The Problem with “Aggregation Theory”, Demand at Scale, Supplier Power and Value

Good morning,

Monday is the Memorial Day Holiday in the United States; there will be no Daily Update. Enjoy the holiday, whether it be from work or from me 😊

On to the update:

The Problem with “Aggregation Theory”

A lot of you have emailed me this blog post by Lyall Taylor called The Problem with Ben Thompson’s ‘Aggregation Theory’, so I thought it would be a nice change of pace from the current news cycle to respond. To be clear, I love posts like this! This is how ideas get better.

Taylor lays out his thesis at the beginning:

Superficially, this theory seems to have a lot of explanatory power. Take the example of hotel booking platforms. These organisations are able to centralize the demand of people looking to book accommodation, and direct that traffic to available sources of supply. If you own a hotel and aren’t on the platform, you can’t reach buyers any more, and so your only choice is to use the platform and pay Expedia (for e.g.) a huge cut (‘take rate’) to make bookings on your behalf.

The problem I have with the theory is that it implies there is something fundamentally new or unique about the economics of the brave-new-world of tech, when in reality, the old economic rules still work just fine. This, in turn, creates the raw material to rationalize bubble thinking/valuations, instead of more level-headed analysis. The reality is that from time immemorial, it has always been the case that certain points in the supply chain make more money than others, reflecting differences in market power. Porter’s Five Forces, for instance, has long been used as a framework for analysing where and how much market power exists, and explaining and predicting why some firms make more money than others. If your suppliers for e.g. have a lot of bargaining power, all else held constant, you tend to be less profitable, and vice-versa.

I appreciate the reference to Porter’s Five Forces: (very) long-time readers will know that it is one of my favorite frameworks as well, and absolutely a foundational part of Aggregation Theory; I actually made an illustration invoking Porter’s Five Forces in the very first month of Stratechery to explain Apple’s power over carriers:

To put it in theoretical terms, the Bargaining Power of Buyers (i.e. wireless consumers) drives iPhone carrier adoption:

In 2010, Verizon acceded to the iPhone because customers were leaving for AT&T

In this view, instead of carriers hiring the iPhone to attract high use/high revenue wireless buyers, the lack of iPhone repels wireless buyers and drives them to rival carriers, forcing the holdouts to give in to Apple’s demands.

Here’s the funny thing, though: I think that Taylor agrees with Aggregation Theory! Here’s the next paragraph (emphasis mine):

There isn’t a lot that is novel about that insight, and the truth is, contrary to what Ben argues, demand and supply have always been of equal importance, and remain so. The real reason certain platform companies have become powerful is not because demand has become more important than supply, but because in many cases, the demand side has become more concentrated than the supply side, thereby giving it more market power. Demand has therefore become more ‘consolidated’ (an old-hat term which I prefer to the new-hat ‘aggregated’) on the demand side than supply has on the supply side…

That is precisely the point of Aggregation Theory: not that there is now more demand than supply, but rather that Aggregators consolidate demand to gain power over supply.

To be fair, Taylor’s argument is also that this is nothing new:

But this is not the first time that has ever happened. Carnegie and Rockefeller got rich by consolidating their industry and controlling the infrastructure that allowed both suppliers and competitors to access the market. If you ‘aggregate’ for e.g. all the railways that provide access to market, surprise surprise – you will make a lot of money (in this respect, ‘aggregation’ is just a synonym for monopoly). I also recently wrote a blog post about how PBMs (Pharmacy Benefit Managers), working in conjunction with health insurers, were getting rich by controlling which pharmaceutical products were able to achieve reimbursement (and hence have market access).

Again, I have no objection to this point: controlling a part of the value chain is the surest route to monopoly profits. The counter-examples of Carnegie (steel) and Rockefeller (oil refining), though, are, to Aggregation Theory’s point, about controlling supply, not demand. This isn’t a surprise, and herein lies what I think is Aggregation Theory’s unique contribution.

