Analyzing eBay - How wide is eBay's moat?

eBay is often thought of as a business with a wide moat, because its core eBay site has a strong network effect and it has the largest number of users among its competitors. As with most network effect businesses or technologies, once a dominant player emerges, it is practically impossible to dislodge because of the value the network has to its users (the value created for its users grows polynomially as the number of users increases linearly). eBay was seen as the dominant franchise.

eBay started as a giant swap meet for people to buy and sell to each other. eBay was a venue for traders to meet and trade, much like a stock exchange. Such exchanges are economic entities that enjoy a tremendous network effect, and they are able to command economic rent. (The stock exchange analogy is conceptual only. In real life, there are large market makers participating in the U.S. stock exchanges each of which accounts for a large proportion of trading volume. This erodes the ability of the exchange to command economic rent, because the market makers can just link up among themselves to create a parallel exchange)

Because each participant in an exchange can potentially engage in two-way trade with all other participants, each additional participant increases the number of trading possibilities polynomially (think of it as a complete graph - such a graph has n(n-1)/2 edges). Traders, who value the number of trading possibilities available in an exchange, the value of the exchange grows tremendously as the number of participants increases. In practice, once a critical mass of participants is reached, the value of the exchange to all its participants probably grows at a rate far greater than the polynomial growth that the number of trading possibilities would suggest. In real life once a critical mass of traders is reached, benefits like economies of scale in trading volume and market liquidity kick in once a critical mass has been reached.

This economic characteristic makes it extremely difficult for smaller exchanges to compete with a larger dominant exchange. In fact, like all network effect entities, once a large exchange achieves a size beyond its competitor(s) by some amount, a tipping point is reached and competing exchanges will shrink rapidly as participants migrate to the dominant exchange. eBay was thought to be the dominant exchange and hence unassailable.

However it is probable that this assertion that eBay's site has a network effect is wrong. This is because eBay may actually be a marketplace and not an exchange. Exchanges have a network effect, while marketplaces do not.

There difference between the two lies in the trading patterns and behavior of its participants. In an exchange, all participants are traders that buy and sell from each other. In a marketplace, participants generally perform only one role: they are either buyers or sellers. Marketplaces are venues for two groups of people to meet, and for each group to derive benefit from the other group. The value of a marketplace to a participant is proportional to the number of participants that belong to the other group. For example, the value of a market to a seller is proportional to the number of buyers present, and the value of the market to a buyer is proportional to the number of sellers present.

Marketplaces do not have strong network effects because the value of the market only increases proportionally to increases in the number of participants. (Unlike an exchange, whose value increases disproportionately). However marketplaces do exhibit a self-reinforcing feedback loop effect. The more buyers there are, the more valuable the market venue is to sellers. This causes more sellers to come on board. The increased number of sellers in turn makes the market venue even more valuable to buyers, which causes more buyers to come on board. This in turn makes the market venue even more valuable to sellers, enticing more sellers to come on board, and so on. Examples of marketplaces are newspapers, shopping malls, and supermarkets/department stores that sell on consignment.

Newspapers (especially the classifieds section) are essentially a market venue for advertisers and readers. The more readers there are for a classifieds section, the more important it is for advertisers to advertise there. With more advertisers, readers will find the classifieds more valuable because of the increased ranges of products and services available. This brings in more readers, which in turn brings in more advertisers. (In a sense, the "news" in a newspaper is just a sideshow used to bring readers in - the real business of a newspaper is in being a market venue for readers and advertisers.)

Shopping malls operate on the same principle. The more people there are who visit a mall, the more valuable the mall is to shop owners. And the more shops there are, the more useful a mall is to customers.

Like exchanges, marketplaces tend to be "winner takes all" types of businesses. If an marketplace becomes much larger than its competitors, the business will eventually drain away from the smaller markeplaces and migrate to the larger marketplace. However, unlike in an exchange where it is practically impossible to dislodge a dominant player, it is relatively easier for a competitor to dislodge a dominant marketplace. How so?

