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Network Effects: Competing business models


Venture capitalists heavily weight business models — ways in which firms can extract
rents from their nets of activities — in their funding decisions, and the structure of a
firm’s business model ultimately determines its potential for overall profitability because
it assesses the pervasiveness of the standard. In a new economy, virtual business model,
hypercompetitive concerns may force firms to act opportunistically in the interest of expediency.
In such situations, there would not be enough time nor advantage in integrating partners with
ongoing business units. Relationships with value net partners will be performance based.

In old economy business models, outsourcing was most prevalent when an industry’s
structure became well established and suppliers could be qualified to undertake tasks
formerly done in-house. In the new economy, internet-enabled industries, new entrants
can be virtual and enter market space through alliances. No time exists to
develop brand equity, social capital, and numerous other stabilizing factors that
cement supplier—buyer relationships within old economy industries because of the
embryonic condition of most parts of the new internet-enabled industries.

A negotiating quid pro quo. As virtual firms face their own questions of make or buy —
own or outsource — they eventually find that some resources must be owned. Virtual
firms still need a bargaining chip in e-space that will pull customers to their portal rather
than to a competitor’s portal. That chip can be strong brand equity, the standard-setting
first-mover’s advantage, platform strengths from getting partners to join the virtual
firm’s systems bandwagon, or other anchoring advantages.
The strength of brand equity could be based upon an installed base of  millions
of satisfied customers. The bargaining chip could be a legal monopoly — such
as a valuable patent — or a path of knowledge that comprises a trade secret (Hagedoorn,
1993). The resource’s value may be its scarcity, such as for example, knowledge workers
with a high degree of talent or specialized skills that are difficult to recruit.
Whatever the bargaining chip, virtual firms need a quid pro quo to recruit
the most desirable partners into their networks.

Syndication. The vertical nature of e-commerce requires virtual firms to solve a problem
for one application by specializing in several vertical steps used in creating a total service
offering for a narrow group of customers, for example, business-to-business (B2B)
applications for morticians. They can build their infrastructure solution quickly, using the
best software modules available from outsiders at that time. As service provider, they
may (or may not) have created de novo one of the modules integrated into the turnkey
service offering. After devising an infrastructure to serve those particular B2B customers
well, the virtual firm grows by solving the same problem for similar, horizontally related
customers again relying upon its vertical expertise to amass a winning suite of solutions.
By applying the vertical applications and relationships created to serve the first industry
group’s needs to other, similar industries, the virtual firm leverages its investment in a
turnkey solution in many different, but specialized markets — hoping to become a
platform that many systems providers will adopt.

Leveraging standard solutions. Once the virtual firm has created a platform package of
standard systems, it can apply that package of systems (or relationships with substitute
vendors offering comparable applications for its package) to similar types of products as
well as to types of customers. That is essentially what Amazon.com has done — by
applying their retailing platform to sell many similar kinds of products — books, CDs,
toys, electronic items, drugstore items, hardware, flowers and so on. By outsourcing-
partner firms’ turnkey software for applications that it did not create in-house — for
transaction processing, inventorying, logistics, customer satisfaction, mail, reverse
auction, or other applications — virtual firms like Amazon.com create bundled packages
for specialized customers. The virtual firm manages customers’ use of the package by
serving as an application service provider (ASP) and updates the modules comprising its
package, as better infrastructure platforms become available. By subcontracting this
proprietary infrastructure for use by others that are developing total service offerings for
other vertical markets, the virtual firm leverages itself into the constellations of firms in
other value nets in reciprocal networks. Proprietary solutions
are valuable — even if the software has been outsourced to other application service
providers because they have become standards for solving a genre of problems and of
network externalities . Value can be extracted through collection
of royalties or by leveraging a success into inclusion in subsequent opportunities within
the reciprocal networks where firms operate.

Entrée into other constellations. While bundling these pieces in customized packaging
for each respective vertical market it serves (and outsourcing its own ASP offerings to
other value nets), the virtual company coordinates its own partner network while
becoming a player in the outsourcing landscape of other companies’ constellations of
partners. Once the software is proven, virtual firms use the
backbone of their systems to leverage that platform repeatedly to enter additional
networks as the outsourcer of the proprietary function they built in-house. The more users
that join the virtual firm’s platform, the more valuable it becomes, due to network
externalities. The larger the user base, the greater the usage tolls that are
extracted as transactions rise.

Inflexibility, in the form of switching cost barriers, occurs as more users adopt a virtual
firm’s platform. But lower entry barriers (hence smaller capital outlays to recover) and the
relentless pursuit of newer technological solutions (even at the cost of self-
cannibalization) ease the transition of platform users from one syndicated bundle of
standard solutions to another, making it difficult to extract rents for a piece of the
platform without its complements. Moreover, syndication practices reduce the power of
recognizable brand equity among application providers (giving power to the system
consolidator, e.g., a website built by Razorfish creates cachet, rather than to the
subcontractors that Razorfish employs). Thus, the very expansion modes embraced to
accelerate market entry and meet deadlines for customer deliverables reduce both
corporate brand identity and strategic inflexibility. The virtual business model creates
new types of inflexibility as it eliminates old forms of power.


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