Lessons from the irrational human quirk that made Amazon a $1 trillion company

Amazon is by far the largest public eCommerce platform on the planet. They dominate the market with 49.1 percent of all U.S. eCommerce sales and they recently became only the second company in history to cross the $1 trillion market capitalization mark.

They sell anything you can imagine, offer multitudes of streaming content and ancillary services, and has a hosted cloud computing platform relied on by many of the web’s biggest sites (and on its own is the fifth biggest enterprise software company on the planet). But what’s the one thing Amazon’s customers talk about most? Amazon Prime. Created as a way to offset customer’s irrational hatred of shipping fees, Prime has grown into a pillar of the Amazon customer experience.

With this relentless focus on the customer experience, Amazon has been able to grow their company from an online book reseller to the retail juggernaut we know today. Much of this success can be tied back to what Jeff Bezos calls the “Virtuous Cycle.”

The Virtuous Cycle via CB Insights.

Starting with Customer Experience, this diagram shows how Amazon finds success by leveraging their infrastructure to both craft a better customer experience and grow the business as a result. It goes like this:

  • Customer Experience — Amazon starts by offering a remarkable customer experience. Once people start hearing about these experiences, through word of mouth or positive press coverage, they’ll come to the website. This leads to an increase in traffic.
  • Traffic — The traffic results in increased sales (obviously), but  also allows Amazon to expand their footprint. They did this by opening up their marketplace to third-party sellers.
  • Sellers — For sellers, the wider audience and superior customer experience offered by Amazon was attractive to tap into. For Amazon, opening up to third-party sellers meant more available products.
  • Selection — More selection means Amazon customers will have a wider range of options to choose from. They’ll also have access to the network benefits of large-scale distribution if the third-party sellers use Amazon’s fulfillment services. Which cycles back to customer experience—if you’re more likely to find what you’re looking for, you’re more likely to have a good experience

This cycle is the basis for how Amazon thinks about their company, and it’s working. One of the benefits of this growth is a Lower Cost Structure. As their scale increases, Amazon has had both the capital and volume to build out massive and efficient fulfillment and logistics infrastructure, which ultimately allows them to pass cost savings on to consumers in the form of Lower Prices. That, of course, feeds into the Virtuous Cycle by improving customer experience.

This closed-loop cycle forms a kind of flywheel, where the energy Amazon puts into each stage makes the whole process faster and more efficient. 

With this idea in mind, it’s easier to explain how Amazon took a service like Prime, historically a loss leader, and used it to spur massive growth in their company. Prime memberships have grown more than 300 percent since 2013. Amazon started wih the idea of free shipping and, through the lens of the Virtuous Cycle, morphed it into a subscription/membership service that now dominates a number of different markets. 

They did this by playing on the irrational psychology of shipping costs, consistently adding value to their service, and bundling together essential items, all of which gave Amazon the ability to move past a successful eCommerce store to the ubiquitous subscription service it is today.

The irrational customer bias toward low shipping costs

In the early days, Amazon had a problem: How could the company get people to shop online when they hated shipping costs? So much that even if Amazon showed the customer that they would save money by shopping with them over their local bookstore, the shipping costs were still a deterrent. 

Why do people hate shipping fees so much? One reason is that we don’t see shipping as an extra service.  With few exceptions (like in-store pickup or Amazon’s own Locker services), any time you order a product online, it has to be shipped to you. The shipping part is a given, so it feels like a part of the transaction that should already be built in. Fees for shipping don’t seem like an add-on service with a clear benefit, they feel like a tax that don’t provide us anything extra in return. 

Amazon needed to find a solution and after a few failed experiments, they landed on the answer: Amazon Prime.

“It turns out that you can have people pre-pay for shipping through a program like Prime and they’re incredibly happy to make the trade. And yes, on some orders, and for some customers, the financial trade may be a lossy one for the business, but on net, the dramatic shift in the demand curve is stunning and game-changing.”

Eugene Wei

What Amazon found was that by bundling the cost of shipping into the price of the product and offering that shipping as “free,” consumers avoided that feeling of being ripped off with additional fees for something they couldn’t avoid. Free shipping makes purchases more analogous to shopping offline in a physical store (where shipping fees don’t exist, or, more precisely, are already built into the goods) and cause people to avoid that feeling of being “taxed.” This concept was so powerful and useful for Amazon, that they didn’t always cover the full costs of shipping in the purchase price, instead taking a loss on the shipping costs to facilitate the sale.

Amazon originally offered free shipping using purchase thresholds (e.g., get free shipping by spending $49), which is a method now employed by many stores. Free shipping was successful at getting consumers to buy online, but Amazon’s real innovation was adding a membership component to their free shipping model. 

