March 2016

The economic essentials

of digital strategy
A supply and demand guide to digital disruption
by Angus Dawson, Martin Hirt, and Jay Scanlan

In July 2015, during the championship round of the World Surf Leagues

J-Bay Open, in South Africa, a great white shark attacked Australian surfing
star Mick Fanning. Right before the attack, Fanning said later, he had the
eerie feeling that something was behind me.1 Then he turned and saw the fin.
Thankfully, Fanning was unharmed. But the incident reverberated in the
surfing world, whose denizens face not only the danger of loss of limb or life
from sharkssurfers account for nearly half of all shark victimsbut also
the uncomfortable, even terrifying feeling that can accompany unseen perils.
Just two years earlier, off the coast of Nazar, Portugal, Brazilian surfer
Carlos Burle rode what, unofficially, at least, ranks as the largest wave in
history. He is a member of a small group of people who, backed by board
shapers and other support personnel, tackle the planets biggest, most
fearsome, and most impressive waves. Working in small teams, they are
totally committed to riding them, testing the limits of human performance
that extreme conditions offer. Instead of a threat of peril, they turn stormy
seas into an opportunity for amazing human accomplishment.

Full story: Mick Fanning shark attack, Surfing Magazine, July 19, 2015, surfingmagazine.com.

These days, something of a mix of the fear of sharks and the thrill of big-wave
surfing pervades the executive suites we visit, when the conversation turns
to the threats and opportunities arising from digitization. The digitization
of processes and interfaces is itself a source of worry. But the feeling of not
knowing when, or from which direction, an effective attack on a business
might come creates a whole different level of concern. News-making digital
attackers now successfully disrupt existing business modelsoften far
beyond the attackers national boundaries:

Simple (later bought by BBVA) took on big-cap banks without opening

a single branch.

A DIY investment tool from Acorns shook up the financial-advisory

business.

Snapchat got a jump on mainstream media by distributing content on a

platform-as-a-service infrastructure.

Web and mobile-based map applications broke GPS companies hold on

the personal navigation market.

No wonder many business leaders live in a heightened state of alert. Thanks

to outsourced cloud infrastructure, mix-and-match technology components,
and a steady flood of venture money, start-ups and established attackers can
bite before their victims even see the fin. At the same time, the opportunities
presented by digital disruption excite and allure. Forward-leaning
companies are immersing themselves deeply in the world of the attackers,
seeking to harness new technologies, and rethinking their business
modelsthe better to catch and ride a disruptive wave of their own. But they
are increasingly concerned that dealing with the shark they can see is not
enoughothers may lurk below the surface.

DEEPER FORCES
Consider an insurance company in which the CEO and her top team have
reconvened following a recent trip to Silicon Valley, where they went to
observe the forces reshaping, and potentially upending, their business. The
team has seen how technology companies are exploiting data, virtualizing
infrastructure, reimagining customer experiences, and seemingly injecting
social features into everything. Now it is buzzing with new insights, new
possibilities, and new threats.

The teams members take stock of what theyve seen and who might disrupt
their business. They make a list including not only many insurance startups but also, ominously, tech giants such as Google and Ubercompanies
whose driverless cars, command of data, and reimagined transportation
alternatives could change the fundamentals of insurance. Soon the team has
charted who needs to be monitored, what partnerships need to be pursued,
and which digital initiatives need to be launched.
Just as the teams members begin to feel satisfied with their efforts, the CEO
brings the proceedings to a halt. Hang on, she says. Are we sure we really
understand the nature of the disruption we face? What about the next 50
start-ups and the next wave of innovations? How can we monitor them all?
Dont we need to focus more on the nature of the disruption we expect to
occur in our industry rather than on who the disruptors are today? Im pretty
sure most of those on our list wont be around in a decade, yet by then we will
have been fundamentally disrupted. And how do we get ahead of these trends
so we can be the disruptors, too?
This discussion resembles many we hear from management teams
thoughtful about digital disruption, which is pushing them to develop a view
of the deeper forces behind it. An understanding of those forces, combined
with solid analysis, can help explain not so much which companies will
disrupt a business as whythe nature of the transformation and disruption
they face rather than just the specific parties that might initiate them.
In helping executives to answer this question, we haveparadoxically,
perhaps, since digital makes everything newreturned to the
fundamentals of supply, demand, and market dynamics to clarify the
sources of digital disruption and the conditions in which it occurs. We
explore supply and demand across a continuum: the extent to which their
underlying elements change. This approach helps reveal the two primary
sources of digital transformation and disruption. The first is the making of
new markets, where supply and demand change less. But in the second, the
dynamics of hyperscaling platforms, the shifts are more profound (exhibit).
Of course, these opportunities and threats arent mutually exclusive; new
entrants, disruptive attackers, and aggressive incumbents typically exploit
digital dislocations in combination.
We have been working with executives to sort through their companies
situations in the digital space, separating realities from fads and identifying

