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Nov 11 2019
Why Amazon’s recent challenges are rooted in its business model
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22 min
What’s Happening
Over the past 6 months, Amazon has been on the receiving end of public criticism rooted in its marketplace business model. A wave of media reports described products on its ecommerce platform that were counterfeit, expired, dangerous, defective, blacklisted by the US government, or manufactured in unsafe overseas factories. Its private-label brands have also been a source of criticism of late, with claims they enjoy a privileged position on an uneven playing field as they compete with the rest of Amazon’s 3rd-party marketplace sellers. The challenges to Amazon’s reputation have been exacerbated by some of its rivals (e.g. Walmart and Oracle, as well as other undisclosed backers) banding together in an “anti-Amazon” nonprofit called Free and Fair Markets, which a WSJ report in late Sep 2019 revealed. In response, Amazon is undertaking a counter-campaign that includes plans to spend “billions” policing products on its ecommerce site.
Amazon was founded in 1994 as a retailer buying wholesale inventory from “1st-party sellers” (usually brand manufacturers), holding title and ownership to that inventory. Around 1999, 5 years after it was founded, Amazon launched a “3rd-party seller” business in parallel that allowed other sellers to use its platform to sell directly to customers. In the 3rd-party seller model, Amazon does not take title or ownership to inventory, instead providing services to the seller. On, items sold by 3rd-party sellers have language on their product page such as “Ships from and sold by [Seller]” or in the case that the seller has decided to use Amazon fulfillment services, “Sold by [Seller] and Fulfilled by Amazon.” Since launch, the 3rd-party seller model’s share of Amazon’s physical gross merchandise sales has grown to 58% ($160B). Amazon has an estimated 2.5M merchants selling on its platform, enabling Amazon to offer 120M different products.
According to Amazon, the growth of 3rd-party sales (52% CAGR) has largely been driven by the business tools and services it offers – such as payments, tracking, reporting, importing, short-term loans, price automation, and customer service. Of particular note are Amazon’s logistics services – Fulfillment by Amazon (inventory storage & shipping), 2-day delivery for Prime members, and the recent push for one-day shipping. It also offers an advertising program, which grew more than 45% in the last quarter (Q3 2019) with strong adoption by sellers (among others). Amazon generates substantial revenue from 3rd-party sales and seller services – $43B in 2018.
Most tech companies (e.g. eBay) defend themselves from liability stemming from 3rd-party content or products on their platforms using Section 230 of the Communications Decency Act. Amazon generally has relied upon a combination of Section 230 and the body of law that attributes liability to the seller of record to disclaim responsibility for 3rd-party products. Up until recently, it has been able to hold itself apart as a provider of services rather than being the “seller of record(though its annual reports for almost 2 decades have noted that activity by 3rd-party sellers could pose risk for its business). In Jul 2019, however, a US federal appeals court held that Amazon can be held liable in part for products sold on its platform (a major reversal of prior federal rulings). The opinion said the liability stemmed from Amazon’s role as middleman between 3rd-party seller and customer, making it hard for customers to pursue a claim against the seller or manufacturer (e.g. in the case of injury). One of the drivers for this recent spate of negative reports is the growing sense that Amazon might be held responsible for 3rd-party seller behavior.
Amazon’s expanding portfolio of private-label brands is another source of criticism. Private-label represents only 1% of sales but are reportedly among Amazon’s most profitable products by design. While grocery retailers have had their own private-label brands for years, how Amazon has executed on its dual role as both marketplace and seller has not always been as transparent. The call for Amazon’s breakup by presidential candidate Elizabeth Warren in Mar 2019 was, in part, motivated by a perception of anti-competitive behavior in promoting Amazon’s own brands – e.g. alleged use of proprietary data to identify new private-label opportunities and compete with other sellers. Amazon responded on Twitter, “We don’t use individual sellers’ data to launch private label products” (though it didn’t address aggregated seller data). It has also said that private labels do not have an advantage in search results; however, criticism has lately ramped up with reporting that Amazon is promoting its own products on prime real estate within competitors’ product pages.
Challenges to Amazon’s business model
Amazon has faced a steady cadence of challenges to its 3rd-party seller business model over the past 6 months:
  • Jun 2019 – The NYTimes reported on a surge in counterfeit books on Amazon’s platform. In one case, a medical handbook was so widely counterfeited that, of 34 books bought on Amazon in a test, 30 were counterfeit. The report highlighted an Amazon business practice known as commingling, in which sellers have the option to pool their inventory of a given item with that of other sellers and Amazon. While more efficient and therefore cheaper for sellers, commingling also limits traceability and accountability.
