Although Columbia Business School often gets pigeonholed as a finance school, it’s really a top-notch program to learn about strategy. My professors in various subjects – from marketing to tech investing – have pushed my classmates and me to think deeply about competitive advantage. Indeed, this semester I am taking a course called Economics of Strategic Behavior, which provides a focused approach to business strategy and demystifies competitive advantage.
Every business school student is introduced to Michael Porter’s five forces, the most prevalent framework to analyze the structure of an industry. These forces are: 1) barriers to entry, 2) existing industry rivalry, 3) threat of substitutes, 4) bargaining power of suppliers, and 5) bargaining power of buyers.
What I like about my “Economics of Strategic Behavior” class is that it builds on Porter’s framework by prioritizing the five forces. My professors opine that barrier to entry is, by far, the most important force when analyzing the competitive dynamics of an industry. Competitive advantage therefore stems from the ability of companies to create moats around their industry in such a way that they deter potential entrants from capturing any value. The outcome is an out-sized return on capital for long periods of time.
Competitive advantage can be derived from unique capabilities or unique positioning. It’s the latter, however, that provides a more durable and sustainable advantage. These positional advantages can be distilled as:
- Demand advantages in the form of customer captivity and network effects
- Supply advantages in the form of patents and unique technologies
- Economies of scale when high fixed costs are spread out to generate low avg. costs
- Information or regulatory advantages
When an industry incumbent has a pronounced advantage, it’s incredibly difficult for an entrant to gain traction or turn a profit.
During this week’s class, we analyzed eHarmony, the leading online dating site to find Mr. or Mrs. Right. Although the eHarmony case was written in 2008, the company still maintains a leadership position in the relationship-seeking segment, which speaks volumes of its competitive advantage: in fact, about 2% of marriages in the US are due to eHarmony!
As an online marketplace, eHarmony developed a demand advantage that stemmed from targeting, attracting and maintaining a quality pool of singles seeking a serious relationship. One of the toughest things about online marketplaces is that they are devilishly difficult to initialize because of the proverbial chicken-and-egg problem: when there is nobody on the other side of the platform, then there is no real value proposition for an initial user.
To get over this hump, a founder’s credentials, experience and networks can served as the spark of trust essential to seed an online marketplace. As a practicing psychologist, eHarmony’s founder, Dr. Neil Warren, had developed a reputation as an expert after writing several books on the subject of love and marriage, making numerous speeches at conferences, and appearing on national TV and radio programs. By tapping into the psyche of conservative and faith-based communities, eHarmony was able to get over 100,000 quality registrations in just a matter of weeks.
With initial liquidity in the marketplace, eHarmony managed to build several levers that effectively captured customers. Leveraging Dr. Warren’s credibility, eHarmony built a matching algorithm for prospective customers. At the time, no other online dating site provided anything remotely close to effectively match highly compatible people. The algorithm served as a powerful hook to incent users to fill out the 250 question Relationship Questionnaire.
The Relationship Questionnaire was instrumental on two fronts: first, it generated an important filter that weeded out casual daters, thus ensuring the quality of the marketplace by increasing the signal-to-noise ratio; second, the significant upfront investment – in time and effort – to complete the questionnaire lowered the relative cost of the subscription. After users’ personality profiles were fed to the algorithm, users could see but not communicate with their matches – an incredibly effective teaser for non-paying members to purchase a subscription. As a result, eHarmony’s conversion ratio was 3x higher than that of its competitors.
To sustain its customer captivity, eHarmony imposed several measures of control that initially seemed counterintuitive to me. First, eHarmony rejected the membership request of roughly 20% of users who were willing to pay. This additional filter ensured that the quality of paid users was very high, enhancing the value proposition for existing and potential members looking for a serious relationship. Second, unlike other online dating sites, eHarmony deliberately limited the number of matches available to its customers.
Given eHarmony’s target customer, it actually made sense to artificially restrict the set of choices because it reduced the level of competition among users, implicitly increasing their expected payoff. Limiting the number of matches also created an illusion of scarcity. This illusion induced users to pay up since they were not-so-subtly reminded that there were only a couple of fish left in the sea. More powerfully, by controlling and limiting the number of matches, eHarmony mitigated user skewness, the phenomenon in which a few of the “hottest” members command a disproportionate interest and hits throughout the platform. Many dating sites suffer from this, which would often lead to way too many men trying to connect with only a couple of women, consequently producing a poor user experience on both sides. Nearly 60% of eHarmony’s members were women, though, indicating that its user base was well balanced and of high quality.
As eHarmony gained greater control over the serious relationship-seeking customer segment, the company exerted positive network effects. Both sides of the marketplace – men and women – benefited from each additional high quality member of the opposite sex. This virtuous cycle is inherently defensible and difficult to break for competitors looking to gain market share. While eHarmony’s network effects were a function of its high quality and expensive-to-acquire membership base, the network effects also enhanced and reinforced its customer captivity. Accordingly, eHarmony charged a 10% premium relative to Chemistry, its closest competitor.
Strategically, one of the most important decisions eHarmony made was to choose the right niche within the online dating industry. After targeting this niche, eHarmony tailored its product and services in such a way that it efficiently captured the hearts and minds of those souls looking to find “true love.” Online marketplaces are hard to build, but if done right, they can become incredibly successful businesses given their network effects-based competitive advantage.