Monday, 9 June 2014

The Downside of Scalability: The Piracy Problem - and the Business Model Solution

I have written previously about how scalability is allowing enormous rewards to accrue to top performers across a range of industries. This phenomenon is behind large bankers’ bonuses as well as soccer players’ and movie stars’ outsize paychecks. At first glance, scalability seems to be an attractive property of an industry to be in, if you are amongst the most capable in that industry. However, I’ve recently been considering one big downside of scalability: the way that imitation, or piracy, can erode your position. The gains to be had from scalability are fragile.

Scalability applies when the marginal cost of reproducing a product or service is low-to-zero*. In these circumstances, some fixed cost is expended to create a product, but then it can be distributed widely very easily. This creates a ‘winner-takes-all’ dynamic in an industry, where customers gravitate towards the best offerings in the field. The movie industry makes most its money from a few blockbuster hits, the book publishing industry earns its profits from a handful of bestsellers, and top selling singers sell millions of records, while the majority of musicians scrape by.

Digitization means more and more industries are showing this scalability property, as digital delivery of has close-to-zero marginal cost. What used to be delivered in person can now, sometimes, be done online. For example, in the higher education industry, online courses (MOOCs) are threatening to disrupt the traditional lecturer-based pedagogical model. In finance, exchange traded funds (ETFs – often marketed over online trading platforms) are highly scalable and low-cost alternatives to traditional stock broking or mutual fund investments, and have already captured substantial market share.

However, the very nature of low-to-zero-cost replication means that scalable products are the most vulnerable to piracy and imitation. The most obvious manifestation of this is digital piracy: the peer-to-peer sharing of music, movies, TV shows and software over the internet**. Piracy has led to a dramatic decline in some industries, for example the market for (legal) recorded music has been shrinking for some time. Scalability is therefore a mixed blessing, even for top performers in a given industry.

Examining the economics of piracy is rather interesting. To provide a simplified sketch: copyright holders are essentially trying to take the role of a monopolist, arbitrarily restricting the supply of a good. They try to pick a price that maximizes their profit. The introduction of piracy creates a parallel market, with a structure resembling perfect competition, in which price falls to marginal cost – which in this case is essentially zero.

In this light, an industry becoming scalable looks destined for decline. However the erosion of profitability is not inevitable. It depends a lot on how the industry responds, and in particular on what business model the firms choose to adopt. The TV industry has weathered the digital storm far better than the music industry, with channels such as HBO going from strength to strength. This may have a lot to do with their subscription-based business model, which provides viewers unlimited usage once the fixed fee is paid.

The music industry was amazingly slow to respond to the transition to digital media, and in fact it was new entrants such as Spotify who successfully marketed unlimited-use subscription based services. These services are far more appropriate for a digital age than the outdated notion of buying individual albums. The record labels’ attempt to sustain high album prices in a digital world was misguided and hastened the album’s decline. Musicians have had to adapt by concentrating more on generating revenue from live shows, a distinctly unscalable service, now that the scalable recorded-music revenues are evaporating***.

Having praised the TV industry’s subscription based models, I should also point out that not all is well here. Many people are driven to illegally download TV shows for the simple reason that the legal ways of obtaining the shows are either inconvenient or don’t even exist at all. I would love to subscribe to Netflix, as they have some great shows, but they are not available in France where I’m presently based.

Furthermore, illegal content can be higher quality than the legitimate offerings. When I was in the US last year, I paid for and watched Breaking Bad’s final season using Amazon Instant Video. The first problem was that the checkout process was painful, just because I was using a British credit card. Then, having purchased the episodes, my enjoyment of the streaming video was harmed by a poor internet connection, and there was no option to download the shows. If I had downloaded whole episodes using BitTorrent instead, my viewing experience would have been, quite simply, better.

In summary, scalability can be a route to massive rewards, but it can also be a path to major disappointment, when piracy or imitation prevents a top-performer from appropriating a slice of the enormous value they can create. The careful crafting of a business model can mitigate that risk, but it requires foresight and an ability to change the standard ways of doing things. Entrepreneurs have an opportunity to experiment with new ‘scalability-robust’ business models when incumbents fail to adapt – and those that succeed can transform an entire industry.

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* It is actually highly relevant whether the cost is low or zero. Piracy is much easier when the replication cost is zero than when it is some small but non-zero amount.
** There are other manifestations that don’t rely on internet technology, such as taping songs playing on the radio or photocopying pages from a book.
*** Academics concerned about the rise of MOOCs might want to take note: a demand for live tuition will likely remain, as long as (like live music) it offers a superior experience to the recorded version.

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