Structural Change and Marketplaces

First, many people around the world are now perfectly accustomed to personal transactions on the Internet, such as buying on Amazon. This is an important pre-condition to being open to conducting commerce on the Internet. Briefly put yourself back into the year 1999 – how much of your holiday shopping was online versus offline? Compare that to the most recent holiday season. Ask yourself how you feel about transacting online for your business.

Second, there exists an international payment mechanism in the form of PayPal. This is not to say that PayPal is perfect (far from it), but its global reach is astonishing. Accepting credit cards online also has become a cinch with several providers offering robust and reasonably priced services. There are also services aimed specifically at business transactions, such as Tradecard.

Third, starting a marketplace no longer means spending $20 million on Anderson Consulting to build some monstrous technology. Instead, a small team can develop a fully functional marketplace using open source. Keeping cost low during the inevitably slow early days of any marketplace (it’s lonely for the first buyers and sellers) is crucial.

Fourth, due to increased adoption of APIs, companies no longer have to open up their internal systems in order to build customer facing web sites. This means that instead of horrendous kluges (including import and export via Excel or even manual re-entry) data can now flow easily in and out of operational systems.

But more important than all of the above are structural changes that are beginning to occur in the economy. Most of the marketplaces that were created in the late 90s seemed to assume that simply creating a marketplace would be sufficient to move transactions online and create a competitive dynamic directly between buyers/customers and sellers/suppliers. But structures that had evolved over a long time specifically to deal with a lack of information and communication in the pre-Internet age, such as hierarchies, intermediaries, long-term contracts, purchasing departments, and so on, have a lot of inertia and provide value that cannot be replaced in short order. Now, however, about a decade later, some of these structures are beginning to change profoundly.

The most prevalent structure that’s changing is the firm itself. In many industries, it would appear as if firms were growing ever larger both organically and through mergers and acquisitions (e.g. consolidation in accounting, banking, etc). But there has also been tremendous activity at the opposite end of the scale. For instance, the US Census Bureau tracks non-employer businesses, which are businesses with no paid employees other than the business owner(s). The number of such businesses increased from 15.4 million in 1997 to 17 million in 2001 or about 10% in 4 years, but then grew by 20% over the next 4 years to 20.4 million in 2005 (most recent year for which data is available). The total revenues of such businesses grew even more by a total of 30% from 2001-2005 compared with 9% GDP growth over the same time period.

There are good reasons to believe that structural change to smaller units and individuals will continue and offers opportunities for new marketplaces. To understand why, it’s useful to ask why firms exist in the first place, i.e. why not everything happens as a transaction between individuals in a marketplace. Since Coase first asked this question, several functions of the firm have been identified:

Information sharing and processing -- individuals who compete with each other in a marketplace traditionally have few incentives to share information with each other. For instance, an independent consultant who has just found out some interesting information on the automotive parts market is traditionally unlikely to share that information with other independent consultants. Firms change the incentives of individuals who work there in ways that (at least in theory) allow for better information sharing and processing. For instance, consulting firms routinely make information sharing part of their evaluation and compensation schemes, so that information sharing is explicitly rewarded.

Cooperation and coordination -- inside of a firm it is (within reason) possible for managers to tell employees what to do. Many tasks require that people know what part of the task they should work on and when in order to manage dependencies and avoid the duplication of effort. This generally becomes possible inside a firm by paying employees a salary that does not vary too dramatically (within a given job) with which task or timing of a task is assigned to a particular employee.

Selection and reputation -- traditionally it has been difficult for a potential buyer of services to assess the quality of potential suppliers. If you look at the yellow pages for example, it's impossible to infer the quality from the size of the ad. Large firms address this problem by becoming carriers of reputation. It's easier to keep track of the reputation of a few large firms than many individuals. Firms that do good work presumably grow and their growth sends a signal of quality. The firm in turn will try to recruit only high quality individuals because low quality work will reflect poorly on the entire firm.

Marketplaces don't necessarily have to do better at solving these issues than firms, since they will do much better along a different dimension: Motivation. As described above, many of the advantages of firms are "bought" at the cost of reducing individuals' motivation. Motivation is a big deal at a time when more and more depends on the productivity of knowledge workers. For instance, most developers will work harder, produce better code and enjoy themselves more when working in a small startup than at a large corporation (the key point of Paul Graham’s recent essay).

What does all of this mean for entrepreneurs and for us? Entrepreneurs should be on the lookout for structural change as an opportunity for establishing a marketplace. Human capital intensive industries, such as advertising, consulting, design, engineering, etc, are a good place to look because motivation is paramount and individuals or small firms are already leveraging the Internet to compete. We too will be looking for such opportunities. We already have one marketplace investment with Etsy and we like the dynamics of businesses that have network economics (e.g. Tacoda, Targetspot).

