In Search of Scalability
The Family Papers #026
By Nicolas Colin (Co-Founder & Director) | The Family
A few recent articles (here and here) have triggered a welcome discussion on why we call tech companies “tech companies”. Mostly, it’s because financial analysts can’t put them in any other industrial category. So they’ve created a residual category and called it technology.
But that word, “technology”, is misleading. Technology, after all, is everywhere. There’s as much technology in a big bank or an oil company as in the so-called tech companies. Additionally, these companies’ value proposal has little to do with technology. Amazon and Uber don’t sell their customers raw technology. Instead, they provide them with an exceptional experience made possible by fitting together tangible assets, electronics, executable code, data, design, and human interactions.
Our business at The Family is to breed tech companies. To this extent, we are constantly working on understanding why those companies are indeed different from the old Fordist companies of the 20th century. For us, what many call technology companies are in fact companies that aim to generate increasing returns to scale—through which “output increases by more than that proportional change in inputs”. This is why they’re otherwise known as “exponential organizations” or “scalable companies”.
Once they’ve started growing, tech startups go through consecutive stages of their development that lead to generating superior increasing returns, eventually triggering various positive feedback loops that make it ever easier to grow. Likewise, if a given, non-tech company were to shift its focus onto maximizing increasing returns, it would eventually end up becoming a tech company. In other words, being a tech company, with its many specific features (culture, organizational chart, relationships with stakeholders), is the consequence of radically focusing on increasing returns at scale.
The reason why tech companies focus on that simple strategic goal is that, unlike many others, they have discovered that those increasing returns have become key to crushing their competition and ensuring a long-term return on their investment. Conversely, as software is eating the world, companies that don’t focus on increasing returns are bound to be wiped out by faster-growing, more scalable competitors. The rule of thumb in a digital economy powered by increasing returns is that any company should aim at winning most of the market or it should die. Hence you simply can’t survive at a large scale if your business doesn’t generate powerful enough increasing returns.
Unfortunately, most established companies still ignore or overlook increasing returns as they devise their corporate strategy. The reason is that they’ve grown up in a different world, one that was dominated not by increasing returns at scale but by another, very different microeconomic feature: supply-side economies of scale. As they pursue operational excellence or merge with competitors, Fordist companies have but one goal: getting bigger in order to lower their unit costs of production. This is a very un-tech way of reasoning and I will now try to explain why.
Supply-Side Economies of Scale
The Fordist economy enabled firms to grow bigger than ever before. Thanks to many innovations such as Frederick Taylor’s scientific management or Henry Ford’s liberal wage policy and 40-hour work week, Fordist managers made tremendous progress in breaking out of the constraints that up to then had prevented businesses from growing beyond a certain size. As Pankaj Ghemawat wrote in a 2002 article dedicated to “Competition and Business Strategy in Historical Perspective”,
In the United States, the building of the railroads after 1850 led to the development of mass markets for the first time. Along with improved access to capital and credit, mass markets encouraged large-scale investment to exploit economies of scale in production and economies of scope in distribution. Adam Smith’s “invisible hand” was gradually tamed by what the historian, Alfred D. Chandler, Jr., has termed the “visible hand” of professional managers. By the late nineteenth century, a new type of firm began to emerge, first in the United States and then in Europe: the vertically integrated, multidivisional (or “M-form”) corporation that made large investments in manufacturing and marketing, and in management hierarchies to coordinate those functions.
As a result, one major way in which Fordist firms contributed to post-war growth was unprecedented supply-side economies of scale: the bigger Fordist companies grew, the lower their unit costs became. As those companies reached gigantic size (at least for the time), the unprecedented scale of their operations enabled them to settle on a new regime, that of mass production — the production of abundant standardized products sold at a lower price. The history of business throughout the 20th century reads like the history of the conversion of many sectors to that new regime: from media to agriculture, from banking to luxury, every industry ended up complying with the paradigm of mass production (and consumption).