Demand at Scale

Start with the precept that Taylor and I absolute agree on: over time supply will come to equal demand. Generally speaking, though, demand will be more distributed, and supply will be more concentrated. A smaller number of farms feed a larger number of people; a smaller number of stores sell to a larger number of customers; a smaller number of manufacturers build goods for a larger number of people. Indeed, this is the precise calculus upon which the modern economy is built: technology, from the time of the industrial revolution on, has increased the efficiency of suppliers, resulting in scale and the creation of space for new suppliers of new goods and services to do the same, growing the pie for everyone.

What this means when it comes to consolidation or aggregation or monopolization or whatever term you wish to use, is that it has always been significantly easier to control the supply side than the demand side. It’s a simple numbers game: there are fewer suppliers than there are consumers (even though the total amount of supply still equals demand!), the suppliers are more easily identified, etc.

What makes technological platforms fundamentally different β€” and, in my admittedly biased opinion, Aggregation Theory unique β€” is that zero distribution costs and zero transaction costs flip this numbers game on its head: it is for the first time possible to control individual consumers at scale. Google can literally be a search engine for the entire world. Facebook can literally be a social network for the entire world. Netflix can literally be the entertainment destination for the entire world. Moreover, each of these companies can “know” end users in a way that was never previously possible: Google can give all of its billions of users the exact content they want (and ads), Facebook can create a personalized feed for all of its billions of users (and ads), Netflix can collect money every month from 150 million people around the world.

This is absolutely astounding, and something that Carnegie and Rockefeller and any other would be monopolist throughout history could not even fathom. Carnegie did not know every possible application of his steel, nor did Rockefeller know every lamp that his kerosene was used in; it’s impossible β€” the costs of trying to do so would be overwhelming. What was possible was consolidating and integrating supply, and even moving forward into distribution (like Rockefeller did with railways).

Aggregators, on the other hand, particularly at the beginning, usually don’t have supply at all! Through some sort of breakthrough they figure out a way to better connect end users to existing supply, aggregating demand; suppliers soon notice, and are incentivized to serve the Aggregator better, increasing their attraction to end users, which only increases the Aggregator’s power, and on it goes in a virtuous cycle. And sure, at some point the Aggregator may integrate backwards into distribution or supply, but the foundation of their power comes from aggregating demand, something that was not possible before the Internet.

To that end, a much better critique, if you wanted to make the case that Aggregators are nothing new, would be that Aggregators are like digital Walmarts; the retailer gained power over demand mostly in small-to-medium sized cities, and then aggregated that demand to impose terms on suppliers. The difference, I would argue, is scale, in two respects: first, Aggregators serve the entire world, and they generally do so from Day One. Second, just as Aggregators are not constrained when it comes to how much demand they can accommodate, they are also not constrained when it comes to how much supply they can accommodate. Walmart stores were big, but finite; Aggregators are infinite.

Supplier Power and Value

There were two additional points I wanted to respond to. First, with regards to the music industry:

However, not all tech sectors are like that, and nor is it inevitable that the supply-side will always remain much weaker than the demand-side in many other segments. An example of an industry that is different is music streaming. In the world of music, supply is still more aggregated than demand. Three major studios control virtually all commercial music, whereas at present there are more than three major sources of platform demand (Spotify, Pandora, Apple Music, YouTube, and Amazon), as well as conventional ad-supported radio. Because supply is more aggregated than demand, music streamers aren’t yet making any money, but the big music labels remain very profitable. In Ben Thompson’s parlance, it could be said that the reason is ‘supply aggregation theory’. In conventional parlance, it is because the supply-side is the point in the supply chain with greater market power.

That is pretty clearly not my parlance, but the broader point is obviously correct, and one that I have written about extensively. I wrote in The Great Unbundling:

The music industry, meanwhile, has, at least relative to newspapers, come out of the shift to the Internet in relatively good shape; while piracy drove the music labels into the arms of Apple, which unbundled the album into the song, streaming has rewarded the integration of back catalogs and new music with bundle economics: more and more users are willing to pay $10/month for access to everything, significantly increasing the average revenue per customer. The result is an industry that looks remarkably similar to the pre-Internet era:

img_0112

Notice how little power Spotify and Apple Music have; neither has a sufficient user base to attract suppliers (artists) based on pure economics, in part because they don’t have access to back catalogs. Unlike newspapers, music labels built an integration that transcends distribution.

