Digital Megatrend 3: Increased economies of scale

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Digital increases economies of scale and hence drives concentration in markets. Large digital players (e.g., Amazon, Alibaba) can create cost, talent and data advantages, which in turn can be used to price competitively, innovate rapidly and acquire further market share. All things being equal, large digital players will tend to grow faster, leading to market concentration as smaller players find it hard to compete. Of course this concentration effect has always existed. But it’s more pronounced in the digital world, as the economies of scale, skill and data are more dramatic. Here are five reasons why that’s the case:

First, large digital firms have a cost advantage. Digital reduces variable costs. In a physical business model, additional sales require additional salespeople and/or additional floor space. In the digital world, that is no longer true. This effect applies beyond sales and marketing. Digital firms tend to have higher automation levels throughout the value chain, so functions such as operations also deliver lower variable costs. So as digital firms grow their unit costs plummet and they can offer prices which smaller firms cannot match.

Second, large digital firms have better access to talent. Many digital natives aspire to startup success, but the majority will spend much of their working lives with established firms. Leading digital firms are growing fast and have an exciting value proposition for prospective recruits, together with finely tuned HR machines that enable the best talent to be identified, hired and retained. As a result, large digital firms have better access to talent than smaller firms. As we are often reminded, outstanding digital talent is 10 times more productive that mediocre digital talent. So access to better talent should drive significant productivity and innovation advantages for large firms.

Third, digital leaders are amassing vast quantities of data that can provide a competitive edge. Statistical analysis of broad and deep customer data sets can provide highly targeted recommendations that lead to higher loyalty and cross-sell rates. For example, it’s thought that around 70% of customer purchases on Netflix are the results of proactive customer offers based on analysis of purchasing patterns. In the car insurance market, analysis of customer data sets (e.g., data on driving behavior), combined with external data sets (e.g., accident black spot locations) can be used to drive keener pricing. So as digital firms get bigger they have more data that can be used to deliver better targeted and better priced offers that smaller firms find hard to match.

Fourth, consumers tend to use fewer brands online than in the physical world. When walking along a high-street, a consumer will interact with many brands, even if they choose to purchase from just a few. In the digital space, consumers tend to concentrate their activity with fewer brands. This is particularly true on mobile devices, where consumers tend to use the apps on their home screen frequently, but rarely swipe through to further screens. The world’s ~1 billion smartphone users spend about 90mins a day using apps, on average. But 68% of users use five or fewer apps at least once week. And 22% of apps are only used once. As a result, ‘home screen’ brands will naturally tend to increase market share.

Finally, some of the diseconomies of scale experienced by very large physical firms are less problematic in the digital world.  Classically, large firms suffer diseconomies including long chains of command, difficulty sourcing sufficient high quality talent, and complex technology infrastructure.  Digital firms require fewer people to operate (Amazon’s revenue per employee is three times that of Walmart’s for example) and have fewer problems with complex legacy technology.

In aggregate then, large digital players will tend to out-compete smaller digital players (but note that small digital players can out-compete large physical players as discussed in my previous post). The implications for companies are manifold. Large physical businesses should convert to digital models to fully leverage their scale advantage. Growing digital businesses should follow Amazon’s example and prioritize scale over profits. All businesses need to take a hard look at where they can gain powerful scale vs. where they lack scale and should exit.

Look out for further Digital Megatrends soon.

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