Will zero friction ecosystems destroy value?

Interesting article in Knowledge@Wharton (hat tip Adriana Lukas) on the negative impact of reducing friction in value chains. They took 2 fairly well established strategic tools....:

One theory (Porter's 5 forces) focuses exclusively on industry forces, looking at a firm's surrounding environment to determine how well a business can compete. Known as "industry analysis," the framework's "five forces" of the market -- rivalry, barriers to entry, the existence of substitute products, buyer power and supplier power -- have formed the hub of classic business strategy research since Michael E. Porter of Harvard Business School introduced them in 1979.

The other theory (the "Excellence" theory) concentrates on the company itself, making the assumption that markets work efficiently, and that stronger firms are simply better in some way than others. Known as "firm-level analysis" or the "resource-based view," this analytical framework assumes that a business is successful because it possesses some type of competitive advantage -- a patent, a unique way of doing business, a rare knowledge or talent, a special product -- that other companies in the industry lack.

.....and mashed them together in a simulation model, and then added a bit of game theory:

To mathematically link the two levels of analysis, Chatain and Zemsky set a value for what they call "frictions." The word describes any forces that make it difficult for buyers and sellers to connect. For example, a poor location could be a source of friction for a retailer, because customers will have to go out of their way to visit the store. A poorly designed web site could create friction for an online business if potential customers are unable to find what they are looking for easily.

By Frictions, they mean:

Some industries naturally have higher frictions than others. The consumer market for gasoline, for example, has very little friction: The price and type of gasoline is clearly posted, and gas stations are located at nearly every major intersection, so customers don't have to research locations of gas stations ahead of time to figure out where to go. The market for a good plumber, on the other hand, has a very high level of friction. The service is highly personal, it's difficult to compare prices because the cost of each service varies from job to job, and there isn't a single marketplace where plumbers and customers can meet.

...or in old money, Transaction Costs. Anyway, its all in their paper, over here

But what is really interesting* is the outcome of this work, ie that too little friction destroys value as effectively as too much:

.....the researchers discovered an inverted U-shaped curve: A company's profits would suffer whenever frictions in the market were extremely high or low, but at moderate levels, a company's profits could increase. So there is an optimal level of friction in the marketplace, the researchers concluded. "Even if you're the best firm around, you still want some friction, and this is somewhat counterintuitive," Chatain says. "When you reduce friction, one would usually think it must be good for the strong firm. But it's not always the case. We found that stronger firms want to have less friction than weaker firms, but they don't want to [entirely] eliminate frictions."

That's because the less friction there is, the more firms have to compete directly with each other -- in industry-level parlance, rivalry increases. To win customers, the strong firm will have to cut prices. Eventually price-cutting shaves profit margins to the point that winning over new customers isn't worth it. Having a small amount of friction in the industry allows a company to keep prices at an optimal level.

And the online world is the best friction reducing agent known to man. Implications are fairly "interesting":

- The more your industry can go online, the lower the overall margins
- The lower the margins, the more it resolves to players who have massive scale and/or those operating at subsistence costs (did someone say User Generated Content)
- In a global market, those with the least friction lose - anyone with true "free trade" will be hollowed out by those with a few barriers.

This has some implications on 'Net policy for countries, as it is clear that being a bit more frictitious than your trading partners may help - and it looks like we may have to build the Internet with a bit of friction included, if it is actually going to create rather than continually destroy value. One to watch.....

*If I may - much of this is not that new, I recall reading (and doing) work much like this 15 years ago. We knew transaction costs close to zero would be majorly disruptive, its what the whole underlying premise of the dotcom bubble era was about! But 15 years later, this serves as a timely reminder that a zero transaction cost economy may not be an entirely good thing.