets, the second by revenue model and the last three concepts are built on the idea of a business model as a generic framework that is market, revenue and technology agnostic.

Market concept

De, Mathew, Abraham (2001) and Griffith and Palmer (1999) all describe three broad categories of business model; business to business (B2B), business to consumer (B2C), and consumer to consumer (C2C). This particular concept is too broad for out purpose. Looking at our definition we can see that these descriptions do allude to "who" is having a relationship with whom but not, as in our definition, how it is transforming that relationship.

Revenue concept

Rappa (2001) on the other hand has an extensive list of business models based on revenue models.

Table 1 Business Models on the Web (Rappa, 2001)

Brokerage	Buy/Sell Fulfillment Market Exchange Business Trading Community Buyer Aggregator Distributor Virtual Mall Metamediary ((Sawhney 1999)(1) Auction Broker Reverse Auction Classifieds Search Agent Bounty Broker Transaction Broker
Advertising	Generalized Portal Personalized Portal Specialized Portal - Also called a "vortal" (i.e., vertical portal). Attention / Incentive Marketing Free Model -Freebies create a high volume site for advertising opportunities. Viability is hardest when based purely on advertising revenue. Opportunity to blend with infomediary model.
Infomediary	Revenue can either come from advertising or from the products that the infomediary is collecting information about.
Merchant (etailing)	Virtual Merchant. Catalog Merchant Click and Mortar Bit Vendor (information products)
Manufacturer	Extending the brand. BMW for instance with bmwfilms.com is brand building through advertainment (a combination of advertising and entertainment).
Affiliate	Financial incentives are offered to affiliated partner sites. banner exchange pay-per-click revenue sharing programs Note: broad patent awarded to Amazon.com
Community	Voluntary Contributor Model Knowledge Networks - or expert sites, really a broker type arrangement or possibly infomediary
Subscription	Users pay for access to the site providing high value-added content.
Utility	A version of subscription Possible venue for micropayments

Source: Rappa, M. Managing the digital enterprise e Business models on the Web

Most of the models listed here do not fit our definition of business model; it is an interesting list of revenue models but that is somewhat limited if used to describe business logic. In my experience many companies are using several of those revenue models to complete their business model.

Generic eBusiness model frameworks

In the analysis of business models several generic models have emerged as a tool for the development and analysis of eBusiness models.

These frameworks are different levels of business model abstraction that enable the comparison and decomposition of most, if not all eBusiness models (Osterwalder, 2002).

Dubosson et al (2001) use a framework composed of four perspectives to analyse eBusiness. These are:

• Product innovation
• The products and services a firm offers representing the firm's value proposition to its target audience.
• Customer Relationship
• The value of the relationships (relationship capital) that the firm maintains with its customers in order to satisfy the customer and generate revenues
• Infrastructure Management
• The technology infrastructure and network of partners necessary to create value and maintain relationships.
• Financial Aspects
• Cost and revenue structures

Figure 1 Relationship Between Elements of eBusiness Framework

Source:Dubosson-Torbay, M. Osterwalder, A. Pigneur, Y. eBusiness Model Design, Classification and Measurements

Hamel (2000) in his book Leading the Revolution also uses a four part frame work to describe business models. The Hamel framework consists of:

• Customer Interface
• Empowering customers providing the information needed to make decisions. Possibly value proposition similar to the product innovation and customer relationship component of the Dubosson et al (2001) et al framework
• Core Strategy
• How does the firm choose to compete, what is its product or market scope, what is its basis for differentiation?
• Strategic Resources
• Where does the competitive advantage in the firm rest, on which resource does it rely?  A strategic resource could be a core competency (know), a strategic asset (own), a core process (do)
• Value Network
• Suppliers, partners and coalitions that surround the firm complementing and amplifying the firm's resources.

Hamel also describes bridge components that connect or intermediate the other components of the framework:

• Configuration
• Intermediates the firm's core strategy and strategic resources
• Customer Benefits
• Intermediates core strategy and customer interface
• Company Boundaries
• Intermediates strategic resources and value network

Hamel's (2000) framework is geared toward guiding strategic choices of management as opposed to the actual evaluation of existing business models. The lack of examples of how these elements are played out in real world businesses makes it a theory that is difficult to apply in an analytic sense but useful for decision making or decision guidance tool for management.

