Is it really necessary for Google to screw their customers?

Yesterday, Jason McCabe Calacanis invited me to respond to his post “Has Google Been Naughty?  Yes.  Should the Government Get Involved?  No”.   You can read responses from Vivek Wadhwa and  Robert Scoble along with mine in a handy digest on the Launch blog.   The following post is the full text of my response to Calacanis view of Google’s future path.

There’s a predictable cycle in business, at least in the sectors of technology, media and telecommunications.

In the first part of the cycle, companies achieve success by introducing a new service that delights customers:    call it the “Value Creation” phase.   This is the phase when lots of customers sign up.   Remember when you bought your first Windows computer, your first iPod, or your first smartphone?   Chances are good that you made the switch at the exact same moment when millions of other people were migrating to these new gizmos, too.  Everyone was attracted by a novel combination of utility, cool factor and the right price.

But over time, as the new product/service evolves into our daily habit, some companies are tempted to tweak the formula just enough to lock in the installed user base while extracting much fatter profit margins.  You experienced this when Microsoft forced us to accept bloated upgrades to already-installed software packages, and when Apple leveraged its proprietary DRM to keep your music and media on the iTunes/iPod upgrade path, and when your cellco began to tack on all sorts of extra fees in the monthly bill.

Why do we put up with it?   Once we’re hooked as customers,  it’s painful to switch to a new service.  On top of the expense of buying a new product, there’s the additional cost of time and effort to master the new product’s learning curve, and then there are the myriad tiny adjustments to bolt-on services and perhipherals.   So instead, we typically grit our teeth and pay the fees while the company rakes in mad profits.   Let’s call this second part of the cycle the “Value Extraction” phase.   It follows the explosive growth of “Value Creation” phase.   This two-step process is what drives valuations sky high.

There are only two ways to exit the Value Extraction phase:  either we drop the service cold turkey (ouch! very unlikely) or else we wait until a new technology renders the current habit obsolete and simultaneously reduces the painful cost of switching.   This is the “Value Destruction” phase: it’s the third and final phase of the cycle.  It generally takes a long time to arrive.  But when it does, customers flee in huge numbers.

When Value Destruction happens, the incumbent company is often caught off guard.  Not because they were oblivious, but because they are so invested in preserving the status quo they simply found it impossible to imagine how they might retool their business process and still manage to extract the same fat margins.   Instead, they implode, because they squander their effort in a vain attempt to preserve the Value Extraction phase long after Value Destruction has set in.

For example,  customers vastly overpaid for music CDs for two decades, forced to buy the album when we really only wanted to buy a single: it wasn’t until the combination of “rip, burn, mix” , the iPod and easy, legal online purchasing (via iTunes) that consumers migrated in huge numbers away from the music CD, the cash cow of the recording industry.  After fruitless resistance, the music labels imploded.  Sales of singles simply don’t generate as much profit as sales of albums.

Similarly today, after decades of paying for a bundle of cable channels when we only want to pay for the few that we actually watch, a wave of early adopters have begun to cut the cord.  They are dropping cable television and moving to online video services that offer total control over a vast selection of titles available on demand on the device of our choosing.   Will the cable system implode?  It’s possible, if enough customers decamp for OTT video services.  Watch this space:  in 2010, for the first time ever, cable MSOs saw the number of cancelled subscriptions outstrip new additions.

When good companies turn bad.

As customers, we’ve all experienced this cycle many times.  The switch from Value Creation to Value Extraction frustrates us, sometimes making us incredibly angry.   But rarely are we angry enough to drop the service entirely.   We hang on until someone else introduces a better mousetrap.   Old habits die hard.

  • The switch from Value Creation to Value Extraction happened when Facebook decided to change the default on privacy settings unilaterally, making our private personal pages public, and harvesting our personal data to sell to marketers.   Many users hate it, but there’s no viable alternative (yet).  Facebook pre-emptively co-opted any would-be rival by offering Facebook Connect.  Why switch to a new social network when you can register for any media site with a single click?  So far, Connect has enabled Facebook to avoid the Value Destruction phase.
  • The cycle is happening now in telecommunications:  telcos, cellcos and cable MSOs are overhauling their data plans, moving from unlimited broadband to monthly usage caps. Just like minutes of talk time on your cell phone, these plans are designed like a trap for customers who exceed the cap.  The resulting surcharges are hugely profitable.  Watch the network operators rake in record profits now that we’re all hooked on unlimited data plans.   Given the consolidation in telecom service providers, there are no alternatives and therefore no Value Destruction phase in sight.  Yet.
  • It’s happening now at Twitter as they limit external developers’ ability to create mobile apps.  Soon Twitter will control the entire end-to-end ecosystem of real-time feeds.   After they marginalize outside developers, Twitter will be able to extract juicy profit margins from marketers who seek to participate in the real-time ecosystem.   Until someone builds a better mousetrap, we’ll probably submit without objection to the gradual closing of the Twittersphere.

