Friday, April 20, 2012

How To Own a Market

For a company to own its market, it must have some combination of brand, scale cost advantages, network effects, or proprietary technology. Of these elements, brand is probably the hardest to pin down. One way to think about brand is as a classic code word for monopoly. But getting more specific than that is hard. Whatever a brand is, it means that people do not see products as interchangeable and are thus willing to pay more. Take Pepsi and Coke, for example. Most people have a fairly strong preference for one or the other. Both companies generate huge cash flows because consumers, it turns out, aren’t very indifferent at all. They buy into one of the two brands. Brand is a tricky concept for investors to understand and identify in advance. But what’s understood is that if you manage to build a brand, you build a monopoly. 
Scale cost advantages, network effects, and proprietary technology are more easily understood. Scale advantages come into play where there are high fixed costs and low marginal costs. Amazon has serious scale advantages in the online world. Wal-Mart enjoys them in the retail world. They get more efficient as they get bigger. There are all kinds of different network effects, but the gist of them is that the nature of a product locks people into a particular business. Similarly, there are many different versions of proprietary technology, but the key theme is that it exists where, for some reason or other, no one else can use the technology you develop. 
Apple—probably the greatest tech monopoly today—has all these things. It has complex combination of proprietary technology. By building both the hardware and the software, it basically owns the entire value chain. With legions of people working at Foxconn, it has serious scale cost advantages. Countless developers building on Apple platform and millions of repeat customers interacting with the Apple ecosystem provide the network effects that lock people in. And Apple’s brand is not only some combination of all of these, but also something extra that’s hard to define. If another company made an otherwise identical product, it would have to be priced less than the Apple version. Even beyond Apple’s other advantages, the brand allows for greater monetization.

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