The intrinsic structure of companies has long been a subject of study, most famously by Ronald Coase, the eminent British economist and recipient of the 1991 Nobel Prize in economics. In 1937, Coase published a seminal paper, The Nature of the Firm, in which he explained that, in principle, a firm should be able to find the cheapest, most productive goods and services by contracting them out in an efficient, open marketplace.
However, markets are not perfectly fluid. Transaction costs are incurred in obtaining goods and services outside the firm, such as searching for the right people, negotiating a contract, coordinating the work, managing intellectual property and so on. Firms thus came into being to make it easier to get work done. A well managed company tries to achieve a good balance between the work that gets done within and outside its boundaries.
Over the past few decades, the firm has been going through dramatic changes, driven by both advances in information technologies and the heightened competitive pressures brought about by globalization. Fundamental changes have taken place in the structure of firms and in the overall flow of goods and services in the economy. As this 2005 IBM study noted:
“The nature of competition - increasingly intense, global and unpredictable - requires strength across the board. So the objective is to decompose the enterprise into its component parts, understand with great precision what is truly differentiating - where the enterprise has strengths and weaknesses - and then make decisions about how to build, buy or partner for world-class capability.”
“In this model, companies can focus their energies on their true point of differentiation, instead of trying to master many domains and ultimately squander competitive advantage by dispersing focus and investment. Rather than existing as static and fixed organizations, more enterprises could essentially become an aggregation of specialized entities with complementary interests - expanding, contracting and reconfiguring themselves in a way that best adapts to or even anticipates market dynamics.”
A variety of on-demand companies have emerged in the last few years, aspiring to achieve the scale and success of Uber and Airbnb. They’re hoping to become the Uber-of-X, where X is only limited by their founders’ imagination. Not unlike their industrial economy counterparts, these new on-demand firms are tying to become trusted brands in their chosen market segment, but relying on a large freelance workforce instead of on the classic company workforce. In the process, they’re reshaping both the structure of companies and the nature of work.
A few weeks ago, I read a couple of very interesting articles on this latest evolution of the firm by technology strategist Ben Thompson in his Stratechery.com blog. In Aggregation Theory, Thompson examines the value chain for consumer markets by diving it into three parts: suppliers, distributors and consumers.
In the pre-Internet era of relatively costly supplier transactions, companies gained competitive advantage by controlling distribution. Now, the Internet has fundamentally changed the plane of competition. Its much lower transaction costs have neutralized the leverage once provided by carefully managed backward integration with suppliers, while enabling the forward integration with consumers and end users.
“[N]o longer do distributors compete based upon exclusive supplier relationships, with consumers/users an afterthought. Instead, suppliers can be aggregated at scale leaving consumers/users as a first order priority. By extension, this means that the most important factor determining success is the user experience: the best distributors/aggregators/market-makers win by providing the best experience, which earns them the most consumers/users, which attracts the most suppliers, which enhances the user experience in a virtuous cycle.”
As a result, “Previous incumbents, such as newspapers, book publishers, networks, taxi companies, and hoteliers, all of whom integrated backwards, lose value in favor of aggregators who aggregate modularized suppliers - which they don’t pay for - to consumers/users with whom they have an exclusive relationship at scale.”
The shift of value from suppliers to consumers has now gone through three waves over the past 20 years. First came the modularization of digital content, where companies like Google and Yahoo aggregated all kinds of content previously available through newspapers and magazines. Then came companies like Facebook and Twitter, whose suppliers and consumers are its very users, - communicating and sharing information with each other over social media platforms.
The third wave of the Internet economy is represented by on-demand companies like Airbnb and Uber, whose platforms enable the exchange of physical goods and services, but whose business models are based on digitizing trust and market relationships.
In Airbnb and the Digital Revolution, Thompson explains the key role played by digital trust in the on-demand economy. The competitive advantage of on-demand companies is based on their ability to aggregate lots of resources from their suppliers and integrate them with the trust needed to attract customers. He illustrates his point with Airbnb.
The classic hotels business is based on integrating property with trust, that is, the rooms they make available to customers with the trust created through their brand and reputation that attracts customers to come stay in the hotel. Trust is the hotel’s key barrier to entry from individual competitors with rooms to let.
Airbnb and similar companies have totally shifted this dynamic. Lodgings have now been commoditized, - Airbnb offers more than 2 million listings in over 34,000 cities around the world. Airbnb’s competitive advantage is their Internet-based reputation systems for trust between hosts and guests, based on the ratings of over 60 million stays. By integrating their reservation and trust management systems, Airbnb has been able to achieve their global scale in less than 8 years.
Something similar applies to Uber and other on-demand companies. “[W]hat makes them work is not simply mobile access to the Internet, location data, and all the rest; equally important is the systematization, and by extension commodification, of trust. To be sure the latter isn’t a new concept: Ebay deserves special credit for pioneering the fundamental mechanic as applied to Internet businesses. The addition of mobile, though, made this mechanic exponentially more powerful: we went from a vision of apps that let you book last minute hotels to apps that made every house in every city in the world a potential place to stay.”
“It has been a consistent thesis of mine that the Internet Revolution, which I believe has only just begun, will prove to be in the long run just as transformative as the Industrial Revolution,” writes Thompson in his concluding paragraphs. “In other words, it’s not only that we would become more productive; it’s that society as we know it would be fundamentally changed. How, though, hasn’t been entirely clear: if the industrial revolution moved us from subsistence farming in the countryside to factories in cities, where might we go next?”
“I increasingly believe that it is the sharing economy that is beginning to reveal the answer: a world of commodified trust has significantly less need for much of the infrastructure of modern society, including inefficient sectors like hotels whose primary differentiator is trust, along with the regulatory state dedicated to enforcing that trust. On the other hand, this brave new world has brand new holes through which people can fall: those who have lost trust, or do not have the means to build it… Just because the future is coming into focus, though, doesn’t mean the road there will be smooth.”