What Amazon found is that people were willing to pay upfront to lock themselves into free shipping on all purchases later. This might be because people tend to overvalue the benefits of free stuff.  As Duke professor Dan Ariely writes in his book Predictably Irrational: The Hidden Forces That Shape Our Decisions, “Most transactions have an upside and a downside, but when something is FREE! we forget the downside. FREE! gives us such an emotional charge that we perceive what is being offered as immensely more valuable than it really is.”

Amazon discovered that people would be willing to pay upfront, to receive the perceived value of free later on and avoid those pesky thresholds, which also allowed buyers to feel like they were getting the should’ve-been-included shipping cost for nothing. That’s the irrational part (it doesn’t cost nothing, it costs a yearly membership fee!), but it’s a psychological quirk Amazon has rode to the bank.

Fees for shipping don’t seem like an add-on service with a clear benefit, they feel like a tax that don’t provide us anything extra in return.

The rise of Amazon Prime

Three years after launching free shipping with thresholds, Amazon introduced free shipping as a paid-upfront service called Prime, in February 2005.

Currently priced at $119, Prime memberships give customers  access to all sorts of perks. While a Prime membership now offers much more than when it started, one of the biggest selling points is simple, fast, hassle-free shipping. And at the outset, that’s all Prime came with (albeit at a reduced cost—Prime’s launch price was $40 cheaper than it is today). That’s important, because 96 percet of customers are more likely to shop on a site that offers free shipping, even if they’re technically paying for it as a part of their membership fees or it’s built into the cost of goods.

Free, easy shipping is one of the sparks that moves the Virtuous Cycle forward. Streamlining the experience of purchasing a product through Amazon makes customers feel like they’re getting what they deserve on each transaction (shipping) for free (even though they’re paying for it). This is a great customer experience in itself, but it’s also a powerful motivator to come back for additional purchases. Forty-six percent of Prime customers say they purchase from Amazon at least once a week.  With that kind of buy-in, it’s no surprise that Prime memberships have been on the rise for the past five years. But this means that Amazon’s shipping costs have increased as well.

Gross shipping costs via GeekWire.

Amazon’s commitment to the customer experience is not cheap by any means; they’re on pace to hit $7 billion in gross shipping costs. However you look at it, the choice to offer free, easy shipping is for the benefit of the customer. If you take the 100 million subscribers at $119 per year that’s $11.9 billion dollars in revenue. When you account for the $7 billion in shipping and $5 billion for video content, Prime memberships are just shy of breaking even (and if you add in other ancillary services that come with Prime like the Kindle lending library or Prime Music, it’s probably running at a loss).

That said, Prime definitely has advantages for Amazon as well. By labeling items as Prime available, the company can capitalize on existing inventory. When an item is known to be in stock and easily shipped to the customer from a nearby warehouse, Amazon can highlight it in their on-site search results.

This also means that third-party sellers without free shipping are at a disadvantage. The draw of a Prime item over another can steer the customer toward products that utilize Amazon’s own fulfillment service. By tapping into the obvious customer preference toward subjectively free, streamlined shipping options, Amazon is making sure that their brand is tied to the idea of convenience. The customer knows that their purchases will arrive within two days, without issue, and will meet their needs accordingly.

Add value over time to form deeper customer relationships

While Prime started out as a way to prepay for shipping costs, it now offers video, music, reading, exclusive deals, credit cards, membership sharing, and a ever-expanding list of services. Each of these additional products and services is included in the existing Prime membership, adding value for the customer. They build on top of the Virtuous Cycle as a way to continually make the customer experience better.

When a customer makes a purchase, finds an exciting new show, or reads a great book, it adds another positive dimension to their overall Amazon experience.

Each touch point serves to enhance the customer relationship and is a way for the customer to promote their experiences to others. This helps move the needle for the traffic phase of the Virtuous Cycle. You can see this evidenced in how Prime subscribers have grown from 25 million in 2013 to 90 million in 2017.

Prime subscriber growth via CB Insights.

In 2018, that number has increased to over 100 million subscribers. When you consider that Prime members spend, on average, $1,300 per year as opposed to $700 for non-Prime members, you can see additional benefits, as well. Prime members account for  85 percent more revenue per customer than non-Prime members. This helps Amazon increase the lifetime value of their customers, deriving more revenue from each customer they acquire through Prime, and it helps offset the loss leader that is free shipping.

Free, easy shipping is one of the sparks that moves Amazon’s Virtuous Cycle forward.

