Embracing Chaos

Amazon has a history of facilitating disruptive change.  First by selling books online, they demonstrated the advantages of a well-run online store.  Then with music, movies and just about everything else, they have shown that centralizing inventory and customer experience allows for reduced costs and an improved experience over a traditional distributed retail model.  Today, Amazon Web Services is starting to disrupt IT operations similarly by providing a higher quality service at lower cost than most companies can manage themselves.  They achieve these scale economies through centralization.  With Kindle Amazon is attempting another disruptive change, this time in the way people read books.  Lower distribution costs give electronic “e-books” an intrinsic advantage over physical books, hinting that e-books are inevitable.  But will Kindle be able to “cross the chasm” and become a mass-market device?  Amazon’s complementary assets, scale and technology all make it likely that Kindle will succeed.

Several startup companies have sold e-book readers in the past, but none successfully.  Sony is the only other large company to have tried.   Assurance that a risky new technology is backed by a company that won’t disappear is important for mass-market adoption, giving Sony and Amazon an advantage.  This is especially important for devices that consume media, as the device’s utility dwindles without new content.  Amazon is especially well positioned to offer media for Kindle through its complementary assets.

Amazon’s established relationships with book publishers are extremely valuable to Kindle.  Book publishers control e-book content.  Amazon’s history of selling physical books has earned them the trust of almost every publishing house, ensuring easy access to electronic versions of books. In addition to existing e-books, Amazon’s scale gives them leverage to encourage publishers to release electronic versions of books.

Beyond that, Amazon has rare technology to make electronic versions of books available with far less work on the publishers’ parts.  Amazon has spent years scanning physical books to enable a feature called “Search Inside This Book” on their website.  Along with Google, they have one of the only large archives of scanned physical books in the world.  This enables selling e-books for books that publishers don’t even have original electronic copies of, with rights negotiations as the only remaining barrier.

Innovators have been jibbing together their own e-book readers out of laptops and PDF files for years.  Early-adopters look for concrete advantages like the ability to search books.  Med-students give Kindle rave reviews for this capability.   The easy availability and portability of dozens of books appeal to the small segment of truly voracious readers.  Kindle seems to serve these early segments well.  To cross the chasm into the mass market of the early majority, Kindle must make the experience simple and reliable.  Kindle’s wireless data connection sets it apart from all previous e-book readers.  By leveraging Sprint’s nation-wide 3G cellular data network, Kindle can load content without the operator even owning a computer.  Thus Kindle dodges the inevitable complexity that arises anytime a PC is involved.  This, along with Amazon’s well-established customer service, promise to make Kindle much easier for the early majority to accept.

Kindle seems well positioned for acceptance by the mass market.  If successful, Amazon will need to balance publishers’ need for DRM against consumers’ desire for open content.  The music industry has exposed these issues but certainly not solved them.

[This is another recycled homework assignment.  Something to keep y'all entertained while I'm in New Zealand!]

[I wrote this for my excellent class on Open Innovation.  With mere weeks to go until I finish my MBA, I haven't found much time to write original stuff for this blog, so I'm recycling a bit.]

The music recording industry is in trouble.  Disruptive changes in music playback technology have seriously reduced demand for their mainstay business, physical CD sales.  CD sales comprise 80% of the industry’s total revenue, but have dropped sharply in recent years.  Last year sales dropped by 19%, and the channel is in danger of freefall as retailers start to re-allocate store space currently assigned to CDs.  The industry’s hopeful replacement revenue stream, digital downloads, looks like it will only replace a fraction of the loss.  What went wrong?  How did an entire industry fail to keep up with technological innovation?

The recording industry’s value in the economy comes from providing consumers access to great music.  The value chain includes discovering talent, developing the talent to create and record great music, and distribution of that music to consumers.  The early stages of the pipeline have remained about the same for decades.  But technology has permanently changed how music is distributed to consumers.  This fact was driven home to EMI management when a group of teenagers were invited to take as many free CDs as they wanted after participating in a focus group, and they didn’t take a single one!  The recording industry has acted as a manufacturer of physical goods.  But really their business is in licensing Intellectual Property (IP).  When it was inconvenient for consumers to reproduce high-quality recordings the distinction was unimportant.  But today physical distribution of recorded media provides a tiny fraction of the value in the music value chain.

