platform-business

Dissecting Platform Business Models With Nick Johnson [Lecture]

Nick Johnson is the Principal at Applico; he is also the co-author of the best selling book “Modern Monopolies,” which is incredible reading to understand the business model that is dominating today’s business world.

With Nick, we explored the dynamics of platform business models.

How did you get to study business modeling and the platform business models?

Nick Johnson: My background before I joined the company that I’m at now, Applico. Alex, our CEO, was also my co-author on the book. I worked at an economics think-tank for several years, and Alex was working at running Applico.

They were doing a lot of app development and started to see that they were working with large enterprises, Applico was as well as big tech companies, the Googles and so-on of the world.

And started to understand that the way these companies were using technology was very different from more traditional companies. We started to formulate what eventually came to be our understanding of this platform business model, and thought that it made sense.

We saw that business model as the kind of future business model of the 21st century increasingly becoming dominant, so we decided to focus Applico particularly on creating platform businesses or helping our clients with creating and launch platform businesses. I joined about five years ago, primarily intending to help shift the company in that direction.

Out of the first couple of years of work, understanding these platform models and how they work, which no one had kind of broken down. Systematically there were some academic writing on platforms or multi-sided platforms as they sometimes get called.

But no one had gone in a practical sense and broken down “how do these businesses work, what do they do, how do you understand how to build them?”.

So we built the process around that to help clients run through that process and help them launch new businesses. Out of that work came the book, “Modern Monopolies”, which essentially lays out the blueprint for this platform model, why it’s been the “secret sauce” of a lot of the big tech companies for the last 20-30 years, and then how it’s starting to make its way into some more traditional industries.

Everything from day-to-day distribution, finance, health care, industries that have undergone a tremendous amount of change over the last 20-50 years compared to some other of the more recent industries. Like media and content, for example, and retail.

But you’re starting to see these platform models come into more and more of these industries, in the sense that we help large companies that are companies that are competing with some of these big tech monopolies figure out how they launch their platform businesses and scale them up.

Gennaro Cuofano: Before we get to the definition of platform business model, in the past you would have built a successful company by controlling the supply chain, and that’s how you actually created a competitive advantage. And from your study, from your research, it turns out that’s not the way it works anymore.

How has the business world changed since platform business models dominate?

Nick Johnson: This platform model that we focused on and that the book is about, is rather than owning the underlying supply chain, or all of the supply, and have that sit on your balance sheet. It’s about just facilitating transactions and interactions between some third-party consumer, and a third party producer; someone who is creating value whether that’s selling a product or a service, or creating content, or an app.

There are a lot of different permutations of this model. At the core, it’s really about facilitating transactions and network, and which you’ve started to see over the last 20-plus years is that this network model quickly aided by things like mobile phones, and the rise of more connected technology.

As that becomes more dominant, part of the value of that is scale; they tend to have winner-take-all effects driven by kind of strong network effects between the consumer and producer sides of that network.

So rather than a traditional business where you tend to reach a certain kind of scale and then due to complexity, you cap out the size of that business. Otherwise, you start to run into diseconomies of scale.

In ecnomics, economies of scale is the mechanism for which an organiaztion saves costs as it gains increased level of productions.

A linear business model creates value by selling products or services down the supply chain. Thus, its value starts from controlling the supply chain.

What is a diseconomy of scale?

Nick Johnson: These platform businesses mostly have unlimited economies of scale and can expand to the total size of the market, which is why you tend to have “winner-take-all” or “winner-take-most.”

Markets dominated by platforms business models tend to have one or two big winners in a market, and very rarely you have a third big platform that operates successfully.

Gennaro Cuofano: So the main difference is between a linear business model, which was the business model of the past, and the platform business model, which dominates today’s markets.

There is another interesting point that your research points out in the book, which is about the economy of scale. As you scale, you can capture higher and higher portions of the market. While with the linear business model, this is not possible because it is a point where the economy of scale becomes inefficient.

platform-vs-linear-business-models

Source: Applico

Example of how platform business models manage to grab most of the total addressable market compared to a linear business model. As the linear business model grows in scale it becomes inefficient as the cost per transaction grows. Thus it becomes way more expansive to grab the total addressable market. Thus the linear business at a particular stage it reaches “diseconomies of scale.”

How have economies of scale changed in a world dominated by platform business models?

Nick Johnson: We’ve seen this several times where traditional businesses get too large, they have too many different lines of business, and the economies of scale kind of peter out as you reach a specific size.

