The term long tail, coined by Wired editor Chris Anderson in the October 2004 issue, refers to a socio-economic trend away from a hit-based economy to a niche-based one.  In essence, the theory of the long tail states that the revenue potential of all the less popular, long tail markets taken together far exceeds the revenue potential of the most popular hits.  Sure, maybe hundreds of thousands of people want to buy the newest Justin Timberlake CD and whoever sells that particular product will likely see a huge short-term revenue spike but put into context, Justin Timberlake will never account for more than a tiny percentage of all CDs sold over any given period of time.  Tens of thousands of obscure artists may only sell a few thousand records a piece but taken together, the value of their music far exceeds that of even the biggest star. 

The Internet Changes Everything

In the past, traditional retail stores had no choice but to focus on stocking only the best-sellers.  Traditional retailers have limited shelf space, and even the largest of them don’t have room to stock more than a miniscule fraction of the product universe.  The internet changes that.  Online retailers like Amazon.com (AMZN) can have a seemingly infinite inventory which allows them to truly take advantage of long-tail niche traffic.  Whereas Best Busy (BBY) can stock the CDs of perhaps the top 2,000 best-selling recording artists, Amazon can stock millions of artists, including many most people will never hear of.  Best Buy’s model relies on consistently guessing the public’s musical tastes week after week after week.  Amazon’s is much broader:  just carry everything and make all the sales everybody else is missing out on.  And as we know from long tail theory, those “other sales” dwarf that of even the biggest hits.  The question is, will maintaining such a massive inventory increase or decrease profitability?

Chris Anderson did a study entitled Are niches more profitable than hits? to find the answer to this very question.  What he finds is encouraging.  Profit margins on blockbuster new releases are horrible, even though they command premium prices on the shelves.  But then an interesting thing happens:  gross margins on DVDs over the next few years increases dramatically because the acquisition costs of older DVDs decreases much more quickly than the retail sale price.  Thus, it becomes clear that selling fewer copies each of older, less popular DVDs can be much, much more profitable than selling only blockbuster new releases.  As an online retailer with an almost infinite inventory capacity, Amazon.com has the scale to take advantage of this phenomenon in a way Best Buy can’t.  There is no way a brick and mortar retailer could sell enough long-tail DVDs to remain profitable because they don’t have the shelf space to carry them.  Amazon can, however, and it can do it with every product imaginable, not just DVDs.  It has the same scale advantages when it comes to books, music, electronics, accessories, exercise equipment, and everything else under the sun.

And here’s the kicker, long-tail traffic is much more focused and profitable than regular traffic.  Somebody who goes into Best Buy and asks to see the HD TV’s is just browsing.  They are researching a future purchase and aren’t likely to buy anything on the spot.  Even worse, they may take the information obtained browsing your selection and use it to make a purchase elsewhere.  Long tail traffic, on the other hand, is far more targeted.  Instead of asking to see HD TV’s, a long tail customer might ask to see a Sony FWD42PV1A/S 42″ High Altitude Plasma TV.  This is a customer who’s already done his research and is ready to buy.

 A Note On Valuation

What I’ve written here is no secret to the market and Amazon is fully valued and I would probably not buy it at thsi price.  This post is meant to be more of a case study on what the long tail phenomenon means for the future of our economy and a framework to go about profiting from it.  It may well be that some other company comes along and harnesses these forces even better than Amazon does.  Plenty of other internet companies, including both Yahoo (YHOO) and Google (GOOG), take advantage of the long tail in that they serve advertisements on all those obscure search queries.

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