When the Flywheel Heads Down a Slippery Slope

Earlier this week, the US Consumer Product Safety Commission (CPSC) filed a complaint against Amazon over the sale of hundreds of thousands of hazardous products, including carbon monoxide detectors that failed to detect carbon monoxide, hairdryers missing the required protection from possible electrocution, and even flammable children sleepwear.

"The dangerous products were offered by third parties using the "Fulfilled by Amazon" (FBA) program, in which Amazon stores products in its warehouses, ships them to customers, and takes a sizable cut from the proceeds. The CPSC's administrative complaint alleges that Amazon hasn't taken enough responsibility for dangerous third-party products that it ships via FBA."

As someone who studies marketplaces, scale, and supply chains, and has a strong interest in Amazon, this is a fascinating case study regarding the role of each in our lives; what drives platforms to succeed, and when are these incentives aligned with those of the consumers? But more importantly, when are they not?

Multiple terms need to be explained here, terms which will be crucial to understanding the subtlety of this story and why it might be slightly different from the common question regarding marketplace regulation. 

The Mystery of Buying from Third-Party Sellers

Let's start with a simple term: third-party sellers. Third-party sellers are independent sellers who offer a variety of new, used, and/or refurbished items on Amazon. The WireCutter had a long expose about this a few years ago:

"If you shop on Amazon, you’ve probably bought things from third-party sellers without knowing it. I have. Third-party sellers now dominate Amazon sales, accounting for 54 percent of units sold on Amazon in the second quarter of 2019, according to Statista.  ‘Third-party sellers are kicking our first-party butt,’ Amazon CEO Jeff Bezos told shareholders in a 2019 letter, calling the increase—from 3 percent of sales in 2000 to over half today—’remarkable’."

As the quote indicates, they are the main engine behind Amazon’s growth on the retail side. Most of these independent sellers offer great products at very affordable prices. Unfortunately, this is not the case with all, and that is where the problem starts. 

A few years ago, a family member bought a brand-new Samsung phone on Amazon, but a few weeks after using it, the phone bricked. When reaching out to Samsung’s customer support to diagnose the issue, they said they had never sold the specific phone. 

While contacting both Amazon and Samsung, and after a brief back and forth, it was clear that the seller (on Amazon) wasn't authorized to sell the phone. It was not fake, but it was not an authorized sale, and when looking through the seller’s reviews, there was no indication regarding their status as an authorized Samsung reseller. Ultimately, Amazon granted us a full refund, but if not for the quality issue, we wouldn’t have known that this was a third-party seller. 

This story is quite a common occurrence. If you look up a product on Amazon, the Amazon search will not distinguish the genuine seller from the resellers or from any potentially fraudulent sellers.  

The official distribution channels are actually quite aware of this issue. Here is a simple example taken from the Amazon discussion board for sellers. One of the sellers posted the following:

"First of all, we only sell genuine products sourced from the official distribution channels. When we sent our products to Amazon, we checked all of them for quality assurance. A couple of days ago, one of the buyers of our product initiated the return process and accused us of sending them a fake Chinese made product when in fact we only sent to Amazon our genuine Korean made products. They also posted a negative review accusing us of selling a fake product. We are suspecting that one of the sellers of the same product is sending Amazon a fake product for fulfillment and that fake product is being commingled with other genuine products."

The response from another vendor:

"There are nine sellers on that listing. If you did not use FNSKU labels, your product is mixed with theirs."

In other words, as a third-party seller, you can sell whatever you want regardless of whether it is an original product or a fake one, and Amazon will do very little to help consumers distinguish between the two.

Why?

Network effects, or more specifically, cross-side network effects. The more sellers Amazon has, the more products it can offer. The more products it has to offer, the more prices decrease (as these sellers compete). The more prices decrease, the more value is created for Amazon customers, attracting additional customers to the Amazon marketplace, which, in turn, creates more value for Amazon sellers: more traffic, easier access to more customers.

This has been discussed ad nauseum, so I will not continue, but the idea is simple: Jim Collins calls it the Flywheel effect. It starts, and it keeps gaining momentum through its own acceleration. 

But I would like to argue that Amazon's flywheel is even more robust, and this brings me to the second and probably more important aspect of the CPSC’s complaint; the idea (or service) of Fulfilled by Amazon (FBA).

