Differentiation and Value Capture in the Internet Age

It’s hard to have a conversation with anyone in tech without the word “scale” entering the conversation; “Internet scale” is a particularly popular variation of the term. Scale is a concept that is at the root of most venture investing: because software has zero marginal cost – one copy costs just as much as 100, or one million – there are massive profits to be gained from reaching huge numbers of customers on a uniform product or service.

The idea of scale, though, isn’t something unique to the 21st century; in fact, it was the key driver of the 20th, and it all started with Henry Ford and the assembly line.1

Henry Ford didn’t invent the car; before the Model T there were all kinds of automakers producing cars that were mostly custom-built and only available to the very wealthy. However, they were notoriously unreliable and very difficult to repair. Ford changed all that by building one model in one color with interchangeable parts at scale: this allowed Ford to charge a shockingly low price of $825 upon the Model T’s introduction in 1909 ($21,650 in today’s dollars). What was even more impressive was that, over the following years, Ford continued to decrease the price: a Model T in 1925 cost a mere $260 ($3,500 today). This had a massive impact on the adoption of the automobile, and the entire world began to adapt, paving roads, building gas stations, establishing diners and garages, etc.

Over time, though, the Model T was very much a victim of its own success: by massively expanding the market for cars and triggering the development of car-friendly infrastructure, Ford created openings for other car manufacturers that previously didn’t exist. A company like General Motors didn’t need to compete with Ford by building a Model T clone; instead they could develop multiple brands at different price points to capture particular segments of the market. The market was so big that scale could be brought to bear in a much more finely-grained way.

Today, few if any of us drive the exact same car with the exact same color with the exact same interchangeable parts. In the United States you can buy the Nissan Versa for $12,800 or a Lamborghini Veneno Roadster for $4.5 million. Admittedly, the latter isn’t produced at scale (there will be only 9 built in 2014), but the Mercedes-Benz CL-Class is, and it costs over $100,000. A huge percentage of people have a car that fits their preferences and lifestyle, and while they all do the same thing in a technical sense, you can pay for exactly the type of experience that you prefer.

A few weeks ago I wrote about the smiling curve and how value would increasingly flow from publishers to aggregators operating at scale:

The Smiling Curve for publishing
The Smiling Curve for publishing

However, I didn’t spend much time on the left side of this graph, beyond noting that readers will often be loyal to a specific writer, or to a focused publication. That writer or publication has one unique superpower: they are the only one of their kind. To use the strategic term, they are differentiated, and differentiated people – or products – can charge far more than their marginal cost. And no one is more differentiated than Taylor Swift.

A few weeks ago, in a widely discussed move, Taylor Swift pulled her music off of Spotify, and then proceeded to become the first artist in history to sell more than 1 million records in a week three albums in a row.2 In an interview with Yahoo Music, Swift argued that Spotify devalued music:

Music is changing so quickly, and the landscape of the music industry itself is changing so quickly, that everything new, like Spotify, all feels to me a bit like a grand experiment. And I’m not willing to contribute my life’s work to an experiment that I don’t feel fairly compensates the writers, producers, artists, and creators of this music. And I just don’t agree with perpetuating the perception that music has no value and should be free.

The thing is, though, given that music has a marginal cost of zero – to create one more copy doesn’t cost a cent – its natural price is, well $0. Free by a different name. And, when you look at the industry from this perspective, Spotify is the positive force for music that its CEO, Daniel Ek, believes it is:

Our whole reason for existence is to help fans find music and help artists connect with fans through a platform that protects them from piracy and pays them for their amazing work. Quincy Jones posted on Facebook that “Spotify is not the enemy; piracy is the enemy”. You know why? Two numbers: Zero and Two Billion. Piracy doesn’t pay artists a penny – nothing, zilch, zero. Spotify has paid more than two billion dollars to labels, publishers and collecting societies for distribution to songwriters and recording artists.

It’s a compelling argument, and Ek is justified in making it. In fact, I’d go so far as to say he is completely correct when it comes to any random song. But here’s the thing: Swift is completely correct too, especially when it comes to her music in particular. Swift herself explained why earlier this year in an op-ed in the Wall Street Journal:

In mentioning album sales, I’d like to point out that people are still buying albums, but now they’re buying just a few of them. They are buying only the ones that hit them like an arrow through the heart or have made them feel strong or allowed them to feel like they really aren’t alone in feeling so alone…There are always going to be those artists who break through on an emotional level and end up in people’s lives forever. The way I see it, fans view music the way they view their relationships. Some music is just for fun, a passing fling (the ones they dance to at clubs and parties for a month while the song is a huge radio hit, that they will soon forget they ever danced to). Some songs and albums represent seasons of our lives, like relationships that we hold dear in our memories but had their time and place in the past.

