AGGREGATION THEORY

Posted onTuesday, July 21, 2015

The last several articles on Stratechery have formed an unintentional series:

Airbnb and the Internet Revolution described how Airbnb and the sharing economy
have commoditized trust, enabling a new business model based on aggregating
resources and managing the customer relationship

Netflix and the Conservation of Attractive Profits placed this

commodification/aggregation concept into Clay Christensens Conservation of
Attractive Profits framework, which states that profits are earned by the integrated
provider in a value chain, and that profits shift when another company successfully
modularizes the incumbent and integrates another part of the value chain

Why Web Pages Suck was primarily about the effect of programmatic advertising on
web page performance, but in the conclusion I noted that the way in which ad
networks were commoditizing publishers also fit the Conservation of Attractive Profits
framework

In retrospect, there is a clear thread. In fact, I believe this thread runs through nearly every
post on Stratechery, not just the last three. I am calling that thread Aggregation Theory.

The value chain for any given consumer market is divided into three parts: suppliers,
distributors, and consumers/users. The best way to make outsize profits in any of these
markets is to either gain a horizontal monopoly in one of the three parts or to integrate two of
the parts such that you have a competitive advantage in delivering a vertical solution. In the
pre-Internet era the latter depended on controlling distribution.
For example, printed newspapers were the primary means of delivering content to
consumers in a given geographic region, so newspapers integrated backwards into content
creation (i.e. supplier) and earned outsized profits through the delivery of advertising. A
similar dynamic existed in all kinds of industries, such as book publishers (distribution
capabilities integrated with control of authors), video (broadcast availability integrated with
purchasing content), taxis (dispatch capabilities integrated with medallions and car
ownership), hotels (brand trust integrated with vacant rooms), and more. Note how the
distributors in all of these industries integrated backwards into supply: there have always
been far more users/consumers than suppliers, which means that in a world where
transactions are costly owning the supplier relationship provides significantly more leverage.

The fundamental disruption of the Internet has been to turn this dynamic on its head. First,
the Internet has made distribution (of digital goods) free, neutralizing the advantage that preInternet distributors leveraged to integrate with suppliers. Secondly, the Internet has made
transaction costs zero, making it viable for a distributor to integrate forward with end
users/consumers at scale.
This has fundamentally changed the plane of competition: no longer do distributors compete
based upon exclusive supplier relationships, with consumers/users an afterthought. Instead,
suppliers can be aggregated at scale leaving consumers/users as a first order priority. By
extension, this means that the most important factor determining success is the user
experience: the best distributors/aggregators/market-makers win by providing the best
experience, which earns them the most consumers/users, which attracts the most suppliers,
which enhances the user experience in a virtuous cycle.
The result is the shift in value predicted by the Conservation of Attractive Profits. Previous
incumbents, such as newspapers, book publishers, networks, taxi companies, and hoteliers,
all of whom integrated backwards, lose value in favor of aggregators who aggregate
modularized suppliers which they dont pay for to consumers/users with whom they
have an exclusive relationship at scale. For example:
Google

Previously, publishers integrated publications and articles. Google modularized

individual pages and articles, making them directly accessible via search

Google integrated search results with search and profile data about users, enabling it
to sell highly effective advertising

Facebook (and Ad Networks)

Previously, publishers integrated content and advertisements. Facebook modularized

advertisements by allowing advertisers to target customers directly, not via proxy

Facebook integrated News feed ad inventory and profile data, enabling it to sell highly
effective advertising

Amazon

Previously, book publishers integrated editing, marketing and distribution. Amazon

modularized distribution first via e-commerce and then via e-books

Amazon integrated customer data and payment information with e-book distribution
and its Amazon publishing initiative (the framework is clearest when it comes to books,
but the integration of distribution and the customer relationship also applies to most of
Amazons business)

Netflix

Previously, networks integrated broadcast availability and content purchases. Netflix

modularized broadcast availability by making its entire library available at any time in
any order

Netflix integrated content purchases and customer management, enabling a virtuous

cycle of increased subscription demand and increased content purchase capability

Snapchat

Previously, networks integrated mass-market advertising and general interest

programming. Snapchat (and many other services) modularized attention

Snapchat is integrating individually interesting content with mass market advertising

inventory, giving brand advertisers a new way to reach a large audience efficiently

Uber

Previously, taxi companies integrated dispatch and fleet management. Uber

modularized fleet management by working with independent drivers

Uber is integrating dispatch with customer management, enabling it to scale worldwide

Airbnb

Previously, hotels integrated vacant rooms and trust (via brand). Airbnb modularized
vacant properties by building a reputation system for trust between hosts and guests

Airbnb is integrating property management and customer management, enabling it to

scale worldwide

Its interesting to consider the order of these examples: the pioneer of this model was Google
which modularized content providers. Its easy to see why this is the case: content has
always been monetized by proxy, whether it be paying for newspapers (or advertising space

in those newspapers), paying for CDs, or paying for cable TV. The shift to digital has exposed
these proxies for the rent-collection mechanisms they are.
Facebook, though, has built in some respects an even stronger position: its suppliers are its
users, so while it, like Google, aggregates content that it gets for free, it also has exclusive
access to that content. Snapchat and other user-generated content networks are similar.
The third wave are industries that dont have such an obvious digital component. Airbnb, for
example, deals with vacant rooms; what makes it work is the way it has digitized and thus
commoditized trust. Uber deals with cars; it has digitized both trust and dispatch. More
importantly, both have nailed the user experience in a way that incumbents have been sorely
lacking. Both companies also sit in a sort of middle ground between Facebook and Google:
their suppliers are not exclusive in theory, but increasingly are exclusive in reality as both
benefit from a virtuous cycle of more users leading to increased utilization of suppliers.
What is important to note is that in all of these examples there are strong winner-take-all
effects. All of the examples I listed are not only capable of serving all consumers/users, but
they also become better services the more consumers/users they serve and they are all
capable of serving every consumer/user on earth. This, above all else, is why consumer
technology companies are so highly valued both in the public and private markets.
Looking forward, I believe that Aggregation Theory will be the proper framework to both
understand opportunities for startups as well as threats for incumbents:

What is the critical differentiator for incumbents, and can some aspect of that
differentiator be digitized?

If that differentiator is digitized, competition shifts to the user experience, which gives a
significant advantage to new entrants built around the proper incentives

Companies that win the user experience can generate a virtuous cycle where their
ownership of consumers/users attracts suppliers which improves the user experience

The Uber and Airbnb examples are especially important: vacant rooms and taxis have not
been digitized, but they have been disrupted. I suspect that nearly every industry will
belatedly discover it has a critical function that can be digitized and commodified,
precipitating this shift. The profound changes caused by the Internet are only just beginning;
aggregation theory is the means