De, Mathew, Abraham (2001) going beyond the four segment framework, have developed a framework that seems more pragmatic for the analysis of eBusiness, the components of their framework are as follows:

• Transaction costs
• Costs incurred by a buyer or seller by completing a transaction. This includes intangible and tangible costs across the entire customer life cycle. For example a buyer may buy online as opposed to going to a store due to the time, travel costs, hassle, opportunity costs (Liang and Huang, 1998).
• Switching costs
• Once one is a customer what is the cost of switching to another product/service (Shapiro and Varian, 1999)
• Network externalities
• Participants in network affect other members of the network without paid compensation and has been used to study the success and failures of information products and companies (Shapiro and Varian, 1999).
• Versioned products/niche marketing
• Preventing commoditization of products and charge premium to consumers
• Infrastructure investment
• Defined by De, Mathew, Abraham (2001) as Internet infrastructure and refers to hardware or software
• User experience models
• The processes or steps that a buyer moves through to obtain a product (Kim, 1997). The design of these processes, in large part determine the transaction costs.
• Revenue models
• De, Mathew, Abraham (2001) identify 4 basic revenue models; Advertising, retail, banking and information harvesting

Summary of business model frameworks

Of all the frameworks presented only the last three generic  eBusiness  frameworks seemed appropriate to the evaluation of eBusiness of how eBusiness works and how firms compete in eBusiness.

Interestingly the three generic models shared some commonalities that may be helpful in deriving competitive advantage for eBusiness.

Table 2 eBusiness frameworks compared

Summary	Hamel	Dubosson	De, Mathew, Abraham
Value of Relationship to Customer	Customer Interface	Customer Relationship	User Experience Models, Transaction Costs, Switching costs
Value of Network to Business and Customer	Value Network (business facing)	Infrastructure Management (includes partners)	Network Externalities
Value of Product to Customer	Core Strategy	Product innovation	Version/Niche Market
Infrastructure		Infrastructure Management  (includes IT)	Infrastructure investment
Financial Value to Business		Financial Aspects	Revenue Models
	Strategic Resources

Analysis of these models infers several things:

(the first 3 are not news to most businesses)

1. The product needs to be valuable to the customer
2. The business needs to invest in infrastructure
3. The business needs to make money

(the last two though are more interesting)

4. eBusiness needs to create value for the customer above and beyond the product
5. The network of partners and customers is viewed as valuable

Areas undervalued that change the economics of doing eBusiness

We will focus on the last two themes derived from the eBusiness frameworks as they do provided a possible focus for eBusines beyond the delivery of their existing products. The first theme in the eBusiness model frameworks was that eBusiness needs to create value above and beyond the product how to achieve that is maybe alluded to in the second theme, namely; the most underutilized unexploited theme was that the network of partners and customers is valuable. Why does that seem underutilized and unexploited?

To answer that question we look at the focus that element of the frameworks. All the frameworks talked about the value of the network, one even called it a value network (Hamel, 2000) but mostly emphasized the network of partners, only one of the frameworks though included customers in that network. Even the framework that did include customers in the network and (De, Mathew, Abraham, 2001) spoke specifically of network externalities (effects) did so in an unsophisticated, superficial fashion. The De, Mathew, Abraham (2001) framework stated that network externalities in B2C companies were very limited and less significant than B2B or C2C, this statement is inaccurate and limited in its imagination of the value of networks of customers.

Companies that need to provide customers with value above and beyond the product could try to make their current network of customers more valuable to other customers and potential customers. If a company can enable its current network of customers be valuable to customers and potential customers then the company will actually benefit from a positive network effect i.e. the size of a companies customer network becomes more valuable than the sum of its parts.

In the next section we shall review some of the recent thinking on network effects. We shall also give some examples of companies that have gained competitive advantage through network externalities and introduce some key enablers to leverage network effects.

