In a Harvard Business Review article, Rita McGrath explains why she believes Barnes & Noble may topple Amazon in the ebook market. David Rothman over at TeleRead posted an excellent response to McGrath. Without repeating what Rothman has already said, McGrath’s piece deserves a closer examination.

In her article, McGrath correctly characterizes Amazon’s business model as vertical and states that this decision is grounded in early market leaders’ need to delivery a quality user experience. However, as standards come about, other companies can challenge this vertical business model. She then goes on to state:

But here's the more interesting move to me: while B&N has announced that they too will be offering a touch-screen book reader, using B&N's electronic bookshop does not confine a user to their device alone. While they won't be compatible with Kindles or Sony readers, they will work with the iPhone and iPod touch, Blackberry, and most MAC and Microsoft Corp Windows laptop and desktop computers.

The number of screens on which a user can access content, however, is not the issue. After all, Kindle books can be read on multiple devices (Kindle, iPhone, iPod Touch). The issue that McGrath raises is whether the ebook market is ready for a more modular structure.

In their book “Information Rules” Carl Shapiro and Hal Varian discuss the advantages of proprietary control when it ensures a better experience (and especially when that control is exercised by the market leader). They go on to qualify this:

However, failure to open up a technology can spell [a company’s] demise, if consumers fear lock-in or if it face[s] a strong rival whose system offers comparable performance but is nonproprietary.

The market may be maturing to the point where consumers do, in fact, fear this lock-in. Having Amazon’s tight control over the user experience in the news certainly does not help lessen these fears. However, if Barnes & Noble (or any other company) wants to capitalize on this, it needs to alter its strategy.

First, Barnes & Noble must recognize that accessing content on multiple screens is, in and of itself, insufficient in alleviating consumers’ fear of lock-in. Barnes & Noble content, just like that of Amazon, will work on multiple devices -- but only in the software the company allows you to use. If you don’t want to use the company’s software, you are out of luck. More importantly, Barnes & Noble is wrapping content -- even its public domain books -- in proprietary DRM. In other words, Barnes & Noble’s response has not been to open its technology and embrace standards. Its platform creates the same kind of lock-in created by Amazon.

Second, Barnes & Noble must recognize that reading content on multiple screens forfeits any remaining value if the devices are unable to communicate with one another. As I said in a previous post, after reading a couple of chapters on a phone, users will not want to laboriously try to find their place again once they reach their PC. Without this device-to-device communication, Barnes & Noble’s platform is not a comparable competitor to the Amazon ecosystem.

While this will turn off some customers, McGrath correctly recognizes that Barnes & Noble’s approach does have a separate advantage: working with multiple devices allows Barnes & Noble to tap into the market segment that wants to read ebooks on PCs rather than spend the money to purchase a dedicated e-reader. However, the size of this segment is unknown and may be small (in terms of users and the amount of content purchased).

To succeed, Barnes & Noble should instead be moving to establish additional partnerships with companies manufacturing dedicated e-readers in order to ensure its compatibility with those devices. Doing so will help to truly reduce fear of device lock-in and can therefore help modularize the market.

In her recent article on InfoWorld, Jennifer Kavur asks whether ePub is the next PDF. Kavur claims that since its adoption as a standard in late 2007, ePub has driven ebook sales. This is a bold statement to make, especially given the size of Amazon and Sony. Despite the lack of any exact sales figures, it seems reasonable to guess that most U.S. ebook sales occur in a proprietary format.

Kavur, however, is correct when she states that open standards are good for publishers and consumers. But, those open standards have value only when they are widely adopted. Up to this point, the major ebook distributors have largely ignored the ePub standard. Sony’s device supports it -- but if you buy from its store, you’ll get its proprietary BBEB format. Barnes & Noble has said that it will eventually sell it, but currently offers ebooks only in the protected eReader format and has given few details regarding the eventual DRM it will use. Amazon has the most distance from the standard -- its device won’t even read the file type.

Why has ePub not been more successful? After all, content creators have embraced its use. Carl Shapiro and Hal Varian provide a possible explanation in their book “Information Rules.” According to the authors, those who control the distribution channels can control the standards surrounding those channels. To illustrate their point, they tell the following story:

When [Thomas] Edison opened the first public telephone exchange, his operating manuals prompted “Hello!” as the proper way to answer the phone. . . At the same time, Alexander Graham Bell, the inventor of the telephone, proclaimed that “Ahoy!” was the correct way to answer the telephone.

Edison’s “standard” won out not because it was better or because Edison knew more about the telephone. Today, we answer the telephone saying “Hello” because Edison’s distribution of user manuals gave him greater influence in how voice data should be transmitted.

Currently, a small number of companies control ebook distribution. These companies have recognized that this control gives them an opportunity to exert significant influence over ebook standards. If they can establish their proprietary format as a desired standard in the eyes of consumers, these companies stand to profit considerably.

UPDATE: Since publishing this post, Sony has announced that it will abandon its proprietary BBEB file format and DRM technology and instead use ePub and Adobe DRM.

A couple of weeks ago, I, along with the rest of the ebook community, was trying to digest all of the news related to Amazon’s deletion of George Orwell books from a number of Kindle devices. There was (and still is) a flood of articles related to the decision and the subsequent actions by Amazon executives and Kindle consumers. One of these articles, published by the New York Times, interviews Jonathan Zittrain who lays out briefly why Amazon’s actions are troubling. Intrigued, I decided to buy his book “The Future of the Internet: And How to Stop It” and have since had a hard time putting it down.

In his book, Zittrain discusses the history of modern technology, focusing on the oppositional forces caused by generative technologies (e.g. the PC and the Internet) and appliancized technologies (e.g. the iPhone and the Kindle). Generative devices, which invite contributions and changes from anyone, offer numerous advantages, most notable of which is increased innovation. Application specific devices (which are closed and centrally managed), on the other hand, give up these benefits in order to be simple and stable.

To achieve this simplicity and stability, however, appliancized technologies must be tightly controlled, often through explicit regulation. Perhaps the most visible example of this today is the iPhone. To develop commercially for the device, developers must submit an application to Apple for approval. Many applications do not make Apple’s cut, often for unknown reasons. While this regulation has many obvious problems, it does result in an enjoyable user experience.

Today, this same issue confronts ebooks and e-readers. To put books on a Kindle (or any other e-reader), publishers and authors must distribute their content in approved formats. To sell in the Kindle store (or many of the other stores tied to a device), publishers and authors have even fewer options -- the proprietary file format and the accompanying DRM are required.

This control, as many Kindle owners discovered, does not end at the point of purchase. Tethered devices and their stored content can be controlled throughout the product’s life. This control is not all bad. Amazon, for example, has used its control to design a better customer experience. (I, for example, love how both my iPhone and Kindle know what page I’m on and update my place in a book automatically). Even Zittrain recognizes that these tethered devices can offer a superior customer experience -- provided that the manufacturer understands what the customer wants both now and in the future. And, this is the real issue. Perfect customer knowledge is unlikely at any point in the product stage -- but the negative ramifications of an appliancized device are greatest in the early stages of a product’s life.

Amazon’s decision to create a closed Kindle ecosystem is grounded in sound business principles. However, this decision comes at a price. By maintaining strict control, the company may be forfeiting opportunities to spur innovation around its device -- innovations that could help grow the ebook market and perhaps even lead to additional demand for its Kindle ebook store.

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.