#6 — What is Amazon?

Hello and welcome to Weekend Reading Volume 6. A few things covered this week: infinite shelf space, checkers vs. chess, and the importance of eating your own cooking.

What is Amazon? (Zack Kanter Blog)

When it comes to building a business, you can opt for the Amazon model or the Ben and Jerry’s model. With the flood of easy capital over the past decade, we’ve seen no shortage of tech companies, and a number of non-tech companies masquerading as tech companies, follow the Amazon playbook — spending aggressively in pursuit of growth. However, as Joel Spolsky notes, “The trouble with the Amazon model is that all anybody thinks about is Amazon. And there’s only one Amazon. You have to think of the other 95% of companies which spend an astonishing amount of venture capital and then simply fail because nobody wants to buy their product.” So this week we dig into Amazon.

To understand Amazon, it makes sense to first understand Walmart. The company’s algorithm looks something like this:

“a) “a wide assortment of good quality merchandise”, b) offered “at the lowest possible prices,” c) backed by “guaranteed satisfaction” and “friendly, knowledgeable service,” d) available during “convenient hours” with “free parking” and “a pleasant shopping experience,” e) all within the largest, most convenient possible store size and location permitted by local economics.”

Walmart basically optimized how to run a retail store:

“Walmart can be thought of as a bounded search for the optimal selection, inventory, and pricing of SKUs that a local market could support. It was bound, or constrained, by the characteristics of the local economy, and so each Walmart location was a direct reflection of the local market dynamics.“

The key here is that Walmart was bound both by the local economy and by finite shelf space. They’re playing a game of checkers, and they’re doing it better than any other retailer. But as technology advanced some of the constraints Walmart faced were no longer hard constraints. Instead of playing checkers, Jeff Bezos saw an opportunity to play chess:

“Jeff Bezos had a big realization in 1994: the world of retail had, up until then, been a world where the most important thing was optimizing limited shelf space in service of satisfying the customer — but that world was about to change drastically. The advent of the internet — of online shopping — meant that an online retailer had infinite shelf space…An online retailer would be limited not by each local market, but by the economics and behavior of the national or international population at large.”

So all of the sudden the nature of retailing starts to change. The move from finite shelf space in physical stores to infinite shelf space for online retailers and from serving local markets to serving national or international markets was a paradigm shift:

Bezos…wanted to build an unbounded Walmart. By removing the constraint of geography — and therefore the local economy — and by adding search functionality, the new formula became simpler: the more SKUs it added, the more items would be discovered by customers; the more items that customers discovered, the more items they would buy. In this world of infinite shelf space, it wasn’t the quality of the selection that mattered — it was pure quantity.”

Offline retailers faced problems of scarcity (i.e. limited shelf space) while online retailers faced problems of plenty (i.e. discovery). This meant that the attributes required to win offline were different from those that mattered online:

“Amazon correctly hypothesized that because vendor selection was not important in the world of infinite shelf space, Amazon itself — or, more accurately, its vendor onboarding process — would be the bottleneck to growth. Another way of saying this is that Amazon did not have enough time, knowledge, or capital to fill the infinite shelf space that they had created.”

With limited shelf space, Walmart faced a real opportunity cost when it came to stocking its shelves. A few more of product X meant a few less of product Y. To address this, Walmart built competencies around merchandising and procurement. For Amazon, none of this mattered. What mattered was the quantity of vendors and SKUs. Having identified the vendor onboarding process as a bottleneck to growth, the company decided to open the floodgates by creating Amazon Marketplace:

What if, instead of the painfully slow process of onboarding and negotiating with vendors, Amazon could instead open its website to third party sellers? Amazon Marketplace solved a whole host of problems all at once. By allowing sellers to bypass the gatekeepers altogether, Amazon could rapidly fill its infinite shelf space with a vast selection of SKUs not available from other retailers. And instead of slowly building its own inventory on promising SKUs, Amazon could make a seller’s already-stocked inventory instantly available to eager customers. And, perhaps most importantly, it solved the problem of how to negotiate pricing with a rapidly-expanding SKU base. When Amazon was competing against sellers for a given SKU, there were two possibilities: either Amazon had negotiated the best possible price with the vendor and would ‘win’ the sale, or it had failed to get the best possible price and another seller would win the sale instead — but Amazon would collect a 12–15% commission, and gain a data point that its nascent vendor team could use in price negotiation. And, of course, ‘losing’ the sale to a third party seller still meant that Amazon would keep the customer.”

Heads I win, tails you lose is not a bad business model if you can make it work. And so the Amazon flywheel is born:

“Circa 2002, we start to see the emergence of a pattern: 1) Amazon had encountered a bottleneck to growth, 2) it had determined that some internal process or resource was the bottleneck, 3) it had realized that it could not possibly develop and deploy enough resources internally to remove that bottleneck, so 4) it instead removed the bottleneck by building an interface to allow the broader market to solve it en masse. This exact pattern was repeated with vendor selection (Amazon Marketplace), technology infrastructure (Amazon Web Services, or AWS), and merchandising (Amazon’s Catalog API). Amazon was becoming a platform; that is, an aggregation of resources made available through a series of interfaces.”

What is amazing about Amazon — and probably the reason why there is only one Amazon — is this ability to methodically identify and overcome bottlenecks to growth. But the masterstroke was that the company found a way to avoid bureaucracy as it grew:

“In the world of infinite shelf space — and platforms to fill them — the limiting reagent for Amazon’s growth would not be its website traffic, or its ability to fulfill orders, or the number of SKUs available to sell; it would be its own bureaucracy…In order to thrive at ‘internet scale,’ Amazon would need to open itself up at every facet to outside feedback loops. At all costs, Amazon would have to become just one of many customers for each of its internal services.”

Whereas many companies eventually collapse under their own weight, Amazon continues to execute at a breathtaking pace. From AWS to its fulfillment network to Whole Foods, Amazon is its own first-and-best customer (H/T Stratechery). One of the takeaways from Amazon that is broadly applicable is the importance of eating your own cooking.

Yahoo Finance, “10 Amazon Prime Day Memes to Post on Social Media