#38 - The Ben Thompson Starter Kit

Aggregation Theory & Other Lessons from Stratechery

Software is eating the world and it has a healthy appetite. Covid-19 throws fuel on this fire, collapsing years of change into weeks. Tech analyst and Stratechery author Ben Thompson offers some of the best frameworks for understanding this change. This post explores a few of his ideas.

Aggregation Theory

Thompson is best known for Aggregation Theory, a framework describing the winner-take-all dynamic playing out across the digital economy. Aggregation Theory provides an explanation for the dominance of companies like Facebook and Google and a lens for evaluating the risk of disruption.

Aggregators need to check three boxes: 

  1. A direct relationship with users. 

  2. Zero marginal cost for serving new users, or infinite scalability.

  3. Declining customer acquisition costs (CAC) over time. 

When combined, these three characteristics lead to winner-takes-all situations.

Facebook is the canonical aggregator. While the company invests billions of dollars into data centers, the cost of serving an incremental user is zero. Amassing 2.6 billion users would be impossible otherwise. These users provide content (supply) like photos and stories for free. Publishers wanting to reach Facebook’s users also provide content. Lastly, most of Facebook’s eight million advertisers buy ads through a self-serve portal. Only high rollers get a salesperson. 

Additionally, there’s a positive feedback loop between users, suppliers and advertisers. More users create more content, attracting more users. The more users, the more advertisers want to be on the platform. This virtuous cycle drives the winner-takes-all dynamic. 

While the marginal costs of serving a user is zero, supplier acquisition costs vary. Thompson defines four levels of aggregation, depending on these costs:  

Because advertisers, suppliers (user generated content and publishers), and users all flock to Facebook for free, it’s a super aggregator, the rarest kind. Most companies aren’t this lucky. In contrast, Netflix spends billions of dollars every year for content and Uber spends heavily acquiring drivers. Consequently, Netflix and Uber are lower level aggregators. Differences in supply acquisition costs means that Facebook can have higher profit margins than Netflix or Uber. In general, more control over supply translates into higher profitability. This explains why Netflix shifted to creating its own content. 

Internet Assumptions Require a New Playbook

The determinants of success in the digital economy are different from the physical economy. The digital world is one of abundance, not scarcity. Discovery and curation drive value. This flips many traditional business models upside down, making them vulnerable to disruption. Profits and market cap are shifting from companies that control distribution to companies that control users. Winning today requires a operating with internet assumptions: 

In the internet economy, the distribution of digital goods is free and transaction costs are zero. As Thompson writes in Aggregation Theory:

This has fundamentally changed the plane of competition: no longer do distributors compete based upon exclusive supplier relationships, with consumers/users an afterthought. Instead, suppliers can be commoditized leaving consumers/users as a first order priority.

The center of gravity shifts from controlling supply to controlling demand. Users are king. As businesses compete for users, discovery and user experience become differentiators. Compare the experience of American Airlines to Netflix. 

Disney+ is an example of a company adjusting its business model to play by internet assumptions. Disney has a deep pool of content and existing consumer relationships (theme parks, branded experiences, etc). Disney+ forges direct user relationships. With a direct relationship and zero marginal costs for additional users, Disney+ checks two of the three aggregator boxes. 

Regulators too will need a new playbook for dealing with internet assumptions. Protecting consumers is at the heart of U.S. antitrust laws. Aggregators like Google and Facebook operate at unprecedented scale, but they cost consumers nothing. 

Infinite Niches

The rise of aggregators bifurcated the internet economy into a handful of giants like Amazon, Facebook and Google and a long-tail of smaller players with a hollowed out no-man's land in between. Sorry, Yelp

The internet removes the constraints of geography and distribution. Global reach combined with zero distribution costs open up new business opportunities, allowing a long-tail to proliferate. While the number of left-handed fly fishers in any given town is limited, they’re able to find each other online. The internet serves infinite niches

One of the best ways to compete with an aggregator is to be so highly differentiated that consumers go out of their way to find you. Direct traffic is the holy grail for internet businesses. Owning a niche is a good strategy for earning loyal traffic. 

The flip side of infinite niches and zero distribution cost is an explosion of content and competition. For sites unable to drive direct traffic, Facebook and Google will gladly sell you some if you’re the highest bidder. In a world of infinite content, controlling discovery is a valuable position. 

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