Business Model Innovation in the Digital Economy

INTRODUCTION

Most Internet ventures failed because they did not have viable business models and sustainable long-term strategies. Their business models failed to satisfy the two fundamental questions associated with the characteristics of the Digital Economy (Lee & Vonortas, 2004):
• Does your organization’s business model follow the fundamental economic principles of the Digital Economy? That is, what is the underlying economic logic that explains how your organization can deliver value to customers at an appropriate cost?
• Does your organization’s business model capitalize on the “disruptive attributes” of the Digital Economy? That is, how can you organization capture the full benefits of the Internet innovation?
These two fundamental questions lead business executives to consider several strategic questions regarding the implementation of an innovative business model in the Digital Economy.
• What are the functions and components of a viable business model in the Digital Economy?
• What are the disruptive attributes of the Internet innovation and how does an organization capitalize on them for competitive advantage and profits?
• What are the differences between the traditional organizational transformation process and the value creation process in the Digital Economy?
• How do transaction costs and network effects in the Internet economy change a company’s competitive position?
• How do the cost and revenue structures in the Digital Economy differ from in the traditional industrial economy?

BACKGROUND

A business model is the method of doing business by which a company can generate revenue to sustain itself (Rappa, 2003; Turban, King, Lee & Viehland, 2004). It describes the basic framework of a business. It also tells what market segment is being served (who), the service that is being provided (what), the means by which the service is produced (how) (Chaudhury & Kuilboer, 2002), and how it plans to make money long term using the Internet (Afuah & Tucci, 2003, p. 51).
A firm’s business model should also spell out how the company is positioned in the value chain or within the business ecosystem. Weill and Vitale (2001) define an ebusiness model as a description of the roles and relationships among a firm’s consumers, customers, allies, and suppliers that identifies the major flows of product, information, and money, and the major benefits to participants. Timmers (1998) defines business model as an architecture for the product, service, and information flows, including: a description of the various business actors and their roles, a description of the potential benefits for the various business actors, and a description of the sources of revenues.
A business model consists of multiple components and performs different functions. A “new economy” business model requires four choices on the part of senior management, argued by Rayport and Jaworski (2001). These include the specification of a value proposition or a value cluster for targeted customers; a scope of marketspace offering, which could be a product, service, information, or all three; a unique, defendable resource system, that is, the associated resource system to deliver the benefits; and a financial model, which includes a firm’s revenue models, shareholder value models, and future growth models. In a similar effort, Chesbrough and Rosenbloom (2002) identify the functions of a business model as: 1) to articulate the value proposition; 2) to identify a market segment; 3) to define the structure of the firm’s value chain; 4) to specify the revenue generation mechanisms(s) for the firm; 5) to describe the position of the firm within the value network; and 6) to formulate the competitive strategy to gain advantage over rivals. Other efforts to bring together the various lines of thought and to establish a common denominator for the business model discussion include Alt and Zimmermann (2001) and Dubosson-Torbay, Osterwalder, and Pigneur (2002).
Rappa (2003) identifies nine basic Internet business models: brokerage, advertising, infomediary (e.g., recommender system, registration model), merchant, manufacturer (direct marketing), affiliate (provide commission for online referrals), community (voluntary contributor model or knowledge networks), subscription, and utility (e.g., pay by the byte). In addition, Turban et al. (2004) also identify several types of Internet business models, including name your price, find the best price, dynamic brokering, affiliate marketing, group purchasing, electronic tendering systems, online auctions, customization and personalization, electronic marketplaces and exchanges, supply chain improvers, and collaborative commerce.
In order to sustain a successful business venture, a viable business model should address a number of issues and the dynamics of the respective elements which include: what value to offer customers (strategic goals and value proposition); which customers to provide the value to (scope of offerings); how to price the value (pricing); how much and who to charge for it (revenue models); quantity of resources required and the associated costs to provide the value; what strategies, structures, and processes need implementing to offer value; and the legal issues that may influence the general vision of the business model (Alt & Zimmermann, 2001). In addition, in order to prosper in e-commerce, a firm’s Internet business model must capitalize on the “disruptive” attributes and characteristics of the Internet or Digital Economy to enable it to offer innovative solutions and value to customers.

