July 3, 2022

Digital transformation

How does value change once we talk about digital transformation?

This article provides an theoretical overview on how digitalization transformes value creation and thus business interaction in an increasingly digital world. The presented structure follows to some extend the coursea lectures on Digital Transformation in Financial Services by the Copenhagen Business School (Hedman: 2022). This is a first draft.

8 min read (1943 words)

digital transformationbusiness value

From Digitization to Digitalization

To understand value in the digital age it is imporant to distinguish Digitization from Digitalization.

Digitization describes the process of converting any kind of data into a digital format. For example, when you scan an analogue photography or a report to a digital file. The format of the data itself gets changed but the underlying process stays the same: the report is still a report and the photograph still a photograph. The underlying process might be adapted as storage of data will change and information might be accessed differently but there is no transformation in the way these kind of data will be processed once digitized.

“Digitalization is the use of digital technologies to change a business model and provide new revenue and value-producing opportunities; it is the process of moving to a digital business.”– Gartner: 2022

Following the definition by Gartner, Digitalization describes the transformation of a business model that goes along with incorporating the potential of digital technologies. This is totally different from adapting existing processes due to new data formats as it targets the transformation of a whole business with respect to value-producing opportunities. Digital has become the way to do business.

In general, business is a form of social interaction and – looking at Digitalization – the quality of those interactions are transforming fundamentally and digital data has become an essential part of those interactions. Therefore, Digitalization impacts how digital becomes part of our daily lives. Users are adopting to technology and show changing behaviors.

Post-Millenials

If we think about pre-Generation Z retail bank customers, generally speaking (and thus oversimplifying), we could describe them as slow moving customers: once they had settled with a bank they did not change their bank easily. It would take a lot of marketing efforts or discount offers to persuade a customer to change banks.

With Post-Millenials (also called: Generation Z or zoomers) we talk about a totally different demographic cohort. There are varying definitions what birth years should be considered, but this is a secondary characteristic, as it is all about how digital became part of daily life and how the mind adapted to this immersion.

Looking at digital transformation we can attach the following attributes to Post-Millenials:

  • Always connected and mobile first
  • Multitasking
  • Tech savvy and digital innovation focused
  • Personalized and fast interactions
  • Convenience over brand loyalty

Value through digital transformation

As the world became more and more digital, relationships between people and people, people and businesses, businesses and businesses transformed.

In essence the social function of a bank are relationships: in its simplest form based on customer objectives you have depositors and borrowers and the bank connects and mediates funds among those groups. To provide a loan you need some funding and depositors and borrowers are brought together as abstract entities. Markets where distinct groups are brought together and benefit from each other are called two-sided markets or two-sided networks.

Examples of two-sided networks:

  • Uber: riders – drivers
  • Airbnb: hosts – guests

Examples in finance:

  • PayPal: sellers – buyers
  • Visa: merchants – shoppers

With Digitalization the elementary social function stays the same but the quality of how processes between various financial service providers and their consumers are set up are totally transformed. The understanding of this connection – the network – shifted in two-sided-markets.

“Network effects refers to the impact that the number of users of a platform has on the value created for each user.”– Parker 2016:18

Network effects

Supply economies of scale describe the reduction of unit cost through efficiency when the quantity of produced items increase. This is what kept the Industrial Revolution going and could create powerful monopolies in the production sphere. In contrast – and for this topic I am following Platform Revolution by Parker and van Alstyne – demand economies of scale describe the way how bigger and bigger networks became possible through technological innovation. The growing number of users of a network has a direct impact on each user of this network.

In a two-sided network two kinds of network effects are distinguished:

  1. Direct (same-side) network effects deal with the situation that new customers join the same side (same user group) in a two-sided-market. Direct networks effect deal with the changes for borrowers if additional borrowers are added to the network.
  2. Indirect (cross-side) network effects deal with the situation that new customers join the opposite side (another user group) in a two-sided-market. Indirect networks effect deal with the changes for borrowers if additional depositors are added to the network.

We talk about positive network effects when the effect on other users (same-side, cross-side) is beneficial. The more merchants are added to Visa the better the card acceptance and thus the benefit for cardholders (shoppers). The more cardholders the more consumers for merchants.

On the contrary negative network effects describe an effect where an increasing number of users is not beneficial anymore. Parker and van Alstyne give the following example: If Uber would attract to many drivers the driver downtime would go up and therefore have a negative effect on the drivers (negative same-side effect).