Music IP is legally controlled by copyright.  Digital Rights Management (DRM) technology has been used to enforce licensing agreements on digital recordings files.  Until 2007, the recording industry only sold digital music with DRM, in an attempt to control copyright violations.  The great irony of DRM that has prevented its acceptance by consumers is that by restricting the use of the legally distributed digital music, DRM makes the legal product lower quality than the illegal product.  The lack of consumer incentive to use a lower quality product, combined with the impracticality of enforcing copyright agreements on individual consumers makes the appropriability regime in the distribution of music to consumers very weak.

We can think of innovation in this content space as the creation of compelling new music.  A hot young band with a new album or style of music has an innovation they want to commercialize.  As discussed earlier, the appropriability regime with consumers is quite weak.  The value of the labels’ distribution assets are waning, putting the band in the position of the attacker’s advantage according to Gans’ and Sterns’ innovation framework.  The band should go it alone and seek novel distribution techniques, ignoring the incumbent labels.  The appropriability regime is less clear with respect to incumbent labels – the album itself is well protected by copyright law since the legal recourse is straightforward against a large recording company, but a novel style of music is unprotectable.  So a promising band considering partnering with an incumbent label should consider how easily the value of their art could be expropriated.

The recording industry has focused too long on a part of the value chain that is no longer economically relevant.  They should look to other industries for inspiration as to how to create value in an environment where content and innovation are created more openly.

Although most corporate mergers fail (often due to mis-aligned incentives on the part of the deal-makers) there is a solid economic foundation for the proposed Microsoft + Yahoo! merger.  Most of their assets will work no better combined than separate.  But the merged Microhoo ad network would be significantly more valuable than the sum of two ad networks alone. 

Why bigger is better for online advertisers

The reason lies in network effects of the online search + advertising industry.  Imagine you’re an ad buyer which is to say you have a service you want consumers to find online.  Unless you’re a huge company, you have limited energy to expend buying your ads.  So rather than buying and managing separate ads from each Microsoft, Google and Yahoo, you’re likely to just deal with a single ad publisher.  The sensible ad buyer will choose the ad publisher which gives them the most value for limited effort. 

Right now the clear choice for an online advertiser is Google.  Because they have the most search traffic, they are best able to reach customers.  Combined with their adsense network, Google clearly has the largest inventory for an ad buy making them the natural choice for anybody not willing to spend a lot of energy managing their online advertising.  This logic underlies the recent acquisitions of Doubleclick, AvenueA/Razorfish/whomever, and now Yahoo!  Network effects in advertising mean that the largest network will be the most sucessful.  So the mergers will continue as far as the anti-trust regulators allow them to until a handful of bitter enemies remain.

This much might be obvious to some of my readers.  But I felt like sharing this analysis since I’ve read nothing in the common press that explains the basic economic motivation of this deal.

Wrinkles, twists

An irony of the network effect comes from the auction nature of keyword buys.  Advertisers bid for the right to get their message in front of customers.  When more advertisers are competing for the targeted eyeballs of consumers, the prices for advertising go up.  This means that prices will tend to be higher on the larger ad networks.  So bargain seekers can get more advertising for their dollar by seeking out smaller networks.  This appears to contradict the logic that bigger is better for ad networks.  But many advertisers are limited not so much by budget but by the ability to reach highly qualified customers.  If you are selling poodle tattooing services in the pacific northwest, odds are you will not hit max out your advertising budget on any of the ad networks simply because not that many people are searching for your services.

I could probably fill pages with speculation about the culture clash between Microsoft and Yahoo and other reasons why it will or won’t work.  But if you’re interested in that stuff, I’m sure you’ll have no problem finding it in the backwaters of the blogosphere.  I can’t help but drop a couple relevant ideas though.  First, from what I hear, the executive management at Microsoft is so dysfunctional right now, Yahoo will provide fertile new ground for their turf wars.  If the top bosses are adept, they will use the many iterations of re-orgs to sluff off ineffective execs to projects where their overall damage can be minimized.  Second, I think I hope Microsoft has evolved enough humility to understand that they’re better off simply shutting down Yahoo’s services than forcing everything to port over to NT servers.  Right, guys?

Disclaimer

I feel compelled to point out that the opinions expressed here are mine and mine alone.  In no way does this article reflect any official position of my employer.  This is my personal analysis of the economics behind the industry I work in.