Amazon marketplace, commoditizing the complement and road to persistent differential returns

Hey,

Welcome to a new edition of The Hypothesis.

Today, I present a different take on how Amazon built a moat using third-party or 3P sellers business and pocketed the lion's share from the value created. You can also listen to the full article if you want, using the audio player above.

Amazon launched the Marketplace in 2000, allowing 3P sellers to sell their products on its website. Since then,, the marketplace has grown to over 6 Mn listed sellers and 1.5 Mn active sellers. In 2007 it contributed to only 13% of total units sold on Amazon, which has snowballed to 56% in 2021.

Amazon Marketplace is perhaps the single biggest move that converted Amazon from an e-commerce player to a retail juggernaut and became its biggest cash cow. It is also the part of Amazon that gets frequent attention from lawmakers such as Senator Elizabeth Warren as the two screengrabs show (from her Presidential run-up).

But you already know this. And what does this have to do with commoditizing the complement,, and what exactly is a complement? Let me unpack this further.

A complement is a product that you buy along with another product. Car and gas are complementary to each other. Smartphones and mobile data plans are complementary. House and furniture are complementary. Cigarettes and lighters are complementary.

An interesting characteristic of complementary products is that if the demand for one product increases, the demand for its complement also shoots up. If more people are buying new houses, the demand for its complement furniture goes up.

Smart companies have used this dynamic to build near-monopolistic businesses by commoditizing the complement of their products, thereby ushering in explosive demand for their products. Such companies undertake one or both of these two approaches. They drive down the price of complements to the marginal cost of production. They make the complements undifferentiated to capture the lion's share of the value created.

Let’s look at an example - car and gas. People don't buy cars because of high running costs, with the cost of gas being a major contributor. If a car company acquires a gas distribution company and makes gas free or near free, it will commoditize gas as a product. This reduces the running cost of cars and will drive demand for cars. Thus without doing anything in its own layer (cars), by commoditizing the complement (gas), a car company can increase its sales.

On the other hand, if a gas distribution company forward integrates and acquires a car company, it can make the cars available at cost. This means more people will buy cars and thus the demand for gas will also increase, again displaying the principle of commoditizing the complement.

Though, both of these strategies would be economically untenable.

That doesn't mean that commoditizing the complement is just a theoretical principle. Let's look at a real-life example. Computers and OS are complementary. When Microsoft launched Windows, it coded it to run on any hardware that met its standard, unlike macOS by Apple, which ran only on proprietary hardware.

Microsoft then licensed Windows to all PC OEMs such as HP, Compaq, IBM, and Dell, fostering a competition to make PCs that met the Windows specification requirement. Over a period, Microsoft carved out a dominant share of the value created while PC business became a commodity with low margins as PC OEM competed with each other. One should remember how IBM sold its PCs business to Lenovo, and Compaq merged with HP to save itself.

The strategy of commoditizing the complement has been played out numerous times in the tech industry: Facebook and news publishers, Microsoft and Internet Explorer, Google and Images. It gives us a new strategic lens to evaluate the rise of Amazon's marketplace.

Amazon and 3P sellers may look like competitors at first glance. But if you see Amazon as a multi-brand retail store (like Walmart), you see that a retail store and products it sells are complements. If demand for products increases, it leads to more footfalls in the store, driving up sales. Thus, Amazon (the website) and 3P sellers are complementary to each other.

Several steps taken by Amazon seem to have commoditized its complement - the 3P sellers. Starting in 2009, Amazon rebuilt 'Seller Central' a portal that allowed sellers to easily manage their products on Amazon, including listing the products, setting prices, and running promotions.

Amazon made it very easy for a seller to signup for the marketplace through Seller Central. In fact, it was so easy that it led to many dubious sellers signing up and selling poor quality products, as long-time Amazon watcher Brad Stone notes in his book Amazon Unbound.

….Amazon Marketplace, where independent sellers hawked their wares on Amazon.com, exploded with a surge of low-priced products (including counterfeits and knockoffs) manufactured in China.

A few early 3P sellers were able to take advantage of the opportunity by designing products loved by customers, manufacturing at low cost in China, and selling it in the US at high mark-ups.

However, as more sellers onboarded due to Amazon's massive seller outreach and ease provided by seller central, this advantage was quickly arbitraged away. Soon there were numerous sellers selling products practically undifferentiated from each other. This allowed Amazon to foster intense competition in the sellers’ layer.

Another move by Amazon further commoditized the sellers layer - Fulfilled by Amazon (FBA). FBA allows sellers to store their inventory at Amazon's warehouses and let it handle the logistics of delivery to customers. While this gives an advantage of standardization to the sellers, it also further commoditizes them.

FBA makes the purchasing experience completely undifferentiated for the customers. A seller could be located one hop away from the customer or 10,000 miles away, FBA arbitrages out the geographical proximity or distance between sellers and customers.

All of these resulted in sellers competing aggressively on price, bringing down the overall prices in the marketplace, aka getting commoditized. This created large fresh demand for the 3P sellers' products, and Amazon captured a large chunk of the value through seller and FBA fees.

Forbes estimates a topline of $ 90-100 Billion for Amazon from seller and FBA fees in 2020. This is almost twice the size of AWS, which is the poster boy of Amazon's growth story. All driven by Amazon's moves to commoditize the sellers to drive up demand.

That’s all ! I hope you liked this essay on how Amazon used the strategic principle of commoditizing the complement to its advantage.

I will now see you in the next issue. Here’s what’s upcoming at The Hypothesis:

• The biggest social network you haven't heard about

• The most profitable media company in Europe

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Stay safe.

Rohit