#005 - Product Management Lessons by Meituan Co-Founder - Pt 5: Market Concentration
5 min read - Balancing the Effects with scale
Let’s get you up to speed:
Wang Huiwen is the co-founder of Meituan, who recently retired at age 42 with an estimated net worth of >US$2B. He opened a Product Management course at Tsinghua University in September 2020. This article and others in this PM series are my translation and edits based on a compilation of the content of his course shared online. You can see other articles in this series here.
Market Concentration
Network Effects and Matthew Effect that we covered previously prelude to market concentration in this chapter. (Note: Network Effects determine the eventual market size, while Matthew Effect determines who will lead in the market.) Even in a big market, if the market concentration isn’t high, there won't be big companies in the business. (e.g. the F&B industry). So big markets aren't enough; investors also look at whether there will be big companies in these markets.
A metric to measure market concentration is the Concentration Ratio (CR). CR3 means the combined market share of the top 3 companies in the industry (CR7 for top 7, and so forth). For example, the CR3 in the Telecom industry in China is 100%. (Note: CR is a lagging indicator.)
Another way to think about market concentration is how many companies will remain in the business. The final number of companies is either 1, 2, 3, or 7, or infinity. 7 because that's the number of items humans can hold in our limited working memory.
The crux of the problem is how do we determine the eventual market concentration of the industry as early as possible? This judgment is key in strategic decision making.
The most fierce competition usually occurs in industries where only 2-3 companies would remain. The industry with only one player remaining would actually have less competition. The most hard-fought sector in the Internet industry in China is long-form videos. (Note: Youku-Tudou, iQiyi, Tencent Videos, Bilibili, etc.). After 16 years, no one made any profit, and every year, each player still burns through hundreds of millions. The sector probably lost >$15 billion since the beginning. If investors knew this from the beginning, they probably wouldn't have invested in video.
As such, knowing (judging) how many players will remain is critical to early strategy. If there will only be one, then you should form Matthew Effect as early as possible. And usually, only when exponential Network Effects are present, there will be only one winner to take it all. If there will be 2-3 players left, which is the case for most sectors, then you should be in the top 2-3 as soon as possible. If you're not, investors would not invest in you.
However, it's not advisable to over-invest too early. Because the early investments usually have a low return on investment (ROI). If you over-invest in the early stage, these low ROI investments become liabilities in the long term.
For Social Networks, the initial investment is relatively small. As long as the product is great, it will grow organically through word-of-mouth. Then as Network Effects kick in, it will enter a self-fuelled growth flywheel.
For Group Buy, it requires a significant initial investment. At the start of the Thousand Groupons War, we at Meituan had to decide how much investment is appropriate. Our strategy at the time was to ensure that we are always among the top three in the industry in terms of market share. Because in industries where there will only be two or three companies left, investors would only invest in the top three.
In addition, we also set out to have the highest ROI among the top three players. There were other players outside the top three who might have a higher ROI than we did, but they were irrelevant. Investors wouldn't look at them. Top-tier investors not only can foresee how big the market size will be but also how many players will remain because they would get the data from all the companies in the sector. So we had to be the one with the highest capital efficiency in the top three.
Tying It All Together In Practice
We mentioned earlier that Network Effects of the group buy model operates on a city level - your business in Shanghai has nothing to do with your business in Beijing. China has 30+ provincial cities, 300+ prefecture-level cities, and 2000+ county-level cities. During the Thousand Groupons War, the problem that everyone had to solve was how many cities to operate in, given that your resources were limited since you operate on negative margins when you start.
There was one group of companies. They also understood Network Effects. These people thought that if they operated in multiple cities, they'd spread too thin the resources allocated to each city, so they should concentrate on a small number of cities, grow the business in each city well, rather than cast the net wide.
Now, do you think they're right in their thinking? This is an important question. In building a company, at various times, you'd face such a decision, and these are the decisions that lead to success or failure.
Let me give you the results first. A group of companies launched in 25-30 cities, while another group of companies launched in 150-200 cities. Meituan launched in 94 cities. Both of the former groups died.
Doesn't quite gel with your understanding of Network Effects right?
That's why running a business is so hard. Everyone thinks that s/he understands Network Effects, but the difficulty lies in understanding the different elements of Network Effects, the trade-offs between the different elements as well as the conflicts between Network Effects and anti-Network Effects and which element has the stronger effect.
All else staying equal, you should have fewer cities, otherwise, your resources will be diluted that you're not competitive in any single city and your competitors will reach the critical mass in those cities. But all else is not equal, a key factor to consider is where do all these Group Buy platforms get their users?
During 2010 and 2011, there were basically two or three acquisition channels. The main one is web directories like hao123. (Think Craigslist or Yahoo!) Web directories have a notable characteristic, which is that since they have to put up all sorts of content, their screen real estate is extremely limited, so for each sector, they can only put up a few websites. For Group Buy, they'd put up six websites. To be one of the six is a 0 to 1 difference because otherwise, you don’t get any traffic.
Unlike today, every app knows where you are and ads can be sold location-based, web services like hao123 don’t know where you are and they could only sell ads for the whole country. Here we have a Scale Effect at play, namely Scale Effect in Marketing. (Note: Wang Huiwen refers to Networks Effect as a subset of Scale Effect but I wrote them as distinctive.) If you have 100 cities, then your advertising expenses would be spread out among 100 cities. And if you only have 25 cities, either you couldn't afford to buy ads, or you’d waste a huge amount of traffic in cities you don't serve. As you waste traffic, the cities that you did operate in, because they had to shoulder the disproportionate costs, would lose their competitiveness as well.
On the other hand, for companies that operated in 150-200 cities, although they might have traffic, their talents were spread too thin, so their offline capacities in each city weren't as competitive, plus they had huge cash burns, they’d also lose out.
There are also other areas that you see these trade-offs, like in product R&D, capital & fundraising, etc. I won't get into them but the point is the same.
The interplay between different effects that benefit or suffer from scale is intricate. We first need to understand these effects, then understand the trade-offs, and find the optimal balance. Finding the balance is through experimentation.
👋 Hi! I’m Tao. As I learn about building products & startups, I collected some of the best content on these topics shared by successful Chinese entrepreneurs. I translate and share them in this newsletter. If you like more of this, please subscribe and help spread the word!