Network effects

Literature review

Network effect

The network effect is the concept that members of a network affect other members of a network in a positive or negative fashion.

The difference between network effects and network externalities really comes down to network ownership or beneficiary of the networks value. If a network is not owned or there is no beneficiary of changes in the network value etc. then the term network externality is appropriate, if there is an owner or beneficiary of the network then it is called the network effect  (Liebowitz and Margolis,1995 and Katz and Shapiro 1994).

A classic example of the network effect is the success of Microsoft (Liebowitz and Margolis, 2001). The dominance that Microsoft enjoys has been encouraged by the fact that more people use Microsoft products. Once Microsoft had a large amount of users it attracted developers who created more useful applications that attracted more users. The more users that used Microsoft then effected peoples decision on what operating system they should buy, obviously if they used the Microsoft operating system they could communicate with other people using Microsoft applications and so on. This can be called the network effect and in addition it is a virtuous loop so it is continually getting stronger (Arthur, 1996).

Network effects have also been apparent in some technology standards, like VHS and Betamax, 8 track and cassettes. The VHS vs. Betamax example is interesting because it illustrated inferior technology achieving network dominance and pushing out a superior technology.

A network effect can, in many ways, be perceptual, i.e. a customer can make a decision as to which network to join based upon their perception of that networks value. Companies also take advantage of perception of network value, through psychological positioning a company can actually dissuade possible new entrant from attempting to compete against them if the new entrant believes the market is locked in (Arthur, 1996).

Positive network effects as discussed in the examples also exhibit increasing returns, which can then lead to significant competitive advantage.

One thing that might help temper the positive review that the network effect is from Arthur (2000), in a paper about the myths of high tech economy, is myth #1 "All Networks are Subject to Network Effects." This will be illustrated in later examples.

The next section will discuss the theory behind valuation of a network.

Valuation of networks

While talking about network effect it is appropriate to talk about the valuation of networks. As we have stated, if a network is more valuable then it is more attractive to potential members and therefore can benefit from positive network effects.

Three theories have been presented that come from such people as NBC network pioneers to inventers of important computer standards like Ethernet. The three theories are from Sarnoff, Metcalfe and Reed, (Reed, 1999)

Sarnoff

The first model to try and quantify the value of a network was the Sarnoff broadcast model (Reed, 1999) (David Sarnoff was an NBC broadcast pioneer), the concept being that the value of a network was the sum of its nodes. Sarnoff's model is really talking about the value of a network to advertisers, the more viewers the more value.

Figure 2 Sarnoff Broadcast Network

Source: That Sneaky Exponential. Reed 1999

A broadcast network is not a model that exhibits a strong network effect (Arthur, 2000) on the members of the network, it does exhibit a network effect on the owners potential advertisers though, i.e. advertisers will be more attracted to a bigger network than a smaller one with all other variables being equal. From this observation we can surmise that no matter how big the network, the owner of the network will still have to try just as hard to get new customers on the network to increase its value to advertisers.

Metcalfe

Bob Metcalfe, inventor of Ethernet , realized that the value of a network in which all of the nodes were capable of connecting with each other became much more valuable than a broadcast network.

It might be helpful to think about the fax machine, if you have 99 fax machines they are all capable of communicating with one another and if each of those connections is equally valuable then we can say the network is worth 99² if then one more fax machine was added to the network it would be worth 100².

Metcalfe's law was then a network was as valuable as the square of its nodes or, where V=value and n=nodes on the network, V=n² (Reed, 1999). 

Figure 3 Metcalfe's Law

Source: That Sneaky Exponential. Reed 1999

Metcalfe's law was focused on the value of a network, but as we stated earlier if a network is more valuable and

This is nice guideline but does assume that every connection in a network is equally valuable; this is not true in most cases. Metcalfe's law then is still useful when looking at the value of interconnected networks and it is clear that an interconnected network is more valuable than a broadcast network.

We can also state that this network does exhibit network effect on potential members of the network, therefore, in theory the owner of the network will not have to try so hard to get more people on the network because the bigger the network the more attractive it will be.