Mass production brought about a new range of problems, practices, and knowledge. The “experience curve” was the concept designed by the Boston Consulting Group’s Bruce Henderson to account for the capacity of larger firms to achieve superior operational effectiveness. The larger those firms grew, the more they could lower their unit cost of production. It is no coincidence that the experience curve dominated strategic thinking until the 1980s—when Michael E. Porter introduced more sophisticated frameworks. The experience curve, which is about reducing costs at scale, was in accordance with the stakes of a booming Fordist economy. It revealed supply-side economies of scale as a first positive feedback loop that made it convenient for companies to grow bigger.
Yet the same experience curve didn’t lead to the domination of every market by one firm only. One reason is that at a certain point, supply-side economies of scale reach a limit: for every single company, there’s a size beyond which unit costs can’t get any lower; quite the contrary, they start to increase again because of longer distribution routes, higher cost of raw materials, or a higher number of employees generating bureaucratic inertia and stronger collective bargaining power. As Carl Shapiro and Hal R. Varian and Shapiro wrote in their landmark and visionary 1998 book Information Rules,
Despite its supply-side economies of scale, General Motors never grew to take over the entire automobile market. Why was this market, like many industrial markets of the twentieth century, an oligopoly rather than a monopoly? Because traditional economies of scale based on manufacturing have generally been exhausted at scales well below total market dominance, at least in the large U.S. market. In other words, positive feedback based on supply-side economies of scale ran into natural limits, at which point negative feedback took over. These limits often arose out of the difficulties of managing enormous organizations. Owing to the managerial genius of Alfred Sloan, General Motors was able to push back these limits, but even Sloan could not eliminate negative feedback entirely.
For this reason, oligopolies were the norm in the Fordist economy. On almost every market (with exceptions such as railroads, telecommunications, and utilities—all sectors that called for vigorous regulations), dominant Fordist companies had to share the market with lesser competitors. To try and explain the prevalence of oligopolies, Bruce Henderson once cautiously devised what he called the “Rule of Three and Four”: “A stable competitive market never has more than three significant competitors, the largest of which has no more than four times the market share of the smallest.”
Strategic Positioning
Another reason why the experience curve didn’t turn into a decisive competitive advantage has been forcefully pointed out by Michael Porter: even if a firm is able to continually improve operational effectiveness, “competition based on operational effectiveness alone is mutually destructive, leading to wars of attrition that can be arrested only by limiting competition.”
Indeed on many markets confronted with high competitive pressure, dominant firms used operational effectiveness as a means to cut prices, maximizing the consumer’s surplus in the process. The consequence of the resulting “war of attrition” was the exhaustion of every competitor on the market. The airline sector since the 1980s is a good (and frightening) example of that terrible fate: any achievement on the operational effectiveness front is quickly imitated by competitors, often with the help of consultants, forcing everyone to cut prices even more and reducing profit margins in the process. In the video below, Porter goes as far as calling airlines “the least profitable industry known to man.”
In some cases, however, dominant firms were able to secure a producer’s surplus due to a sustainable competitive advantage. Indeed, business strategy according to Michael Porter is the discipline refined to help firms implement what he calls strategic positioning and to escape the war of attrition that careless competitors fell into while pursuing operational effectiveness along the experience curve. As defined by Porter, “sustainable competitive advantage is about preserving what is distinctive about a company. It means performing different activities from rivals, or performing similar activities in different ways.” In the presence of a sustainable competitive advantage, the dividends of improved operational effectiveness, instead of contributing to the war of attrition, can be divided between the consumer (lower price) and the producer (higher margin).
Porter’s critics have argued that in promoting strategic positioning, he simply encouraged rent-seeking and even complacency: “Why go through the hassle of actually designing and making better products and services, and offering steadily more value to customers and society, when the firm could simply position its business so that structural barriers ensured endless above-average profits?”
This kind of objection is unfair: as proved by Apple, designing and making better products is a sustainable competitive advantage. But it is true that strategic positioning was an option available only to the big corporations, as they were alone in having the sophisticated value chains needed to sustain competitive advantages. Hence a second positive feedback loop: big size was not only a factor in operational excellence, it was also the necessary condition to turn strategic positioning into sustained profitability.
