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June 10, 2003

In Search of the Perfect Business Model: Increasing Marginal Utility

"We're in this love together,
And like berries on the vine,
It gets sweeter all the time"
     -Al Jarreau, We're In This Love Together

As companies continue to slog through this muddy economy, many executives are looking deeper into customer metrics in an attempt to uncover some little nugget that might give them a competitive edge in the marketplace. Marketing managers are digging through piles of customer data, evaluating every little thing from the cost of customer acquisition to customer churn, share of wallet and frequency of customer engagement.

In thinking through metrics just like these, one might wonder, "What metric would highlight the ultimate in terms of sustainable competitive advantage?" It would need to be something that encompassed (1) a clear advantage relative to competition, and (2) something that increased the lead over time. In other words, the competitive advantage would constantly be improving. What if a company could generate a higher level of satisfaction with each incremental usage? What if a customer were more endeared to a vendor with each and every engagement? What if a company were always more likely to grab a customer's marginal consumption as the value continued to increase with each incremental purchase?

This may be the nirvana of capitalism – increased marginal customer utility. Imagine the customer finding more value with each incremental use. Some may suggest that this concept already exists in the form of volume discounts. However, this offers a vendor no real competitive advantage, as all of its competitors are likely to offer the same discount to large purchasers. Others may feel this is just a buffed-up version of "high switching costs." On the contrary, increased marginal customer utility preempts the need to impose switching costs, which can be seen as "trapping" or "tricking" the customer. Instead, the customer who abandons increasing marginal customer utility would experience "switching loss."

This is arguably the advantage that Amazon has compared to many of its online rivals. Customers that have signed up for "one-click" ordering experience a dramatic increase in convenience during the checkout process vis-à-vis a new retailer. More interestingly, Amazon attempts to learn about you with each and every purchase, as well as with each and every browsing episode. As such, the company can offer you suggestions that a new retailer could never anticipate.

An even more powerful example exists at another web powerhouse, eBay. Frequent eBay shoppers may have noticed how fanatical eBay sellers are regarding their online eBay reputations. Less than five seconds after winning an auction, you may find yourself under assault (email assault that is) from the eBay seller requesting that you immediately leave "positive feedback" about the experience. Why do these vendors care so much? Because they believe that the vendor with the best reputation will close more transactions and likely receive higher prices for their auctions. In other words, these sellers are experiencing increasing marginal utility as they incrementally engage with eBay.

Sometimes a negative example does as much to explain an idea as a positive example. U.S. cellular carriers appear to have boxed themselves into a corner, whereby customers receive increased marginal utility if they switch vendors, as opposed to remaining loyal to their current service provider (decreasing marginal utility). In an effort to acquire new customers, carriers have made it a common practice to subsidize the costs of a new phone. This strategy works well, as many new cell phone customers are quite interested in owning the latest and greatest piece of hardware. The problem is, however, that when a current customer wants a new phone, the carrier quotes a full price (minus the subsidy – after all, the customer is already acquired). Therefore, the cheapest way to obtain a new phone is to be disloyal and switch carriers.

Two other companies in which Benchmark Capital has invested are also attempting to create increasing marginal customer advantage. As the leading provider of "network neutral data centers," Equinix encouraged carriers and ISPs to build facilities within their data centers to offer bandwidth. The more connections Equinix brought in, the more carriers wanted to be in the data center to peer with one another. The more carriers that you could peer with transit-free, the more content providers wanted to be there as well. Ironically, many of these providers can completely eliminate certain bandwidth charges by bypassing the Internet and directly connecting (via wire connections in the ceiling of the data center) to other content providers who are their business partners. As more and more carriers and content providers host here, the value to each new customer increases.

OpenTable, which might be best understood as the Expedia for restaurants, recently implemented a program known as OpenTable VIP. For its most active consumer customers, OpenTable alerts its 1,500 restaurant partners that a particular customer is an "OpenTable VIP." As these restaurants understand that these customers are high-frequency (and likely high-margin) diners, they typically make a special effort to impress these customers. As these customers enjoy being impressed, they are then encouraged to book through OpenTable in the future which will lead them to be treated well again and again, --increasing marginal utility.

The Internet appears to be a fertile ground for programs that offer increasing marginal utility. As most Internet businesses revolve around the creation of a network, the utility of the marginal customer may be influenced by the size and scope of the customer base itself. Also, the ability to aggregate a tremendous amount of customer data increases the likelihood that one could satisfy customers in some type of increasing fashion. Lastly, as the Internet matures, and companies become more reliant on revenue from current customers, we will likely see a rise in attempts to lock-in customer loyalty. Just recently, USA Interactive, Barry Diller's Internet conglomerate, announced plans for a cross-property membership rewards program. This concept should not be limited to the Internet. All companies would serve themselves well to uncover some form of increasing marginal customer utility. Make them love you more and more each day.

Posted by Bill Gurley on June 10, 2003 at 08:00 AM | Permalink | Comments (0) | TrackBack

DISCLOSURE: The information contained Above the Crowd has been obtained from sources believed to be reliable but is not necessarily complete, and its accuracy cannot be guaranteed. Any opinions expressed herein are subject to change without notice. The author is a general partner of Benchmark Capital, a venture capital firm in Menlo Park, Calif. Benchmark Capital and its affiliated companies and/or individuals may have economic interests in the companies discussed herein. © J. William Gurley 2005-2006. All rights reserved.