I recently read The Second Machine Age by Erik Brynjolfsson and Andrew McAfee and they highlighted a phenomenon extremely critical for technology and game companies. The economy has evolved, especially for apps and other entertainment products, from a system in which there are multiple profitable products to one where there is one product that sees tremendous success and virtually all competitors are failures.
Why the economy has become winner takes all
There are three reasons described in the book that winner-takes-all markets have come to dominate the landscape. In addition to the three I detail below, I have noticed an additional strong factor in the app and gaming spaces.
- Shifts in the technology for production and distribution, particularly these three changes: a) the digitization of more and more information, goods, and services, b) the vast improvements in telecommunications and, to a lesser extent, transportation, and c) the increased importance of networks and standards. Digitization creates winner-take-all markets because with digital goods capacity constraints become increasingly irrelevant, according to Brynjolfsson and McAfee. A single producer with a website can fill the demand from millions or even billions of customers.Facebook is a great example. Since they have had little trouble scaling (not meaning to underestimate the tech effort but proprietary technology was not the key to Facebook’s growth), it did not leave room for competitors to be a successful second or third social network. In the twentieth century, even a business as successful as a Facebook would only have been able to satisfy a subset of potential customers, leaving profitable opportunities for competitors to satisfy people who could not get Facebook. With digitization, everyone can get Facebook.
- Technological improvements in telecommunications and transportation that expand the market individuals and companies can reach contributes to winner-takes-all markets. If there are many small local markets, there can be leading local providers in each (winners for those markets), and these local heroes frequently can all earn a good income. If these markets merge into a single global market, top performers have an opportunity to win more customers, while the next-best performers face harsher competition from all directions. A similar dynamic comes into play when technologies like Google or even Amazon’s recommendation engine reduce search costs. Suddenly second-rate producers can no longer count on consumer ignorance or geographic barriers to protect their margins.A great example is the demise of chain restaurants, like Darden’s Red Lobster chain, which were very profitable until Yelp came around and helped people find better dining options.As the authors point out, when there are capacity constraints or significant transportation costs, then the best seller will only be able to satisfy a small fraction of the global market. Inferior products will also have a market. Fast forward to now and the top-quality provider can capture the whole market. The next-best provider might be almost as good, but it will not matter. Each time a market becomes more digital, these winner -take-all economics become more compelling.
- A third reason the authors cite is the increased importance of networks (like the Internet or credit card networks ) and interoperable products (like computer components) can also create winner-takes-all markets. The App store is an example of this phenomenon. When Apple’s app ecosystem is strong, buyers will want to buy into that platform, attracting even more developers. But the opposite dynamic can unravel a dominant standard, as it almost did for the Apple Macintosh platform in the mid-1990s. Like low marginal costs, network effects can create both winner -take-all markets and high turbulence.
- There is a fourth driver that the authors do not discuss but that contributes to the winner-takes-all phenomenon: The emergence of freemium and free-to-play business models. When a product is sold discretely as a one-time purchase, it is created to have a limited life, be a consumable. People will use it or play it, finish it and move onto a product so there is room for second and third best products. With a free-to-play or freemium product, however, rather than creating a consumable the company creates a service that is constantly upgraded with new content and features. Thus, the user never uses up the product and has no need to switch to the second best offering.
People will not spend time or effort on the tenth-best product (or even second best) when they have access to the best. And this is not a case where quantity can make up for quality: ten mediocre mapping tools are no substitute for one good one (just ask Apple). When consumers care mostly about relative performance, even a small difference can lead to a thousand-fold or million-fold difference in earnings.
Winner takes all takes hold of the game industry
This winner-takes-all phenomenon is exemplified with the struggles many game companies have faced over the last ten years. In the 1990s and early 2000s, many game publishers and developers enjoyed success. Companies like Midway, Acclaim, THQ, Atari, etc., generated solid shareholder return and revenue growth. Now none of those companies exist and winner takes all is largely the reason. In their heyday, these companies could publish a shooter that might not be industry leading or a sports game that was second best but when people played through their first choice they still had to go out and buy something for entertainment.
Also, premium products usually launched at relatively high price points (US$40-60). If somebody did not want to spend that much, they might buy an older or second tier product until the price dropped. Products also were not localized or launched in all markets (console makers limited the rights), so the number one product might not be available in Russia, Germany or Japan, leaving an opening for other games.
Now, products are available, usually for free, to practically everyone and the good products are constantly improved. Thus, there is no reason for someone to play something other than the best free-to-play game in the genre they want. Also, cost is not an issue; people control how much they spend on a product and can still enjoy the top game for zero dollars, meaning no competitor can be cheaper (unless they pay people to play, which the way user acquisition is going sort of happens already). Thus, companies with a low budget or just mediocre talent have failed almost monthly because there is no longer any reason for players to consume their products. The games industry shifted from a traditional market to a winner takes all market.
9X becomes 9000X important in winning
This summer, I wrote a post how a product has to be 9X better than an established competitor to capture its market and this truth is particularly relevant in a winner-takes-all economy. If the number one product becomes so dominant that it consumers all the profits in the industry, then you must become number one or fail. Thus, being nine times better than the competitor generates nine times infinity in terms of success and profits, because being number two dooms you to failure (thus your expected return at number two is zero).
- Driven by “digitization,” many business sectors—particularly technology and gaming—have evolved into a winner takes all model in which the number one product dominates and generates all revenue and profit. There is no value to being number two.
- Free–to-play and freemium games have contributed to the winner-takes-all phenomenon in the app and gaming space, as users no longer consume a product and move on to the next, but stay with the best product as it is now a service that is constantly evolving.
- The emergence of winner takes all magnifies the impact of having to be 9X better than a competitor to get a customer to change to your product, because if you cannot attract your competitor’s customer there is no value to being number two in a market.