Digital economy

A framework for the digital economy

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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

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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

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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

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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.

Data are the digital fuel

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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.

Founders of digital ventures

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I have been asked which competencies founders of digital ventures need. My response: Clearly, they need economic knowledge on digital businesses. As a founder I need to know:

  • how the digital economy works,
  • how to deal with network effects,
  • how to build platforms, and
  • how to select the right business model.

Head start of media companies

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Media companies should be better prepared for digital business than many other companies. They are used to produce and sell information goods. And often they are experienced with two-sided markets. Both areas are important in digital business.

The customer is key

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Customers can easily switch vendors in the transparent and often global digital marketplace. They are often hunting for the best deal and whichever vendor can offer this best deal will get the business (spot market).

The best deal is not necessarily the one with the best price, there are other values as well (e.g. convenience). And sometimes network effects are important and platforms are developing.

My thesis is that owning the customer is the central success factor in the digital economy. Whatever the specific situation looks like, vendors should not compromise on keeping their customer relationships. Otherwise they may end up as interchangeable subcontractors to dominating platforms.

This is just a first exploration into a plethora of topics. More elaborate thoughts will follow.