Fulfilled by Amazon and Scale

When a seller decides to sell on Amazon, they can choose between two options: Fulfilled by Amazon (FBA) or Fulfilled by Merchant (FBM).

How does it work and what advantages do each offer? Amazon charges all sellers 15% of the product’s selling price on each product sold, regardless of how it is fulfilled. 

FBA charges two types of fees on top of the seller fee: fulfillment fees and inventory storage fees. The FBA fulfillment fee includes the entire picking, packing, and shipping process, while the FBA inventory storage fees include storing the products in Amazon fulfillment centers. 

What do you get for paying for this? Amazon fulfills the orders using its vast and efficient distribution system. FBA solves the problem of scale that smaller sellers would never be able to address on their own. For lower-volume operations, FBA can be a compelling choice for sellers aiming to keep pace with larger competitors in offering ever-faster delivery.

FBA also addresses a central customer service challenge for online sellers who are perennially dealing with complaints about damaged shipments or late arrivals. In fact, since Amazon is the one fulfilling these, any complaints posted about the seller (and not the product) can be removed if the seller requests it. 

The seller can also choose FBM, where they themselves are responsible for all fulfillment experiences. 

If you think it's a no-brainer, you are right: 92% of Amazon sellers use FBA. About a third (34%) of sellers use a combination of FBA and FBM, while just 9% use FBM exclusively. In 2020, more sellers adopted the FBA method.

What has been driving this? In August 2020, almost a year ago, Forbes wrote that Amazon announced it would soon require FBM sellers who participate in the Prime Program —those guaranteeing two-day shipping or less, but managing delivery themselves— to begin shipping items on the weekends. 

The announcement also requires sellers in the program to offer Prime to customers across the entire country, rather than its current policy which allows them to limit it to nearby areas. 

“These changes will help deliver an experience our Prime customers expect, including fast delivery,” the company said in a note to sellers, noting the policy will go into effect in February 2021.

This clearly pushed many sellers to turn to Fulfillment By Amazon (FBA) and pay Amazon to handle storage, packaging, shipping, and customer service. FBA had only 73% of the sellers in Jan 2019, up from 69% in 2018, and 58% in 2017. So after a slow growth, a high jump in 2020. 

These changes are driven both by the consumer side and the supply side:

Customers expect next-day delivery. Consumer Trends Report reveals that 80% of U.S. consumers expect free shipping on orders above a specific dollar amount, and 66% expect free shipping for all their online orders. On top of that, 41% expect delivery times of 2-3 days after purchasing — with another 27% expecting same-day or next-day delivery for everything they buy online.

On the supply side: Amazon's distribution system, which was built over the last few years, is better equipped in doing so, and in fact, the more products flow through this system, the cheaper the cost of delivering these products becomes. 

Here, it's not only an issue of scale (warehouses and their employees are fixed costs, so the more products, the lower the cost per product). Delivery is about density, which means that the more products Amazon offers, the more likely Amazon delivery people will be visiting an area, which lowers the cost of delivering products to the same neighborhood.

In other words, this is a second Amazon Flywheel, focusing here on the supply side: the more products sold within its distribution system, the lower the cost and the faster the service, which in turn, allows Amazon to attract more customers, who expect fast service, which ultimately forces other sellers to join the FBA system. 

But like (almost) every network effect, there is also a negative side to consider. 

Scale and Long Tail Abuse 

We use the terms scale and scalability quite a bit, so it's essential to clarify what they mean. 

Primarily, I would like to differentiate the term scaling from mere growth. When I use the term scale (or scaling), I refer to firms that create a separation between their revenue growth rate and their cost growth rate. For this to happen, the firm must enjoy some type of economies of scale. 

Network effects are demand-side economies of scale and Amazon seems to be achieving this: the more customers, the higher the value to the consumer as more sellers sell on Amazon’s FBA or FBM. But, Amazon also achieves supply-side economies of scale: as more customers use Amazon and more sellers use FBA, Amazon becomes more efficient in delivering products. Amazon itself can then lower the prices of its products. 

I should note that Amazon is quite unique in having both these types. Most firms only enjoy one type (e.g., Intel only achieves supply-side, while Uber only enjoys network effects).

And this is precisely the point: If only one of these scale economies is enough to create significant urgency for growth (to use and generate a competitive advantage), the existence of two types of economies of scale makes growth even more urgent. 

