Communications of the ACM
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Communications of the ACM
Emergent Patterns of Integration in Electronic Channel Systems
This research is exploratory, looking to identify emergent patterns of structural change in channel systems in electronic markets. The insights we've gleaned are valuable and useful to both corporate and IT managers, as more and more electronic markets and "electronic market makers" claim the territory between incumbent firms and their customers [1, 2, 6]. Their arrival has left traditional industry participants and channel partners scrambling to identify appropriate strategic responses.
Newspaper and magazine publishers worldwide were caught off guard when online services like America Online (AOL) emerged in the early 1990s to compete for their readers and advertising revenue. Today, many retailers, manufacturers, and service providers across many consumer goods categories research the activities of online retailers like Amazon.com and online auctioneers like eBay. These new electronic market makers and intermediaries are not merely new entrants; they often preempt traditional sales and distribution channels and abrogate the customer connection, thus usurping the revenue stream. From an organizational perspective, they start to change industry structures. One of the most visible examples is the merger of AOL and Time Warner, announced in January 2000 and ultimately cleared by the Federal Trade Commission in December 2000. It left incumbent firms worrying about their business models and regulators concerned about industry concentration and market access conditions (such as those in broadband cable services).
Our research is case-based, concentrating on companies widely considered pioneers and survivors of the dramatic decline of corporate valuations and increasing numbers of business failures in the high-tech sector since 2000. Secondary sources of information include reports from investment banks, as well as our own experience working with some of the largest publishers, retailers, and manufacturers in Europe and the U.S.
To give our qualitative analysis a theoretical foundation, we rely on the structure-conduct-performance approach of Industrial Organization theory a framework widely used by economists to analyze industry structure change. Following this approach, we first describe the structure of select electronic markets and channels using an industry-classification scheme that has been applied in electronic publishing markets, one of the earliest electronic consumer markets.
Based on this description of industry structure, we observe vertical and horizontal integration activities; we've identified integration as the most important mechanism of change "in industry structures in response to the [digital] convergence phenomenon" [3]. We've since built on these findings to identify underlying economic incentives that could explain the integration behavior of organizations. This understanding is required by businesses and regulators to identify and implement appropriate responses.
Online Services Value Chain
Consistently describing the behavior of firms requires a classification scheme for online value systems, or "virtual value chains" [9]. We use the electronic value chain concept (see Figure 1) [10], describing not only adjacent stages of value-added activity but revealing access dichotomy between content services (such as the Wall Street Journal Interactive Edition) and distribution systems (such as AT&T Worldnet Internet access).
The parallelism of infrastructure and content is also evident and of great strategic importance in the U.S. cable television market, where providers, including Time Warner Cable, have leveraged ownership of coaxial cable infrastructure to gain control over access to content and programming by tens of millions of subscribers. In the area of online services, the issue of infrastructure access extends beyond wireline infrastructure to include human-computer interfaces (such as the screen of the Windows operating system), as well as software applications (such as the Web browser). AOL maintains its own user interface, integrating innovative applications into it, including the Web browser in 1995.
The 2-3-6 classification concept includes six core processes representing the fundamental building blocks of a digital interactive service. These processes are arranged in two strings and a sequence of three stages terminating with the consumer. The first string relates to content creation and manipulation, the second to infrastructure provisioning. A core process does not necessarily represent a firm's boundaries; firms are usually composed of combinations of core processes. The distinction between process and firm boundaries greatly improves consistency in categorizing types of businesses and in tracking changes in business focus.
A 1996 study conducted under the auspices of the European Commission applied the 2-3-6 concept to investigating how the Internet had changed industry structures in European publishing [4]. One finding suggested that business opportunities in electronic channel systems fall into distinct categories. Although the names for the market segments, or strategic roles, were chosen arbitrarily, their business focus and activities within an online services value system were not (see Figure 1). This segmentation is reflected in the organization of media firms; for example, the consumer online services leader AOL reorganized itself in October 1996 into three divisionsAOL Networks, AOL Studios, and ANS Communications each reflecting the characteristics of the strategic roles of online network, community organizer, and platform provider, respectively. Today, almost seven years later, the organizational structure of many media firms, including Bertelsmann, reflects a distinction between (digital) content production, infrastructure services, and consumer-access operations.
Emerging E-channel Systems
With the growth of electronic markets beyond electronic publishing, we have expanded the application of the 2-3-6 classification concept to include emerging consumer goods and services markets. We base our selection of the most important ones on size and growth estimates from secondary sources. However, with any exploratory study of an emergent phenomenon, the availability of reliable, relevant, and consistent data is a challenge to the researcher, as well as to the business executive. Because U.S. government statistics (such as the North American Industry Classification System) do not yet provide the level of disaggregation required for our purposes [7, 11], we've had to rely on revenue estimates compiled by market researchers (including Forrester Research and Jupiter Communications) and investment banks [5, 8]. We carefully cross-check these estimates with actual Web-site traffic measures (such as numbers of unique visitors, as provided by Media Metrix, www.mediametrix.com).
