A framework for the digital economy

For teaching my students I like to work with a framework to structure and summarize the course. So, here is one for the digital economy.

In digital business we usually deal with goods (or services) that are fully or partly digital. In order to understand the digital economy you, therefore, have to know the specifics of digital goods. What characteristics do digital goods have? How do the resulting cost structures look like? And what follows from that for developing pricing strategies for digital goods?

Having laid this groundwork, we can further analyze how digital goods are offered or used in markets. In these systems we have to deal with several characteristics as well. Very often network effects play a prominent role as well as switching costs and compatibility in developing a sound strategy for a digital business.

On top of all that, we see more and more platforms in digital business. For some businesses the market does not only consist of two parties (seller and buyer), but of three or more parties, i.e. they are multi-sided platforms. Multi-sided platforms not only combine all topics discussed with digital goods and digital markets, they present some further challenges (e.g. chicken-and-egg problem) for building and managing them successfully.

From substitutes to complements

We are used to think in terms of substitutes (one product/service replaces another). So our competitors are those with similar products and our pricing needs to be lower than our competitors’ (or our quality needs to be better).

In the digital world, however, complements (products/services which complement each other) play a much more important role. This has significant consequences on who our „competitors“ are, how to form our relationship to these „competitors“ (or partners) and how to set prices (complements influence each other).

“Platformed” world

Business is more and more becoming a “platformed” world. More and more of the largest companies (based on market capitalization) are platforms. For an economist, of course, this development is not surprising. Platforms exhibit massive economies of scale (supply-side and demand-side economies of scale/network effects) and, thus, are inherently driven towards fast growth.

Many business leaders are now confronted with competition from platforms and soon realize that it is very hard to fight against platforms. So some of them are thinking about becoming a platform themselves. But be well aware, that platforms need a much different management than conventional businesses.

Digital Business defined

What makes a business a “digital business”? In order to justify a new category of businesses, such a category needs to be substantially different from the existing ones (otherwise what value would a new category have?). And in fact, I claim that digital businesses have two economic characteristics which make them profoundly different from “traditional” businesses:

  1. All digital businesses work with near-zero marginal costs in an important part of their business.
  2. Very often digital businesses are exposed to network effects, indirect and/or direct network effects.

Digital businesses deal with goods or services that are completely or partially digital. Even an online shop wich sells physical products operates on a digital platform. And the main feature of digital goods is that they have near-zero marginal costs. Zero marginal costs have a very profound and far-reaching impact on many business decisions.

Digital goods or services are offered in digital markets. Very often such markets show network effects, wich often play a crucial role for the business. More and more digital markets are not only built by two parties (buyer and seller), but by multiple parties. These multi-sided platforms require a significantly different management and represent definitvely a new type of business.

Algorithmic world

More and more often algorithms determine our world. Google search is obviously based on an algorithm, movie proposals in Netflix are derived from an algorithm, the products Amazon is recommending to us are calculated by an algorithm, and our newsfeed on Facebook is determined by the Edgerank, an algorithm. And there are a lot more examples.

While algorithms are convenient (and cheap) – no human effort is needed during execution –, the question remains whether they are also effective and wise. Can you really “calculate” (and that simply is what algorithms do) human behavior? And even if one could, would we human beings want to be calculated? Or wouldn’t we just for the sake of demonstrating that our actions cannot be calculated decide differently?

And how do these algorithms change our behavior and thinking? Have you realized that you already have altered some of your actions, so that the “machine” can “understand” you? And if these algorithms just recommend to you what you like (movies, music, news articles, books, products, locations, opinions etc.), how do you ever get your sight on new thoughts which usually are much more enriching for your life?

Data are the digital fuel

As many have pointed out already, data are at the core of the digital economy. Data are the digital fuel, they drive digital businesses. The more and better data you have, the more and better services you can offer.

Whether it is personalization, predictive actions or matching, all require data. What is important is not so much the amount of data you collect from each single user, but the combination of the data of your (and maybe even partners’) users.