QWeb 2016
Dot matrix
Exhibit 1 of 1

Exhibit

Digitization can disrupt industries when it changes the nature of

supply, demand, or both.
Degree of change in the nature
of supply and demand

Modest
Find newcheaper and
easierways to connect
supply and demand
Address unmet
demand by unbundling
or tailoring
Make it easy and
make it now

Uncover latent
supply
Make capacity
available in smaller
increments

Make new
markets

Unconstrain
supply

Undistort
demand

Demand
Enrich the product
or service with
information,
social content,
or connectivity
Do more of the
customers work
for them

Supply
Reimagine
business
systems

Create new
value
propositions
Hyperscale
platforms

Change supplyside cost structure

by automating,
virtualizing, or
disintermediating

Face new competitors and/or

opportunities by leveraging
customer relationships or
information
Create or fight network effects

Extreme

the threats and opportunities and the biggest digital priorities. Think of our
approach as a barometer to provide an early measure of your exposure to a
threat or to a window of opportunitya way of revealing the mechanisms of
digital disruption at their most fundamental. Its designed to enable leaders
to structure and focus their discussions by peeling back hard-to-understand
effects into a series of discrete drivers or indicators they can track and to help
indicate the level of urgency they should feel about the opportunities and threats.
Weve written this article from the perspective of large, established
companies worried about being attacked. But those same companies can use
this framework to spot opportunities to disrupt competitorsor themselves.

Strategy in the digital age is often asymmetrical, but it isnt just newcomers
that can tilt the playing field to their advantage.

REALIGNING MARKETS
We usually start the discussion at the top of the framework. In the zone to
the upper right, digital technology makes accessible, or exposes, sources of
supply that were previously impossible (or at least uneconomic) to provide.
In the zone to the upper left, digitization removes distortions in demand,
giving customers more complete information and unbundling (or, in some
cases, rebundling) aspects of products and services formerly combined (or
kept separate) by necessity or convenience or to increase profits.
The newly exposed supply, combined with newly undistorted demand, gives
new market makers an opportunity to connect consumers and customers by
lowering transaction costs while reducing information asymmetry. Airbnb
has not constructed new buildings; it has brought peoples spare bedrooms
into the market. In the process, it uncovered consumer demandwhich, as
it turns out, always existedfor more variety in accommodation choices,
prices, and lengths of stay. Uber, similarly, hasnt placed orders for new cars;
it has brought onto the roads (and repurposed) cars that were underutilized
previously, while increasing the ease of getting a ride. In both cases, though
little has changed in the underlying supply and demand forces, equitymarket value has shifted massively: At the time of their 2015 financing
rounds, Airbnb was reported to be worth about $25 billion and Uber more
than $60 billion.
Airbnb and Uber may be headline-making examples, but established
organizations are also unlocking markets by reducing transaction costs
and connecting supply with demand. Major League Baseball has deployed
the dynamic pricing of tickets to better reflect (and connect) supply and
demand in the primary market for tickets to individual games. StubHub and
SeatGeek do the same thing in the secondary market for tickets to baseball
games and other events.
Lets take a closer look at how this occurs.