For a small exchange to dislodge a larger exchange, it essentially has to convince a large number of participants to move from the large exchange to its smaller exchange. In fact, to beat the larger exchange, it literally has get enough people to move over so that it becomes the larger exchange. In other words, the strategy for a smaller exchange to beat a larger exchange is to become the larger exchange. This is going to be difficult, because participants of the larger exchange derive higher value simply because it is the larger exchange. It is difficult to come up with a proposition to get them to switch over.

However, for a small marketplace to dislodge a larger marketplace, it only needs to convince one group of participants to move over. Once it has done this, it can count on the self-reinforcing feedback loop to draw in the other group of participants. The participants know this too, and they may be willing to bet that the market owner will be able to convince their group peers to move over. For example. they may believe that the market owner has the clout/salesman ship to bring over lots of their group peers. The hurdle to overtaking a large competitor is lower than in the case of exchanges.


Signs suggest that eBay is a marketplace, not an exchange.

Although I have no figures to back this up, it looks probable to me that the bulk of today's eBay users are not traders. Rather they are divided into two groups of users: buyers and sellers. It appears that more and more of the trading on eBay is between people who specialize in selling (such as the eBay Power Sellers) and people who visit eBay only to buy/hunt for bargains (i.e. buyers).

If this is true, it would explain why eBay is trying to move away from its "flea market, swap-meet auctions" format to a more commercial "buy it now" format with fixed prices and store fronts. This look-and-feel transition, if true, signals that the underlying economics of eBay have changed. This change of format is not simply a cosmetic matter, or a matter of catering to the changing zeitgeist (which is what retail and fashion businesses have to do to stay relevant to their customers). (Even if the underlying economics are exchange in nature, eBay's current moves towards a marketplace business model means that the underlying economics will eventually become marketplace economics)


The competitive landscape - Amazon Marketplace.

If indeed eBay is being used as a marketplace, then it susceptible to competition from Amazon, in particular the Amazon Marketplace which was launched in 2001.

While eBay does seem to be orders of magnitude larger than Amazon (2007: eBay Gross Merchandise Volume of USD 59.3b, compared to Amazon Revenue of USD 14.8b), Amazon does have very strong mindshare with buyers as the "defacto place to buy things online". Amazon's mindshare with the general public will make it possible for them to convince large numbers of buyers to move over. Likewise, their fulfillment capability could also convince large numbers of sellers onboard. This could then precipitate the self-reinforcing feedback loop which could grow their marketplace significantly and threaten eBay's position.

Strategically, the only two Amazon capabilities that eBay cannot counter, is (1) the fulfillment feature for sellers, which can attract sellers on board, and (2) Amazon's mainline store, which can be used to offer loss leaders and coordinated merchandising to bring in buyers. These are two very strong competitive tools that Amazon has in its fight against eBay. eBay's competitive advantage over Amazon (as of now) is its larger size.

This competition is shaping up as a contest between a large bazaar of vendors selling to customers (eBay) and a huge shopping mall with an anchor tenant (Amazon).

The two may be able to co-exist, but only if (a) the e-commerce market is large enough and both players to maintain size parity with each other; otherwise tipping point economics will take over and only one will survive, or (b) each specializes in a different product range, or (c) each specializes in a different type of buyer/seller; for example eBay goes for traders/swap-meet, while Amazon goes for conventional buyers and sellers. Because the online ecommerce market is still growing and its ultimate size and form is unknown, the growth and competitive parameters of both Amazon and eBay is tricky to quantify.


eBay's other businesses - PayPal, Skype and online Classifieds (Gumtree, Kijiji)

While eBay's other businesses are strong, they are still small relative to eBay's overall business.

Nonetheless, they have strong competitive positions, and eBay may end up as a conglomerate with a collection of strong online businesses. Betting on them is a venture capitalist's game, not the game of an investor looking to invest in a running business. I'll take a look at eBay's other businesses sometime, possibly in another post.