Wednesday, July 17, 2019

Shopify and the Power of Platforms

While I am (rightfully) teased about how often I discuss Aggregation Theory, there is a method to my madness, particularly over the last year: more and more attention is being paid to the power wielded by Aggregators like Google and Facebook, but to my mind the language is all wrong.

I discussed this at length last year:
  • Tech’s Two Philosophies highlighted how Facebook and Google want to do things for you; Microsoft and Apple were about helping you do things better.
  • The Moat Map discussed the relationship between network effects and supplier differentiation: the more that network effects were internalized the more suppliers were commoditized, and the more that network effects were externalized the more suppliers were differentiated.
  • Finally, The Bill Gates Line formally defined the difference between Aggregators and Platforms. This is the key paragraph:
This is ultimately the most important distinction between platforms and Aggregators: platforms are powerful because they facilitate a relationship between 3rd-party suppliers and end users; Aggregators, on the other hand, intermediate and control it.
It follows, then, that debates around companies like Google that use the word “platform” and, unsurprisingly, draw comparisons to Microsoft twenty years ago, misunderstand what is happening and, inevitably, result in prescriptions that would exacerbate problems that exist instead of solving them.

There is, though, another reason to understand the difference between platforms and Aggregators: platforms are Aggregators’ most effective competition.

Amazon’s Bifurcation

Earlier this week I wrote about Walmart’s failure to compete with Amazon head-on; after years of trying to leverage its stores in e-commerce, Walmart realized that Amazon was winning because e-commerce required a fundamentally different value chain than retail stores. The point of my Daily Update was that the proper response to that recognition was not to try to imitate Amazon, but rather to focus on areas where the stores actually were an advantage, like groceries, but it’s worth understanding exactly why attacking Amazon head-on was a losing proposition.

When Amazon started, the company followed a traditional retail model, just online. That is, Amazon bought products at wholesale, then sold them to customers:


Amazon’s sales proceeded to grow rapidly, not just of books, but also in other media products with large selections like DVDs and CDs that benefitted from Amazon’s effectively unlimited shelf-space. This growth allowed Amazon to build out its fulfillment network, and by 1999 the company had seven fulfillment centers across the U.S. and three more in Europe.

Ten may not seem like a lot — Amazon has well over 300 fulfillment centers today, plus many more distribution and sortation centers — but for reference Walmart has only 20. In other words, at least when it came to fulfillment centers, Amazon was halfway to Walmart’s current scale 20 years ago.

It would ultimately take Amazon another nine years to reach twenty fulfillment centers (this was the time for Walmart to respond), but in the meantime came a critical announcement that changed what those fulfillment centers represented. In 2006 Amazon announced Fulfillment by Amazon, wherein 3rd-party merchants could use those fulfillment centers too. Their products would not only be listed on Amazon.com, they would also be held, packaged, and shipped by Amazon.

In short, Amazon.com effectively bifurcated itself into a retail unit and a fulfillment unit:


The old value chain is still there — nearly half of the products on Amazon.com are still bought by Amazon at wholesale and sold to customers — but 3rd parties can sell directly to consumers as well, bypassing Amazon’s retail arm and leveraging only Amazon’s fulfillment arm, which was growing rapidly:


Walmart and its 20 distribution centers don’t stand a chance, particularly since catching up means competing for consumers not only with Amazon but with all of those 3rd-party merchants filling up all of those fulfillment centers.

Amazon and Aggregation

There is one more critical part of the drawing I made above:


Despite the fact that Amazon had effectively split itself in two in order to incorporate 3rd-party merchants, this division is barely noticeable to customers. They still go to Amazon.com, they still use the same shopping cart, they still get the boxes with the smile logo. Basically, Amazon has managed to incorporate 3rd-party merchants while still owning the entire experience from an end-user perspective.

This should sound familiar: as I noted at the top, Aggregators tend to internalize their network effects and commoditize their suppliers, which is exactly what Amazon has done.

Amazon benefits from more 3rd-party merchants being on its platform because it can offer more products to consumers and justify the buildout of that extensive fulfillment network; 3rd-party merchants are mostly reduced to competing on price.

That, though, suggests there is a platform alternative — that is, a company that succeeds by enabling its suppliers to differentiate and externalizing network effects to create a mutually beneficial ecosystem. That alternative is Shopify.

The Shopify Platform

At first glance, Shopify isn’t an Amazon competitor at all: after all, there is nothing to buy on Shopify.com. And yet, there were 218 million people that bought products from Shopify without even knowing the company existed.

The difference is that Shopify is a platform: instead of interfacing with customers directly, 820,000 3rd-party merchants sit on top of Shopify and are responsible for acquiring all of those customers on their own.

by Ben Thompson, Stratechery |  Read more:
Images: Stratechery