Google's cash machine: How sustainable is it really?

Barriers to entry have typically been used by traditional offline players to deter entry into an industry. This has the effect of creating a business environment where healthy profits and sometimes even monopolistic (economic) profits are possible. In the online space, there are few of these barriers to entry, but there is something else that often works just as well called network externalities, or network effects.

Network effects occur around a platform and there are two significant types — same-side and cross-side. Network effects can also be positive or negative. Platforms can be further analysed in terms of having a “money” side and a “subsidy” side. For example, in Google’s case, the subsidy side comprises the people who perform the searches and the money side is the merchants that buy the paid placements from Google. A user doesn’t pay to perform searches on Google, but that doesn’t mean that there are no costs associated with it — in effect, the merchants subsidise the users that perform the searches.

Same-side network effects increase the value of the goods/service as more people join the same side of the platform, whereas cross-side network effects increase the value of the goods/service as more people join on the other side of the platform (and vice versa for either if the network effect is negative).

Continuing with the analysis of the impact that network effects have on Google’s business model, we find that Google has:

Weak positive same-side network effects on the subsidy side — you using Google does not make its search service much more valuable to your friends, except that your word-of-mouth references will urge them to consider it in the absence of a better alternative.

Strong negative same-side network effects on the money side — as more merchants have joined the Adwords programme, they have found that the click-through history of the incumbents has made it more difficult to unseat the incumbents from prime position, unless the entrants are prepared to suffer initial losses. This discourages new merchants from entering the Adwords programme in competitive areas (financial services, travel and so forth), or at least restricts them to small budgets and low positions on the SERP.

Very strong positive cross-side network effects from the subsidy to the money side — as the number of users and searches performed on Google has increased dramatically, so too has the number of merchants that are keen to buy Adwords inventory from Google to enable them to reach those potential customers.

What we really want to get to the bottom of is: How do these networks effects affect Google’s earnings capabilities or sustainability? Does it have any weaknesses brought on by network effects?

At the heart of Google’s cash machine is a combination of the scarcity of Adwords inventory (which can only grow at the rate of growth in new searches) and the very strong positive cross-side network effects, which pushes up the cost of Adwords inventory. The positive cross-side network effects are very strong, because Google’s users are buyers on a scale that exists nowhere else on the web. Why are they buyers? Because of the relevance of the search results.

Google’s most fundamental weakness is that it hasn’t created strong network effects on the subsidy side or significant traditional barriers to entry in search, and so its very existence as the premier search player hinges almost entirely on the relevance of its search results, compared with those of its competitors. If another start-up comes along that provides a better search experience, offers more relevant results and generates grassroots buzz, Google has only its brand and past success to protect itself. And in our current disruptive innovation business paradigm, that’s not much protection.

Google may be the proverbial 800-pound gorilla now, but if it’s not first to realise that incremental innovation around the way that we search today will not do for the way that we will want to search in the future, then it will be brought to its knees by a disruptive upstart faster than you can say Netscape, Yahoo! or Microsoft.

Based on a previous post by the author at corpv2.com