Reed

The final proposed model for the valuation of networks is Reed's (1999) group forming networks. Reed's hypothesis is, in simple terms, that a network of networks (groups) is more valuable than the square of its nodes. Reed proposes that the value of a network of networks (groups) becomes an exponential equation and the number of nodes become the exponent. Reeds equation would therefore read V=2ⁿ

Figure 4 Reed Group Forming Network

Source: That Sneaky Exponential. Reed 1999

Figure 5 Network value gain over time

Source: adapted from "That Sneaky Exponential-Beyond Metcalfe's Law to the Power of Community building" Reed 1999.

These formulas are supposed to help us see the power of the network effect but they do not represent reality. Network effects have many other variables beyond the number of nodes on a network. Other variables like switching costs, transaction costs, value derived over time will also influence network effects and increasing returns.

Examples of eBusiness benefiting from network effects

Aol  vs prodigy

Early on in the history of the internet AOL and prodigy were online services that provided access to their own content and then the internet.

 Prodigy had a 60% share of the online service market in 1993. Two years later, Prodigy had shrunk, and AOL had grown, both reaching about 28% shares. After two more years, AOL had almost 60% of the market, and Prodigy's share was under 10%.

This goes toward proving Arthur's (2000) myth #1 "All Networks are Subject to Network Effects."

Clearly if prodigy had been benefiting from network effects, 60% of the market would have surely been unassailable, or at least long standing.

AOL and prodigy basically provided email to others on the same network and access to content initially. Content is then a broadcast network and email is a Metcalfe network, so the bigger Metcalfe network would have been having some positive network effects.

AOL focused on community tools like chat rooms and because of this when it did start to grow it benefited from Reed's Law (Reed, 1999) and established a very strong position.

More research should be done to discover when AOL started to focus on chat rooms and community focused tools.

AOL was also the first online tool to be launched for Microsoft DOS (feb. 1991) almost a year before prodigy released a tool for DOS (Carlson, 2000).

Ebay vs onsale

Ebay and onsale are two eBusinesses that built a business on the premise of online auctions.

On labor day in 1995, eBay started life as a digital flea market facilitating buyers and sellers complete transactions between one another and taking a small percentage in the process.

OnSale, by contrast, built its business buying and reselling computers, peripherals, and consumer electronics in an auction format.

Both companies were considered top of their game in 1997 and were viewed as competitors, especially as OnSale started to create its own exchange using and eBay type format.

OnSale was a one of the only formidable competitor to eBay in 1997, OnSale had revenue that exceeded $30 million in the first 6 months of that year (Court, 1997).

Despite OnSale copying eBay's format only 2 years after eBay had been formed it found it impossible to compete. Only one of the companies exist today.

EBay is certainly a great example of a Metcalfe model and Reed (1999) proposed that it is a Reed group forming network. It seems on the surface that it is a Metcalf model based upon the fact that  ebay is linking individual buyers and sellers (or nodes). The augument for eBay being a Reed network is that people do seem to congregate around the areas of most interest to them and you may have one seller and 50 potential buyers.

Whether or not it is a Metcalfe or a Reed model the online auction model is very hard to compete with,  here is some additional anecdotal evidence to support that based on the recent moves by yahoo auctions and eBay in Europe and Japan.

Yahoo auctions were first into japan, eBay was number 2. eBay just recently announced that it was withdrawing from the Japanese market (Belson, et al, 2001).

EBay was first into Europe, yahoo was number 2. Yahoo just announced that it was closing yahoo auctions in Europe (Wolverton, 2002).

These are both very well funded valuable companies and neither of them felt they were making in-roads in those areas that they were the second entrant into.

Other companies leveraging network effects

Two companies that demonstrate or have perhaps discovered the power group forming networks are yahoo and Amazon.

yahoo

Looking at Yahoo's investments in the last few years it has moved from being a portal, a Sarnoff network, to an aggregator of services that contribute to building Metcalfe and Reed type networks. For example:

• Yahoo groups
• Creates an email list with management tools with a home page for a group. Certainly a group forming network
• Yahoo Clubs
• Initial group forming network created by yahoo now merging into yahoo groups due to the popularity of the email list function
• Messenger
• A Metcalf network of instant messenger clients
• Personals
• Almost pure Metcalfe
• Auctions
• Another significant Metcalfe
• Classifieds
• Metcalfe
• Games
• Group forming network

Amazon

Amazon is a company that was singled out in De, Mathew, Abraham's (2001) eBusiness paper as a company that did not benefit significantly from network externalities (effects). The fact that this was written in 2001 might make us wonder when the last time these professors bought a book on Amazon.