And it becomes about the coordination costs, mostly, of managing that business, which starts to exceed the benefits of continuing to scale in that fashion. Whereas in the platform model, you do not own all the assets, you’re just providing the names of connection rather than the means of production.

And that’s a much more scalable model, and you’re able to connect a lot more than you’re ready to control directly. You have to set the rules of playing field, and then enable the parties to interact, which is why you see a company like Airbnb for example, having more rooms on its platform than any hotel company – even though it doesn’t have rooms that it owns itself.

Gennaro Cuofano: Another interesting point I think, is also about the misuse of the term “platform”, because as you say in the book, today when you say that a company follows a “platform business model“, this will right away evaluate the company because it implies that it has better scalability and investors like that. But the definition of a platform business model is tricky, and many of those companies do not fit in.

What’s the definition of a platform business model?

Nick Johnson: When we talk about platforms that distinction between technology and business model is a key one. A lot of people, when they think about tech companies and these platform businesses they go “they’re a technology company so its the technology that’s the differentiator.”

However, the technology at a certain point becomes a kind of a commodity, and that’s not a sustainable advantage in and of itself. It’s really about what these companies do with the technology.

So this platform model is what where you have a multi-sided network, and you’re facilitating transactions, whereas the kind of tech company model, where you create software and sell it, eventually someone is going create that similar software better, faster, or cheaper than you are.

That becomes hard to have that as a defensible advantage, whereas these networks are much harder to replicate, and as you get more and more scale and market power, they become much more defensible.

A platform business model creates value by tapping into network effects that make it scale fast, which enables a large number of users to exchange and transact.

Gennaro Cuofano: And there is another argument which I think is also important. As companies try to emulate platform business models, they get confused, and they try to do probably too many things at once, but as your research points out that there is a critical element of any platform business model which is the core transaction.

What is the core transaction?

Nick Johnson: The core transaction essentially is that repeatable interaction between that consumer and that producer that you want to happen over and over. It’s the engine of the platform business, and you need to have essentially four steps to that transaction:

One is where you’re getting the inventory  into the platform, which you call the “create step.” Two, you have to have the consumer be able to connect to that inventory, that value, in some way. They have to be able to consume it, obviously, so if that’s a video on YouTube, you have to be able to watch it.

If you’re ordering an Uber, you have to be able to order the car. And there’s a compensate step, where that producer has given them some kind of value, so then they have to figure out how you’re giving value back to the producer from the consumer to close the loop on that transaction.

Why is the core transaction so crucial for a platform business model?

So that core transaction is the engine that drives all these successful platforms. They typically start with one core transaction. So the example I would give is a company like Facebook, which does pretty much everything under the sun today.

Facebook started very simply, the core transaction came in. “I create a profile with a photo, and I can connect with other people in my college network that I’m friends with, and they have to accept me” so it’s a double opt-in model where both sides accept the other and that was really it, that was all Facebook did in its initial phase.

All the other stuff that came much later on like wall posts, messaging, bringing businesses in another kind of content platform dynamic. All that stuff came much later, and you start with an initial core transaction, and you’re able to scale by building additional core transactions on top of that, which is something you see with a lot of platform companies.

Start with one core transaction, and build a network around that, and then they scale by adding in new core transactions and eventually end up as almost platform conglomerates where they have a bunch of these interlocking networks and core transactions that work together

Gennaro Cuofano: So its really about optimizing the first core transaction, and then moving forward, bringing more and more core transactions in the platform business model.

I find it very difficult to distinguish among the several platform business models as they seem very similar in many aspects. But your research shows a framework for that.

How are platform business models primarily categorized?

platform-types-applico

Source: Applico

Nick Johnson: The two big categories for different types of platform businesses we call maker and exchange platforms. The main dynamic that helps you understand the difference is maker platforms have a “one to many” dynamic, so it’s a broadcast dynamic where someone is, for example, creating a video on YouTube, or creating an app on the app store, and then any number of people can download that.

The concept we use to describe this is called “matching intent”. So for that inventory that’s being provided, how many people can use that at once, and the maker platform dynamic, that is a “one to many” matching intent, where any number of people can use the same unit of inventory.

The Exchange platform business models, rather than a “one to many” connection, you have a “one to one” or at the very least “one to a few” relationship where typically you’re connecting directly with another party in a one to one manner.

The matching intent is 1:1 or 1: a few so for example if you order a car on Uber that you’re connecting directly with that driver, that driver can’t then take 20 other ride requests at the same time.

