Feb 19, 2014
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One of the most powerful implications of the rise of the Internet over the last 20 years has been the slaughter of exiting offline industries. As each year passes it seems only inevitable that every offline industry will be decimated by the rising tide to move online.
The Internet is so powerful against incumbent offline industries because it heavily promotes the values of deflationary economics. That is, improving efficiency and driving down prices.
Last week I wrote about “Your margin is my opportunity” and how Amazon’s Jeff Bezos has been a pioneer in driving down the cost of delivering products and services over the Internet.
In this week’s post I want to delve deeper into Deflationary Economics to show you how the model works and how you can seize this opportunity too.
Deflation is a decrease in the general price level of goods and services. This means that the price that you sell your product to your consumer decreases or they are able to buy more of your product for the same price.
Deflationary Economics is where you drive down the cost of providing a product or service to a customer over time. This means you reduce the margin that you earn on each individual transaction, but you increase the overall number of transactions significantly.
Deflationary Economics work by reducing the cost of a product whilst increasing the ability or supply to the market.
For example, enterprise software is usually very expensive and only available to a select number of very large companies. A competitor that was using Deflationary Economics would create a reduced version of the same product that could be sold at a massive reduction to a much wider market. The competing company would earn significantly less per customer, but would be able to earn revenue from a much bigger total addressable market because more people could afford to buy the product.
Deflationary Economics is a good thing because incumbent competitors can simply not compete against you.
When an existing company is providing a product in an industry at a high margin, it is impossible for that company to compete against a new market entrant who is offering a simplified version of that product at a massively reduced price.
Existing companies cannot reduce the price of their product for a number of reasons. Firstly, that company has an existing cost structure that is based upon it’s high margin product. Secondly, it must justify the price of it’s product to it’s existing customers. Thirdly, as companies mature they look for higher margin opportunities to satisfy growth. Lower margin opportunities are just not attractive to big companies of a certain size.
I believe Deflationary Economics are extremely powerful on the Internet because they perfectly align with the innate characteristics that make the Internet so incredible.
The Internet has effectively connected every person in the world who has access to a modem. Over the last 15 years we’ve went from a couple of hundred million people online to well over 1 billion. Over the next couple of years that number will likely reach 5 or 6 billion people connected through an open network.
The Internet massively reduces the cost of delivering information or communication. When you convert things to bits and you use the existing infrastructure of the Internet, you no longer have high overheads or are forced to use propriety hardware or software.
Moore’s law is “the observation that, over the history of computing hardware, the number of transistors on integrated circuits doubles approximately every two years”. Whilst this observation was originally about transistors, we’ve seen the same effect in just about every aspect of technology.
The Internet is a level playing field where the biggest corporations have exactly the same voice as an individual sitting in their bedroom. This means everyone who has access to the Internet has access to the same information and opportunities as everybody else.
The Internet has been built on Open Source technology and so it is only right that the Open Source movement continues to play a crucial role in the development of the network. It is increasingly cheaper to start an online based company because the building blocks of what you need are available as Open Source components.
There are many examples of high profile companies that have used Deflationary Economics in the age of the Internet to build massive organisations. A lot of these companies share the same goals, values and vision but are attacking different offline incumbent industries.
Whilst there are many companies to choose from, here are three that I think have had a massive impact.
For a long time, the telecoms industry had a tight stranglehold over the communications of every day individuals. When you control the technology behind a service you effectively have a monopoly over who uses it.
Skype is destroying that monopoly by offering free voice and video calls that can be delivered over the Internet. Skype has actually just surpassed the traditional telecoms industry for international phone calls.
Skype is an excellent example of taking a common human requirement and moving it to an open network to massively reduce the cost or providing that service. By using Internet Protocol rather than Public Switched Telephone Networks you can provide a comparative service without the overheads or without paying a gatekeeper to access a technology.
MySQL is the world’s most popular open source database and has been a landmark company in the history of Deflationary Economics on the Internet.
MySQL powers some of the largest and most profitable websites on the Internet and allows any individual to use those same tools without paying a penny to anyone. This is because MySQL is Open Source. This seems quite contradictory. Why would you allow your software to be used by some of the largest companies for free?
In a recent PandoMonthly interview, Venture Capitalist Danny Rimer revealed former MySQL CEO Mårten Mickos’ incredible insight:
“The relational database market is a $9 billion a year market. I want to shrink it to $3 billion and take a third of the market.”