We've also identified pioneers for each emerging electronic market, again using revenue estimates and measures of Web-site traffic. In the case of public companies (such as AOL), we also use company reports. Finally, we matched pioneers against the characteristics of the strategic roles in Figure 1, including value-added activities/core processes, inputs/suppliers, and outputs/customers (see Figure 2); for reference, the European Commission's 1996 findings are depicted in the first gray-shaded row.
Online networks. Two key characteristics of the online network role, as outlined in Figure 1, are aggregation of content and offering competing products, or electronic marketplaces. They can reduce buyer search costs finding product and price information, as well as seller costs finding buyers. Online network firms (such as the AOL portal and the AOL shopping channel) have emerged to provide a marketplace across many categories of consumer goods. These firms increase market transparency by offering competing, as well as complementary, products.
Auction sites (such as eBay) represent another form of cross-category market. In the future, such online network-type firms, or retail portals, could exploit individual consumer profile and behavior data to increase customer satisfaction, loyalty, repeat purchases, and cross-selling opportunities.
Community organizers. While online network firms like AOL target the mass market, community organizers usually cater to the regional, functional, or cultural needs of a specific community of interest. Community organizers differ from online networks in that they tend to offer content of only one sort or a single vendor's products and services. For example, the online publisher CNET, which operates a comprehensive site (see www.cnet.com) covering news of the information technology industry, is considered a community organizer because it caters to technology-savvy users. Lufthansa.com, the Web site of the leading German airline, is considered a community organizer, because it offers and sells only the carrier's airline tickets, whereas Expedia and Travelocity could be considered travel service online networks, because they offer complete travel solutions, including reservations for hotels, rental cars, even tickets to local events, from a variety of competing vendors.
Networks tend to be starting points providing search utility, whereas communities tend to be online users' final destinations fulfilling their primary needs. AOL and Netscape's Netcenter are rarely the destination, whereas AOL's news channel and Netcenter's news service are in fact destinations for millions of Web surfers.
Platform providers. Platform providers integrate information technology into systems or platforms to facilitate and enable content creation (such as authoring tools), dissemination (such as point-of-presence networks), and content consumption (such as Web browser and software application plug-ins).
Platform providers can be categorized as providing Internet access and Web hosting services to any vertical market; examples are BBN and UUNET. A second group caters to the specific needs of a particular vertical market; examples are listed in the platform-provider column in Figure 2.
Integration patterns. Based on the identification of strategic roles, we've analyzed the integration activities of leading firms within each role. Figure 3 treats AOLthe consumer online services pioneeras an example of how different types of integration activities can alter a firm's boundaries. As depicted, two types of integration direction can be observed; any move within a vertical market is considered vertical, while a move across vertical markets is considered horizontal. Applying the 2-3-6 classification scheme reveals that AOL started out increasing its degree of vertical integration in online publishing in the early 1990s. Since the mid-1990s, AOL has reduced vertical integration in non-online network categories and has instead aggressively expanded horizontally across vertical markets.
In order to develop more generalizable results, we expanded the sample of firms in Figure 2 to include additional companies in the four categories of online markets. Due to a lack of information from primary sources, we again turned to the rankings of unique visitors from Jupiter Media Metrix and information from investment banks.
Based on the expanded sample, we observed the following pattern: Online networks tend to expand horizontally across vertical markets, community organizers integrate vertically, and platform providers expand either way (see Figure 4). In the online network category, two groups are distinguished: highly vertically integrated online networks (such as AOL and Microsoft's MSN service) and less vertically integrated online networks (such as Internet portals like Yahoo! and Lycos). Each group expands horizontally across vertical markets. Some firms in this category reinforce their positions in information systems and user interfaces (such as AOL's acquisition of Netscape in 1999); others integrate backward into content packaging (such as Lycos's acquisition in 1998/99 of publisher Wired). Moreover, many firms in this category are startups, including AOL, Excite, Infoseek/Go, Lycos, Netscape Netcenter, and Yahoo!.
In Internet retailing, Amazon.com started out in books and quickly entered other consumer goods categories. Today, it sells electronics, DVDs, toys and games, cell phones and services, and outdoor livingall under the Amazon.com umbrella. Similarly, some financial service providers have expanded horizontally beyond their initial business focus; for example, Waterhouse, an online brokerage service, expanded into retail banking products (such as money-market checking, Federal Deposit Insurance Corp.-insured bank accounts, and credit cards).
Whereas online networks expand horizontally, community organizers tend to stay focused on a single vertical market, integrating in a forward direction into distribution, as well as in a backward direction into content creation. For example, many online retailers have integrated backwardly by adding warehousing and logistics capabilities. We've also observed many traditional content providers integrating forwardly into online content packaging, even into market-making. One prominent example is Disney's acquisition of the ESPN Sportzone online community and the Infoseek Internet portal.