Coming back to supply economies of scale increased production is made possible through internal changes in production. With demand economies of scale and network effects this is totally turned around: innovation is externalized and the platform itself is a tool of orchestration. (Cf. Parker 2016:18ff)

“Network effects are creating the giants of the twenty-first century. Google and Facebook each touch more than one-seventh of the world's population. In the world of network effects, ecosystems of users are the new source of competitive advantage and market dominance.”– Parker 2016:28

Digital platforms

In a linear production process (a pipeline — Cf. Parker 2016: 12) a producer produces a service or product before it can be consumed by consumers. A platform follows an entirely different pattern: the platform provider does not produce anything but orchestrates the social interactions between producers and consumers, whereby a producer can at the same time also be a consumer, etc. Orchestration does not refer to simple interactions but to qualitative interactions that shift with the demands of its users and focuses on enabling innovation. A platform is designed to adapt to ever changing conditions and to scale in any direction needed.

“A platform is a business based on enabling value-creating interactions between external producers and consumers. The platform provides an open, participative infrastructure for these interactions and sets governance conditions for them. (…) value may be created, changed, exchanged, and consumed in a variety of ways and places, all made possible by the connecions that the platform facilitates.”– Parker 2016:10

Common to any platform is its modular structure and its design for scalability. Scalability not only refers to growing networks but also to the integration of third parties. Henry Chesbrough coined the term Open Innovation:

“At its highest level, open innovation is a recognition that no man is an island and we can't do it all ourselves. Organizations should make much greater use of external ideas in their own innovation activities along with their internal ones, and equally, and this is the part that often gets left out, unused and underused internal ideas should be allowed to go outside for others to use in their innovation activities. So there's an outside in part to open innovation where you take things from the outside and bring them in for yourself. Then the second path, which is the inside out, where things from inside go out for others to use as well. That's what I mean by open innovation.”– Chesbrough 2017

  • Outside-in refers to the integration of external parties to the platform.
  • Inside-out is when internally developed resources are provided for re-use to external parties.
  • Coupled open innovation is a combination of both, when innovation is co-created between platform providers and third parties.

Technically this refers to Open APIs, Software Development Kits (SDK) and legal usage agreements. As Hedman/Henningsson point out there is a area of conflict as two divergent interests come together: generativity versus control. On one side platform providers search for generativity, id est innovation, about limitless potential and on the other side they want to control quality and maximize their own profit. (Cf. Hedman 2022)

Digital ecosystems

As digital platforms compete with each other, we often observe a winner takes all phenomenon. When Yahoo was leading the search engine market, it was competing with Infoseek, Lycos, Excite, etc. With the massive growth of web offerings new search technologies became important and Google offered something totally different that took advantage of this growth: the more searchers, the better the index became. The winner takes all paradigm tries to dominate a market, which is also called value domination. The early wars for standards such as the well known VHS vs. Betamax “battle” are illustrative example for power plays via technology, customer base, brand names, etc.

Another way of gaining influence is the winner takes some paradigm, where the goal is not full market domination but finding a healthy balance of co-existence within a bigger ecosystem. This answers to the increasing complexity of relationships between digital service providers. Instead of black and white, competitors are also considered as partners and it becomes important to understand when and where which business interests prevail.

As mentioned before, within a digital platform there is a tension between generativity and control. Projected to digital ecosystems we see an area of tension between evolution and stability. Evolution is about fostering unbound creativity, whereas stability is about preserving standards/compatibility.

To balance this tension legal frameworks — partner programs — regulate the degree of involvement of each partner within an ecosystem as well as to channel desired and undesired innovation. Market collusion describes the impact on profitability by the position of a business in an ecosystem.

Summary

This article is first in a planned series on value and how to understand value in the digital realm.

  • Digitalization describes how businesses are transformed once whole services and products become digital
  • As business is primarily about (social) interaction we must understand how people utilize digital services and how user behavior transforms.
  • Users, becoming the main innovators and businesses starting to orchestrate their interactions,
  • we observed the rise of digital platforms and varying strategies to gain market influence.
  • With ongoing innovation and new technologies the relationships and dependencies between businesses are getting more and more complex
  • and therefore it is not only about market dominance but also about cooperation – about digital ecosystems.

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