MySQL was later sold to Sun Microsystems for $1 billion.
Mårten understood that by making MySQL Open Source he could use the ubiquity of access to gain a majority share of the market. This had the outcome of reducing the size of the market in order for MySQL to grab a third of it.
I’ve already mentioned Amazon as a pioneer of the strategy of Deflationary Economics in their retail business, but they have also used the same tactic to great success in their Web Services business.
Amazon Web Services (AWS) offers unparalleled access to computing resources in the cloud at much lower prices than any other competitor can offer. This allows anyone in the world to access instant computing power that can be scaled up or down and where the customer will only pay for what they have used.
The AWS model is completely contradictory to traditional web hosting solutions and massively reduces the cost or infrastructure required to launch a new product on the Internet.
Amazon has massively increased the availability and reduced the price of computing in the cloud. By following the the tide of Deflationary Economics, Amazon was able to enter an industry and grab the majority share in just a couple of years.
As software continues to eat the world the power of Deflationary Economics will become even more important.
It is only a matter of time before all incumbent industries migrate to the Internet. The existing cost structures of offline incumbent industries will not be able to survive online.
This therefore presents us with the opportunity to reimagine existing industries in this brave new world.
Fortunately we don’t need to invent anything new or imagine a new revolutionary new method for shrinking the size of a market whilst simultaneously grabbing the dominant position.
Companies like Amazon, Skype and MySQL have shown us how to shrink a market by using existing architecture, open standards and the innate characteristics of the Internet to our advantage. By blowing up the traditional cost structure of an industry, we can significantly increase the availability whilst reducing the cost. This reduces the size of the market, but opens the door for many new customers who were unable to purchase in the previous industry.
There are many signals that show an industry is on the precipice of being disrupted. Whilst it seems like this movement has been going on for a long time, the majority of industries have not been touched and have not made any movement towards the Internet.
These are the characteristics I would look for when thinking about entering an industry by moving it onto the Internet.
1. Unbundling an existing product Unbundling is the act of taking an existing product and selling the individual components. When a customers is forced to purchase a bundle, some percentage of those customers are paying for products or services that they don’t need.
I wrote about this in How to disrupt an industry through unbundling.
Can you see an opportunity where customers are forced to buy a bundle? Is there an opportunity to significantly reduce the price by splitting the bundle and moving the individual components on to the Internet?
2. Finding the low end of the market The word disruption has been bastardised over the last couple of years. Many think about disruptive technologies, but in reality, real disruption happens in the market place.
As I covered in How to find disruptive opportunities, by introducing a product that specifically targets the low end of the market you can serve a customer segment that either does not have access to the current incumbents products or is paying too much for the privilege.
By entering the low end you can reinvent the cost structure to provide a product or service to the bottom of the market. The incumbents won’t fight against you because it is unviable for them to serve that segment of the market and compete with you on price.
Once you have saturated the low end of the market you can use your significantly reduced cost structure and constantly iterated product to move up market and compete against the incumbents for the middle of the market. This will drive the incumbents upmarket because they will be unable to compete against your much lower cost structure.
To read more about this theory, you should read The Innovator’s Dilemma.
3. Take advantage of the Economies of Scale of the Internet One of the big advantages of the Internet over the offline world is the huge economies of scale that are made available to you.
The Internet offers a shop front to the world. From day one of your business you can serve the entire world without the cost structure of a traditional offline business.
Storage, sending bits over the wire and communicating with your customers are all things that are essentially free on the Internet. As I covered in Killing offline businesses online. By using The Long Tail effect of the Internet you are no longer restricted to the constraints of the offline world.
The Deflationary Economics and the Economies of Scale of the Internet are a powerful one, two combination that are destroyed a number of existing incumbent industries. As more and more industries are forced to move online, we are going to see this same story play out over and over again.
We are in a exciting position as people who build for the Internet first. We do not have the biases, overheads or responsibility of the offline world. We are free to reimagine a world where the industry exists to better serve the consumer. By reducing the margins of incumbent market leaders and increasing the availability of the product or service, we can use Deflationary Economics as a proxy to disrupt an industry and position ourselves as the dominant player.
It’s only a matter of time before every industry is forced to move online. Can you see an opportunity that is worth pursuing?
To read more about Deflationary Economics, Venture Capitalist Mark Suster has an excellent post.