Unmet demand and escalating expectations

Todays consumers are widely celebrated for their newly empowered
behaviors. By embracing technology and connectivity, they use apps and
information to find exactly what they want, as well as where and when they
want itoften for the lowest price available. As they do, they start to fulfill
their own previously unmet needs and wants. Music lovers might always

have preferred to buy individual songs, but until the digital age they had to
buy whole albums because that was the most valuable and cost-effective
way for providers to distribute music. Now, of course, listeners pay Spotify a
single subscription fee to listen to individual tracks to their hearts content.
Similarly, with photos and images, consumers no longer have to get them
developed and can instead process, print, and share their images instantly.
They can book trips instantaneously online, thereby avoiding travel agents,
and binge-watch television shows on Netflix or Amazon rather than wait
a week for the next installment. In category after category, consumers are
using digital technology to have their own way.
In each of these examples, that technology alters not only the products
and services themselves but also the way customers prefer to use them.
A purification of demand occurs as customers address their previously
unmet needs and desiresand companies uncover underserved consumers.
Customers dont have to buy the whole thing for the one bit they want or to
cross-subsidize other customers who are less profitable to companies.
Skyrocketing customer expectations amplify the effect. Consumers have
grown to expect best-in-class user experiences from all their online and
mobile interactions, as well as many offline ones. Consumer experiences
with any product or serviceanywherenow shape demand in the digital
world. Customers no longer compare your offerings only with those of your
direct rivals; their experiences with Apple or Amazon or ESPN are the new
standard. These escalating expectations, which spill over from one product
or service category to another, get paired with a related mind-set: amid a
growing abundance of free offerings, customers are increasingly unwilling
to pay, particularly for information-intensive propositions. (This dynamic is
as visible in business-to-business markets as it is in consumer ones.) In short,
people are growing accustomed to having their needs fulfilled at places of
their own choosing, on their own schedules, and often gratis. Cant match
that? Theres a good chance another company will figure out how.
What, then, are the indicators of potential disruption in this upper-left zone,
as demand becomes less distorted? Your business model may be vulnerable if
any of these things are true:

Your customers have to cross-subsidize other customers.

Your customers have to buy the whole thing for the one bit they want.

Your customers cant get what they want where and when they want it.

Your customers get a user experience that doesnt match global

best practice.

When these indicators are present, so are opportunities for digital

transformation and disruption. The mechanisms include improved search
and filter tools, streamlined and user-friendly order processes, smart
recommendation engines, the custom bundling of products, digitally
enhanced product offerings, and new business models that transfer
economic value to consumers in exchange for a bigger piece of the remaining
pie. (An example of the latter is TransferWise, a London-based unicorn using
peer-to-peer technology to undercut the fees banks charge to exchange
money from one currency into another.)

Exposing new supply

On the supply side, digitization allows new sources to enter product and
labor markets in ways that were previously harder to make available. As
software eats the worldeven in industrial marketscompanies can
liberate supply anywhere underutilized assets exist. Airbnb unlocked
the supply of lodging. P&G uses crowdsourcing to connect with formerly
unreachable sources of innovation. Amazon Web Services provides on-thefly scalable infrastructure that reduces the need for peak capacity resources.
Number26, a digital bank, replaces human labor with digital processes. In
these examples and others like them, new supply becomes accessible and gets
utilized closer to its maximum rate.
What are the indicators of potential disruption in this upper-right zone as
companies expose previously inaccessible sources of supply? You may be
vulnerable if any of the following things are true:

Customers use the product only partially.

Production is inelastic to price.

Supply is utilized in a variable or unpredictable way.

Fixed or step costs are high.

These indicators let attackers disrupt by pooling redundant capacity

virtually, by digitizing physical resources or labor, and by tapping into the
sharing economy.

Making a market between them

Any time previously unused supply can be connected with latent demand,
market makers have an opportunity to come in and make a match, cutting
into the market share of incumbentsor taking them entirely out of the
equation. In fact, without the market makers, unused supply and latent
demand will stay outside of the market. Wikipedia famously unleashed
latent supply that was willing and elastic, even if unorganized, and
unbundled the product so that you no longer had to buy 24 volumes of an
encyclopedia when all you were interested in was, say, the entry on poodles.
Googles AdWords lowers search costs for customers and companies by
providing free search for information seekers and keyword targeting for
paying advertisers. And iFixit makes providers costs more transparent by
showing teardowns of popular electronics items.
To assess the vulnerability of a given market to new kinds of market makers,
you must (among other things) analyze how difficult transactions are for
customers. You may be vulnerable if you have any of these:

high information asymmetries between customers and suppliers

high search costs

fees and layers from intermediaries

long lead times to complete transactions

Attackers can address these indicators through the real-time and transparent
exchange of information, disintermediation, and automated transaction
processing, as well as new transparency through search and comparison
tools, among other approaches.

