The Mathematics of Disruptive Innovation

In my post How Rent-Seeking Will Kill the Hollywood Studios, I stated that the hollywood studios have implemented a strategy of milking their existing markets instead of trying to capture a new market.

I also mentioned that this business strategy would ultimately kill the hollywood studios.

In this post, I’d like to give a thought experiment to justify why retreating up-market cannot sustain a company when new markets undermine their existing business models.

Suppose we have two companies: Company A and Company B.

Suppose Company A has a customer base of 100,000,000 people and Company B has no customer base.

Suppose that some new technology creates market A of 10,000,000 million new customers and that this market has a growth rate of 10% per year. Also, market A undermines market B at a rate of 5% per year.

Suppose that company A captures 10% of market A per year, and still captures 100% of the diminishing market B.

Suppose that company B captures 90% of market A per year, and does not have any investment in market B.

We can model this situation with the following equations.

Company A = 10^8 * (.95)^year + 10^7 * (1.10)^year * 0.10

Company B = 10^7 * (1.10)^year * 0.90

Simply calculating the results by plugging in the year yields the following results

year Company A Company B
0 101,000,000 9,000,000
1 96,100,000 9,900,000
5 78,988,603 14,494,5900
10 62,467,436 23,343,682
20 42,576,092 60,547,499

I admit that I’ve created a very simple model.

First, we have no exact number of how much a new market can undermine a business besides the fact that it must do so by a value greater than zero: it could be 0.01% or greater than 10%.

Secondly, there are hundreds of variables working together to determine the growth rate of a specific market. That prevents it from being constant over any length of time.

However, the simulation does show the long-term damage caused by bad business strategy. Any decline in a market can severely damage a company over the long run and make it vulnerable to bankruptcy or acquisition.

Ultimately, market forces will punish any company that fights disruption. If a company fights disruption then they can only delay the inevitable by changing the rate of decline.

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You can not solve political problems with technology

Politics will kill a project far faster than anything else. I can speak from a position of knowledge since I’m an employee of a giant acquisition company, and I’ve seen my fair share of “system integration” attempts.

Let me justify this statement with a little thought experiment.

Melvin Conway introduced Conway’s Law in 1968 to express his observation that “organizations which design systems … are constrained to produce designs which are copies of the communication structures of these organization”.

Essentially, people will build systems around themselves.

As a consequence, integrating different systems necessarily introduces political problems because now you have forced people to work together, and they may not necessarily like each other.

For example, I’ve seen situations where different groups within an organization (i.e. Accounting and Marketing) have two separate ldap authentication server or two separate windows domain servers.

Now suppose, you have a CTO demand that these two group integrate their systems because the CFO of the company had a spreadsheet that showed huge cost savings associated with integrating their systems.

Unfortunately, you can only understand so much about your organization from a spreadsheet.

These groups know about each others existence, and they also know about their IT structure. Yet, they did not try to integrate their systems on their own. This suggests that someone in these different departments know something that the CTO and CFO don’t.

In this case, the CTO and CFO don’t realize that Marketing and Accounting built their systems this particular because they have huge beef with each other.

For illustration sake, let’s suppose we have Ange as the director of Marketing, and Bryan as the director of Accounting. Suppose that Ange and Bryan do not get along, and do as much as possible to “protect” their respective groups from the other person. That would lead them to create an IT infrastructure that separated themselves from each other.

This situation creates a type of “cold war” between the groups, but still enables them to work together for the benefit of the larger company.

However, the moment the CTO forced them to integrate their systems that “cold war” turns into a “hot war”. Also, those personal problems don’t go away if a third party does the integration on behalf of the two groups. If anything that third party simply gets caught in the cross-fire, or ends up having to act as peacemaker.

Ultimately, you can’t really solve political problems with technology. I’ve never been to business school, but I hear that one of the first things you learn is that most mergers fail through cultural incompatibility between acquirer and acquiree. Having worked with our various subsidiaries, I understand why that is the case.

Personally, I believe that you really have to solve the human problem first before you ever try to integrate systems. If you can’t solve that problem then the only alternative is to simply fire your entire management team and hire completely new people.

How Rent-Seeking Will Kill the Hollywood Studios

Having worked in the entertainment industry for 3 years, I have learned the internal workings of how movie studios make money. After countless hours discussing business models and technology, I’ve come to believe that the hollywood studios have strategically positioned themselves on the wrong end of an innovation disruption.

First, let me tell you the classic story of how disruptive innovation destroys companies.

