How Platforms Scale without Increasing Costs

With the rise of mobile and connected technology in the 21^st century, a new business model is displacing the old linear one. This new model is the large, horizontally integrated platform business. Rather than delivering products to customers in a linear fashion, a platform business focuses on facilitating interactions between consumers and producers so that they can exchange value.

As the Connected Revolution continues, platform businesses will create more value than linear businesses and take the lead as the dominant force in most industries. In fact, by many counts they already are. Platform companies like Apple and Google sit atop our economy, and most of the mega-successful startups of the last decade have also been platforms, such as YouTube, Facebook, Twitter, Amazon, Instagram, Uber, Airbnb and many more.

Platform businesses are structured fundamentally differently than the once-dominant linear businesses of the 20^th century. And despite their newfound prominence in our economy, many people still don’t have a good understanding of how platforms work.

To understand why platform businesses are so powerful today, you need to take a deeper look at the cost and profit structures of their business model.

Less Total Cost to Scale

Compared to a linear business, a platform faces much less risk exposure – as defined by total fixed and quasi-fixed (e.g., payroll) costs – in order scale to a majority market share, as measured by the Quantity of Supply of Interactions.

The economies of scale, as pioneered by Bruce Henderson, eventually reach a point of diminishing marginal returns. A linear business will need to continue to add to its payroll, build more factories or buildings, etc.

Like many linear businesses, platforms have significant upfront costs. For platforms, these initial costs go toward creating the technology the business is built around as well as early user acquisition. But unlike linear businesses, platforms don’t scale by adding resources such as physical infrastructure (stores, factories, etc.) or additional inventory. Instead, platforms grow through highly scalable ecosystems that are driven by network effects between consumers and producers.

That’s why a linear business’s costs continue to rise as it grows while a platform’s costs tend to level off logarithmically. This ability to grow through ecosystems rather than resources allows platforms to scale to an extent that linear businesses can’t.

Greater Profit Generation at Scale

While linear businesses can start generating revenue right away, platforms have limited ability to generate revenue early on. When platforms have few users, they create little value, due to the chicken-and-egg problem. Platforms overcome this problem when they reach critical mass, which is the point where the value to new users of participating in the platform exceeds the cost of participation (V > C).

Once a platform scales past critical mass, network effects work to its advantage and helps drive the business toward a majority market share. As this happens, the cost of user acquisition declines and the value the platform creates starts to flow through to the bottom line.

Still, since a platform doesn’t own production directly, it may generate less profit than a linear business does even after hitting critical mass. So it’s not just that platforms can grow larger than linear businesses – platforms have to grow much larger than linear businesses in order to be profitable long term– think of eBay serving tens of millions of buyers and sellers or Uber serving millions of riders and drivers. Or look at Airbnb, which is on track to become the largest hotelier in the world.

This growth imperative for platforms is bad news for linear businesses, because as a platform reaches maturity and starts to take over the whole market , its profits both eclipse and squeeze the profits of the linear businesses still remaining in the industry.

A Winner-Take-All Dynamic

Platforms have to harness massive scale.

When a platform reaches critical mass, network effects create a positive feedback loop that drive further growth and profit generation. Post critical mass, these network effects also act as a moat against competitors.

A platform generates revenue by monetizing transactions, so it wants to facilitate as many transactions as possible. Combine this with platforms’ inability to generate revenue when there are only a few users, and you can see why most platforms either make it big or don’t succeed at all.

A platform business scales to create more value to its users, generate more profits for itself and protect itself from competition. Every linear business today should be on the look out for potential platform substitutes, or better yet, thinking about how it can build a platform of its own.

Filed under: Platform Innovation | Topics: platform economics, platform innovation, platform thinking, platforms