How Revenue Distribution is Driven by the Cost to Make a Copy
by Vlad Dascalu, 2006-01-02
Especially if you're a soon-to-graduate student, you've probably asked yourself what to do next. There are so many opened possibilities: get a job, start a start-up, do consulting... In this regard, the decision of choosing a specific domain (industry) will be based on different factors: reward, risk, environment...
One of the biggest factor that I think one should study before leaping ahead in a specific industry is the revenue distribution in that industry. What I mean by revenue distribution is: how are the money divided between the players in the market? And is there a variation of this distribution that varies by industry? What drives this variation?
In each industry, there is some sort of criteria (mostly economical) that can be used in order to make an hierarchy. For example, in the MP3 players market, the current leader is Apple, while in the movie industry, one could say that the top-performer is Brad Pitt or Tom Cruise. Yet there are some industries where I can't name the leader on the top of my head. For example, does anybody know the name of the best hair-cutter in the world?
This is the first sign that confirms a variation of wealth distribution based on the industry. And when I looked at the figures, they have only confirmed the theory. The number 1 in the MP3 player market, Apple, accounts for 67% of the total units sold, and around 80% of the total revenue. It is said to be the only company that makes a profit out of the MP3 player market, all the other ones working with a loss. So this is one industry where the top-performer takes it all, and the rest barely keep floating. Google is another example, accounting for over half of the searches; the others in the industry remain battling for the rest of the market.
However, in the hair-cutter industry, this doesn't appear to be true. The most famous hair-cutter probably makes around $500,000 a year, maybe more. But this amounts only to a fraction of the total market of hair-cutters, world-wide. There is room for the hair-cutter around your neighborhood's corner to perform his job, earn a decent living and still make a profit. And the top-performer in this industry earns barely 0.1% out of the total market.
So there we have it --the two extremes: on one hand, one type of industry where the leader gets it all, and on another hand the other type of industry, where each player gets an approximately equal amount of share of revenue, based on his work and the quality of it, but where the top-performer doesn't manage to dominate most of the market.
Why the best hair-cutter doesn't manage to become like Google or Apple, and win 80% of the market? How Google and Apple manage to do that?
It all stands in the cost to make a copy.
When the hair-cutter is called to cut Tom Cruise's hair, he might earn for the night an outstanding $10k or so. But his work finishes there. He worked 4 hours, and won $10k. If tomorrow Brad Pitt calls in, he will have to spend another 4 hours, all over again (for another client), and he will win again another $10k. Each new client brings an equal quantity of time that must be invested all over again. Because, in the hair-cutter industry, the cost to make copies is high. Creating a copy of a hair-cut is relatively the same (as amount of time) as creating a brand new hair-cut. If you spend your time working on a prototype (an original hair-cut), you won't be able to cash in by making copies of it with a low cost and then selling those copies to several clients at a relatively low price.
Quite contrary, in industries like search engines, or MP3 players, the software, the design, the planning is performed only once. After you have those ready, the additional costs of a copy (the costs that must be paid for an additional customer) are quite low. Another customer to Google means on average 100k up to 1 MB more of bandwidth, which is relatively cheap compared to what would you have to bill one customer if you provided a search engine of Google's quality, just for him. Due to this, Google can offer the service for free, and still cash in on those advertisement fees. Apple is an another good example: the R&D and design teams that created products like Apple iPod made the hard-work, and made it only once. The cost to create an additional iPod (from the hardware components perspective) is 50%, or under, of the product's price, which creates huge profit margins for each product they sell.
So if you want to know how the revenue distribution will happen in a given industry, just look at the cost to make a copy in that industry. If we're talking movies, search engines, or something similar, then the winner will take it all, and others will fight for the remaining market share; that is true because the leader will have the financial resources to make copies of his product/service for everybody, and everybody (almost) will choose the best service/product available. If the cost to make a copy is high, then the revenue distribution will be mostly equal between the suppliers, because the best suppliers won't be able to create cheap copies to saturate the market.
This works out in a granular fashion: there are a lot of gray areas: a lot of intermediate industries where the truth is somewhere in the middle: the cost to make a copy is average, and the market share of the leader is also medium (in the 20% - 30% range).
I've tried to think up of counter-examples, but I can't think of any, and if they exist, probably it's just a temporarily situation until the market has time to shape it accordingly.
Which brings me back to the original question: in what industry should we invest our time/money/future?
If we're looking for an all-or-nothing approach, if we're sure that we'll become the market leader in our field, then industries where the cost to make a copy is low are the best. However, those are also risky: if we fall in the second place or the third place, the revenue stream will quickly disappear, because the competition can make as many copies as it wants in order to satisfy all customers.
If we're looking for a less riskier approach, industries where the cost to make a copy is high are suitable. Like consulting, for example. Here, you'll get your share of revenue, even if you're not the best in the field. But if you are the best, you won't be able to win huge amounts of money, because you won't be able to produce, with low costs, your service/product to the whole world.