There is very often a concept of kind of limited inventory based on this with a direct connection. This includes things like market places obviously, on the exchange side, as well as investment platforms where you’re matching some consumer with a financial product and someone providing that.

Also, messaging platforms where you are interacting directly or social networks where you have this double opt-in model; similar to how Facebook initially operated where you connect with someone else, and they connect back to you to make that connection.

The one-to-many model, for example, happens with a content platform, something like Twitter, where you can follow somebody and they don’t have to follow you back. It’s an asymmetric connection that enables this kind of one-to-many model.

The two main kinds of platforms business models are maker and exchange platforms. Maker platforms have a one-to-many dynamic. While exchange platforms work on a one-to-one or at most a one-to-a-few basis.

Are traditional business strategy tools like Porter’s five forces still useful? 

Nick Johnson: I think it’s useful. At eye level, I think where you started to see this change is that the kind of traditional frameworks like Porter’s Five Forces and the value chain focused on optimizing and improving linear business models where you kind of own all that value, you’re providing that service directly to a customer.

The mental model and framework that you have to use for a platform business are very different. It’s not about what you own; it’s really about what and how you can generate value by connecting rather than owning everything on your balance sheet.

I think at a high level some of those things in terms of competition and technology; and some of the other things that you see in those kinds of linear business frameworks makes sens. But you have to think of them in a platform context with the companies that are going to be the most successful and get the most value are ones that are connecting things rather than just owning.

How do you build network effects?

Nick Johnson: Part of the great value that a platform creates, it’s scale. A network effect implies that the more users join the platform so the more consumers participating later will get value.

That network brings value to each producer and vice versa, so the more producers join, the more value it’s offered for a customer.

Initially, network effects are like a double-edged sword. That’s because early on you don’t have any of either group (producer and consumers). You have to figure out how do you get both of these groups to join at the same time or how can fake one side of the network to get the other side to show up and then kind of go back and then actually acquire that third-party supply for example if you were faking the supply early on.

By trying to hold one of these sides constant or figuring out how you can provide enough value to both sides; early on, you can get this thing off the ground. And then once you start to reach that initial point where there’s enough of a liquid network where you can begin to match people together; you don’t have a lot of failed transactions, or for example, someone comes and can’t find what they’re looking for and then leaves.

Once you start to get to that point which tends to be called critical mass, then that network effect starts to work for you and makes it easier to acquire customers and producers and when you can reach that point that is when you begin to scale quickly.

That’s why you often have this kind of hockey stick growth curve for successful platforms where it starts very, very, slowly and then once they hit this point of critical mass, it starts to take off very quickly.

Network effects indicate that the value of a product or service increases as more users join in. Popularized by Robert Metcalfe, the law that brings his name states that networks value is proportional to the square of the number of users that join a platform.

Gennaro Cuofano: If you look at Uber business model, for instance, at their balance sheets and their financials and stuff you notice that what they point out as the most valuable thing as a platform business model they have is actually what they call liquidity network effects.

They argue that over time, they are going to be able to capture so much value from those networks that the company is going to become highly profitable.

Uber network effects case study

Nick Johnson: I think Uber is an interesting example, so the challenge that they have is that their network effects are hyperlocal in the sense that every new market they go into, so if they go into a new city, there is minimal spillover between the existing markets they are operating in and that new market.

They have to start to create much of this network from scratch every time they go to a new city. This makes it very hard to scale that business, compared to a business like Facebook. That has somewhat less regional or less local network effects because people interact online with people across all kinds of areas as well as across different types of content.

It’s a little less local in the sense of specific region; it’s easier to scale that kind of business up, so Uber’s challenge is that for example, in the initial markets they operate in such big markets like San Francisco, New York, Chicago, they do quite well.

But, where they’ve been spending a lot of money in particular if you look at their financials, they spend a lot of money in China, trying to launch and essentially scale the business up there from scratch. When they’re going against new competitors, and they hadn’t yet hit that critical mass point which took a lot of investment for them to try to get there.

Eventually, they backed out of China and have been finding it’s difficult to replicate in new markets, which is what’s been pushing a lot of the red ink on their balance sheet and their income statement. It’s different stages.

FourWeekMBA Note: Plaforms like Uber to keep a balance between the supply and demand use strategies like dynamic pricing.

dynamic-pricing

How do you know when you reached the critical mass to scale?

Depending on where that network is, you kind of reach that point of critical mass typically when you start to see people starting to join more organically, and you’ve got a lot more organic traffic, and your customer acquisition cost starts to go down.

Going back to Uber case, you start to see that as you go into established markets with Uber where they have definitely reached that point of critical mass and sometimes will have 70 plus percent market share.

