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.

Does this Apple look rotten to you? The World’s Largest Company and a $1bn Pyrrhic Victory

Apple, the world’s largest company by market capitalisation, reached two milestones last month. On 20th August, it became the most valuable company in history, in nominal terms, after surpassing the previous record set by Microsoft in 1999. And it was declared the victor in a long-running court case with Samsung over patent rights, in which it was awarded a cool $1 billion in damages.

Apple is a lot of people’s darling company. It has done incredible things: it has revolutionised many industries from computing to music through to mobile telecommunications. But its relentless pursuit of court cases based on intellectual property is a bad omen. It hints at a company that is paranoid, aggressive and insecure, not one that is cool, calm, and confident as Apple always used to seem.

Superficially the lawsuit is a rational manoeuvre: by disarming your competitors you can maintain your dominance in the market.

But that is precisely the problem. Not only does Apple come across as petty and bullying by pursuing its court cases, it appears to be aiming for a monopolistic position from which it can exploit its market power and dictate smartphone prices. This has been astutely ridiculed by Samsung which points out, “[it is] unfortunate that patent law can be manipulated to give one company a monopoly over rectangles with rounded corners.”

Courts around the world have refused to side with Apple. A judge in the UK dismissed Apple’s suit against Samsung, saying “[Samsung products] are not as cool. The overall impression produced is different.” In Germany, the Netherlands, Japan and Korea courts have found in Samsung’s favour. It is perhaps unsurprising that Apple’s only major victory was on its home turf in California – and the figure awarded in damages is absurd, like a number Dr Evil might pull out of the air.

What is also quite shocking is the fact that Samsung is one of Apple’s biggest suppliers. Plenty of management research shows that cooperative relationships across value chains contribute to long-run success – exemplified best by Toyota’s rise and longevity. Innovative technologies are shared, supply chain management can be optimised, best practices spread. Samsung is dangerously conflicted, acting as both supplier and competitor to Apple, and a long-running feud will do neither company any favours.

With regard to Apple’s new record market capitalisation this is only a nominal record. Accounting for inflation, Microsoft still holds the real record (peak valuation in $850bn 2012 dollars). Microsoft achieved that milestone in the late nineties, shortly before the tech bubble burst.  Apple is beginning to look like Microsoft in other respects. For starters it has transitioned from a rapid growth phase to the ‘mature company’ phase that stock analysts seem to dread (its first dividends, paid in July, are a key indicator of this). Microsoft adopted bullying tactics with its competitors (Netscape, BeInc…). And Microsoft did its utmost to maintain its monopolies over various software classes. It very quickly became an uncool company, its valuation flatlined, and right now it seems to be destined for decline.

Will Apple go the same way? It seems to be well on the way. Its products have been revolutionary – but its improvements with each new product generation are now more and more incremental. The release of a new iPhone (the 5th generation) will be a great test. The sales are likely to be strong, but sales numbers will be less important than the quality and originality of design when considering Apple’s long-run competitive advantage. Near field control, mobile wallet, or 4G technology cannot be considered revolutionary developments – they are already available so widely. On the other hand, soft-SIM technology, femtocells or something entirely novel could demonstrate that Apple still has what it takes to innovate.