CHAPTER 4

Scale and Scope in the Digital Economy

On March 19, 2019, the APNews published a story about the last remaining species of its kind in Oregon. But it is not a biological species going extinct. Oregon’s Blockbuster retail store became the last on Earth when the only other store in Perth, Australia closed its doors on March 31, 2019.1

The store systems and operation are so archaic that one wonders how it could function:

The computer system must be rebooted using floppy disks that only the general manager … knows how to use. The dot-matrix printer broke, so employees write out membership cards by hand. And the store’s business transactions are backed up on a reel-to-reel tape that can’t be replaced because Radio Shack went out of business. Everything in this store is a technological oldie—the systems, the video tapes and CDs, the service. And this is precisely why it survives and thrives.

In 2004, Blockbuster had 9,000 high-end, high-tech stores globally. In 2014, it closed all company-owned stores. A few franchised stores remain in business primarily as tourist attractions—remnants of a vanished retail empire and obsolete technologies. The store is a symbol of the new market competition in which many companies and technologies go from raise to demise quickly. The Oregon store now sells T-shirts, caps, and other goods with their own branding “The Last Blockbuster in America,” and they seem to fly off the shelves.

Many people attribute the failure of Blockbuster to Netflix—the company that flipped the in-store model to mail-in self-service. But it is more complex than that. If you think about it, why didn’t Blockbuster buy Netflix or build a competitive mail-in offering? It didn’t for a long time, and when it did it was too late. This is because of path dependency.

The Blockbuster business model and revenues critically depended on the collection of late charges.2 Late charges are a penalty that the customers pay for returning the rented movie to the physical store past its due date. I paid a lot of late fees myself. I would say that I probably paid late fees on 60 percent of my rentals. I hated the late fees because in most cases there were some extraneous circumstances that did not allow me to drive to the store and return the movies on time. If the store was more conveniently located, or if there was another easier way to return the movies, I would have done it. Hence, I did not consider it my fault for being late and the penalty seemed unjust. But Blockbuster was too attached to collecting penalties from its customers and did not want to give up the easy revenue. They knew very well that a subscription-based business model would eliminate the penalties and drain their key revenue source.

But why didn’t they see the emerging subscription model by Netflix as a threat that could cannibalize their rental revenues?

The reason why they did not see the mail-in subscription as a threat is because of what I call the illusion of assets advantage. The Blockbuster executives felt secure behind their massive network of 9,000 physical stores. Coming from the world of physical assets, this network was their highest managerial achievement. At that time, most retailers viewed such asset accumulation as a means to put a Chinese wall around their customers. The more stores they had, the more customer visits they expected.3 Thus, in a classical path dependent thinking, the Blockbuster executives could not comprehend that the asset-based competitive advantage could evaporate quickly. A competitor without assets was perceived as a soldier without weapons—not a great threat. Well-established managerial traditions, practices, and pride got in the way of seeing the new reality. The asset, that is, the physical store, was the cause of the inconvenience to consumers, and the inconvenience was the source of the late penalty revenue stream. Netflix eliminated the asset and built a new asset-less retail model.

Eventually Blockbuster introduced mail-in self-service, but it was too late. The story of Blockbuster’s failure is about how scale in the physical world works against you and how scale in the digital world works for you when competing against a traditional asset-based business. Once the asset-less movie rental model was adopted and consumers started to reduce or abandoned store visits altogether, the ownership and management of physical stores became a cost-drag for Blockbuster.

Scale and Scope in the Traditional Economy

Economists like to measure growth in terms of scale and scope. Scale is how fast companies go from small to large, that is, large volumes of production, a large network of stores, hotels, and so on. Scale correlates with market share because companies need scale to meet customer demand. In the world of physical resources scale implies investment in physical assets. Thus, in the traditional physical economy, scale gave the owners of assets a reliable protection against new entrants.

In 2016, Tesla made a bold statement that it would increase the production of its Model 3 electric car to 500,000 units by 2020. Many logistics experts were skeptical about this goal because Tesla did not have experience with mass production.4 Scaling the production to such magnitude for a product that comprises more than 10,000 individual parts is the know-how and expertise of companies that have over 100 years history in car manufacturing. Tesla lacked not only the experience but also the ability to hire all the needed talent to achieve this goal. As expected, it failed to produce the 500,000 cars and meet the expectations of thousands of consumers who had signed up on a waiting list for the Model 3 Tesla. The car manufacturers in Detroit indeed had a competitive advantage secured by the known challenges in scaling the production of physical goods. Despite all the hype in the press about the Tesla creative destruction of Detroit car manufacturing, the Big Three kept their cool and waited to become fast-second in the newly emerging category of electric cars. Fast-second companies do not partake in the risk of market development, but they can only succeed if they have enough time to catch up. As it can be seen from this example, fast-second is a strategy that works in the traditional market competition. In 2019, all the Big Three announced rollouts of their own brands of electric cars, which is beginning to negatively impact the demand and market leadership of Tesla.