Where you can see the incentives they’ve had to offer to drivers and customers have gone down over time compared to what they were early on but a lot of that spending that they have to do has been driven by growth and new markets rather than those kinds of fore markets where they already critical mass.

Gennaro Cuofano: To emphasize your point, Uber is a particular example as you said because they have to start over again to inject liquidity in networks and they try to go to a new market just because, of course, it’s a very localized service.

There is also another argument which I liked a lot in the book which is many time times when people think about disruptive business models they think to those companies are stealing market shares from other companies, but you argue that those digital business models, rather than stealing market shares. They are creating a bigger market.

Do platform business models create more prominent and larger markets?

Nick Johnson: These platform businesses enter the market and they lower in barriers to entry, lowering transaction costs and by doing that they start to enable new customers to join in in a market that might not have been able to get them otherwise. Or they also start on the supply side often bringing new sources of supply into the market, and by doing so they can expand the total size of the market.

What’s the critical difference between a modern monopoly to an old monopoly?

Nick Johnson: The old monopolies tended to build a kind of top-down system and owning all the supply so that no one could enter. These modern monopolies as we call them in the book do so by owning the means of connection and essentially having market power by facilitating both sides of the network. So they don’t actually own the supply, but they own the means by which the supply can connect with the demand.

Is scale an essential element for any platform business model?

Nick Johnson: I think that scale is one of the critical aspects of the platform model. However, if you’re operating in a small market, given the kind of control and easier ability to get that business off the ground, you would want to start a linear business.

So if it’s not a significantly sized market where you have enough supply and enough demand to justify using a platform model versus a traditional model, then a platform probably isn’t the right fit.

It tends to be in these relatively large markets where there is a lot of different sources of supply and a lot of different customers. If you have these kinds of very consolidated markets or very small markets then platforms are typically not able to get traction and get enough size to pay back the start-up costs and make it worthwhile.

What suggestion do you have for anyone starting a platform business model from scratch?

Nick Johnson: Starting up a new platform, the biggest challenge is always that chicken and egg problem, how you get both sides of the supply at once. There are some ways that you can kind of cheat that problem.

One is to sort of pay the supply side. For example, you hold that constant in the initial stages and operate as a linear business until you can build enough demand to be then able to get those third part producers to join in a platform model.

Another way is if you’d have some single user utility to enable any consumer or producer that comes even if they’re not able to connect to the other side there is some value they’re getting out of that.

If there’s some software tool something that you are also providing that can be one way. Another way would be looking at; you can start to incentivize users to join by offering them joining fees or other things like do you get a lot of credit to join up front.

You have to figure out different ways to subsidize that early participation and if you can do that successfully then eventually you can kind of dial that down over time. That initial challenge is always the most difficult in terms of getting these businesses off the ground.

Key takeaways

  • A platform business model creates value by enabling users of a group of users to exchange value.
  • A linear business model instead creates value by selling a product or service down the supply chain.
  • Modern monopolies are built on top of platform business models.
  • Network effects are the most important element and asset platform business models “own.”
  • A platform business model to get off the ground needs to master a key core transaction.
  • Rather than owning the means of production a platform business model owns the means of “transaction” or the ability of users to connect and interact smoothly.
  • The two main types of platform business models are the maker and exchange platforms. The maker works on a one-to-many logic. While the exchange platform works on a one-to-one or one-to-a-few basis.
  • Platform business models follow a winners-take-all or winners-take-most logic.
  • Platform business models expand the total size of the market.
  • Compared to a linear business model they scale up efficiently by grabbing most of the total market value. So where linear businesses become inefficient when they reach too much scale, platform business model instead gets most of their potential from the scale.
  • Another key element of any platform business model is liquidity, or the ability to keep those platforms able to have users exchange value continuously and in a frictionless way.
  • When a platform reaches a critical mass that is when scale picks up. Usually critical mass happens when more and more users join the platform organically.

Suggested reading: Modern Monopolies

modern-monopolies-book

Suggested resources:

Read next: 

Other key resources:

Business models case studies:

Published by

Gennaro Cuofano

Gennaro is the creator of FourWeekMBA which reached over a million business students, professionals, and entrepreneurs in 2019 alone | Gennaro is also Head of Business Development for a high-tech startup, which he helped grow at double-digit rate and become profitable | Gennaro is an International MBA with emphasis on Corporate Finance | Subscribe to the FourWeekMBA Newsletter | Or Get in touch with Gennaro here

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