How to Understand [any] Industry's Structure: Demand-side Benefits of Scale
This is also known as Network Effects and it refers to the benefits that a company or industry can enjoy due to the large number of customers they have.
Following yesterday’s discourse, we’ll be touching on Demand-side Benefits of Scale, as the next major source of barriers to entering an industry (you can catch up with yesterday’s here).
This is also known as Network Effects and it refers to the benefits that a company or industry can enjoy due to the large number of customers they have. This means that as more people use or consume a particular product or service, it becomes increasingly valuable to other customers. These benefits can pose a serious barrier to entry for new competitors, as they may struggle to attract customers and build a similar level of demand.
These benefits are also due to the trust customers have in larger companies and the value of being a part of a larger network of customers. Buyers may also value being in a “network” with a larger set of fellow customers.
For instance, Instagram has a large user base, and as more people joined the platform, its value for existing users increased because there were more people to connect with. This created a positive feedback loop, where as the user base grew, more people were moved to join the platform. The “network effects” make it challenging for new social media platforms to compete with Instagram, as users prefer a platform where they can easily connect with friends, family, and fans rather than starting on a new platform. Also, Instagram has leveraged its large user base to attract advertisers who want to reach a larger audience. This makes it difficult for smaller social media platforms to attract advertisers and generate revenue.
So, the demand-side benefits of scale in social media create a serious barrier to entry for new social media platforms. This also reflects the idea that the value of a product or service increases as more people use it, making it difficult for new companies to compete with established players.
Let’s fire down with some actual examples
Demand-side Benefits of Scale (Restaurant context)
In a restaurant setting, for instance, let's imagine two restaurants, Maple and TJ Restaurant are located in the same locality, and they both offer the same food quality and pricing. Maple has been around for some years and has established a good reputation in the community; so it has built a loyal customer base, and many people tend to prefer to eat there.
And then, TJ Restaurant just opened and is relatively unknown in the community. Even though TJ Restaurant offers the same quality and pricing as Maple, fewer people tend to eat there since it doesn’t have the same customer base that Maple has built over the years.
This shows how Demand-side benefits of scale can create serious barriers to entry for new competitors. Maple has the advantage of a built-up customer base and a good reputation in the community, making it harder for TJ Restaurant to attract a significant number of customers and compete effectively. So, TJ Restaurant may struggle to survive or may need to spice up its offering to attract people by serving unique dishes or price discounts.
Demand-side Benefits of Scale (Automobile industry)
Here, longstanding players like Toyota, Ford enjoy the benefits of economies of scale and operational efficiency that new entrants may struggle to match.
Let’s say a new company wants to start producing cars. They’ll face considerable challenges in developing a brand reputation, attracting customers, and developing supply chain efficiencies. In contrast, Toyota already has an established reputation and a customer base that can help drive sales, even without much advertising.
Also, due to its large customer base, Toyota can leverage suppliers to provide large and frequent orders, getting discounted prices and preferential treatment in the process. This makes it difficult for new companies in automobile to compete on price, and they may have to innovate in other areas such as sustainability or technology to establish themselves in the market.
In essence, this is how demand-side benefits of scale can be a barrier to entry for new entrants as they struggle to reach the same level of production, sales, and customer loyalty as established brands.
Demand-side Benefits of Scale (Microprocessor industry)
Now, microprocessors are essential components in computer systems, mobile phones, and other electronic devices. Let’s consider Intel, a long-standing player in the microprocessor industry. Due to its reputation, Intel already has the advantage of economies of scale and operational efficiencies that other new microprocessor companies may have trouble matching. Besides, chip fabrication requires a huge initial investment, and as new companies lack an extensive customer base like Intel, they’ll most likely struggle to recoup these initial investments.
Intel may also have exclusive contracts with certain manufacturers that established an unspoken monopoly on the production of some microprocessors. This way, demand-side benefits of scale limit newer companies’ ability to gain market share or establish a strong brand like Intel has.
Demand-side Benefits of Scale (Fintech industry)
For instance, Paystack and Flutterwave have already built up a large customer base and a good reputation in the market. As Fintech companies often store and manage sensitive financial data; security, and regulatory compliance are essential for success in the industry. Paystack and Flutterwave have invested significant resources in technology, compliance, and security to maintain customer trust. New entrants may find it challenging to allocate significant resources to these areas; giving Paystack and Flutterwave an advantage in terms of security and regulatory compliance.
So, demand-side benefits of scale can be a serious barrier to entry in Fintech, making it difficult for new entrants to establish a significant customer base, forge partnerships and match the technology, security, and compliance needs of established players.
Demand-side Benefits of Scale (Music industry)
Established artists benefit from the reputation and following they have built up over the years, which can make it difficult for new entrants to break through and capture a significant market share.
Big labels have an advantage due to their size and resources in promoting their artists, accessing airplay, tour sponsorships, capital-intensive video production, distribution networks, etc. Their large customer base enables them to leverage significant data analytics in predicting music trends, ensuring their artists’ success. In contrast, new entrants lack audience familiarity and influence, making it challenging to garner listenership. They may also lack access to good channels of distribution which further impedes their chances of garnering an audience. They have to invest heavily in diverse channels of exposure and handle most of the promotional and managerial aspects personally, which could even affect their ability to focus on their artistic output.
Basically, the music industry shows how demand-side benefits of scale can be a barrier to entry, as new artists struggle to break in and establish themselves in a crowded field. While established players enjoy economies of scale, wider distribution, network effect and have already cornered a considerable customer base.
Ultimately, entry into the industry depends on time, availability, accessibility, and an artist's ability to stand out via creativity, innovation, and story-telling ability, among other factors.
Next up
We’ll talk about Switching Costs