All in all, Fordist markets were characterized by the coexistence of two positive feedback loops. One, inspired by the taste for growth, was the race to increase operational effectiveness at scale; the other, imposed by the sense of profitability, was the urge to design and implement what Michael Porter introduced as a competitive strategy. Operational effectiveness led most players (who invariably imitated one another, in no small part thanks to consultants) to cut down the prices, leading to wars of attrition; but competitive advantages enabled some among them to escape those dreaded wars that systematically resulted from a competition solely based on price. As a rule, for Fordist M-form corporations, scale proved the key both to lower unit production costs and to sustained long-term profitability.
Technology-Driven Increasing Returns
The reason why those financial analysts are so focused on the technology in companies such as Amazon, Facebook, Uber and Airbnb is because digital technologies (information and communication technologies, or ICT) have made possible yet another feedback loop for businesses that seize these technologies as an opportunity to scale up.
Contrary to the economies of scale feedback loop, which is more or less a logarithmic function, ICT-driven feedback loops tend to have the shape of an exponential function. In other words, the more so-called tech companies deploy those technologies on transition markets, the more their returns to scale increase instead of diminishing, providing them with a strong competitive advantage and a capacity to eventually grab most of their market—as opposed to being one competitor among others on an oligopolistic market.
There are two reasons why increasing returns becomes the dominant organizational feature in the digital economy.
The first is that traditional competitive advantages tend to weaken, even to disappear. As software is eating the world, the digital transition is tipping the balance between price-cutting and strategic positioning. As it lowers barriers to entry and empowers the buyers, it makes it more difficult for companies to sustain a traditional competitive advantage. This shift has been foreseen by Michael Porter in a 2001 article in which he stressed how, from the point of view of his famous “Five Forces”, the rise of the Internet made it more difficult for companies to achieve strategic positioning:
[In terms of strategic positioning,] most of the trends are negative. Internet technology provides buyers with easier access to information about products and suppliers, thus bolstering buyer bargaining power. The Internet mitigates the need for such things as an established sales force or access to existing channels, reducing barriers to entry. By enabling new approaches to meeting needs and performing functions, it creates new substitutes. Because it is an open system, companies have more difficulty maintaining proprietary offerings, thus intensifying the rivalry among competitors. The use of the Internet also tends to expand the geographic market, bringing many more companies into competition with one another. And Internet technologies tend to reduce variable costs and tilt cost structures toward fixed cost, creating significantly greater pressure for companies to engage in destructive price competition.
Built-In Network Effects
The second reason why increasing returns are now trumping economies of scale is that the digital economy in and of itself creates the possibility of conquering another kind of competitive advantage under the form of network effects. Amazon is a case in point: like any traditional retailer, it could have kept on competing on price; but because technology enabled it to generate powerful network effects (with features such as user reviews, wish lists or the recommendation engine), it has been able to build its own sustainable competitive advantage into its product in the form of an exceptional customer experience. Like we wrote in a previous issue,
[on Amazon’s market], the only way to retain customers without bringing down the prices [is] to provide an exceptional experience. [Amazon] has accordingly set a new standard… The more you rely on [it] for your day-to-day life, the more difficult it becomes to even consider offers by its competitors. Of course, you can compare prices whenever you have something to buy. But saving a few cents here and there may not be enough to compensate for the effort that it takes to go browse prices all over the Internet… Amazon proves that you can design an experience that invites customers to simply trust the company over the long term instead of constantly evaluating the competition.
The rise of built-in network effects as a competitive advantage has two major consequences.