  • Jul 2019 – The EU opened up an antitrust investigation into how Amazon plays its dual role as marketplace and seller. It will look at agreements with 3rd-party sellers, which allow Amazon to use seller data, and how that data is used to compete against them.
  • Aug 2019 – Labor-rights group China Labor Watch found that 1,000+ Chinese youth aged 16-18 were being employed as “interns” at a Foxconn factory making Alexa devices, in some cases for 10 hours a day for 6 days a week.
  • Aug 2019 – A test by the Record Industry Association of America (RIAA) found that 25% of CDs fulfilled by Amazon were counterfeit, vs. 16% from eBay and 11% sold by Amazon directly. A report later in Oct 2019 described a similar dynamic in vinyl records, with record label Tommy Boy Records discovering Chinese vinyl counterfeits of titles it had never pressed.
  • Aug 2019 – The WSJ found 4,100+ items on Amazon that were declared unsafe/banned by federal authorities or had issues with labeling (e.g. false labeling as FDA-approved or DOT compliant, lack of required warnings). 46% were fulfilled by Amazon. In some cases, items taken down by Amazon after notification by the WSJ reappeared within two weeks. The WSJ followed up with a piece in Nov 2019 on how a high proportion of products with issues came from Chinese manufacturers and merchants, which were heavily recruited by Amazon.
  • Aug 2019 – The Washington Post reported on Amazon promoting its own private-label products on competitors’ product pages in an advantageous position. The products were promoted in a “Similar items to consider” section inside the “Buy Box” on the right side of the page. In the Washington Post’s test, only Amazon private-label products were shown in this section across the site.
  • Sep 2019 – An antitrust investigation by the Federal Trade Commission (FTC) took a step forward with investigators interviewing small businesses selling on Amazon. The FTC now has oversight of the antitrust case against Amazon, based on an agreement struck with the Dept of Justice. While in the early stages, the interview length and resources dedicated suggest that the inquiry was serious. Reports differ on the scope but one of the focus areas is likely to be how Amazon competes against its sellers.
  • Sep 2019 – The WSJ reported that Amazon had adjusted its search algorithm to boost its private-label products by incorporating proxies for “contribution profit” within the set of 100+ variables. Engineers on the A9 search algorithms team as well as Amazon attorneys disagreed with the decision. Sources said A9 engineers were pressured for years to increase sales of Amazon-owned brands. A9 now reports to the retail business, after years of independence. Amazon responded, “We have not changed the criteria we use to rank search results to include profitability” (though it didn’t address proxies for profitability). The WSJ noted that Amazon also appears to be shifting away from “relevance” in search results, removing it as a filter offered to users in favor of “featured.”
  • Sep 2019 – The American Apparel & Footwear Association (AAFA) representing 1,000+ brands asked the US Trade Representative to put several major Amazon international sites – (Canada), (Germany), (UK), (France), (India) – on the “2019 Notorious Markets List” for counterfeit goods. The list in 2018 included companies like Chinese ecommerce players Taobao and Pinduoduo.
  • Oct 2019 – CNBC reported on customer complaints about foods that were expired or labeled “not for sale” on Amazon – including baby formula and baby food. One study found that of the top 100 foods, 40%+ of sellers had 5+ complaints about expired products. In one case, a product discontinued for two years was found on Amazon. In another, customers received water bottles filled with tap water. Sellers are supposed to provide Amazon with an expiration date and guarantee shelf life of at least 90 days. The issue is complicated by Amazon taking responsibility for items fulfilled through Amazon, striking out negative reviews and providing the statement “This item was fulfilled by Amazon, and we take responsibility for this fulfillment experience.” Amazon says that it monitors 22M+ pieces of feedback every week for quality and safety concerns, using a database called Heartbeat.
  • Oct 2019 – Several D-Link internet routers with serious security flaws – e.g. ability to hijack the router, monitor traffic, and send wifi users to malicious sites – were reported as being sold on Amazon. The routers were discontinued without end-of-life support, meaning the flaws would not be fixed. In one case, a router was even listed as “Amazon’s Choice” for the category.