Through Prime, Amazon has made their service indispensable to their customers. For many people, Amazon is a one-stop shop for everything from household goods to entertainment. By continually adding value to this existing relationship, Amazon has been able to increase the price of Prime membership twice in the last five years. These price increases are not the only way that Amazon is capitalizing on Prime memberships. They’re also using add-ons like Prime Now, a mobile-focused same-day shipping platform, to boost their expansion revenue. These additional services add extra monthly charges on top of the existing $119 for those customers who opt for them.

By consistently adding value to the customer experience, Amazon cements their relationship to an ever-growing audience. The idea of having to either pay for shipping or wait more than a few days feels out of place in today’s online shopping market. That is in big part because of the popularity of Amazon Prime and the expectations it’s instilled in shoppers across the entire spectrum of eCommerce. 

Amazon used their increasing market share to influence not only their customers but also the entire eCommerce space. Forging a deeper relationship with their Prime customer base gives Amazon the power needed to expand its business into an umbrella of different products, services, and technologies.

Bundle together essential products for a simpler buying experience

As Amazon grows, they’re able to lower their prices, invite more third-party sellers to the service, and find different ways to streamline the customer experience. Prime members receive exclusive deals for specific items, or groups of items, that can be bought as a bundle. Amazon also creates ad-hoc packages based on items that, according to company data, customers typically purchase together. Not only does this make it easier for the customer to buy more through the service, but it also takes away some of the cognitive load a customer might feel when making a purchase.

By recommending additional products that are typically purchased together, or by bringing together items that should be purchased together, Amazon is able to potentially boost their overall cart value as well. Though Amazon now run a half dozen multi-billion dollar businesses, online shopping still generates the bulk of Amazon’s revenue.

Net revenue in billions for Amazon’s online stores via CB Insights.

Amazon’s core feature—its online store—generates the most revenue by far (about 3.5x the next closest business). When we take a look at Amazon’s additional services, like subscription (Prime, Pantry, etc.), Amazon Web Services (AWS), and third-party sellers, the impact of the Virtuous Cycle is evident as well.

Online Stores and Subscription Services are the bread and butter of Amazon’s core product, the experience stage, where customers are wowed by the ease with which they can make a purchase, the sheer breadth of the available product selection, and the perks they can access through their Prime memberships. This leads to more customers, which you can see in the three year growth of Subscription Services from $4 billion to $10 billion, and it’s where the cycle moves into the traffic stage. 

From there, we enter the seller stage, where Third-party Seller Services have doubled from $16 billion to $32 billion over the past three years. That leaves AWS and the “Other” category (which includes things like Amazon Fire tablets and Alexa devices). With the availability of different products, the ease with which customers can buy and receive these products, and the consistent revenue coming from Prime memberships, Amazon can grow their product offering into other markets, like cloud storage, cloud computing, and electronics.

This stands as a good example of the Virtuous Cycle at work. By focusing on the customer experience and making it as simple and straightforward as possible to make a purchase, Amazon is actively growing their company. That gives them the ability to offer lower prices for product bundles, recommended purchases, and additional services like AWS. The entire process builds on the idea that the experience a customer has with the service is as important as the products that they buy.

Key takeaways

Prime started out as a way to prepay for “free” shipping, and then it branched out to help grow Amazon into the dominant eCommerce provider it is today. The Virtuous Cycle gave Amazon a way to strategically add value to their service and the guided the direction needed to make sure their customers were on board.

► Focus on the experience

Customers who have a bad experience with your service aren’t likely to come back. Make sure that everything your company does not only supports the customer but also heightens their experience with your product. No one will recommend a product or a service that doesn’t provide at least a good experience.

► Find a way to subvert biases

Nobody likes paying shipping costs. By tapping into a pain point nearly every eCommerce customer shares, Amazon was able to build out a service that helped their company grow. If you can alleviate the potential issues a customer might see with your product or service before the purchase has been made, you’ll be removing any potential roadblocks in the customer journey.

► Consistently add value

Prime members now get so much more than free shipping. Whenever a customer interacts with your service, be it through a purchase or by just browsing your website, find a way to make it valuable. The more value a customer sees in your company, the more you’ll be able to build on the relationship you have with them.

► Make it easy

KISS is a design acronym that stands for “Keep it simple, stupid.” It’s harsh but true. When you make it simple for customers to make a purchase, request a quote, contact support, or just find the item they’re looking for, that leads to a better overall experience with your company.

► Be indispensable

Amazon built their service to provide everything under the sun. While you might not be able to achieve that level of ubiquity, it’s important that your customers think of you at the right times. Find a way to make your product or service the best possible solution to a customer problem and they’ll remember it when the time is right.

Sam Hollis
Sam Hollis is a writer at Jilt. When he's not writing about high growth eCommerce startups, he likes to play the piano and cook. See more his writing at his Contently page.

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