Even when a new technology threatens to disrupt the Value Extraction phase, the incumbents do everything in their power to maintain their hegemony.  They impose severe penalties on customers who dare to make the switch.   That’s why your mobile network imposes an Early Termination Penalty if you want to switch before your contract has expired.    That’s why movie studios, like the record labels before them, use the legal system to criminalize customer behavior and sue the most active viral collectors of their wares.   This is why your personal data is locked up in a proprietary format, or in an online database with no ability to for you to download it or export it.  Lock-in is the key to preserving the Value Extraction phase as long as possible.

But the effort to coerce consumers into maintaining the status quo can backfire.   Sometimes it spells doom for the incumbent.  The seeds of self-destruction are planted when innovative companies switch to coercive mode, when they move from Value Creation to Value Extraction mode.   In the process, they generate a combustible combination of consumer dissatisfaction and fat-margin economics that attract investment in disruptive technology.   In other words, success in phase two is what attracts would-be disruptors to start phase three.

Is Google an Exception?

Until now, under the banner of the “Do No Evil” slogan, Google has managed to be wildly successful without coercing their end users.   Google so completely dominates the interlocking businesses of search and online advertising, they have not needed to impose artificial constraints in order to extract vast profits.   Google has been in a perpetual Phase One, finding ever more ways to create value and attract more users.

As consumers, we’ve enjoyed a steady stream of innovative new products from Google, from Mail to Maps to Chrome, 411, Google Documents, Picasa, Android and more.   And nobody can complain about the price.   It’s hard to argue with free, even if it means giving Google access to vast amounts of personal information.   By giving away free products, Google drives ever-greater value into their core business of search and their ability to target audiences via DoubleClick.

In a way, Google inverted Phase Two:  instead of coercing customers into coughing up ever-more cash, Google has co-opted entire industries, devaluing them by introducing a free product that reinforces the core business of search.  Google has adopted a scorched-earth approach to any business that threatens to encroach on their lucrative turf:  would-be rivals in mapping, email, messaging, operating systems and desktop applications have the novel challenge of competing with Google’s free product suite.   This  approach starves rivals of cash to fuel disruptive innovation and it imposes a giant hurdle in front of startups who must compete with free products, presumably forever.

How long can Google maintain this inverted version of the Value Extraction phase?   Perhaps we are seeing an end to this remarkable phase of innovation.

The peculiarity of Google’s business model was explained in Tim Wu’s  “The Master Switch.”   Wu points out that Google’s weakness is owning neither content nor connections.   Positioned between content owners and network operators, Google’s perch is much more precarious than it may appear.    Google depends upon the cooperation of both content companies and network operators to exist, but increasingly both camps have voiced objections to Google’s dominance.   For years Google has faced a succession of lawsuits brought by copyright owners.  Increasingly, network operators threaten to charge Google a toll for using their pipes.

The obvious next move for Google is to compete with one or both camps.

For a short while, it appeared that Google might be tempted to compete with the network operators.   But bidding for wireless spectrum and local municipal WiFi turned out to be a headfake.   Rather than compete with carriers in the commodity pipe business, Google would prefer to co-opt a network operator, by giving them the free Android operating systems with lots of terrific apps and a cut of the search revenue in exchange for controlling end user access to search.

The real action is in content.  Google has been on a shopping spree lately, accumulating content and the components to build an end-to-end distribution platform for rich media content.   NextNewNetworks gives Google’s YouTube a source of original video programming.  Plus YouTube has vowed to give away $5 million to top video bloggers.   A recent batch of acquisitions add up to the components of a distribution platform: enables users to synchronize digital content across multiple devices;   Widevine is a DRM system to secure high quality digital content;   Green Parrot improves the quality of streaming video;   EBook Technologies will enable the distribution of Google Books to multiple devices.   Three weeks ago, Google debuted the new cloud-based Music uploading system to compete with Amazon. And YouTube is about to introduce a premium video service to compete with Netflix and Amazon Prime.

As the owner of the largest video service in the world, the second-largest App Store, a new music service and a digital book store, and increasingly as a purveyor of rich content for phones and tablets, Google faces a giant conflict of interest.  They must now face the temptation of massaging search results to favor their wholly owned content brands and content aggregation sites.

That’s why it’s no surprise to hear complaints that Google’s latest revision of the search algorithm reorders the results to give prominent placement to Google-owned properties.

Whether it’s deliberate or unconscious, the urge to fatten margins by adding a content business on top of search and advertising means that Google is venturing away from the delicate balancing act as a neutral switchboard poised between content providers and network operators.   The search giant appears to be evolving towards a new suite of content products and services designed to compete with Apple and Amazon.   The temptation to skew search results in favor of wholly-owned products may prove irresistible.

The integrity of search results has always been Google’s main claim to the banner of “Don’t Be Evil”.   If search gets compromised, then Google will have sown the seeds of their own destruction by creating a juicy opportunity for disruption by a rival who doesn’t need to subsidize a vast range of free applications and services.