BUSINESS MODEL INNOVATION

Although the changes made possible by the Internet are strategic and fundamental (Ghosh, 1998), the underlying technologies are not radically different from the existing technologies that support business operations. Computing and communication technologies, which are the technological foundations for the Internet, have both been improved incrementally over the past few decades. Bower and Christensen (1995) argue that the technological changes that damage established companies are usually not radically new or difficult from a technological point of view. However, the Internet is considered a disruptive innovation to many businesses. It is disruptive to the traditional way of doing business in that it is transforming the rules of competition and inventing new value propositions and business models. The successful implementation of a viable business model in the Digital Economy requires a paradigm shift. In moving toward e-commerce as an enabler, a business executive must be able to identify the disruptive nature of the innovation and then capture the benefits. Table 1 lists several disruptive attributes of the Internet and e-commerce identified by Lee (2001). Organizations in the Digital Economy must understand and capitalize on the disruptive attributes of the Internet and e-commerce to transform their business models for success.
Business model innovation in the Digital Economy is the use of new knowledge (both technological and market) that capitalizes on the disruptive attributes of the Internet to design and implement an innovative way of offering products or services that customers want. Examples of successful business model innovations that were able to capitalize on some of the disruptive attributes of the Internet include channel innovation (e.g., Dell’s build-to-order virtual integration model), process innovation (e.g., Boeing virtual design and e-procurement PART page), customer experience innovation (e.g., Schwab), auction and reverse auction model (e.g., eBay and Priceline), online virtual community (e.g., iVillage), customer-relationship (e.g., Yahoo!), and affiliate network (e.g., Amazon).

VALUE CREATION IN THE DIGITAL ECONOMY

In a competitive market environment, businesses exist to create value for their customers. To understand how a business creates value, a simple “input-transformation-output” model can be utilized to describe the process of value creation. In the Industrial Economy, inputs to a value creation process are raw materials or all of the necessary physical inputs that are required to produce the finished products or services. Outputs are finished products or intermediate goods used as inputs to another transformation or value creation process. Information, such as design and engineering know-how as well as production methods and procedures, is applied to facilitate the “physical” transformation process, which involves one or more of the four value-adding activities: alter, transport, inspect, and store (Meredith & Schaffer, 1999). Management’s focus is to make the transformation process more efficient by implementing techniques such as lean manufacturing, total quality management, and business process re-engineering. In contrast, input to the value creation process in the Digital Economy is information (e.g., customer profiles and preferences, i.e., the digital assets, as well as production and distribution status) that firms gather, organize, select, synthesize, and distribute (Rayport & Sviokla, 1995) in the transformation process to provide individual customers a bundle of customized solutions. In the Digital Economy, information is a source of value, and every business is an information business (Earl, 1999). Since physical and digital economies co-exist within a firm or supply chain, management should go beyond concentrating on improving the transformation process itself, to focus on leveraging information assets and capitalize on the disruptive features of the Internet and e-business to create more value for the customers. Table 2 compares the transformation processes, and Table 3 presents organizational goals and value creation strategies to assist business executives in designing and implementing a viable business model in the Digital Economy.

Table 1. Summary of disruptive attributes of the Internet and e-commerce

Open Platform. Internet provides an open and nonproprietary platform for communication and collaboration. The open source movement in software development (e.g., Raymond, 1999) has contributed to Internet-enabled collaboration and free information sharing.
Network Effects. Network effects exist in the industrial economy (e.g., regular telephone service) but are much stronger in the Digital Economy. For knowledge-intensive products, such as software operating systems, characterized by high upfront costs, network effects, and customer groove-in (Arthur, 1996), achieving a critical mass of installed customer base is vital for success.
Connectivity and Interactivity. E-commerce enables close connections with customers and among supply chain or business ecosystem partners’ information systems. The benefits include real-time pricing, flexible products and services versioning, gathering customer information, and a very low cost for the distribution of information goods.
Information Sharing and Exchange. In the Digital Economy, the traditional trade-off between richness and reach in information exchange no longer exists (Evans & Wurster, 1997). Information can reach many customers or business ecosystem partners through the Internet without sacrificing the richness of the contents.
Prosumption. Prosumption (Tapscott, 1996) is the term to describe the convergence of design with development process, and the production of goods and services by customers in the e-commerce environment. Internet-enabled collaborations can reduce both concept-to-design and design-to-production cycle times.
Digital Assets. Digital assets are information about customers (e.g., purchasing patterns and profiles). A firm that exploits the Internet should build and utilize its digital assets in order to provide customer value across many different and disparate markets. In the Digital Economy, information is a source of revenue, and every business is an information business (Earl, 1999). A firm should use information to create new businesses and/or reinvent customer relationships through the implementation of a virtual value chain (Rayport & Sviokla, 1995).
Cost Transparency. The vast amount of information about prices, competitors, and features that is readily available on the Internet helps buyers “see through” the costs of products and services (Sinha, 2000).
Industry Scope. Value generated in Internet-enabled business transcends traditional industrial sectors. A firm or business ecosystem (Gossain & Kandiah, 1998) or business Web (Tapscott, Ticoll & Lowy, 2000) must provide unique (and customized) “solutions” (as opposed to single product or service) to individual customers.
Speed and Frequency of Changes. Change is fast and frequent in the Digital Economy. Firms in every industry must learn to adapt quickly to changing business and economic environments. Arthur (1996) states that adaptation in a turbulent environment means watching for the next wave that is coming, figuring out what shape it will take, and positioning the company to take advantage of it.
Virtual Capacity. The advance in network and storage technologies gives customers the feeling that it has infinite virtual capacity to serve them (Afuah & Tucci, 2003). General online merchandise stores (e.g., Amazon.com) and all-purpose business-to-business mega exchanges can offer enormous variety without building huge physical display areas that rack up costs and alienate many shoppers. In addition, virtual communities have infinite capacity for members to participate in discussions and sharing of information anywhere and anytime for as long as they want.

