By Saurin Desai
Rdio - a now virtually defunct company - was once a streaming music service provider offering an expansive catalog of 7M+ songs. Launched in 2010, it enjoyed a first mover advantage in the then-nascent media streaming market. Rdio is a curious yet compelling case study vis-à-vis its eventual Chapter 11 bankruptcy and subsequent intellectual property sale to Pandora in 2015. Rdio, despite a superior product offering and first mover advantage, was afflicted by flaws in its business model due to missteps in leveraging the attractive qualities of information goods, lack of a sound pricing model, and poor execution in building network effects to gain market dominance – the sum effect of which was responsible for its drastic, albeit puzzling, failure.
Rdio took a rather myopic view on long term success. Instead of prioritizing rapid growth, it focused on being sustainable (i.e. cash positive and profitable) right from inception. The “fatal flaw” associated with this approach lies in the market dynamics of the streaming industry. This industry has immensely high fixed costs due to the exorbitant fees paid to record labels for licensing rights (Spotify’s cost of sales was $7B+ in 2021 – the bulk of which was licensing fees) and expensive operational costs (salaries driven by a booming technology labor market, underlying technology infrastructure, etc.). This makes profitability very difficult to achieve – let alone immediately (Pandora only began to turn a profit three years ago in its decade-long history and Spotify just became profitable in 2022). Rdio sought to stay profitable by initially only offering a paid version of the app. This approach was self-defeating in two ways. First, although the company had high fixed costs (stemming from licensing), variable costs were negligible (and thus the contribution margin would be 100% of the price charged). Thus, the key to financial success for Rdio was achieving a critical user / subscription volume as each transaction yielded pure contribution margin profit. A paid version of the app posed significant upfront costs for customers (who were less familiar with the streaming industry back then), thereby limiting their user base; in contrast, Spotify offered an ad-supported free plan. Second, since digital music is an experience-good, in that its utility can’t be discerned pre-purchase, a consumer really can’t determine his / her willingness-to-pay without a trial. As a result, digital music platforms end up pricing their services out of the market – limiting the serviceable available market.
While Rdio employed a freemium model later on, its positive effects were greatly muted due to Spotify’s first mover advantage. All of this coupled with Rdio’s unappealing marketing and poor execution to build network effects enabled Spotify to cement an “unassailable” position at Rdio’s detriment. Rdio’s failure to market its superior product effectively meant a lot of otherwise-interested users hadn’t heard of them. Furthermore, its initial lack of freemium product pricing (using “free” to create demand for the paid plan) meant they couldn’t employ second-degree price discrimination on the basis of intertemporal premium utility (i.e., utility driven from getting or experiencing things sooner rather than later). This could’ve manifested itself with an ad-supported vs. paid ad-free plan; capitalizing on the “annoyance” factor present with advertisements to extract more from consumers. However, due a uniform pricing plan, consumers couldn’t self-select into different buckets (ad-free vs. ad-supported) and Rdio couldn’t extract additional value from consumers who would’ve paid more; i.e., consumer surplus couldn’t be extracted.
This also had the effect of limiting their user growth and retention metrics – leading to ineffective network effects. Metcalfe's Law states that the value of a network (in this case, Rdio’s ecosystem of users) rises exponentially as its nodes (users) grow. This is because the current users benefit when more users join a network – and so do the new users. To understand this, think about how useless G-mail would be if nobody had an email address! The implications being that Rdio should’ve strived to increase switching costs (i.e., effort-based, psychological, or monetary costs borne by consumers for switching to different products) after adoption by virtue of a superior product offering, competitive prices, etc. to increase customer stickiness or build a competitive moat that monetizes the customer base by selling access to it via advertising. The trouble was that they went about it exactly in the reverse order by not using a freemium model at the onset, thus destroying significant potential value. Contrasting Rdio’s strategy with Spotify’s, it is easy to see the differing outcomes: Spotify is the market leader in music streaming and has highly effective network effects due to its freemium model, investments into building its customer base via discounts / promotions, bundling initiatives, and social features (collaborative playlists, Spotify Wrapped, etc.) that increase the value of being on the Spotify platform due to being able to share experiences with your social network.
