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CHAPTER II - Fragmentation and Concentration

To help consider where technology is likely to encourage greater concentration of economic activity and where it is likely to promote fragmentation, it can be useful to look at what essential roles are typically carried out by business enterprises. According to Deloitte’s John Hagel, most companies engage in three different types of activities, which he described as “an unnatural bundle of functions”:

  • First, almost all businesses are responsible for “infrastructure management”—the operations that are involved with manufacturing and logistics, including the task of managing a supply chain that runs from acquiring inputs to distributing finished goods (or services) to customers. These activities may be routine, but they are often high value: for many companies, the ability to manufacture and distribute high quality products efficiently represents an important competitive advantage over rivals.
  • The second basic function is product innovation and commercialization, which encompasses product development and marketing. Typically, this function puts a premium on creativity and, at least in theory, is critical for the ability of companies to respond to the needs of the market.
  • Finally, companies need to manage customer relationships by providing them with such things as product support or even advice that can make them better consumers (and more loyal customers). This category also includes getting input that can be important in tracking customer satisfaction and identifying opportunities for new product offerings.

In reality, the economics, the skills and the cultures required to be successful in each of these types of business activities are quite different, and keeping them all in one organization virtually requires that each is sub-optimized. At the same time, the pressure of competition puts a premium on performing all of these functions as well as possible: if quality is compromised in any one of these areas, the marketplace consequences can be severe.

Infrastructure Management. Of the three categories, the first has already seen the most change. The stripping out of infrastructure management through the process of outsourcing is a familiar story that has been unfolding for decades. The outsourcing of manufacturing has led to the transfer of millions of jobs from higher wage locations to lower wage areas. Other infrastructure tasks, such as the physical transportation of goods, has long been outsourced: while many companies maintain a fleet of trucks, few if any operate their own railroad or airline. And very few firms mine the raw materials that go into their products.

Since infrastructure management can benefit from powerful economies of scale, there are strong forces at work that encourage concentration. Consider Foxconn, the Taiwan-based company that is responsible for manufacturing approximately 40 percent of all consumer electronics products in the world. The company has grown entirely by providing high quality, low cost manufacturing; it makes no products under its own brand. Foxconn has some 1.3 million employees, which makes it one of the five largest private employers in the world. Its largest factory complex, located in Shenzhen, China (known as “Foxconn City”), consists of 13 factories that cover more than a square mile of land and employ several hundred thousand workers, many of whom live in on-site dormitories operated by the company. Foxconn also operates large factories in other low-wage countries including India, Malaysia, Brazil and Mexico.

On the other hand, new technologies such as 3D printing could disrupt the tendency toward concentration in manufacturing. In the future, what gets transported may not be manufactured products but rather the algorithms that direct a 3D printer to create a particular product. The example that is often cited to illustrate this change is the case of an airliner somewhere on earth that needs a replacement part. Rather than having to wait for that part to be shipped from a warehouse that maintains an inventory of parts, the instructions are sent electronically to a remote printer that creates a new part just when and where it is needed. While there may indeed be future cases like this, it is likely that the economies of scale provided by large scale manufacturing will continue to prevail for many mass market products.

Product Innovation. By contrast, fragmentation is more likely to occur in product innovation/commercialization, which is driven by the “economies of skill.” Large organizations tend to foster bureaucratic structures where rules and prescribed procedures proliferate. Among the policies that work against innovation in the corporate world are agreements that assign all ownership rights to inventions and ideas developed in the course of workers’ employment to their employers. In an op-ed in The New York Times, University of San Diego School of Law professor Orly Lobel explained that the scope of “this ownership runs deeper than inventions and artistic works, extending to skills, ideas and professional ties—tacit knowledge and social relations that cannot be subject to patent or copyright…that corporations lay claim to at increasing rates.” To explore the impact of these restrictive agreements, Lobel and a colleague ran a series of behavioral experiments in which participants were asked to solve various problems. Subjects who were told that they were “free to perform similar work for other ‘employers’ in the virtual workplace” of the experiment spent more time working on the assigned problems and made half as many errors than a second group who were asked to relinquish any ownership of work done in the experiment.

Since creative people often prefer to work independently or in smaller, more flexible work environments, many large companies have sought to collaborate with smaller, more entrepreneurial firms, either by forming partnerships or through acquisitions. A growing number of large companies have recognized the limits of their ability to innovate on their own and have made use of open competitions to solicit innovative ideas from anyone who wishes to contribute. For example, InnoCentive, which enables companies to post problems and offer rewards for the best solutions, has attracted more than 250,000 “solvers” who have submitted more than 30,000 solutions to more than 1,400 challenges since 2001, earning more than $9 million in rewards. Interestingly, the majority of winning solutions came from people who had not previously won any previous awards and who often lacked the kinds of credentials or experience that “experts” in the various fields would be expected to have.

Customer Relationship Management. The third category is the one that most companies consider their core competency. But in reality, there are relatively few companies that are strong in this category. An example of a business that depends on strong customer relationships is a financial service provided by a personal financial advisor who has the ability to make investment advice based on knowledge of individual customer’s circumstances and goals. Currently, such a service is available only to the affluent, but technology is making it possible to expand this type of service to a larger mass market. Netflix, which knows a lot about its subscribers’ viewing preferences and uses that knowledge to suggest other content that customers will like, is also in the customer relationship business, as are tech companies like Google and Facebook that have the ability to regularly collect large amounts of data on user behavior and utilize it to improve their products. And, as USC’s John Taplin pointed out, Netflix and Google have begun to move into content creation, where margins tend to be higher, based on their deep knowledge of customer preferences. (By contrast, many traditional content producers may find themselves at a disadvantage in competing with these new players, because they do not have millions of customers regularly telling them what they like and are interested in.)