COST AND REVENUE MODELS

Rather than searching for the single dominant effect or cost advantage that will provide a long-term sustainable competitive advantage for a company, companies wishing to take full advantage of the disruptive power of Internet commerce must understand the underlying economic logic of the Digital Economy (Lee & Vonortas, 2004). There are four cost factors: scale, scope, switching costs, and transaction costs from both the demand and supply sides that must be examined to determine the viability of the business model.
Internet commerce and virtual value chain have redefined the concepts of economies of scale, allowing small companies to achieve low unit costs in markets dominated by big companies. In addition, online mega store or exchange models are able to spread fixed costs over a larger customer base and offer a wide selection of goods. On the demand side, marketing strategies in markets in which strong network effects exist must be designed to influence customer expectations in order to achieve a critical mass of users.
In the Digital Economy, companies can not only identify and take advantage of the economies of scope in production and distribution, they can also redefine economies of scope by drawing on a single set of “digital assets” to provide value across many different and disparate markets (Rayport & Sviokla, 1995). The combination of demand-side scale and scope economies reinforces network effects in the Digital Economy. For example, Amazon and Yahoo! are able to expand their scope of offerings to provide customers a package of “solutions” across numerous industrial sectors due to the ability to exploit its large installed based of customers.
In the Digital Economy, strategies to increase trading partners’ and customers’ switching costs include prosumption (e.g., Dell’s direct order model), virtual communities (e.g., fool.com), an extranet that allows partners access trade-specific information (Riggins & Rhee, 1998), and developing a strong trust relationship with the end-customers by participating in business ecosystems (Gossain & Kandiah, 1998) or b-Webs (Tapscott et al.,2000).
The Internet has dramatically reduced the costs of many kinds of market transactions. It could prove easier and cost effective to disaggregate many value-creating activities out to the open market so companies can concentrate on their core competences. Companies must also reduce customers’ (transaction) costs of doing business with them by making it easy for customers to obtain and

Table 2. Comparison of organizational transformation and value creation processes

Table 3. Organizational goals and value creation strategies in the Digital Economy

INPUT

Organizational Goals:
Design innovative products and services to meet customer’s latent needs
Reach the critical mass by building an installed base of customer
Take advantage of the network effects to build a successful e-business Management Strategies:
Increase collaboration throughout the product design process
Synchronize product design requirements within a supply chain or business ecosystem in the early stages of the development process
Leverage knowledge capital critical to the design process through external linkages (e.g., alliance partners, research labs and universities)
Achieve demand-side economies of scale by increase installed customer base’s collective switching costs
Reduce customer’s transaction costs (i.e., make it easy for customers to do business with you)

TRANSFORMATION VALUE ACTIVITIES

Organizational Goals:
Improve efficiency and effectiveness of business or supply chain transformation process Match the performance of the physical activities to the digital world Management Strategies:
Sustaining innovation approach: Apply conventional management techniques (e.g., lean manufacturing and total quality management) to improve process efficiency Achieve production economies of scale and scope
Disruptive innovation approach: Take advantage of the lower transaction costs in the digital economy to redesign organizational structures and to reconfigure value creation systems compare product-related information, identify customer decision process, and be able to provide assistance.

