Michael D. Ryall maps Amazon's early value network, illustrating the relationship among the players involved in delivering a product or service: a firm, its suppliers, and its customers.
Hi my name is Michael Ryall. I'm a Professor of Strategy at the University of Toronto's Rotman School of Management. Over the past decade, researchers have made significant strides towards the development of a mathematical theory of strategy that I refer to as the value capture model. The value capture model is intended to analyze the competitive drivers of performance within an industry. This exhibit illustrates in qualitative form several key insights that arise from the value capture model using a graphical device called value network maps.
Let's begin with a generic value network map. The starting point is the value network itself. A value network consists of all the agents engaged in the production of economic value, including upstream suppliers, production partners, downstream firms, and ultimately end users, everyone who is linked indirectly or directly through a path of transactions that terminates with a final sale.
To set up the map, we take the set of agents in the value network and arrange them around an inner circle that represents the value pi, that is the aggregate quantity of economic value produced with the joint activities of those within the value network. Generically, this is the aggregate end user utility or willingness to pay for an industry's products and services minus the economic cost of the materials and resources used to provide them.
This economic value winds up being appropriated by the members of the value network that created it. And of course this includes the buyers. Outside the circle of agents making up the value network is what we call the competitive periphery. This consists of all the agents outside the network who would create more economic value by transacting with someone inside the network than the value they create through their present transactions. Basically, these agents create excess demand for transactions with the agents in the network.
The demand from the periphery for a firm guarantees that firms some minimal share of the value produced. The amount guaranteed is equal to the quantity of value required to prevent that firm from abandoning its network in favor of dealing with agents in the periphery. Typically within a network the sum of everyone's minimum share, guaranteed in this way by competition, does not add up to 100%.
This means that the amount of value captured by a firm comes from two sources, an the amount of value guaranteed it by competition from the periphery, as I've just described, and an additional amount appropriated by what we loosely refer to as persuasion, such things as arguments of fairness, bargaining skill, industry norms, everything other than competition from the periphery.
Taken as a whole, the value network map highlights several important points. First, industries differ in the extent to which value capture is determined by competition versus persuasion. These differences imply different resources required for success. Second, the minimum value shares guaranteed by competition to others in a firm's network impose a ceiling on what a firm's own ability to capture value is.
The firm's maximum share of value is one minus the minimum shares of everyone else. What the firm gets is something in between its minimum guaranteed by competition and this maximum. Third, the agents presently transacting with a firm do not generate competition for it. For example, as its potential buyers become actual buyers, a firm must rely more and more upon persuasive, rather than competitive, resources.
Let's consider a specific case that illustrates these ideas, amazon.com in the first six or seven years of its existence. Amazon was unprofitable throughout this period – and by the way, continues to struggle even today -- as a result of an unfavorable balance in competition for it and its buyers. To see this begin with its value network. As an online book retailer, this value network was simple.
It consisted primarily of upstream book publishers, amazon.com, and downstream book buyers. Now at the same time that Amazon started its business, Barnes and Noble launched its own online retail book business called barnesandnoble.com. So to keep the example simple, let's suppose that the competitive periphery of Amazon's value network consisted entirely of the agents in Barnes and Noble's value network, that is barnesandnoble.com, it's buyers, and its book suppliers.
So these would be in the competitive periphery of amazon.com's value network map. One of the salient features of this online retailing business was that online retailers were not constrained by shelf space as were their bricks and mortar counterparts, which is still true today obviously. Therefore, everyone who preferred to transact with amazon.com got to transact with amazon.com.
The only reason that barnesandnoble.com's buyers were transacting with it was that they preferred that to transacting with Amazon. All the buyers were where they wanted to be. At the same time though, Barnes and Noble had the capacity to serve both its and Amazon's customers. Note the imbalance. While Amazon's customers preferred its services to those of Barnes and Noble, Barnes and Noble was a close second for them.
In other words, if one had forced Amazon's customers into the Barnes and Noble network, the value produced by that network would have increased. Alternatively however, adding amazon.com to the Barnes and Noble network would have resulted in no increase in value because Barnes and Noble buyers were content to purchase from Barnes and Noble. Thus, on the one hand competition from the periphery was strong for Amazon's customers, assuring them a significant share of the value. On the other hand, it was essentially non-existent for Amazon, resulting in zero guaranteed capture value and as a result, a long string of losses.