Digital Economics: The Hollow Middle

This is a multipart series on digital economics. More here.

Markets have been pushing us more and more towards a bi-polar world, where products are either superstar successes or lonely niche players. What I’d like to do in this post is write up what’s behind this trend. So fair warning, this post is just a laundry list of reasons for bi-polar product success. But if you stick with it and read below, then you’ll have more context for next week’s post where we’ll apply this framework to industries like newspapers, music, tv, etc.

Let’s start with a movie example. Below are the top grossing movies from 2011, with gross in thousands. So Harry Potter grossed $3.81 million ($3810k), and on down the list:

If you graph this list but go out through the top 200 movies, then you’ll get the chart below. So on the far left column in #1 spot we have Harry Potter at $3810k, then next to it is #2 Transformers with $3524k, and on through the top 200. Note how by the 200th movie you can’t even read the movie gross since it is too low to see since it was just $18k.

This chart has a power law distribution, where the top few dominate the total. This is typical for movies and many other types of entertainment. Why are things in this shape? And why is it getting more and more top skewed across many industries? Let’s look at the list of reasons.

Economics of Superstars

Sherwin Rosen wrote a widely cited paper in 1981 called The Economics of Superstars where Rosen observed that certain industries have incomes highly skewed towards the top performers. And this can happen even if the differences in quality between the performers are very minor. So for example the top classical soloists reap nearly all the income from recordings, even though the next best are nearly indistinguishably as good. Why? Because as a consumer I can pick what I want, and why buy second best when the best is the same price? It’s a winner take all situation. In fact the rise of the record industry in the middle of the last century was associated with an implosion of the middle ground for musicians. Where before there were lots of bands performing locally, this fell apart and all the income went to the top performers once the recording industry made vinyl records plentiful.

By now this effect is so commonplace we don’t give it a second thought. At least for sports, music and movies. But it’s important to understand the economics of superstar effect can come into play in any market where technology makes access to top performances reproducible and cheap. So for example newspapers are getting hit by this effect right now. And once it hits, the local “middle” market dies out and all rewards go to the top.

Network Effects

Network effects occur for products which become more valuable the greater number of people are using the product. This is a fairly common effect in technology. For example, the more people who use Facebook, the more useful Facebook is to any particular user. Microsoft Windows rode that effect to dominance in the 1990’s. Again, we are used to this effect in markets where it is already dominates. What we need to look out for is markets where network effects are newly coming into dominance. So for example the smartphone market was at first driven by the quality of the phones themselves. But now network effects are becoming dominant because it’s more about the app ecosystem than the phones themselves. So to understand where the smartphone market is headed you have to look at the Apple iOS versus Google Android app ecosystems, not at the phones.

Unbundling

Product bundling is a marketing strategy of selling several different products as a bundle to customers. With digitization, some products that tended to be bundled in the past are becoming unbundled. And in fact this can go back and forth. For instance, in the 1950’s customers bought music singles on 45 RPM vinyl. Then long playing record (albums) came into vogue starting in the 1970’s, and music primarily moved into bundled vinyl albums. Now technology has reverted back to singles again, but this time with digital singles, not 45s. The theory of bundling is pretty interesting if you want to dig into this paper.

What’s the impact? The unbundling of albums has hurt the income of musicians and record companies, because now people buy a la carte just what they want. So while it’s a consumer win, it’s tended to destroy the middle market. Currently cable tv is cited as another example of unwanted bundling. You have to buy a “package” and pay for channels you don’t want. We’ll get into that more later in the next post.

The Long Tail

Chris Anderson wrote a wired article in 2004 about the long tail and followed up with a book in 2006. From 2004-2009 the long tail was all the rage, but has died back since. Anderson’s long tail thesis was that 1) traditional retail stores had a “short head” and could only stock so many items, but 2) with online retailing you can have very deep stock of products and can make more money selling lots and lots niche products than blockbusters. Now clearly blockbusters continue to get most of the money, so Andreson overhyped his thesis. But the long tail insight is still valuable on the niche product side. The niche market is in fact getting deeper and deeper, so there are more and more marginal products out there. And what’s gone away is the middle ground.

Like I said, this week’s post is more a laundry list of what’s driving bi-polar markets than an analysis of particular industries. So with this background we can look at particular industries and make some forecasts next week. But before we go, let’s sum up.

The Hollow Middle – summary

Here’s the forces pushing us toward “the hollow middle”, with superstar or niche products and nothing in between:

Economics of Superstars and Network Effects – winner take all, pulling winners up higher.
Unbundling – a la carte splitting winners from losers. Caving in the middle.
Long Tail – creating more and more marginal niche products. Pulling niche products out farther (and lower) to the right.