No Margin for Error

Economists may be the dismal scientists, but at least they got one thing right: the nearer a market gets to a state of perfect competition, the less profit companies make. That simple little law explains why so much commerce has moved onto the Internet so quickly. And it also explains why so many dot-coms are doomed.

The Internet pushes markets closer to "perfection" than was ever possible before. By enabling unlimited numbers of buyers and sellers to easily transact business, and by giving them immediate access to endless information about products and prices, it dissolves the inefficiency – the friction – inherent in traditional marketplaces. Since profits, as the economists will tell you, are themselves products of inefficiency, the Internet also acts like a vice on the margins of on-line suppliers.

That’s great if you’re buying something. Whether you’re General Motors looking to pick up a few miles of radiator hose or Joe Blow out to score a copy of Quake III, you’re probably going to get a dirt-cheap price on the Web – and you’re definitely going to slash your transaction costs. But for the sellers, things aren’t so pretty. Unless they’ve got a patent, or some other artificial shield against perfect competition, they’re going to have to learn to survive on little or no margin. For a lot of them, frictionless commerce is going to be profitless commerce.

Take a look at CDNow, which since its founding back in 1994 has been one of the Web’s most popular e-tail establishments. Among on-line businesses, CDNow is a class act. It has a clean and inviting site, a great selection, and it almost never screws up an order. As business professor Donna Hoffman describes in "How to Acquire Customers on the Web" in the May/June issue of the Harvard Business Review, the company’s strategy for attracting buyers has also been impeccable. It was one of the first to use banner ads, and it was one of the first to realize their limitations. It pioneered affiliate marketing with its Cosmic Credit program, and it now uses a carefully balanced mix of different marketing channels to acquire as many customers as possible as cheaply as possible.

That strategy has worked like a dream. On March 30, Media Metrix reported that during February, normally a slow shopping month, CDNow attracted a record 5.7 million visitors, making it the fifth biggest shopping site. Even more impressive, it processed over a million transactions during the month, more than any other e-tailer, including Amazon.

News like that should have sent champagne corks popping all over CDNow’s headquarters in Fort Washington, Pennsylvania. But, of course, it didn’t. Because just the day before, the company’s auditors had announced that CDNow might not have enough cash to last the rest of the year. Bean counters don’t like to make those kind of announcements about their clients. When they do, you can bet it’s serious.

As a music retailer on the Internet, CDNow has made all the right moves. But it still hasn’t been able to sell products at a high enough price to cover its expenses. Even a great company with a great brand is no match for a perfect market.

The well-publicized travails of CDNow, as well as MotherNature.com, Value America, and many other e-tailers, have dampened the enthusiasm for business-to-consumer Web commerce that raged uncontrollably just a year or two ago. But consumer goods aren’t the only ones subject to old economic laws. The same inexorable logic will play out in business-to-business markets as well.

Seller beware.

Copyright 2000 by Nicholas G. Carr. All rights reserved. Originally published 5/8/00.

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