However, some artists will be like finding “the one.” We will cherish every album they put out until they retire and we will play their music for our children and grandchildren. As an artist, this is the dream bond we hope to establish with our fans. I think the future still holds the possibility for this kind of bond, the one my father has with the Beach Boys and the one my mother has with Carly Simon.

By all accounts, Swift is describing the relationship she herself has with her fans. Her deeply personal and well-written songs speak to adolescent girls in particular in a way few artists ever have; for her (many) fans, Swift is “the one.” She is, to put it in economic terms, highly differentiated.

That’s why I loved her decision to pull out of Spotify.3 Taylor Swift is not some sort of Luddite futilely standing against the forces of modernity; rather, she is a highly differentiated content creator capturing the immense value she is creating instead of ceding it to an aggregator that treats every piece of content the same.

There are other examples of content creators realizing and capturing their value. When it comes to publications, the Wall Street Journal has long led the way in putting much of its content behind a paywall, betting that its focus on finance and business would make its content worth paying for. Other examples are the Financial Times and more recently, the New York Times. To be fair, the results have been mixed, in part because all of the paywalls have varying degrees of leakiness. This, though, gets at one of the most important tradeoffs any content creator has to make: when it comes to capturing the value created through differentiation, reach and profit are inversely correlated.

In fact, this is the exact dynamic that explains how Apple captures such a huge percentage of the profit in the markets they compete in, even as they have a relatively small market share. iPhones, Macs, etc. are differentiated by Apple’s software and ecosystem, and the company charges accordingly. Those higher prices, though, preclude Apple from ever being the majority player.4

There are examples in software too. Developers have decried the App Store “race to the bottom”, when in reality the market is behaving exactly as you would expect: software, like music, has zero marginal cost, which means that absent differentiation the fair price of an app is $0. Omni Group, though, sells iOS apps for a whole lot more: OmniFocus for iPhone, for example, is $19.99; the iPad version is $29.99, and, according to founder and CEO Ken Case, Omni is more than satisfied with the company’s foray onto iOS.

The math is obvious: one customer buying both versions of OmniFocus is worth 50 customers buying one copy at $0.99, and worth an order of magnitude more customers were the app free with ads. Moreover, fewer customers mean lower support costs on one hand, and more ardent evangelists on the other. Customers who are willing to pay for a superior product are valuable in all sorts of ways, and Omni is spot-on in pricing their highly-differentiated apps in such a way that they capture a good part of the value they create.

It’s easy to wonder why more developers don’t take the same route as Omni – or singers like Swift, or publications like the Wall Street Journal – but the truth is creating differentiation is hard. Case told me:

Not every app becomes profitable just because it’s priced reasonably with respect to its value. With OmniGraphSketcher, for example, we didn’t find as large a market as we were hoping to, and though its simplicity was great, as a simple app it didn’t offer enough value to justify raising its price to sustain development in its small market. So we stopped selling it (and released it to the public for free as open source, where it also hasn’t found much traction). The lesson I’ve drawn is that it’s important for us to build higher-value apps

It’s a tough standard, to be sure, but as a consumer, it’s actually pretty great news. Only the best will succeed.

It’s easy to think that the Internet Age is well-established, but the truth is we’re only getting started. Remember, it took nearly two decades for the Model T to develop the car ecosystem to the point where new opportunities emerged to offer differentiated vehicles at much higher prices and much greater per-unit profit (Mercedes-Benz, for example, wasn’t founded until 1926, right about the time that the Model T reached its lowest price). I strongly believe that we are at a similar turning point when it comes to Internet-enabled businesses.

The thing about Internet scale is it doesn’t just have to mean you strive to serve the most possible people at the lowest possible price; individuals and focused publications or companies can go the other way and charge relatively high prices but with far better products or services than were possible previously. It’s working for Apple, it’s working for Taylor Swift, it’s working for Omni Software, and I can’t wait to see the sort of companies and products it will work for in the future.5

  1. I previously used Henry Ford and the Model T as an analogy here; I hope you’ll excuse the recycling as 1) I didn’t have any readers then and 2) The focus and takeaway here is totally different []
  2. I discussed Swift vs Spotify at length in this Daily Update (members-only) []
  3. According to the New Yorker, Swift would have stayed had Spotify been willing to limit her songs to the paid tier []
  4. Which, contra conventional wisdom, is ok, because absolute numbers matter more than percentages []
  5. I’m burying this in a footnote because I’m sheepish, but I’m hopeful that it’s working for me as well []