First, unlike those developed by companies in postal services, railroads or telecommunications, digital-driven network effects are mostly generated by the demand-side: they depend on customers, not on a tangible infrastructure. Hence to sustain these kinds of network effects, tech companies have to retain their customers with an exceptional experience, which network effects precisely contribute to creating as they increase the value of the product—an idea embedded in Chris Dixon’s formula “Come for the tool, stay for the network”. In the presence of network effects on the demand side, acquisition costs are not so much about spending as they are about investing in an improved customer experience. This, after all, is the very definition of a network effect: the more users the product has, the more value it delivers.
Second, network effects contribute to generating powerful increasing returns. Not only do they offset the diminishing returns that result from implementing tangible activities, they also help sustain economies of scale in ways that were impossible to reach in the absence of network effects. For a tech company, when traditional supply-side economies of scale run out of steam, network effects are there to come in their stead and sustain the scaling up to a size at which the company is able to generate economies of scale again. (This doesn’t mean that network effects are not subject to exhaustion past a certain size: they are, and the phenomenon is known as “reverse network effects”.)
In other words, the positive feedback loop initiated by network effects doesn’t replace supply-side economies of scale and traditional strategic positioning. Instead, it amplifies them, thus combining the effects of three different positive feedback loops. To mention Amazon again, the network effects generated thanks to its “architecture of participation” enable it to subsidize more expensive warehouses closer to its customers (competitive advantage) so as to support an even larger scale of operations and bigger purchasing volume (economies of scale).
This has been described in previous issues as the balance between the Northern Side (tangible) and the Southern Side (intangible). As more and more companies choose to compete in both worlds, we can now discern how traditional, brick-and-mortar activities fit together with a new breed of digital activities to sustain network-driven competitive advantages.
In this regard, a few months ago, Spark Capital’s Jeremy G. Philips wrote that “Netflix has scale advantages and strong customer captivity, but zero network effects; it does not become more entertaining with more subscribers.” I happen to disagree with him: while being predominantly fueled by economies of scale and the competitive advantage derived from its original series, Netflix also generates network effects thanks to its recommendation engine while it exploits network effects elsewhere on the Web through the communities of passionate fans that grow around its original content.
Supply-Side Platform Effects
There’s actually a fourth feedback loop, also originated by digital technologies. When network effects built into the product are not enough to sustain increasing returns, tech companies tend to generate or amplify them via the deployment of platforms. The goal here is to outsource parts of the business that impose diminishing returns so as to concentrate on the parts that, on the contrary, generate increasing returns. The result is a powerful supply-side platform effect: a more abundant, diverse, and dynamic supply capacity.
This is not entirely new. Franchise networks work just like that: the franchisee can earn money, but only under many constraints and at the small scale of a restaurant or an auto-repair shop, whereas the franchise operates the brand and other parts of the business that generate increasing returns at scale. The relationship between the Coca-Cola Company and Coca-Cola Enterprises follows the same logic of concentrating increasing returns (the Coca-Cola brand) in one entity while outsourcing diminishing returns (the bottling) in another.
What the digital economy radically changes on the outsourcing front is that it makes possible to outsource activities not only to other companies such as franchisees or Coca-Cola Enterprises, but also to a multitude of connected individuals. This is why platforms have become so prominent in the digital economy: sharing and on-demand models that rely on a contributing community of suppliers are consistent with the strategic goal of maximizing increasing returns pursued by the company operating the platform.
A good example is Airbnb: instead of making the real estate investments necessary to increase its supply capacities, Airbnb relies on a large and flexible community of hosts that spare it from having to absorb the diminishing returns that goes (at least temporarily) with increasing the number of rooms available on the platform. Outsourcing the supply capacity to a multitude of hosts turns fixed costs into variable costs. This is key in maximizing increasing returns as it empowers the company to scale up dynamically and to customize its offers without triggering additional diminishing returns at each step.
The End of the Growth Trap?
In his landmark 1996 article on business strategy, Michael Porter insisted on one of the most important tradeoffs in the Fordist economy: that between growth and profitability. In a section titled “The Growth Trap”, he noted that “among all other influences, the desire to grow has perhaps the most perverse effect on strategy.” Indeed business executives grew up in a world in which they had to make tradeoffs between growth and profitability.
