- thoughts for new players entering media markets

Hot markets, monopoly markets, and commodity markets

In any high-price high-volume market, the amount of transactions and the revenues per transaction are so substantial that the potential for higher profits by pushing more business and increasing product prices totally outpaces the effect of increased production efficiency and cost savings. In a downturn market, it makes more sense to reduce costs and improve efficiency. Geoffrey Moore once visualized this economic logic to me by describing a big water-pipeline representing the business cycle. If there is a massive amount of water coming trough (lots of high-priced business), the most important thing to get a lot out of it at the end (profits) is to have a wide-enough pipe (channel). Having many small leaks (costs) every few feet doesn’t really matter since so much is pumped in (market demand). However, during times when the water pressure is down (less demand) and there is a relatively small flow of water entering the pipeline, each leak will contribute to a relatively higher amount of spill, resulting in no water coming out at the end because all the water has already leaked away through all the small leaks (no margins, fixed costs too high).

Hot markets can lead to either monopolies or to commodity markets. In a monopoly market like the desktop operating system market, the market leader can determine the price and therefore has to worry less about the costs because the margins are easily kept by maintaining high prices. Even with tens of thousands of people working on a new version of windows for years, Microsoft is reported by many to generate a profit margin of up to 85% by maintaining a sufficiently high price. Typically, monopoly players focus less on costs and more on maintaining a high price. That’s why consumers pay more at the end of the day. Of course, high margins can be used towards all kinds of initiatives to stay on top like lobbying and creating complex product lock-in strategies and dependencies. Even without that, the marketing, sales, and development power resulting from these margins provides the monopolist with endless options to stay ahead of fledgling competing initiatives. However, typically new initiatives will only be developed up till the point where market domination is maintained. Internet Explorer went about 8 years without any substantial improvements, until the success of FireFox pushed Microsoft to continue the development of Internet Explorer.

When a market for a certain basic product or service develops into a commodity market, there are more players and each player can only stay in the game by having a sufficiently big channel to market and keeping their costs down (efficiency). This generally leads to lower prices for consumers (and smaller margins for businesses and investors). Lower prices for consumers means more spending power for consumers and more consumption. This is good for investors in general too. It just becomes harder to get extremely high returns on just a few investments. For the market it also means increased innovation because all players in the market continuously have to keep up with developing new technology in order to stay competitive.

Google Economics

The economic principles described above can also easily be applied to Google. The search and pay-per-click market mainly developed by Google has been very hot over the last few years: high prices (cost-per-click prices increasing with 35% at least every year) and high transaction volume (12+ billion searches a month currently with a 35% growth rate for years). The thing to do for Google for years has been to widen the pipe: more users and higher ad-click prices. Fixing small leaks has never been part of the Google DNA and cost-savings have never been the main focus of the hugely expanding organization. In fact, so much money has been flowing in that the huge costs of hiring thousands of high-paid top-engineers and letting them work on thousands of projects didn’t impact profits that much. Each engineer at Google can spend 20% of their time on any project of their choosing. It could be a chess-computer or a digital recipe organizer. Anything. One of Google’s philosophies is that creating an environment where the best minds can express themselves creatively to the fullest extend will lead to many great inventions that will generate future business. And as a long-term investment, this might be true. It’s what science does for societies. In societies however, there is a need to survive and poverty incents people to be creative too. Wealth leads to a declining additional value of efforts/product per person.

In terms of costs savings for operating the business, the priority always has been to support a wide pipeline, not to fix small leaks. Sure, Google has optimized their servers to use less space and energy (they are famous for it even). But they have never publically optimized their operations to use less servers. When looking at 1.75 to 2 cents per search results page, it seems that this number is a bit high. Kalooga spends about a 100x times less, without extensive hardware optimizations. One could speculate that in fact a substantial part of the servers are not used to service users but to support it’s engineering workforce in developing and testing new large scale services and products (remember, long-term investments). And that might make sense business wise. But it’s not a sign of cost savings and efficiency. It’s also not something a new player has to take into account at all when starting a business. It comes from having a lot flowing through the pipe and is not a reason for the flow itself. Future pipelines might come available because of these investments but the return is very much unknown.

Is Google a monopoly? One thing for sure is that Google’s main focus is on pushing search traffic and click prices and that it’s survival is not dependent on excelling in efficiency and cost savings. That means it could be a hot market with enough flow for everyone or it could mean the market is moving towards a monopoly market.