  • Oct 2019 – The WSJ reported that Amazon was selling clothes made in Bangladeshi factories that violated safety standards and were on blacklists by two safety-monitoring organizations. 2/3 were sold by 3rd-party sellers, while the remainder was sold by Amazon itself (but not under Amazon’s own brands). Amazon expects wholesalers and sellers to meet supply chain standards but has relatively few explicit requirements in seller agreements. It also does not conduct inspections unless the products are sold under its own brands.
  • Nov 2019 – Amazon, among other tech firms, was found to have products sold by 3rd-party sellers on its platform made by Chinese firms blacklisted by the US government – surveillance-camera companies Hikvision and Dahua Technology and speech-recognition firm iFlytek.
  • Nov 2019 – In a 62-page letter to lawmakers, Amazon was accused by one of its merchants of forcing sellers to use its expensive logistics services, in a potential antitrust case. The letter contradicts Amazon’s claim that competing logistics services are 50-80% more expensive than its in-house fulfillment, saying that Amazon’s services are as much as 35% more. It also alleges that sellers not adopting Amazon’s services incur disadvantages such as risk of suspension, marginalization of their products, and penalties for delivery issues.
Amazon’s counter-response
Amazon has been undertaking a counter-response to these reports and allegations:
  • Feb 2019 – Amazon announced Project Zero, an effort to drive counterfeits to zero, using automated takedowns, a self-service counterfeit removal tool, and the Transparency product serialization program instituting a unique code on each physical product to help check for authenticity. It initially launched in the US as an invite-only program. Project Zero builds on Amazon’s Brand Registry, which was overhauled in 2017 and offers 200,000+ registered brands certain controls over how their products are listed. (This can, however, result in unintended consequences such as restrictions on secondhand product sales – e.g. Amazon’s flip-flop on rules for used Nintendo games.) Amazon has been making changes to encourage more of its own vendors to enroll in Brand Registry.
  • Jun 2019 – Amazon and Nite Ize (maker of mobile accessories & LED products) sued 11 individuals and businesses in 3 countries for counterfeiting.
  • Aug 2019 – Project Zero rolled out to Europe, in addition to the US. It also announced 3,000+ brands had joined the program and 65M+ suspicious listings had been blocked to date.
  • Aug 2019 – A number of media outlets reported that Amazon was deploying a group of “FC ambassadors” – Amazon employees from fulfillment centers – to post on Twitter about their experience working at Amazon. (Critics, however, have raised questions as to the candor or authenticity of the posts.)
  • Aug 2019 – Amazon published a response to the WSJ article about 4,100+ problematic products, describing how it manages product safety and compliance on its ecommerce platform.
  • Oct 2019 – Amazon announced a new Intellectual Property Accelerator to help small- and medium-sized businesses (even those who don’t sell on Amazon) combat fraud and counterfeit goods by offering pre-negotiated discounted rates on a set of services from a group of law firms – e.g. to help trademark products. Amazon also offers automated tools to identify and take down fraudulent items.
  • Oct 2019 – Amazon released a webpage that describes its public policy positions on a host of issues, including penalties for counterfeiters.
  • Oct 2019 – Amazon responded to the AAFA recommendation that its international stores be put on the Notorious Markets List, with a summary of its efforts to combat counterfeiting. It said that in 2018, it had invested $400M and employed 5,000+ employees in preventing fraud and abuse, blocking 1M+ suspected bad actors and 3B+ suspicious listings. According to Amazon, 99.99% of products viewed on its platform have never received a complaint about counterfeiting.
  • Oct 2019 – Amazon sued two “ecommerce coaches” who it claims encouraged “black-hat tactics” such as fake reviews, disingenuous marketing, and trademark infringement.
  • Oct 2019 Project Zero became no longer invite-only in late Oct 2019, opening to qualifying brands in the US, Europe and recently Japan. Amazon reported 6,000+ brands had enrolled in Project Zero and the Transparency product serialization program, preventing 300,000+ counterfeit products from being sold. Its automated takedown tools also had taken down 400% more suspected listings than the same period in 2018, for a total of 90M+ takedowns to date.
What It Means
As a consumer-facing ecommerce giant, Amazon has been in the public eye for a long time. What it’s facing now is different. It’s not sour grapes by competitors, it’s not resellers resenting Amazon’s cut, it’s not the kind of one-off incidents that might be expected when operating at Amazon’s scale. The challenges that Amazon is facing are rooted in the business model of a 3rd-party seller marketplace, which now represents more than half of its business. There is a tension between an open marketplace growing rapidly through participation of smaller 3rd-party sellers with little red tape, and a large branded retail platform where consumers expect some measure of quality and gating. It’s an existential moment where cracks are emerging in the business model that helped its retail business get to its current scale.