But in the digital economy, things are radically different. Growth is just a byproduct of increasing returns after all, not a goal in itself. If strategic positioning is now about increasing returns, then growth is not the enemy of profitability: quite the contrary, growth is now correlated with profitability, as opposed to what existed in the Fordist economy. As suggested by this McKinsey paper, growth is even the best moat you can dig in a digital economy that’s becoming more competitive every day. As Babak Nivi wrote in 2013, victory will go to “those who have the ability to serve a customer at the highest level of quality and scale, simultaneously.”
This all suggests how much strategy has changed in the digital economy. Strategic positioning is more important than ever in an economy with little room for error. But when strategic positioning is all about maximizing increasing returns, tradeoffs are radically changed. Instead of being forced to choose between profitability over growth, companies can now have both—by focusing on scalability.
Essential Readings
Here are a few articles you can read to further reflect on scalability and strategic positioning in the digital economy:
- Bruce Henderson, “The Experience Curve”, BCG Perspectives, 1968.
- Bruce Henderson, “The Rule of Three and Four”, BCG Perspectives, 1976.
- W. Brian Arthur, “Increasing Returns and the New World of Business”, Harvard Business Review, August 1996.
- Michael E. Porter, “What Is Strategy?”, Harvard Business Review, November 1996.
- Michael E. Porter, “Strategy and the Internet”, Harvard Business Review, March 2001.
- Pankaj Ghemawat, “Competition and Business Strategy in Historical Perspective”, Business History Review, Spring 2002.
- Erik Brynjolfsson & Andrew McAfee, “Investing in the IT That Makes A Competitive Difference”, Harvard Business Review, July 2008.
- Steve Blank, “Make No Little Plans—Defining the Scalable Startup”, January 2010.
- Walter Kiechel III, “Seven Chapters of Strategic Wisdom”, business+strategy, February 2010.
- Sangeet Paul Choudary, “Reverse network effects: Why scale may be the biggest threat facing today’s social networks”, The Next Web, December 2012.
- Babak Nivi, “No Tradeoff Between Quality and Scale”, Venture Hacks, February 2013.
- Babak Nivi, “The Entrepreneurial Age”, Venture Hacks, February 2013.
- Eric Kutcher, Olivia Nottebohm, and Kara Sprague, “Grow Fast or Die Slow”, McKinsey Global Institute, 2014.
- Philip Evans & Patrick Forth, “Borges Map: Navigating a World of Digital Disruption”, BCG Perspectives, 2015.
- Chris Dixon, “Come for the tool, stay for the network”, cdixon blog, January 2015.
- Fred Wilson, “Winner Takes Most”, AVC, October 2015.
- Nicolas Colin, “11 Notes on Amazon”, The Family Papers, January 2016.
- Jeremy G. Phillips, “The Rise and Fall of the Unicorn”, The New York Times, February 2016.
- Marshall W. Van Alstyne, Geoffrey G. Parker, Sangeet Paul Choudary, “Pipelines, Platforms, and the New Rules of Strategy”, Harvard Business Review, April 2016.
- Nicolas Colin, “From Startup to Company, One Step at a Time”, The Family Papers, April 2016.
- Nicolas Colin, “Winner-Takes-Most: the Two Worlds of Increasing Returns”, The Family Papers, April 2016.
- Oussama Ammar & Nicolas Colin, “The New Berkshire Hathaway You Haven’t Noticed (Yet)”, The Family Papers, July 2016.
I also recommend these two remarkable books:
- Carl Shapiro & Hal R. Varian, Information Rules: A Strategic Guide to the Network Economy, Harvard Business Review Press, November 1998.
- Walter Kiechel III, The Lords of Strategy: The Secret Intellectual History of the New Corporate World, Harvard Business Review Press, March 2010.
(This is an issue of The Family Papers, a series which covers various areas such as entrepreneurship, strategy, finance, and policy. Thanks to Annabelle Bignon, Kyle Hall, Laetitia Vitaud.)