EXTREME SHIFTS
The top half of our matrix portrays the market realignment that occurs as
matchmakers connect sources of new supply with newly purified demand.
The lower half of the matrix explains more extreme shiftssometimes
through new or significantly enhanced value propositions for customers,
sometimes through reimagined business systems, and sometimes through
hyperscale platforms at the center of entirely new value chains and
ecosystems. Attacks may emerge from adjacent markets or from companies
with business objectives completely different from your own, so that you
become collateral damage. The result can be not only the destruction of
sizable profit pools but also the emergence of new control points for value.

Established companies relying on existing barriers to entrysuch as high

physical-infrastructure costs or regulatory protectionwill find themselves
vulnerable. User demand will change regulations, companies will find
collaborative uses for expensive infrastructure, or other mechanisms of
disruption will come into play.
Companies must understand a number of radical underlying shifts in the
forces of supply and demand specific to each industry or ecosystem. The
power of branding, for example, is being eroded by the social validation
of a new entrant or by consumer scorn for an incumbent. Physical assets
can be virtualized, driving the marginal cost of production toward zero.
And information is being embedded in products and services, so that they
themselves can be redefined.
Taken as a whole, these forces blur the boundaries and definitions of
industries and make more extreme outcomes a part of the strategic calculus.

New and enhanced value propositions

As we saw in the top half of our framework, purifying supply and demand
means giving customers what they always wanted but in new, more efficient
ways. This isnt where the disruptive sequence ends, however. First, as
markets evolve, the customers expectations escalate. Second, companies
meet those heightened expectations with new value propositions that give
people what they didnt realize they wanted, and do so in ways that defy
conventional wisdom about how industries make money.
Few people, for example, could have explicitly wished to have the Internet
in their pocketsuntil advanced smartphones presented that possibility. In
similar ways, many digital companies have gone beyond improving existing
offerings, to provide unprecedented functionality and experiences that
customers soon wanted to have. Giving consumers the ability to choose
their own songs and bundle their own music had the effect of undistorting
demand; enabling people to share that music with everyone via social media
was an enhanced proposition consumers never asked for but quickly grew to
love once they had it.
Many of these new propositions, linking the digital and physical worlds,
exploit ubiquitous connectivity and the abundance of data. In fact, many
advances in B2B business models rely on things like remote monitoring
and machine-to-machine communication to create new ways of delivering
value. Philips gives consumers apps as a digital enrichment of its physicalworld lighting solutions. Googles Nest improves home thermostats. FedEx

gives real-time insights on the progress of deliveries. In this lower-left zone,

customers get entirely new value propositions that augment the ones they
already had.
What are the indicators of potential disruption in this position on the matrix,
as companies offer enhanced value propositions to deepen and advance their
customers expectations? You may be vulnerable if any of the following is true:

Information or social media could greatly enrich your product or service.

You offer a physical product, such as thermostats, thats not yet connected.

Theres significant lag time between the point when customers purchase
your product or service and when they receive it.

The customer has to go and get the productfor instance, rental cars
and groceries.

These factors indicate opportunities for improving the connectivity of

physical devices, layering social media on top of products and services, and
extending those products and services through digital features, digital or
automated distribution approaches, and new delivery and distribution models.

Reimagined business systems

Delivering these new value propositions in turn requires rethinking, or
reimagining, the business systems underlying them. Incumbents that have
long focused on perfecting their industry value chains are often stunned to
find new entrants introducing completely different ways to make money.
Over the decades, for example, hard-drive makers have labored to develop
ever more efficient ways to build and sell storage. Then Amazon (among
others) came along and transformed storage from a product into a service,
Dropbox upped the ante by offering free online storage, and suddenly an
entire industry is on shaky ground, with its value structure in upheaval.
The forces present in this zone of the framework change how value chains
work, enable step-change reductions in both fixed and variable costs, and
help turn products into services. These approaches often transform the
scalability of cost structuresdriving marginal costs toward zero and, in
economic terms, flattening the supply curve and shifting it downward.
Some incumbents have kept pace effectively. Liberty Mutual developed
a self-service mobile app that speeds transactions for customers while

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lowering its own service and support costs. The New York Times virtualized
newspapers to monetize the demand curve for consumers, provide a
compelling new user experience, and reduce distribution and production
costs. And Walmart and Zara have digitally integrated supply chains that
create cheaper but more effective operations.
Indicators of disruption in this zone include these:

redundant value-chain activities, such as a high number of handovers

or repetitive manual work

well-entrenched physical distribution or retail networks

overall industry margins that are higher than those of other industries

High margins invite entry by new participants, while value-chain

redundancies set the stage for removing intermediaries and going direct to
customers. Digital channels and virtualized services can substitute for or
reshape physical and retail networks.