In conclusion, due to the summed effect of these aforementioned reasons, Rdio was forced to file for bankruptcy due to an untenable market position and low growth trajectory. The key assumption underlying their model was a “build it and they will come” philosophy that over-indexed on technological and product superiority and deemphasized marketing, distribution, and growth objectives. The decision to initially only offer a paid plan assumed that consumers would be willing to pay money before being provided with upfront value – a key mistake given that music streaming was a nascent industry and most people didn’t see the value in paying for digital music. This stunted their growth curve and rendered them unable to leverage the negligible variable costs associated with information goods. In such a winner-take-all industry where only a few companies can dominate (as consumers practically only need one music service) – consistent with a power law-esque market share and revenue distribution graph – Rdio had a critical misunderstanding of consumer motivation, network effects, and information goods pricing strategy that cemented its failure.
As we look towards the future, business leaders would do well to remember Otto von Bismarck’s famous quote: “Only a fool learns from his mistakes. The wise man learns from the mistakes of others”. Therefore, carefully distilling the important lessons from Rdio’s drastic collapse is particularly relevant now as information goods and related markets have posted strong rises in growth. To succeed in this disruptive and increasingly competitive industry, executives need to prioritize on:
1. Building network effects to box out the competition
Investing in making membership within your exclusive network relative to others is critical for building brand loyalty, raising switching costs, and boosting retention rates. For example, Apple spends a sizeable amount on marketing, branding, and R&D. Marketing and branding increases a customer’s favorable perception of Apple products and even boosts the non-functional, “intangible” value of purchasing Apple products. Interestingly, R&D builds competitive moats as Apple differentiates itself on a technical, cybersecurity, and design level. Recently, Apple has introduced novel ways that its suite of products integrate together in an ecosystem; this is by design – it reduces incentives to leave the Apple ecosystem and raises switching costs (i.e., by replacing their iPhone, a customer also loses the ability to reply to text messages on their Macbook). Recently, with the rise in NFTs, many such projects are seeking to differentiate and raise their value by emphasizing the community aspect; they hold special events for members, build online communities, and offer a compelling vision for the NFT projects to gain member loyalty and engagement.
2. Exploit low variable costs to aid in price discrimination
Information goods products will always attract different types of customers – segmented by different wants/needs, psychographics/demographics, and price elasticities. Price discrimination, or charging different prices for the same goods, is a fantastic method to extract maximum value from consumes and the unique cost structure of information goods facilitates this. This can manifest itself through versioning (or offering different versions of the same product for different prices). For example, going back to Apple, iPhones are sold in 64gb, 128g, and 256gb memory. It costs Apple very little to offer more memory in their phones but they’re able to capitalize off the fact that some consumers will be happy with the low-end, but some (i.e. “power users’) customers need more memory and are more inelastic in their demand. Thus, by offering multiple tiers, they can extract more consumer surplus relative to a uniform pricing strategy. However, the most powerful use of price discrimination is to present a lower initial cost to the consumer to trial your product (due to the presence of the lowest tier). This is especially valuable in innovative industries such as information goods with novel use cases; this can help mitigate initial consumer hesitancy.
3. Optimizing for growth at the onset
Focusing on growth (whether than be users, subscribers, revenues, etc.) may pay more long-term dividends than striving for Day 1 profitability. Focusing on growth allows the firm to reinvest its proceeds into the company to build capabilities, create network effects, and focus on increasing demand to lay the foundation for profitable growth. Furthermore, this allows firms to leverage the power of information goods’ low variable cost structure to drive users to its platforms (as incremental revenue per new user will be very close to 100% profits). This can generate long-term up-sell and cross-sell opportunities. Focusing on reaching an astronomical growth trajectory during the early stages with maximize customer lifetime value.