The Perfect Storm (part 5)

Why did Britannica have such difficulty responding to the changes in the market for encyclopedias? Britannica was, after all, the undisputed leader of the encyclopedia industry, with by far the most respected brand name, the most authoritative content, and the strongest sales force. How could its leadership in the market disappear after the entry of an unknown brand (Encarta) with inferior content (From Funk and Wagnalls) and without a commissioned sales force?

We believe the answer is that Britannica wasn’t facing a single change to its business. Instead it was facing several factors that had the combined effect of radically changing the established sources of market dominance and the established models for selling content.

First, digital encyclopedias changed how value was delivered to consumers. Britannica’s success and market power derived from its ability to deliver more value to consumers than its competitors could. This value came from high-quality authoritative text, careful editorial processes for approving content, pre-defined indexes to help consumers search content, and the social status communicated by having an expensive set of encyclopedia volumes in one’s home. Digital encyclopedias didn’t eliminate these sources of value, of course, but they substantially weakened them and introduced a new set of quality metrics: digital delivery; modular, easy-to-comprehend content; audio-visual material; rapid inclusion of new information; hyperlinking and digital searching; and social status that was increasingly communicated by having a computer, rather than a set of leather-bound books, in one’s home.

The second factor that hurt Britannica was a fundamental change in how value was extracted from the market: a shift from a high-margin direct-sales model to a low-margin retail-sales model in which the content  often could be bundled with, or even given away as a sales closer for, an entirely new product: the home computer.

The third factor was Britannica’s market success in its established business: selling print volumes. Successful companies get successful by replicating and protecting their valuable business processes. For Britannica, this translated into a reverence for direct sales. Who ran the company and received promotions to positions of responsibility? Successful salespeople. Because of this, when a new way of selling content emerged, Britannica’s leaders could only see it as a threat to their existing high-margin direct-sales strategy.

The fourth factor was a rapid shift in market power. It is important to remember that delay is usually not a bad thing for incumbent firms. Busy managers are faced with a steady stream of new business opportunities that are risky, unproven, lower in quality (at least from the perspective of how value has always been delivered in the market), and less profitable than the company’s existing business. Recent research by Matt Marx, Joshua Gans, and David Hsu shows that, in most cases, incumbent firms are best served by taking a wait-and-see approach to new innovations: allowing the market to figure out which of the innovations is most likely to succeed, then either purchasing the innovator or partnering with it. This is indeed an effective strategy in many circumstances. But it doesn’t work if the entrant is able to quickly gain enough power in the new market so that the incumbent’s assets are no longer valuable to a partnership – which is exactly what happened to Britannica. In an ironic coda to the story, when Esposito placed his company up for sale in 1996, he asked Microsoft (at the time a $60 billion company that employed the largest editorial staff in the encyclopedia industry) if it would like to make an offer for Britannica’s assets. Microsoft declined.

What does this all have to do with the entertainment industries? Possibly quite a bit. Later in this and subsequent series, we will discuss how the entertainment industries are facing their own perfect storms of change. Technological change – in the form of long-tail markets, digital piracy, artists’ increased control over content creation and distribution, the increased power of distributors, and the rise of data-driven marketing – presents the entertainment industries with a set of threats similar to those that Britannica faced. These threats include a new set of processes for delivering value to consumers, new business models for capturing this value, and difficult tradeoffs incumbent firms must make between protecting established businesses and exploring new opportunities. And ultimately there is an even greater threat: new distributors that play increasingly active roles in the creation of entertainment content and that control customer attention and customer data, two increasingly important sources of market power.

None of these threats, by itself, would be likely to have much of an effect on the established structure of the entertainment industries. But together, we believe, they represent a perfect storm of change that is weakening the very sources of profitability and market power on which the entertainment industries have always relied, and is introducing new sources of profitability and power that the existing businesses and organizations are not well positioned to exploit. But just because we have used the perfect-storm analogy for the entertainment industries doesn’t mean that we think they are doomed to the same fate as the Gloucester fishermen or the Britannica sales team. We are optimistic about the future of the entertainment industries – if they are willing to acknowledge and respond to the threats we have begun to discuss here.

But before discussing how to respond, we need to understand the nature of these threats in more detail. We’ll start in the next series of editorial articles discussing a new way in which companies are succeeding in the entertainment market: by using their customer connections and their data to develop a new set of processes for delivering value to consumers.