– Phill Namara
The online marketplace business model is quite an attractive economic model as value is created through the elimination of search costs when they efficiently connect producers and consumers. When we think of successful marketplaces, we think of businesses that exhibit tremendous external network effects like Amazon’s Marketplace that result in user growth exploding over a short period of time. However, getting to the stage whereby the business’ fixed costs are absorbed by a steady and growing revenue base is difficult because it requires the continual optimisation of the interactions between both sides of the marketplace. If friction exists, then slowly the business can experience negative network effects, whereby more users added to the marketplace decreases the value of the marketplace for all. If the business is capable of optimising liquidity, that is, interactions between producers and consumers, the marketplace typically experiences an inflection in transactions and begins to grow quite rapidly.
So how do marketplaces reach these inflection points?
One method they do so is through curation, the process of optimising the transactions between each side of the marketplace. To ensure the quality of transactions between each side of the marketplace is above the desired level, the creators of the marketplace try to reinforce positive interactions or discourage negative interactions. For example, Airbnb distinguishes “Superhosts”1 from regular hosts using an algorithm based on response rates, cancellation rates and customer ratings. The Superhosts are then rewarded as their listings are placed at the top of the user’s searches.
This creates a virtuous cycle that increases the quality of transactions on the marketplace; as regular hosts strive to improve the experiences they offer for consumers, they are rewarded with a Superhost status and then they are referred an even greater number of potential customers. Now the probability of a customer having a positive experience using the marketplace is improved, increasing the likelihood of their return to the Airbnb marketplace.
Failure to properly curate positive interactions within a marketplace typically leads to greater negative interactions and eventually, detracts from the value proposition, as mentioned earlier. This idea is best illustrated through a case study of eBay, which whilst highly successful today, was expected to fly even higher until Amazon launched its third-party marketplace. The eBay business value proposition was its ability to facilitate peer to peer commerce. The sellers were in-charge of fulfillment, listing and customer service whilst eBay simply connected buyers and sellers. This model worked well, initially, and the marketplace grew rapidly as new buyers and sellers joined to transact, however on eBay, buyers had to research individual seller’s feedback scores and make a judgment as to whether they were reliable. If the seller was mistaken, they often endured a lower quality transaction i.e. shipping times were extended, packaging was poor, they may have received the wrong items etc.
Amazon, with its launch of the Third-party Marketplace, was able to build trust by handling all fulfillment and customer service functions. Thus the purchasing risk lay not between buyer and seller, but rather between buyers and Amazon. This ensured that transactions between buyers and sellers were almost always positive, creating great buyer and seller experiences that resulted in their Third-Party Marketplace stealing incremental market share from eBay.
Learning from the past, we at Montaka focus our deep sector and market knowledge on selecting excellent businesses that are at inflection points in becoming long-term winners. We believe Amazon clears this hurdle comfortably and we will continue to monitor their situation for years to come.