The business model of a 3rd-party seller marketplace is predicated on Amazon being able to position itself as a provider of digital services, shielded from liability for the behavior of sellers by Section 230 of the Communications Decency Act. At the same time, in the interests of growth and the seller experience, Amazon offers a growing number of tools for sellers that encompass nearly every stage of the lifecycle. This means that a 3rd-party seller might rely on Amazon to ship from its manufacturers, store inventory, list and advertise products, set pricing dynamically, take payment for customer orders, pick, pack and ship orders, and provide customer service. While these are all nominally services provided to the seller (who, in this scenario, buys the goods, holds title and takes inventory risk), at some point it may appear disingenuous for Amazon to disclaim responsibility if it is performing many business activities for a seller. All retailers that operate a global marketplace or supply chain – e.g. Hasbro, Disney, Mattel, Walmart, Alibaba, eBay – face a measure of brand risk, but Amazon often also has significant control over its partners’ activities.
The US federal appeals court that handed down the ruling in Jul 2019 that Amazon could be liable for 3rd-party seller products seems to agree. The opinion said, “Amazon exerts substantial control over third-party vendors…Amazon is fully capable, in its sole discretion, of removing unsafe products from its website. Imposing strict liability upon Amazon would be an incentive to do so.” While Amazon has asked the court to review the decision, it is a signal of a growing sense in the realm of public opinion that Amazon’s power demands greater responsibility.
Amazon has often taken the stance that it is one or more degrees removed from the arena of liability, whether it is the products sold by 3rd-party sellers on its platform or how its tools are used (e.g. Capital One hack caused by misconfiguration of AWS firewall settings, use of its facial recognition technology for government surveillance). While reasonable on the surface, these arguments wear thin at their limits. This is particularly true when the risks are knowable in advance and can be mitigated with some combination of good monitoring, automation, design, education, communication, or contractual terms.
In the case of private-label brands, Amazon often compares itself to grocery retailers, which have promoted their own brands in-store for years. The difference, however, is that on a digital platform, shoppers aren’t wandering the aisles – they have a much narrower pathway to discovering products. A typical shopper goes to search, then search results, and then product pages, before making a purchase decision, and Amazon has substantial influence over what they see along that journey. Amazon as a platform has particular power in the market with more than half of all product searches starting on Amazon, but how it makes decisions to elevate some products over others lacks transparency. Grocery retailers, in contrast, can’t avoid being transparent about how they position and promote their in-store brands.
Generally, the direction that the market and regulatory environment is moving in suggests that Amazon will have to be more transparent about how it plays the dual roles of marketplace and seller. It has already committed to doing more policing of its marketplace; it will likely be doing more gating and taking more responsibility (if not liability) for products on its platform – e.g. expiration dates, counterfeits, certifications. That responsibility will cascade to its 3rd-party sellers, which probably means a greater burden on them to register, test, certify, tag, track and inspect. It will also likely mean changes to policies such as reducing the use of commingling, which makes it harder to trace products with issues and also can damage the reputation of blameless sellers when their inventory is pooled with problematic sellers’.
If all this happens, Amazon will probably have fewer (at least initially) but higher-quality 3rd-party sellers, resulting in significant reduction in product-based issues for customers. It will, however, need to institute programs to help smaller sellers meet more stringent requirements. Though regulatory outcomes are harder to predict, it also seems likely that Amazon will relinquish some controls over sellers, particularly those that might seem anti-competitive. It’s already been doing so – for instance, earlier this year abandoning a requirement that sellers not sell a product more cheaply elsewhere. If well-managed, this could, on net, be beneficial to Amazon, helping foster better relationships with its sellers.
Amazon may also need to take a new look at how it represents products from 3rd-party sellers on its website. Part of its value proposition for sellers is that customers trust Amazon and so sellers benefit from their products appearing to be sold by Amazon. While Amazon does reduce risk for customers, how it presents a product – e.g. “Sold by [Seller] and Fulfilled by Amazon” in small print – might suggest more direct control by Amazon over the product than there actually is. Some brands like Williams-Sonoma are also taking issue with how Amazon sells its branded products from 3rd-party sellers, representing the brand so strongly (e.g. Amazon creating an unauthorized Williams-Sonoma “store,” use of the language “Williams & Sonoma at Amazon” along with “Amazon Official Site”) that consumers might believe the products are being sold by Williams-Sonoma.
