In Part I of this post, I discussed the nature of two-sided networks and how network effects leads to the success of a small number of companies in ebook distribution. Part II of this post analyzes how the use of DRM in ebook distribution magnifies these network effects.

There has been a lot of discussion as of late regarding the role of DRM in the ebook industry. Many publishing companies have pushed for strong DRM in order to protect their rights as copyright holders. Because replication of digital files is so easy, many fear that unprotected ebooks will lead the proliferation of pirated copies. While publishing companies’ desire to protect their content (and their source of profit) is understandable, the current use of DRM carries unintended consequences.

Ebook aggregators and distributors have responded to publishing companies’ concerns largely with proprietary file formats and DRM techniques. Amazon’s format and DRM are different than Sony’s which are different from Barnes & Noble’s. By allowing these competing formats, publishers have given up considerable power in the value chain. Why? Because proprietary formats and DRM increase switching costs for users and can eventually lead to winner-take-all platforms.

Consider a new ebook consumer who wishes to purchases a dedicated ebook reader. Currently, the individual can choose from Amazon’s Kindle, Sony’s eReader, several small brands, and soon the Plastic Logic device. The individual will consider many factors in making the final decision. However, one of the most important considerations will be the future of the device and the library of titles it is connected to and compatible with. If a consumer chooses a device (or simply buys ebooks) from a distributor that exits the industry in the future, that device and its files could become all but worthless (witness the Fictionwise debacle in January 2009). With proprietary file formats and DRM, it is very costly for a consumer to pick a loser.

So, how does a consumer sort out the winners from the losers? There’s no full-proof method. But the danger for publishers comes when individuals employ the following simple logic: The company with the most users is least likely to exit the business. Strictly speaking, that makes sense. And, the logic becomes self validating as time goes on and additional consumers employ it. Economists have a name for this -- they call it same-side network effects. Any given ebook platform is more valuable (in this case because it carries less risk) when additional users join it.

This can eventually lead to significant control over the market by a single company. Because of this, the current method of ebook DRM does not benefit the publishing industry. If current DRM practices continue, growth in the ebook market will likely lead to increased power among ebook distributors in the supply chain.

A few days ago, I posted a blog on the benefits of horizontal markets. In researching the post, I came across a large number of ebook distributors -- some vertical and some horizontal. However, nearly all were small, most with a very limited number of titles. It is not difficult to see that ebook distribution is dominated by a few companies. Why? After all, the costs of setting up and selling ebooks is relatively low. Any company who wants to pay for server space could set up an ebook store and start selling. And, trust me, many have. Why, then, is ebook distribution dominated by only a handful of companies? The answer comes from understanding the nature of platforms and two-sided networks.

Ebook distributors connect readers with publishers and authors. These companies create relationships with readers (which costs quite a bit) and maintain those relationships over time (which costs less and offers considerable profit). Because of this, the industry favors larger companies that can leverage existing relationships, that can afford a significant customer acquisition investment, and that have the marketing know-how to bring consumers in. Because of this, it is not surprising that the largest ebook distributors are large companies: Amazon and Sony. (And, they are being joined by other heavyweights: Google and Barnes & Noble).

However, something more fundamental is happening: As a company increases in size (measured by the number of users it is able to acquire and retain), its ebook platform becomes more attractive to publishers and authors. This large base of users provides an incentive for additional publishers to join and for existing publishers to add more content. Importantly, this pattern repeats itself: An increase in size on one side of the platform leads to an increase in size on the other. More users leads to more content and more content leads to more users.

To compete successfully, therefore, distributors must pass a certain threshold of users and content. While theoretically many companies could pass this threshold, the ebook market is relatively small, leading to the success of a few large companies.

These large companies have recognized that the nature of platforms and two-sided networks provides an opportunity to gain market share and exert control over the market. Amazon has grown the size of its platform by subsidizing the content creation side -- publishers are currently paid the same amount for an ebook as a print book. This increases the incentive to provide content by offsetting any potential print cannibalization. And, with this content comes new users.

But, creating a large platform only has value if the company can keep customers. In Part II of this post, I’ll examine how distributors have attempted to lock consumers into a platform by using proprietary file formats and DRM.

This post is a response to a blog written by the folks over at The Idea Logical consulting company. The blog lays out Mike Shatzkin’s predictions for the ebook market, dividing its future into four stages: vision, establishment, transition, and the new marketplace. In the transition stage, which will occur in one to three years, Shatzkin predicts:

Large horizontal aggregators (Amazon, B&N, and the full-line bookstores that build their offerings from wholesalers) will struggle to hold onto a large and loyal customer base as the vertical web increasingly takes hold. Almost all publishers will be among the zillions of sites offering direct downloads to consumers, many through explicit verticals that sell the books of their competitors (as Macmillan’s tor.com sci-fi site, presciently, is doing today.)

Much of the logic underlying this prediction can be found in another of Shatzkin’s posts, in which he discusses horizontal versus vertical markets. In this post, Shatzkin states that on the Internet, content is no longer scarce because any individual can write something and put it on a website. The issue for publishing companies, therefore, is no longer content creation but marketing. And, according to Shatzkin, Internet marketing can only be done cost effectively inside a vertical market because the Internet is organized by niche. Thus, vertical wins; horizontal loses.

The first part of this argument deals with the relevancy of publishing companies and is outside the realm of this response. The second piece of the argument, however, deserves a closer look. After all, there are a significant number of non-vertical, non-niche platforms of the web -- e.g. Facebook, Twitter, Amazon, Craigslist, etc. And, these platforms are highly successful in terms of users, (and with the exception of Twitter, all are successful financially).

While the benefits of vertical marketing are clear, Shatzkin assumes that you cannot market to specific niches using the existing, horizontal infrastructure. Google, among others, has proven this wrong. The context in which each user accesses these horizontal platforms and the user’s ability to search through content provides a pseudo-vertical environment in which companies can market cost effectively. As others have noted, advertisers can reach customers across the entire horizontal network or can focus on any combination of highly specific vertical networks contained within the overall platform. The horizontal web platform combines content breadth with marketing focus, resulting in a superior customer experience.

This customer experience, in fact, is what Shatzkin seems to ignore in his four-stage post. The Internet has changed quite a bit -- but it has not changed the consumer’s desire to minimize search and transaction costs. These are the non-monetary costs associated with using a service and purchasing a product.

Horizontal aggregators, like Amazon, Barnes & Noble, etc., minimize these costs for users by giving them a single place to search, browse, and buy. With a horizontal aggregator, users do not need to visit multiple websites with different content in order to make a final purchasing decision (as individuals do not exist in a single, exclusive vertical) and they do not need to create and maintain separate accounts at multiple sites. Disaggregating content would create real costs for users and would correspondingly lead to a decrease in overall demand. These horizontal networks have value, and that value is tied to the number of users and the amount of content offered.

In the case of Amazon, this value manifests itself most clearly in the relationships it is able to create and maintain with consumers. Horizontal networks can provide superior relationships because the availability of more products provides additional data points with which companies can better understand the needs of an individual consumer.

The introduction and subsequent growth of ebooks has changed much in the publishing business. However, these changes have been and will continue to be guided by consumer behavior and network economics.