Scope is the ability to expand the existing business into new product categories within the same market or into adjacent markets. In the automotive market, there are many categories—sedans, sports cars, SUVs, trucks, luxury cars, and many more. Inventing a new category, as Chrysler did when they introduced the minivan, is a sure way to expand market share. As the market gets consolidated, the big players play in all categories, as it is easy for them to leverage their scale to expand their scope. Niche players who try to dominate one category get acquired as it happened to Rolls-Royce and Porsche.5 This is the reason why Tesla entered multiple categories—sports, sedan, and SUV. Since in the physical world scope is ensured through resources and capacity, it also serves as protection against new entrants.

But do scale and scope effects work in the same way in the digital economy?

Scale and Scope in the Digital Economy

Traditionally it took companies 15 or more years to reach $1 billion ­market valuation. Uber reached $3.7 billion valuation in 36 months (October 2010 to August 20136) and there is a growing number of companies who achieve it in two years on average. The main reason for Uber’s fast-paced growth is that its data-driven business model is not constrained by the accumulation of physical assets. The cars were already available; they just had to be mobilized and put into a money-making service. The growth of Uber can only be limited by their ability to manage the data about the cars, the drivers, and the riders, which requires far less resources than managing and maintaining cars, employing and managing drivers.

The importance of collecting and managing all aspects of the data related to the service can best be illustrated by reviewing the impact that criminal or abusive actions have on the business. Just a small number of criminal actions by a few drivers can seriously impact the trust in Uber and the demand for its services. Not having the right data to stop and prevent such offences is a bigger danger to Uber than the lack or loss of a physical asset. There is a constant supply of Uber cars that come with the drivers, but the reputational damage of a single incident drastically affects consumer demand. Criminal incidents happen in company-owned cabs too, but somehow there was a false belief that employing drivers ensures higher scrutiny than managing a decentralized group of freelance drivers.

As Benjamin Franklin said: “It takes many good deeds to build a good reputation, and only one bad one to lose it.”7 And while there are not many companies that go bankrupt for reputational damage, they pay a significant cost to recover fleeing customers. Thus, the scaling of Uber is contingent only on the trust in the quality of its service, which the data management system makes 100 percent transparent for every driver and client. The transparency maintains the trust and ensures that customers can choose who to ride with and drivers can choose whom to pick up.

Amazon scaled its book selling business fast and then it started to expand its scope quickly to become one of the largest companies in the world. The effect of the scope expansion on Amazon’s market cap is astonishing. It’s market cap grew from $20 billion in 2008 when it embarked on a scope expansion to $950 billion in 2018. This is a 4,650 percent increase in value in 10 years. Scope expansion scales the market cap of digital companies (Figure 4.1).

Figure 4.1 Growth through scale and scope expansion: A model for the digital economy

Data-driven companies have an advantage when they expand their scope. They can apply the same data management know-how to new categories and new businesses. Whether you sell books, shoes, clothes, gadgets, appliances, or anything else, the sales process, the data management, and the analytics that drive the sales are the same. But unlike traditional companies, digital companies do not require capital investment in physical assets to monetize their know-how.

Even more interesting is how Amazon created their cloud services business AWS. AWS was developed in three years out of an internal need to make its sales process more flexible and powerful, as they were expanding the scale of the business to more merchants.8 As management watched the use and operations of the new system, they realized that they had become real experts in managing data and infrastructure. Why not rent this capability to any other companies? Amazon was already renting space on their digital storefront to other retailers. Now they could rent infrastructure, too, not only to merchants who sell on Amazon but to any company in the world.

Thus, in just a few years through expansion in scale and scope Amazon has taken on two traditional giants in two different industries—Walmart and IBM. It is interesting that IBM was in the business of infrastructure management but never thought to build and sell it as a service, while Walmart had the Retail Link system but never thought to package it as a product and rent it to other vendors. Amazon had the thought-advantage to invent an entirely new business because of its continuous expansion through data management and analytics.

Digital Growth

In the new digital economy, scale is achieved not through the accumulation of assets but through mobilizing and onboarding customers on data-driven platforms and products. Scope is expanded not through investments in capacity and assets, but through the digitization of adjacent processes and services. Chat apps like WhatsApp, Telegram, KaKao Talk, WeChat, and so on used to be only for chat. But today they can be used to make calls, order cabs, pay bills, and much more. And why not? After all, we used to do these things by chatting in-person or on the phone to dispatchers, bank tellers, and other service providers.

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