User control: monopolies have to retain and lock-in users. Google users are ‘locked in’ by the product being free without the perceived need to change vendors. Consumers typically only change vendors when they perceive higher value in other products or lower costs. The product cannot be offered cheaper than free so a competitor needs to deliver perceived higher value. To change people’s behavior, some people say it requires a 2x to 10x higher value so a web search competitor winning against Google needs to have results that are at least twice as good…

Another option is to go into new markets where no monopoly position needs to be fought or where substantially better services can be offered. Remember, YouTube, MySpace, and Skype beat Google with superior products and marketing (the latest news is that MySpace has thrown-in the towel in the Netherlands because they couldn’t compete against Hyves, a local social network… http://www.techcrunch.com/2008/10/26/myspace-gives-up-on-the-netherlands/). This shows that it’s not the first mover in the market that becomes the winner but the first party to do it well enough and reach a certain critical mass. Google has done that extremely well in web search but that is also the only market in which they have shown to be unbeatable. Media start-ups need to choose wisely where to compete and where to complement. Many creative start-ups are still showing us how to navigate the media space as a new player. Of course a solid monetization model is key to generate sufficient revenues but that’s a subject for another post.

(re-published from original post in 2008)

or why Google’s hundreds of thousands of servers and billions of dollars a year in hardware costs are not required for a starting search engine

Google SkyNet

Google has an impressive amount of servers and data centers. The total number of servers is unknown but it is believed it runs into the hundreds of thousands. The Un-Official Google Datacenter FAQ (http://www.datacenterknowledge.com/archives/2008/Mar/27/google_data_center_faq.html) reports there are dozens of data centers and including data centers that are under construction, Google has 19 locations in the US, 12 in Europe, one in Russia, one in South America, and three in Asia. Not all of the locations are dedicated Google data centers, since they sometimes lease space in other companies’ data centers. In 2006, Google spent 1.9 billion dollar on its data centers and hardware. In 2007, that number was 2.4 billion dollar. Google has many projects and experiments going and it’s philosophy is that a combination of large data sets, processing power, and brilliant engineers will lead to new and competitive products in the future.

Barrier to entrance?

It is often heard that starting a competing search engine would be extremely expensive due to the costs of the massive amounts of required hardware and costs of operating that hardware. Who would be able to come up with at least the hundreds of millions of dollars required to run the server farm required for a large scale search engine? The reality however is that most of these operating costs are related to performing searches and not to building the search index. And searches also make money… In 2007, every search performed on Google generated about 12 cents on average. When counting the data center costs only towards search results (search still brings in almost all the money and carries the other initiatives) Google’s costs per search results page are roughly somewhere between 1.75 and 2 cents (for the calculation, see the overview provided by the table below. Some items are unknown but extrapolated from other years).

The amount of searches performed every month is not disclosed by Google but are estimates based on research of different organizations like ComScore and Nielsen. Combining the amount of searches performed and the revenues and costs reported by Google in their annual report leads to an estimated 12 cents revenues per search results page.

2005
2006
2007




US searches per month
2,700,000,000
4,177,694,576
5,877,036,708


Global searches per month (incl. US)
5,115,466,667
8,034,028,030
11,523,601,389


Part of revenues from abroad (non-US)
47%
48%
49%


















Revenues per search page (RSP)
$0.10
$0.11
$0.12


Costs per search page (CSP)
$0.04
$0.04
$0.05


Monthly revenues US
$270,000,000
$459,546,403.33
$705,244,405.00


Monthly revenues global
$511,546,667
$883,743,083
$1,382,832,167


Annual revenues global
$6,138,560,000
$10,604,917,000
$16,593,986,000


Annual costs
$2,577,088,000
$4,225,027,000
$6,649,085,000




Gross profit
$3,561,472,000
$6,379,890,000
$9,944,901,000








Google datacenter costs
$1,288,544,000
$1,900,000,000
$2,400,000,000


Percentage of costs of service
50%
45%
36%


Datacenter/Servers costs per page
$0.0210
$0.0197
$0.0174

Of course, there is a substantial investment related to collecting all the information captured in the search index and also to setting up the initial batch of computers storing that index and performing searches for users. This is because an index containing information about billions of websites requires a certain amount of computers that together store the index. These days, the newest generation of computers can easily store many times more information than the original Google computers did. In size, the investment in hardware to start serving users would only be a fraction of the amount of money that Google currently spends on its operations. And as user volumes increase, so do revenues. These new revenues then can be used to cover the costs of the additional hardware required to service the additional users.

The fact that the revenues from each search are about 5 to 10 times higher than the costs of that search (including the hardware costs of other projects!) also means that each additional user on average generates more additional revenues for Google than additional costs. For a new web search player, the initial costs of building a great search engine are a substantial though do-able investment and the hundreds of millions of dollars in service costs only occur when massive amounts of visitors are realized. At that time however, the revenues to cover the costs are also generated by these visitors. With a solid monetization model, new search engines can be started without an investment requirement of hundreds of millions of dollars as is sometimes heard as the reason why it is hard to start a new search engine. With a disciplined costs structure on hardware spending and efficiency (historically not Google’s focus, much more can be done on cost control) and a clear market focus and model to make money, a search start-up can still be successful. Having a successful media market strategy is a subject for another post.

(re-published from original post in 2008)