One of the key issues in Amazon’s business model is that its flywheel is driven by economies of scale, economies of scope, and owning the customer. The flywheel has been wildly successful, but, taken to its fullest extent, it means its business has expanded to infringe upon the scope of many other businesses – including the sellers on its platform. Nearly a decade ago, large retailers like Target and Toys-R-Us trusted Amazon to run their ecommerce business. Now, they are actively avoiding Amazon’s cloud and encouraging their vendors to do as well. Similarly, Amazon’s investment in its own delivery network caused a breaking of ties earlier this year with longtime delivery partner Fedex. Amazon’s expansion of scope also has immediate regulatory implications (e.g. antitrust and calls for breakup), as well as longer-term impact on partner trust and its ability to build new alliances.
Sometimes it seems like the only group that Amazon is reasonably popular with is consumers. In the recent Best Global Brands report by Interbrand, Amazon’s brand value surged 24% and helped it retain the #3 spot. It also gained the top spot in BrandZ’s brand rankings. Consumers trust Amazon more than banks, airlines and other tech firms. The dynamics around Amazon’s reputation are curious – it is more trusted by consumers than many institutions, yet at the same time viewed as a threat by businesses large and small and in the crosshairs of both regulators and labor organizers.
The longer-term impact of the business model challenges described above has been declining trust in Amazon by other businesses. Its rivals – e.g. Walmart and Microsoft – have been teaming up for the past few years in new alliances designed to defend against its encroachment. This may spill over into the consumer realm as well. The WSJ report on Amazon’s adjusting of user search algorithms to incorporate proxies for profitability, for instance, seems in direct contradiction with its stated value of “customer obsession.” The removal of “relevance” as a filter in users’ search results, in favor of “featured,” suggested a similar tradeoff. Its reputation among consumers has demonstrated vulnerabilities – the most recent Harris rankings based on a survey of consumer perceptions showed weaker responses about Amazon in the areas of ethics and culture. Trust is not something that is quickly rebuilt – just ask Microsoft how long it took to rebuild its reputation after its activities and antitrust case in the ‘90s.
Amazon certainly doesn’t lack enemies or critics. Its very real problems are complicated by players with agendas of their own – the many competitors across its many businesses, marketplace sellers and other partners that strain against the strictures of being part of Amazon’s ecosystem, brands that resent Amazon’s intermediation of their relationships with customers, regulators looking to be responsive to complaints from the public, and press with filing deadlines to make and faced with a wealth of market players ready to complain about Amazon. While much of this is just part of doing business at Amazon’s scale, there are signs of a concerted information warfare campaign against Amazon funded by its rivals – e.g. the “nonprofit” Free and Fair Markets organization. While digital information warfare is not new, it has been evolving for the past few years from the realm of nation-states and organized crime to the more mundane arena of commercial competition.
At its scale, Amazon doesn’t just operate in a free market, it also operates on a political landscape – one with tides that are shifting against its current business model. Many of the other tech firms are facing similar scrutiny. The increasing availability of data brings with it more public accountability – both because it becomes easier for the public to know about wrongdoing and also because it becomes harder for a tech firm to claim ignorance or impracticality. Amazon’s presence and scale – which were achieved in part because of the openness of its marketplace – are in turn driving these calls for greater governance and control because of the impact that Amazon has on so many people and entities.
Jeff Bezos has said that it is always Day 1 at Amazon. While some might interpret that to mean “act like a startup, make decisions fast, and avoid process,” emphasizing growth over governance, Bezos has been very clear that Day 1 is centered on customer obsession. Good governance is in the best interests of its customers, who want safe, legal, unexpired, non-counterfeit products. The 3rd-party seller model falls apart if customers begin to lose trust in their experience with Amazon. Amazon is not a startup anymore and is facing its current slate of challenges largely because it is big and in the public eye, and unlikely to move out of it anytime soon. Amazon should view this as an opportunity – a chance to reinvest in its customers’ trust and its relationships with sellers, and open the door to new avenues and markets that greater trust can enable. It has been caught on the back foot because the way it does business has become the way it has always done business. If it’s really always Day 1, then Amazon can’t rest on its laurels and perhaps should take a new look at what its customers want and need today.
Disclosure: Contributors have investment interests in Microsoft. Amazon and Google are vendors of 6Pages.