The dynamics of concentration and fragmentation will also be shaped by the particular nature of various sectors. Industries like financial services, travel and health care, where customers are routinely required to make choices among multiple completing products, are particularly suited to the expansion of customer services business. In health care, for instance, people may begin with questions about insurance, but they also have questions about wellness and the impact that their lifestyle choices have on their health. Because of the importance of health decisions, people are likely to seek advisors whom they can trust. Traditionally, this has been the exclusive role of doctors, but new players are entering the field, including peer-to-peer networks that allow patients to exchange information about shared medical problems. In the travel industry, the proliferation of options has given rise to specialized services like Expedia, Travelocity and TripAdvisor, which make it convenient to get access to a variety of choices, including information on price and ratings from other travelers, in order to make a reasonably informed choice.

Another type of company that excels in customer relationship management is Li & Fung, a Hong Kong-based company that acts as a broker linking apparel designers and retailers with a network of more than 15,000 manufacturers, many relatively small, located around the world. Li & Fung does not make anything itself, nor is it involved with designing goods; its strength is based on its ability to know its customers well and ensure that their most critical needs—in terms of cost, quality and speed—are met reliably.

A very different type of company, Apple does not manufacture its own products, but it has succeeded by excelling in both designing innovative products and in managing customer relationships. Its commitment to innovation has enabled the company to move from its initial focus on building personal computers to creating music players, smartphones, and tablets, each of which fundamentally restructured these product categories. And the company has recognized that the value of all of its products is determined by the entire customer experience with those products, ranging from an initial purchase decision through on-going product support. Whether Apple can continue to base its success on continuous product innovation even as it grows larger remains an open question.

While Hagel’s first function, infrastructure management, can take advantage of economies of scale, this third category is largely driven by economies of scope, based on the advantages that accrue to companies that are able to amass large amounts of information about customers and markets. Both of these functions are likely to experience greater concentration, driven by economies of scale and scope, while product innovation is more likely to see greater fragmentation.

Relationships, Innovation and Health. Bob Brook, Distinguished Chair of Healthcare Services at the RAND Corporation, pointed out how a focus in the health care field on building customer relationships at the expense of other functions has led to less than optimal results from a social point of view. For example, he pointed out that hospitals that provide great customer service have been successful in attracting patients to facilities that are expensive and provide poor quality service otherwise. (One of the weaknesses of the health care system in the U.S. is that it does not provide access to reliable information about the quality of care offered by different providers, although efforts are underway to increase the amount of useful health data available to consumers.) Other parts of the healthcare system suffer from similar distortions: Large pharmaceutical companies have made a lot of money by convincing doctors to prescribe their products rather than less expensive but equally effective generics. Rather than innovating, these companies have based their strategies on building strong relationships with their customers. Perhaps the most important question we should be asking, at least in the area of health, is what system is best designed to deliver not just profits but real value to customers. As long as businesses are driven by short-term profitability, we are not likely to maximize social value. In the case of health care, some 40 percent of the services delivered do not actually improve our health.

Differentiating Dynamics. Irving Wladawsky-Berger noted that economies of scale and scope are relatively straightforward factors and are directly linked to the size and reach of an organization. Economies of scale involve performing routine tasks, including the ability to produce large numbers of standardized products, efficiently and predictably, while economies of scope are the result of amassing a depth of experience in a market, which makes it possible to understand customer preferences or have expertise in regulatory processes. Even though these latter capabilities are not easily automated, they benefit from the size of a company.

Thomas Malone proposed a different three-part framework to describe the core functions of an enterprise—Design, Make, Sell—which are parallel to but not identical to John Hagel’s three categories of business activities. Malone suggested that all three types of activity may be subject to both concentration and fragmentation, and that in each category we could see a concentration in underlying infrastructure and fragmentation in the delivery of products or services. For example, an engineer may be creative but still may need a large infrastructure to support his activities. High-quality customer relationships may be dependent on big data sets, but may be delivered by an independent agent who is provided access to the data he or she needs. In fact, we may see the emergence of concentrated infrastructure and fragmented delivery of services in all three categories. We have already seen how the widespread availability and relatively low cost of virtually unlimited computer power in the cloud (typically supported by very large data centers that definitely benefit from economies of scale) has led to a proliferation of small companies that are able to leverage this highly concentrated resource.

Finally, crowdsourcing may be emerging as an extreme version of fragmentation. At one time, it seemed as if there would be a role for personal curators for the content on the Net (Yahoo began by performing this function), but crowdsourcing through platforms such as Twitter have proved to be more effective, allowing each individual to select the guides he or she finds most useful. And as noted above, online peer-to-peer networks have become trusted sources of information about medical issues and treatment alternatives. These sites have also become valuable sources of information that can be used in research. In an example of collaboration between large and small entities, Genentech announced in April 2014 that it was forming a five-year partnership with PatientsLikeMe that will give Genentech access to data provided by the site’s participants. Genentech announced that it would “use PatientsLikeMe’s network to both inform patients about clinical trials and iterate clinical trial design with patient input.” And Wikispeed, the venture founded by Joe Justice, is exploring whether it is possible to use crowdsourcing to design and build a high performance automobile.

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