OUTPUT

Organizational Goals:
Create numerous innovative knowledge- or solution-based products and services Provide a package of solutions to satisfy or exceed customer’s expectations
Management Strategies:
Transform value proposition by taking advantage of the network effects and demand-side economies of scope, i.e., leverage on a single set of “digital assets” to provide many solutions to individual customers
Increase user’s (or buyer’s) switching costs by offering value across many different and disparate markets
Influence users’ decision-making process through the use of extranet and Web-based collaborative planning tools
Look beyond costs as the sole arbiter of value
Internet commerce provides companies with new sources of revenues via opportunities to offer new “customized” services or solutions in addition to, and sometimes independent of, the traditional products or services sales. In the Digital Economy, pricing can be done in real time. Product can even price below unit cost (in the long run) as long as other e-commerce revenue models, such as online advertising and referral fees, are sustainable. Internet business models also offer companies new opportunities to test prices, segment customers, and adjust to changes in supply and demand. They can create enormous value in the process because online pricing allows companies to make adjustments in a fraction of the time and to profit from even small fluctuations in market conditions, customer demand, and competitors’ behavior (Baker, Marn & Zawada, 2001).
Finally, Tapscott et al. (2000) and Gossain and Kandiah (1998) argue that in the new business ecosystems or b-Webs, customers perceive greater value in one-stop shopping with a known and trusted company. Customers receive “a package of solutions” that satisfies their explicit and implicit needs, rather than purchasing individual products from different vendors. For example, Internet companies, such as Amazon.com, Edmunds.com, and Marshall Industries, are perceived as a single “trusted” source to offer complementary products and services provided by their ecosystem partners to end-customers.

MANAGERIAL IMPLICATIONS

This article identifies major elements and provides specific guidelines to assist organizations in designing an innovative business model in the Digital Economy. A viable business model in the Digital Economy must transform value propositions, and organizational structures and systems to enhance value creation (see Tables 2 and 3). It must be able to take advantage of the Internet network effects and other disruptive attributes (see Table 1) to achieve and sustain a critical mass of installed base of customer. A viable business model in the Digital Economy must also develop trust relationships with business ecosystem partners and customers through virtual communities to reduce their costs of doing business with the company, and to increase their costs of switching to other vendors. Companies must build and maintain a large set of digital assets and leverage them to provide value across many different and disparate markets. Finally, companies must identify customers’ latent needs and transform their business models from a product- or component-based model to a knowledge- or solution-based model.

FUTURE TRENDS

Future research on the analysis, design, development, implementation, and controlling of business model innovation in the Digital Economy include, but are not limited to the following areas:
• Analytical and architectural frameworks for new business models
• Models and modeling techniques
• Specific details and guidelines for business model innovation
• Specific industry perspectives on business models (e.g., converging of technologies and industries, media industry, and communication industry)
• Sustainable business models for digital contents, mobile commerce, collaborative commerce, peer-to-peer architecture
• Trust and business model innovation in business ecosystems

CONCLUSION

A viable business model must follow the fundamental economic principles outline in this article (i.e., costs and revenue models). Most important, an innovative business model in the Digital Economy must capitalize on the disruptive attributes of Internet commerce. E-business initiatives can be implemented as a sustaining innovation to enhance the current way of doing business (i.e., focus primarily on improving the efficiency of organizational transformation). In such case, companies fail to identify and capitalize on many of the Internet’s opportunities. Business model innovation in the Digital Economy requires business planners and strategists to recognize and capture the full benefits of the disruptive characteristics of the Internet and e-commerce.

KEY TERMS

Business Model: The method of doing business by which a company can generate revenue to sustain itself (Rappa, 2003).
Digital Assets: The information (in digital form) a company collected about its customers. Companies that create value with digital assets may be able to reharvest them through a potentially infinite number of transactions (Rayport & Sviokla, 1995).
Digital Economy: The economy for the age of networked intelligence (Tapscott, 1996). The Digital Economy is also a knowledge economy. Information, in all its forms becomes digital, is the input of organizational transformation or value creation process.
Disruptive Innovations: Innovations that typically present a different package of performance attributes— ones that, at least at the outset, are not valued by existing customers. The performance attributes that existing customers value improve at such a rapid rate that the new innovation can later invade those established markets (Bower & Christensen, 1995). Innovations are disruptive when the current organization lacks the necessary models of competitive architecture and organizational capabilities, and are therefore unable in critical ways to do what must be done (Miller & Morris, 1999).
Economies of Scale: Supply-side economies of scale— Reductions in unit costs resulting from increased size of operations. Demand-side economies of scale—The value of a technology or product increases exponentially as the number of users increase (network effects lead to demand-side economies of scale).
Economies of Scope: Supply-side economies of scope—Cost of the joint production of two or more products can be less than the cost of producing them separately. Demand-side economies of scope—A single set of digital assets can provide value for customers across many different and disparate markets.
Network Effects or Network Externalities: A technology or product exhibits network externalities when it becomes more valuable to users as more people take advantage of it (Katz & Shapiro, 1986).
Switching Costs: Investment in multiple complementary and durable assets specific to a particular technology or system (Tirole, 1988).
Transaction Costs: Costs associated with contractual relationships in a market economy, such as costs that the consumer or the producer pays to make the market transaction happen.