Why Marketplaces Fail, and How to Make Them Work in Local | Street Fight

Why Marketplaces Fail, and How to Make Them Work in Local

Why Marketplaces Fail, and How to Make Them Work in Local

smalltownMarketplaces are hard. In the local space, we’ve seen a number of companies such as Airbnb, Taskrabbit, and Groupon see some success. Meanwhile, others like Zaarly, pivoted away from its reverse marketplace model. EBay, the perennial poster child of marketplace success, has seen a resurgence of late, in part due to a recent push into local commerce. But the question for many startups is whether to try their hand at a marketplace, and reap the rewards of the higher margin and lower capital business — or follow the likes of Amazon and Zappos and scale as a reseller.

Earlier this spring, Andrei Hagiu, an associate professor at Harvard Business School, published a piece in the Harvard Business Review, asking just that question: “Do You Really Want to Be an eBay?” Based on recent research, Hagiu, and his co-author Julian Wright, broke down the various pitfalls of building a marketplace, concluding that on the continuum between multi-sided platform and reseller most businesses fell closer to the reseller end of the spectrum. Yes, the upside of a marketplace is attractive, but the authors found that being a reseller often proves to be a better choice.

Street Fight caught up with Hagiu to find out why marketplaces fail, what investors missed with Groupon, and how Intuit’s burgeoning marketplace play could prove different.

What’s the basic delineation between a marketplace and reseller?
Let’s start with one of my favorite examples: Apple’s iTunes versus Apple’s AppStore. I think of iTunes as a reseller, and the AppStore as a marketplace. There’s no possession of physical inventory because we’re talking about digital products, but the key difference would be that iTunes consumers buy directly from Apple. This is basically like going to retail shop, and buying directly from the retailer. Your purchase contract is with apple. If something goes wrong with the music, you call Apple. Apple incurs the cost of supporting the product.

It’s significantly different with the App Store. Sure, Apple still processing the transactions, but in terms of purchase contract, it’s a contract between the user and the app developer. You buy an app, you’re buying it from a third party developer not apple. If something goes wrong with the application, Apple is basically off the hook.

It would seem that most business would want to become marketplaces. What’s stopping them?
The first problem most companies encounter with a marketplace is chicken-and-the-egg issue. If you don’t have buyers, then you’re not going to have sellers, and visa versa. That prevents a lot of marketplaces from getting off the ground. There ways to solve this problem, but for most startups it’s still the main challenge.

After that, you face a number of smaller issues. For instance, since you need do not have control of the sales process, you need to make sure there’s quality enforcement. eBay solves this with a reputation  mechanism. Other marketplaces like Airbnb, have also figured out ways to develop recommendation mechanisms to solve these issues that keep everyone more or less honest.

Thirdly, you want liquidity, and make sure people come back, so you don’t get disintermediated. For example, if a platform facilitated the meeting of the buyer and the seller, but for the next transaction they just interacted without coming to my platform, you’re effectively disintermediated. You need to make sure you give them sufficient reason to come back. That’s an issue with AirBnB.

What can startups do to get around these issues?
There’s only one or two ways to get around it. One is to start as a reseller. You buy the product and then resell it, so you can go to suppliers and say, “give me the product, I’ll resell it and you don’t have to worry about the reach of my platform.” So you’re essentially taking the risk in the beginning as the reseller. Once you’re established, and more buyers come, then you become more attractive to the suppliers to join.

The second way would be to do what eBay did an start in a niche, in which essentially the buyers are the sellers. In the case of ebay, they started in collectibles. That turns out to be a very small market. There’s a bunch of people who essential buy and resell these things. If you have the buyers, you automatically have a few sellers as well.

Moving to local, Groupon has probably seen the most explosive early success as a marketplace in the local space. What went awry?
It’s a perfect example of a common assumption in marketplaces: “We’ll build a marketplace, and just because of the network effect, the market is necessarily going to tip.” Sure, there’s a network effect: the more merchants that offer deals on Groupon, the more attractive it is for consumers and vice-versa. But the mistake a lot of investors made was to think because of that, there’s basically going to be one or two winners (Groupon or LivingSocial); and  therefore, they’ll be worth $18 billion in case of Groupon and a few billion in the case of LivingSocial.

The reason that turned out not to be the case was simply because the switching costs and the entry costs were both very low in the deal space. You and I can build a daily deal company tomorrow. We can onboard a bunch of merchants and consumers easily. For users, it’s very easy to surf a bunch of different websites, and for merchants, its easy to post deals on a bunch of different websites. Even though there’s a network effect, there’s no market tipping point.

Network effects on their own are not enough to make marketplaces to work.

So what can Groupon do to increase those switching costs and make its marketplace more valuable?
There’s several ideas. One natural way would be to offer benefits to repeat users. That’s to say, if you purchase more than 5 deals on Groupon, than you get some kind of special deal. That obviously means that people are just more incentivized to use Groupon instead of LivingSocial or other deals sites. You can do for merchants as well. On the merchant side, Groupon could offer business that run more than one deal a month for x months, a reduced take rate.

One attribute that you identify as negative for a marketplace is when the two sides (buy and sell) are imbalanced. In Groupon’s case, do you see a notable imbalance between the merchants and the consumer side of its business?
I don’t think so. In the case of Groupon, it’s hard to make a case. We’re talking about on one side, individual consumers, and on the other small mom and pop shops. It’s difficult to argue that one side has a lot more power than the other. I don’t think that’s a big source of market failure for the company.

Another company that you’re researching is Intuit. Talk a bit about what they’re doing.
Intuit is trying to turn its flagship product QuickBooks, which is essentially a financial management software product for small business, into a platform or marketplace. The company is trying to make it not just a product, but a marketplace where third-parties can serve as vendors, and come in and make offers to small businesses who are QuickBooks customers. It brings up an interesting question:  should Intuit run this as marketplace like eBay, which is attractive because it doesn’t need a ton of extra investment. Or, would it be better suited to operate as a reseller, where Intuit buys a product and resells it to their small business clients. And there are pretty good arguments to [function as a reseller]: you have more control, you brand matters, you get to select and so on and so forth.

Are there attributes of the small business market that lend to either marketplaces or resellers?
What’s most important to consider is the nature of the small business product. There are certain categories of products like small business supplies where Intuit already functions as a reseller. In fact, Intuit already resell a lot of checks, papers and envelopes. Obviously, the company doesn’t manufacture those

, but they buy them from someone else in bulk and then resell it to small business with the opportunity to add stamping or brand name for additional cost. And that’s a very profitable business. What this suggests, is that for commodity like products, which small business buy a lot of, it can make sense to function as a reseller. It’s a little more complex for products which do not cater to all small business, and there’s more variance in the demand from a small business. For there, it make much more sense to function as a marketplace.

Steven Jacobs is deputy editor at Street Fight.

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