Now, I know what you are thinking: Amazon is big enough already. How much more urgent can it become? The truth is, that the firm has been growing 40% YOY (year-over-year) for the last 20 years, and seems to have no intention of stopping. 

With growth, however, come different types of headwinds. One of them is the notion of long-tail abuse. This means that people may abuse your network for activities that may affect your users negatively, deterring other users from joining and using your product or service. It can be fake products on eBay, it can be misinformation on Facebook, or it can be fake reviews. 

In the case of Amazon’s Marketplace, the sellers hold a large amount of responsibility for the products they sell. Selling flammable children’s sleepwear is criminal activity. But the point I want to make is that it's also Amazon’s responsibility, and in fact, in the specific case, Amazon’s responsibility is even greater due to its double flywheel.  

Let's go back to the complaint and understand why:

The complaint notes that Amazon has extensive control over the third-party products sold in the Fulfilled by Amazon program. Amazon's services for sellers include "storing FBA products at Amazon fulfillment centers, stocking and maintaining an inventory of FBA products, and administering additional sorting and shipping services, including the use of Amazon employees to interact with the product, categorize it with the help of computers and robots, label it, and move it through the distribution process." 

We know from previous cases (discussed in the WireCutter article previously mentioned) that Amazon does not even look at product expiration dates and, in fact, sold expired baby formula. 

I don’t claim that Amazon does not care. I am arguing that Amazon doesn't care enough. The question is whether we should hold Amazon liable and force this to somehow change. 

One argument I hear is that, given its mass, Amazon cannot exert control over such issues. I do not buy this argument. Scale and variety are choices made by Amazon. Similarly, Amazon can choose to allow sellers to join at a rate where it can control their quality and verify the authenticity of their products, or at least check their expiration date(!). TheRealReal manages to do it, what’s holding Amazon back? 

Just to be clear: it probably is hard to address the issue. But this is part of Amazon’s business model. If Amazon is unable to address this issue, then maybe the "Everything Store" is just glorified nonsense. 

Another argument I hear is that, if we start requiring Amazon to review all sellers, why can't we hold Facebook liable for misinformation? The two are not comparable. Amazon is not about free speech. While it's hard to determine what constitutes misinformation and what contrarian opinion and regulate them, it shouldn’t be that hard for products. I am not absolving FB of its responsibility, but I would like to point out that we should be more strict with Amazon, as it offers fraudulent and hazardous products. Just letting the market regulate the issue by itself does not work at this scale. 

My argument is that Amazon can’t eat the cake and have it too.

When Amazon fulfills a product (i.e. FBA), it gives it credentials beyond what a Fulfilled by Merchant (FBM) provides. Since Amazon handles the products, it is responsible to provide some type of inspection. 

Now, I am sure Amazon wants to offer good service and good products, and overall, Amazon’s incentives are aligned with those of its customers, which holds for the average consumer. Nevertheless, the more products Amazon has on its marketplace, the less Amazon will care about long-tail abuse since such incidents are low in numbers. However, these are not equally low in consequences. 

For Amazon, on the other hand, it is more expensive to deal with long-tail abuse because such sellers become more sophisticated over time. If you raise the inspection standards, they will have to apply across the board, increasing the cost of all Amazon products—breaking the flywheel. 

But the point here is that while these may be rare, when they actually happen they cannot be handled using the existing rating system. Ratings are lagging indicators, and since ratings are primarily for products, they don’t capture issues with sellers well enough. 

And indeed, the regulators are after Amazon:

"The bill comes after earlier legislation to hold marketplaces responsible for the safety of products they sell stalled out in that state’s senate. The earlier legislation was written in probable response to a court case in which a woman purchased a laptop from a third-party seller on Amazon.com’s marketplace and was later injured when the device’s battery exploded."

I know that the world functions largely on tradeoffs and that there is no optimal solution, but how much are we willing to pay to have an "everything store.” Is it worth the life of even a single person? I think not! How long before the next defective product ‘fulfilled by Amazon’ causes a fatal injury? We should not take the narrative that this is just how it should be. It shouldn't. Firms that enjoy scale economies should also be liable for long-tail abuse. This is true for Amazon, and it seems to also be true for Uber.

What's your opinion?  What’s the right balance?