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.