A brief example

By definition, disruptive innovation creates a new market by applying a different set of values, which ultimately (and unexpectedly) overtakes an existing market (source: http://en.wikipedia.org/wiki/Disruptive_innovation).

When disruptive innovation begins to undermine existing business models, large corporations do not typically have the political will to kill their affected business sectors. Instead, they try to defend their products from disruption (especially, if the disruption affects their high profit margin products).

At some point, they try to squeeze as much money as possible from their existing business models, once they realize that they can no longer defend against the disruption. After that they can either retreat  somewhere they feel that the disruption cannot reach, or somehow include the new market into their existing business models. However, by that time, anything they do will be “too little and too late”.

Take the example of Eastman Kodak.

Eastman Kodak invented the business of selling inexpensive cameras. Their business model worked so well that at one point, they commanded 90% of film sales and 85% of camera sales in the US.

When consumers started to demand digital photography products, Kodak did not move fast enough to meet that demand. At that time, digital photography had very low profit margins, and also undercut its existing high profit margin film business. By the time digital film generated high profit margins, other companies had already outmaneuvered Eastman Kodak in that space. Eastman Kodak could not do anything to take the existing market share from their competitors.

Ironically, Eastman Kodak invented digital photography in 1975. If they pushed digital photography early they could have easily owned the emerging digital photography market. However, they dropped that product because they feared it would threaten their photography film business.

The studios’ problem

Enter the giant Hollywood Studios (i.e. Disney, Warner Brothers, Universal, NBC, etc …).

Hollywood movies have “release windows”, and each release window has a different set of players who take a cut of the profits.

The different “release windows” typically goes in this order: (a) theaters, (b) dvd/bluray, (c) pay-per-view, (d) premium cable channels, (e) network and cable tv, and (f) syndicated tv.

Before a movie ever gets released, the “profits” have already been divided among the different players in each “release window” through contractual agreement. This situation makes it nearly impossible to adapt to a disruption because everyone depends on the studios for content.

For example, movie theaters threatened to boycott the movie “Tower Heist” when Universal tried to experiment with releasing it on VOD in some markets just three weeks after its theatrical debut. They intended to test the viability of “premium VOD”. Rather than risk a complete loss, Universal capitulated to the theaters, and from then on never attempted to enter the “premium VOD” market ever again.

This situation places all the Hollywood studios in the exact same losing position of Eastman Kodak: trying to defend their nameplates from disruption instead of adapting to it.

In the Eastman Kodak situation, they had an entire business model around film development that would kick and scream if Kodak did anything to undermine them. However, at some point building a digital camera got so easy and inexpensive that pretty much anyone could do it.

Why buy film when your cell phone already has a built in camera? Oh, you need high quality photos well consider the various SLR digital camera’s from Nikon, Cannon, Sony, and … not Kodak.

The rise of digital photography made consumers value film less. To consumers, digital photography added value because it provided more convenience at less cost with more quality. However, Kodak anchored themselves to a business model that opposed the new value system.

Similarly, the rise of video on demand has changed the values of consumers. However, none of the studios can adapt to the new market without undermining their already existing business units. At most, they can only do half-hearted attempts of addressing what consumers really want.

Consider the case of Ultraviolet and Digital Copy. This allows you access to video streaming as long as you purchase a DVD/Blu-ray copy. This goes at least part way to close the value-gap. However, it does not go far enough because it does not really add value from the consumers viewpoint. It is simply another way for the studios to “collect rent”.

The studios think that they are “adding value” when they “collect rent”. However, customers don’t see it that way. To consumers, video piracy and netflix add value because they are less dependent on the studios.

That does not mean that the studios should not have created their own streaming services, though. Given the circumstances, they made the best move they could. Providing that service themselves could not have made their situation any worse; so, why not? However, it simply is not enough to get them the traction they need in the new marketplace.

Now the studios can only milk their nameplates for as much money as possible and attempt to retreat upmarket.

For example, Disney and WB do not really make money selling movies. They make money selling cult memberships.

The studios can always count on their franchises to collect a few very loyal consumers that will buy almost anything packaged with a certain branding. For example, I could literally take a pile of bull shit, wrap it in a Game of Thrones package, sell it, and someone would buy it. See here.

While this has worked very well the last couple of years, I does not seem like a very sustainable business model.

The moral of the story is buy more Netflix stock.

Updated: I corrected a misspelling based on a commenter’s observation that “Kodac” should be “Kodak”