I suspect Taylor hasn’t read this Article; it was a failing of the original Aggregation Theory Article that it didn’t properly consider the importance of supplier fragmentation when it came to analyzing the likelihood of an Aggregator arising; this is a big reason why Spotify is not Netflix.

Second, on “value”:

Furthermore, in competitive free market economies, there is always an evolving competitive jostle for a greater share of the spoils, and ‘aggregation theory’ implies a degree of structural permanence that I do not believe should be automatically assumed. That, in turn, creates the risk of a lack of vigilance about some of the risks of change. When one part of the supply chain is profiting at the other part’s expense, given enough time, one or both of the following things can happen: (1) the portion of the supply chain that is being under-remunerated has an incentive try to adapt and improve its bargaining position, including via market consolidation; and (2) disruptive competitive pressures are also usually eventually brought to bear on points of the supply chain that are over-earning relative to the level of their value-add, and ‘new’ platform businesses will be no more immune to this in the long term than ‘old’ businesses have been (after all, in the long term, the new becomes the old). And at present, many platforms are currently materially over-earning.

I listened to a podcast not so long ago where one of the tech-infatuated guests was arguing that tech is taking over the world and increasingly supplying everything we need, noting that on a recent visit to Sydney, he booked his flight through Skyscanner (Expedia); took an Uber for transport from the airport; stayed in AirBnB accommodation; and booked food delivery through UberEats (if memory serves). He also found activities to do through TripAdvisor, while booking restaurants through OpenTable. The implication was, how we live, work, and play is now being completely overrun and serviced by tech, and so of course tech stocks are increasingly conquering the world.

However, it doesn’t take much reflection to realise that it is actually the real world, not the world of technology, that is providing all these services. All those apps are doing is providing an algorithm that lowers search costs and makes booking easy. Expedia didn’t design, build and maintain the airplane that flew him to Sydney; build or operate the airport; train pilots; or find, produce, refine and transport the necessary jet fuel to power the plane over its continental voyage. Uber didn’t design and manufacture the car used to transport him to his hotel; find, produce, and process the raw materials that go into it (such as steel and aluminium); or actually drive him from the airport to his hotel. AirBnB didn’t design, build, maintain, or clean the house he stayed in, nor supply it with electricity. UberEats and OpenTable didn’t grow and process any raw foodstuffs, or use them to cook a meal, and TripAdvisor didn’t design, manufacture or operate any of the tourist attractions he visited.

In fact, all these companies did was write some pretty simple code that made matching buyers with sellers easier and more efficient, and the real question that should be being asked is whether these platform companies are extracting too much value from the supply chain relative to their value-add, and whether that is likely to be a sustainable situation in the long term, or will invite potential disruption and/or an eventual supply-side/regulatory response.

Honestly, Taylor just made the argument for Aggregation Theory as well as I could have: how is it that “pretty simple code” earns valuations that far outstrip the “real-world” companies that actually provide the goods and services in question? The answer is by consolidating demand at a scale that was previously impossible.

To be sure, all companies are threatened by disruption, and yes, regulatory responses should be expected: I have spent a lot of time the last few years exploring what that regulation should look like. That there is something to disrupt and/or regulate, though, is not evidence that something does not exist.

Note: I want to post a link to this Daily Update as a comment to Taylor’s post, so I am going to make it free to access. In addition, please be respectful if you comment on Taylor’s website (which, to be honest, I don’t think is necessary). As I noted at the beginning, I really appreciated this article β€” this is how ideas become stronger β€” but I want to be cognizant of the size of my audience.


The Daily Update is intended for a single recipient, but occasional forwarding is totally fine! If you would like to order multiple subscriptions for your team with a group discount (minimum 5), please contact me directly.

Thanks for being a supporter, and have a great day!