Online networks tend to expand horizontally across vertical markets, community organizers integrate vertically, and platform providers expand either way.
The situation with platform providers is less clear. Internet access, Web hosting, and application service providers do business across vertical markets. While the few large Internet backbone providers (such as BBN and UUNET) have invested in wireline infrastructure, most small and mid-size Internet service providers are highly specialized, buying capacity wholesale and reselling it locally to retail customers.
An interesting observation is the many instances of service operators that have transformed themselves into software and equipment makers. In the online network category, examples include Netscape's Netcenter, Microsoft's MSN/Start, and RealNetwork's www.real.com site. In the community organizer group, software maker Microsoft sticks out with its many ventures (such as Expedia travel services and CarPoint). This business expansion may suggest that operating one's own technology can become an attractive way to promote it or help set a standard.
Incentives for Integrating Online Networks
As our research found that integration patterns are most consistent for firms in the online network category, we've focused on this category to analyze underlying economic incentive structures. One incentive for horizontal expansion may come from strong economies of scope with customer acquisition activities. Access to customers and individual customer profile information usually has value beyond a single market, as nearly each vertical industry sells to the same customers. Meanwhile, at the same time customer acquisition costs can be saved, cross-selling opportunities can be exploited.
One key incentive for horizontal integration may come from economies of scope derived from the use of information systems. While the initial development and installation costs of an online shopping platform tend to run in the tens of millions of dollars, the effort to extend features for additional vertical markets can be comparatively moderate. The magnitude of the scope advantage clearly depends on a system's flexibilityits inherent adaptability to new, different, or changing business requirements. Such adaptability depends in turn on the system's architecture, or the manner in which its components are organized and integrated. In general, IS architectures emphasize tight enterprisewide integration; examples are the many enterprise resource planning systems. Today, distributed systems architectures (such as the Common Object Request Broker Architecture) allow for more loosely coupled interaction and, thus, more flexible systems.
Scope advantages can be created by whoever designs and operates the system to capture development knowledge and retain learning-curve advantages (such as customer behavior and profile information) within organizations. The forward integration of online networks into information systems and user interfaces could be explained by a combination of network externalities, switching costs, and the need for service differentiation [2].
Portal competition has increased the proliferation of information system-based features (such as email, personal messaging services, comparison shopping agents, and interface customization tools). Some of them (as in AOL's Buddy List and ICQ messaging service) exhibit network externalities; others (such as personal calendars, stock portfolio management, and gift reminder services) lock-in users by creating switching costs when they spend time and effort entering personal information. Lock-in can, in turn, reinforce network externalities.
Patterns of Structural Change
Our observation and analysis of online pioneers like AOL reveal emergent patterns of structural change in channel systems in electronic markets. We have observed three categories of intermediaries over the past few yearsonline networks, community organizers, and platform providersfirst in electronic publishing markets in the mid-1990s and later in other emerging electronic channel systems.
What are the implications for firm-level competition as a result of this analysis? Community organizer-type firms (such as CNET) usually focus on a single vertical market catering to the specific needs of a particular community of interest. As traditional content providers (such as Disney) integrate forward, independent community organizers lacking content-creation capabilities might have no choice but to pay the high costs of creating their own original content or even market foreclosure, as content owners choose to keep their material to themselves. In the case of Disney, ESPN content may be available only for Disney's own online ventures and may not be sold to other community organizer firms.
While facing coordination problems with content creators upstream, community organizers appear to struggle with online networks downstream as well. Online networks (such as AOL and Yahoo!), which aggregate content and provide electronic marketplaces, tend to expand horizontally across vertical markets. However, communities and networks compete with each other for the value that can be captured by exploiting online visitors; for example, in the case of advertising revenue, online networks sell access to a mass audience (quantity), while community organizers offer relationships with a target audience (quality).
Entry barriers. Although online networks benefit from scale advantages from millions of subscribers and unique visitors, they face entry barriers when integrating backward into the online community segment. The first entry barrier relates to the nature of the community organizer business. Because community organizers focus on specific communities of interest, their skills, assets, and brands tend to be highly specific and therefore difficult to copy. The second entry barrier relates to the role of online networks as trusted aggregator and marketplace.
The more an online network integrates backward, the more it risks becoming overly biased when trying to maintain a trusted relationship with its audience. For example, manufacturers establishing retail portals need to be careful about having vested interests in selling their own products ahead of competing products. In the case of online music, the major studios may not only find it difficult to arrange for selling competitors' products directly using peer-to-peer systems (such as the one pioneered by Napster) but would certainly raise antitrust concerns if they consolidated their choices into a single service offering.
References
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Footnotes
The Center for Telecommunications Management at the Marshall School supports this research.
Figures
Figure 1. The 2-3-6 value chain concept for analyzing electronic channel structures and strategies.
Figure 2. Strategic positions in emerging electronic markets and industries.
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