It stuck me recently that GameStop might be falling victim to The Innovator's Dilemma. This book, published in 1997, a model of why a company that is at the top of its industry can fail to maintain their dominant position in the face of disruptive innovation.

If you haven't read the book, I highly recommend it. This summary does a good job of explaining the premise of the book, so if you haven't read it, go read the summary and come back. The rest of this post attempts to apply the model outlined in the book to the situation GameStop (and other niche game retailers) face with respect to digital download.

The argument that digital distribution is a disruptive technology is an easy one to make. It disintermediates retailers, distributors, and manufacturers, by letting publishers and developers by through a single layer of middlemen (in the form of Steam, Impulse, or Direct2Drive) or even directly to their customers.

Digital distribution also removes the sharp shelf-space restrictions that keep a game's shelf-life artifically low and allow game sales to enjoy a long tail. Numbers are hard to find, but digital distribution has also been accelerating in the past few years.

Part of the Innovator's Dilemma model predicts that established players will be able to enjoy significant revenue growth by retreating from low-margin and low-volume markets as those fall to the invading technology. GameStop's last two quarters are the best they have ever been.

However, one part of GameStop's business has been in serious decline over the past several years, and that is PC games. That is partly due to an overall decline in PC games in general, but it is also to the fact that PC games can't be repurchased and sold as used like heavily DRMed console games can. This resale of games accounted for 23% of the company's revenue last year, and that number is increasing. According to the Wall Street Journal, used game sales account for 42% of GameStop's gross profits.

I suspect that the other major reason for GameStop's withdrawal from PC games is that digital downloads have made their strongest inroads on the PC. Steam is selling tons of AAA games, and casual and indie games are sold primarily online at this point.

The company is not mounting much of a defense in the market where its competition is strongest. They will likely lose the console market the same way, since I would be shocked if the next generation of consoles (Xbox 720, Playstation 4, and Nintendo Puu) didn't include large hard drives and the ability to download full sized titles as easily as on a PC.

GameStop is making the choices they are because that is what is demanded of them by their customers and investors. As a multi-billion dollar public company the tiny digital sales available five years ago would have just been a distraction from meeting their growth goals. That allowed Valve and others to get experience and partnerships that give them a huge head start in the the digital distribution space.

Just in the past 18 months Steam has picked up titles from EA, THQ, and Sony Online Entertainment. These major publishers join Activision and Take-Two that joined the service a few years ago. In fact, GameStop was reportedly so upset at how much THQ was favoring Steam that they temporarily refused to offer pre-orders of Dawn of War II. (Or at least that was the rumor.) All the while, the biggest complaint that most of GameStop's customers have is that it doesn't give them enough for a used game. By and large their customers are quite happy with the company.

Broadband penetration in the US has increased from 4.4% to 50% in the past 9 years. At this point the extensive selection available for download is primed to combine with the relatively new viability of large downloads and drive GameStop completely out of the PC game business.

I believe the same thing is likely to happen for console games within the first two years of the next generation of consoles. Within ten years the dedicated video game store will have gone the way of the travel agent, cable driven earthmover, and walled garden internet service provider.

Or at least that's now it seems to me as a retail outsider and recent convert of The Innovator's Dilemma. What do you think?