There are only Three Base Business Models

[Updated 2014-01-05: for completeness reasons, here are two more categories: 4) robbing people, and 5) taking advantage of people. In my book, they don’t qualify as “business” models because they are borderline or actually criminal, but they do exist.]

If you put all business models into the following three buckets, suddenly all sorts of things become clear:

1. Compete on the merits, with negligible switching costs for the customer

This is what we all have in mind when we think of competition and capitalism. In this model, a company provides a product or a service for a customer. The customer has alternate vendors to choose from, and is at liberty to switch to another vendor at any time. The “switching cost” — just how hard, bothersome, expensive etc. it is for the customer to stop doing business with the first vendor and start doing business with another vendor instead — is negligible.

Here are some examples for businesses that use this model:

• Restaurants. If I don’t like the food or the service, next time, I go to a different restaurant. There are no switching costs.
• Our maid service. If I don’t like the way they cleaned my house, I call up another maid service and they will show up next week instead. The only switching cost is that I need to get my house key from the old service, and give it, plus my credit card number, to the new service. Something that’s minimal.
• Amazon retail. If my package was late, or I don’t like their service, I order from somewhere else instead next time. All I need to do is enter my billing and shipping information again at some other site.

As a business, you make money by providing the best possible customer value at the lowest cost. So you make money by being really good at pleasing the customer, and do a good job every time.

2. Acquiring and exploiting a critical resource

This seems to be a diverse group, but they are all share the basic strategy of owning a resource of some kind that’s critical, and of making it as profitable for them as possible to charge for access to the resource.

In the old days, Rockefeller would buy himself as many oil companies as he could, thereby creating a monopoly for oil refining and marketing in the US. He certainly didn’t do that to please customers, but to force customers to have to deal with him, whether they wanted to or not. Presumably his prices did not remain bargain-basement. OPEC tried to do something similar.

In the tech industry, Microsoft worked really hard to make DOS and Windows and then Office “unavoidable”. With the result that customers were forced to keep purchasing upgrades, even if they provided little discernible customer value.

Today’s Web 2.0 business model — used by everybody in Silicon Valley from Facebook to Google and countless startups — is another version of it: create something appealing for free, have users bring all their friends and data so they can’t ever leave again, and sell them out behind their back. I wrote about this earlier.

As a business, you make money by being the best at creating or grabbing resources that are or will be critical for somebody, and building the best toll both in front of them. You focus on the customer only to the extent that they keep considering the resource you own as critical and unavoidable to them.

3. Favored position through regulatory capture

Speaks for itself. The company lobbies, or outright bribes elements of the government to obtain permission to do something for which there is market demand, but which no (or few) others are allowed to provide. There are probably a number of “products” for which this is a good idea (say, the police force) but for most, it is probably not. Often, multiple organizations essentially form a cartel to obtain this exclusive position together and maintain the appearances of competition, in spite of the fact that no new market entrants are allowed, or it is prohibitively expensive for them to enter.

Here are some examples:

• Public school systems. ’nuff said.
• Taxi services. Only a handful are licensed, and independent operators are disallowed.
• Healthcare, and law. Nobody gets to practice it unless they have joined the old boys club (aka passed bar exam, been a resident/associate etc), which limits competition from new (particularly cheap!) entrants, in exchange for ever-increasing salaries for the members of the club. And there are no substitutes; they have been regulated out of existence.
• Telecommunications companies. They come in different flavors, depending on country, ranging from national communications companies wholly or partly owned by the government, to the old AT&T, to last-mile monopolies.

As a business using this model, you make more money by lobbying better. It isn’t really related to anything else, such as customers, or how smart you are.

To me, clearly, #1 is the only model that puts the customer first. #2 is the preferred model to make mountains of money, while not needing to pay attention to the customer very much at all. The empire building model, in other words. And #3 is the model that, IMHO, has no good reason to exist at all because all it does is produce mediocre wealth with substandard customer service, and a large likelihood of corruption.

So the interesting questions are:

If you are a customer, which of those models are you comfortable with? And what does that mean for you in terms of which companies should you rather stop doing business with?

If you are an entrepreneur, or executive, or have a say in your employer’s business strategy, which of those does your company employ? If it is #2 or #3, does your company also say things like “we put the customer first”?