Amazon has several features that are valuable to consumers and will benefit from positive network effects. These features are:

Customer Reviews

Freely contributed opinions from Amazon customers on products that are aggregated as a 5 star rating when that product is listed in search results etc. A Metcalfe network

Figure 6 Amazon: Customer Reviews

Source: Amazon.com

Customers that bought this book also bought

What is called collaborative filtering, Amazon leverages past purchases of customers to help them recommend relevant titles to someone currently browsing or buying products. This is again a Metcalfe network and is not reliant on people contributing content.

Figure 7Amazon: Customers who bought

Source: Amazon.com

Lists

Amazon has created a feature that allows people to publish their "top ten" lists. These are topics created by customers grouping things they like in particular genre or category. Metcalfe

Figure 8 Amazon: Lists

Source: Amazon.com

Guides

Similar to lists Amazon lets customers create guides, these again are really just listings of Amazon products that people aggregate and add there own context too (Seely Brown and Duguid, 2000). Another example of Metcalfe

Figure 9 Amazon: Guides

Source: Amazon.com

Auctions

Yes Amazon also has auctions and as proposed, is either a Metcalfe or a Reed network

These examples are illustrative of very successful eBusinesses taking advantage of network effects now.

Parallel theories of potential key enablers

Based upon what we have discovered about different network effects and the possible benefit to eBusinesses, we will point out here a couple of theories that support the creation of Reed (1999) type networks for the benefit of the network owners.

The reason that we have described this section as parallel theories is because at this time these are separate lines of study that have not been pulled together yet into a complementary framework, i.e. the network effect, community development and knowledge management.

Communities

Group forming networks could be one of the keys to eBusiness success or even as we've seen from the examples, dominance.

Several business related books talk about the power of communities (groups) and how companies can develop them, they are; Net Gain-Expanding markets through virtual communities (Hagel and Armstrong, 1997); The clue train manafesto (Levine et al, 2000); and The Social Life of Information (Brown and Duguid, 2000)

The Social Life of information is a book that is more focused on helping people think differently about the information age. One major premise being, information becomes far more powerful when merged with social context.

Net Gain and The Cluetrain Manefesto are quite specific that the only way to win in eBusiness is to leverage your customers in such a way that it benefits both you and your customers, the previous Amazon example is a great example of the theories in these books being put into practice.

Knowledge management

Knowledge management is a discipline that has been focused on helping enterprises realize the value of their internal intellectual capital. Knowledge management spans a spectrum of uses from analytical decision support systems for quite quantitative data all the way to community collaboration tools that enable innovation and learning (Binney, 2001).

This internal focus of knowledge management is very limiting. Knowledge mangement is a process that becomes more valuable the more people that participate, i.e. it benefits from significant network effects. Knowledge management as a practice needs to look outside the enterprise and start looking at ways that knowledge management can benefit the customers (Davenport, 2001). The enterprise will benefit and so will the customer and the enterprise will become more valuable over time.

Conclusion

The evidence suggests that eBusiness could develop a significant competitive advantage by leveraging network effects, and based on observation the network effect can lead to an almost unassailable position (eBay vs Yahoo, Japan, Europe).

Much more research though is needed in the area eBusiness competition. It seems that across these theories of network effects, community and knowledge management, under the umbrella of eBusiness competition, there is an opportunity to do some quite meaningful research.

The majority of this paper has focused on existing literature, qualitative research and anecdotal evidence. Primary research and some quantities measures would help develop these theories further.

It would also be interesting to find out if Amazon it pursuing a deliberate network effect strategy or if it is an emergent, realized strategy (Johnson and Scholes, 1999) that was not part of their strategic plan.

 

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