March 26, 2008 09:58 AM, By Albert Wenger
Tags: b2b firm marketplaces web_services

There was a brief period of time around 1999/2000 when it seemed that B2B marketplaces would rule the world of commerce, but then most of them collapsed. Just go to the URLs for three of the big names from back then Chemdex, e-Steel, or PaperExchange and you will find that they have either disappeared or completely changed their model, e.g. from a marketplace to a software vendor. Does this mean B2B marketplaces were a bad idea per se? Not necessarily. A lot has happened since then that increases the viability of marketplaces. First, many people around the world are now perfectly accustomed to personal transactions on the Internet, such as buying on Amazon. This is an important pre-condition to being open to conducting commerce on the Internet. Briefly put yourself back into the year 1999 – how much of your holiday shopping was online versus offline? Compare that to the most recent holiday season. Ask yourself how you feel about transacting online for your business. Second, there exists an international payment mechanism in the form of PayPal. This is not to say that PayPal is perfect (far from it), but its global reach is astonishing. Accepting credit cards online also has become a cinch with several providers offering robust and reasonably priced services. There are also services aimed specifically at business transactions, such as Tradecard. Third, starting a marketplace no longer means spending $20 million on Anderson Consulting to build some monstrous technology. Instead, a small team can develop a fully functional marketplace using open source. Keeping cost low during the inevitably slow early days of any marketplace (it’s lonely for the first buyers and sellers) is crucial. Fourth, due to increased adoption of APIs, companies no longer have to open up their internal systems in order to build customer facing web sites. This means that instead of horrendous kluges (including import and export via Excel or even manual re-entry) data can now flow easily in and out of operational systems. But more important than all of the above are structural changes that are beginning to occur in the economy. Most of the marketplaces that were created in the late 90s seemed to assume that simply creating a marketplace would be sufficient to move transactions online and create a competitive dynamic directly between buyers/customers and sellers/suppliers. But structures that had evolved over a long time specifically to deal with a lack of information and communication in the pre-Internet age, such as hierarchies, intermediaries, long-term contracts, purchasing departments, and so on, have a lot of inertia and provide value that cannot be replaced in short order. Now, however, about a decade later, some of these structures are beginning to change profoundly. The most prevalent structure that’s changing is the firm itself. In many industries, it would appear as if firms were growing ever larger both organically and through mergers and acquisitions (e.g. consolidation in accounting, banking, etc). But there has also been tremendous activity at the opposite end of the scale. For instance, the US Census Bureau tracks non-employer businesses, which are businesses with no paid employees other than the business owner(s). The number of such businesses increased from 15.4 million in 1997 to 17 million in 2001 or about 10% in 4 years, but then grew by 20% over the next 4 years to 20.4 million in 2005 (most recent year for which data is available). The total revenues of such businesses grew even more by a total of 30% from 2001-2005 compared with 9% GDP growth over the same time period. There are good reasons to believe that structural change to smaller units and individuals will continue and offers opportunities for new marketplaces. To understand why, it’s useful to ask why firms exist in the first place, i.e. why not everything happens as a transaction between individuals in a marketplace. Since Coase first asked this question, several functions of the firm have been identified:

Information sharing and processing -- individuals who compete with each other in a marketplace traditionally have few incentives to share information with each other. For instance, an independent consultant who has just found out some interesting information on the automotive parts market is traditionally unlikely to share that information with other independent consultants. Firms change the incentives of individuals who work there in ways that (at least in theory) allow for better information sharing and processing. For instance, consulting firms routinely make information sharing part of their evaluation and compensation schemes, so that information sharing is explicitly rewarded.
Cooperation and coordination -- inside of a firm it is (within reason) possible for managers to tell employees what to do. Many tasks require that people know what part of the task they should work on and when in order to manage dependencies and avoid the duplication of effort. This generally becomes possible inside a firm by paying employees a salary that does not vary too dramatically (within a given job) with which task or timing of a task is assigned to a particular employee.
Selection and reputation -- traditionally it has been difficult for a potential buyer of services to assess the quality of potential suppliers. If you look at the yellow pages for example, it's impossible to infer the quality from the size of the ad. Large firms address this problem by becoming carriers of reputation. It's easier to keep track of the reputation of a few large firms than many individuals. Firms that do good work presumably grow and their growth sends a signal of quality. The firm in turn will try to recruit only high quality individuals because low quality work will reflect poorly on the entire firm.

Properly designed Internet marketplaces can address all of the same issues to some degree. For instance, by capturing information digitally (often as a byproduct of the work that’s done), it becomes possible to share that information at no marginal cost and to provide credit to the originator of the information (by tracking and identifying the source). Marketplaces don't necessarily have to do better at solving these issues than firms, since they will do much better along a different dimension: Motivation. As described above, many of the advantages of firms are "bought" at the cost of reducing individuals' motivation. Motivation is a big deal at a time when more and more depends on the productivity of knowledge workers. For instance, most developers will work harder, produce better code and enjoy themselves more when working in a small startup than at a large corporation (the key point of Paul Graham’s recent essay). What does all of this mean for entrepreneurs and for us? Entrepreneurs should be on the lookout for structural change as an opportunity for establishing a marketplace. Human capital intensive industries, such as advertising, consulting, design, engineering, etc, are a good place to look because motivation is paramount and individuals or small firms are already leveraging the Internet to compete. We too will be looking for such opportunities. We already have one marketplace investment with Etsy and we like the dynamics of businesses that have network economics (e.g. Tacoda, Targetspot).

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