Hyperscaling platforms
Companies like Apple, Tencent, and Google are blurring traditional industry
definitions by spanning product categories and customer segments. Owners
of such hyperscale platforms enjoy massive operating leverage from process
automation, algorithms, and network effects created by the interactions of
hundreds of millions, billions, or more users, customers, and devices.2 In
specific product or service markets, platform owners often have goals that
are distinct from those of traditional industry players.
Moreover, their operating leverage provides an opportunity to upsell and
cross-sell products and services without human intervention, and that
in turn provides considerable financial advantages. Amazons objective
in introducing the Kindle was primarily to sell books and Amazon Prime
subscriptions, making it much more flexible in pricing than a rival like
Sony, whose focus was e-reader revenues. When incumbents fail to plan
for potential moves by players outside their own ecosystems, they open
themselves up to the fate of camera makers, which became collateral damage
in the smartphone revolution.

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 ichael Chui and James Manyika, Competition at the digital edge: Hyperscale businesses, McKinsey Quarterly,
M
March 2015, mckinsey.com.

Hyperscale platforms also create new barriers to entry, such as the

information barrier created by GE Healthcares platform, Centricity 360,
which allows patients and third parties to collaborate in the cloud. Like
Zipcars auto-sharing service, these platforms harness first-mover and
network effects. And by redefining standards, as John Deere has done with
agricultural data, a platform forces the rest of an industry to integrate into a
new ecosystem built around the platform itself.
What are the indicators that hyperscale platforms, and the dynamics they
create, could bring disruption to your door? Look for these situations:

Existing business models charge customers for information.

No single, unified, and integrated set of tools governs interactions

between users and suppliers in an industry.

The potential for network effects is high.

These factors invite platform providers to lock in users and suppliers, in part
by offering free access to information.

FINDING VULNERABILITIES AND OPPORTUNITIES IN YOUR BUSINESS

All of these forces and factors come together to provide a comprehensive
road map for potential digital disruptions. Executives can use it to take into
account everything at oncetheir own business, supply chain, subindustry,
and broader industry, as well as the entire ecosystem and how it interacts
with other ecosystems. They can then identify the full spectrum of
opportunities and threats, both easily visible and more hidden.
By starting with the supply and demand fundamentals, the insurance
executives mentioned earlier ended up with a more profound understanding
of the nature and magnitude of the digital opportunities and threats
that faced them. Since they had recognized some time ago that the crosssubsidies their business depended on would erode as aggregators made
prices more and more transparent, they had invested in direct, lower-cost
distribution. Beyond those initial moves, the lower half of the framework had
them thinking more fundamentally about how car ownership, driving, and
customer expectations for insurance would evolve, as well as the types of
competitors that would be relevant.
It seems natural that customers will expect to buy insurance only for the
precise use and location of a car and no longer be content with just a discount

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for having it garaged. Theyll expect a different rate depending on whether

theyre parking the car in a garage, in a secured parking station, or on a
dimly lit street in an unsavory neighborhood. Rather than relying on crude
demographics and a drivers history of accidents or offenses, companies will
get instant feedback, through telematics, on the quality of driving.
In this world, which company has the best access to information about where
a car is and how well it is driven, which could help underwrite insurance?
An insurance company? A car company? Or Apple, which might know the
drivers heart rate, how much sleep the driver had the previous night, and
whether the driver is continually distracted by talking or texting while
driving? If value accrues to superior information, car insurers will need to
understand who, within and beyond the traditional insurance ecosystem,
can gather and profit from the most relevant information. Its a point that
can be generalized, of course. All companies, no matter in what industry, will
need to look for threatsand opportunitieswell beyond boundaries that
once seemed secure.

Digital disruption can be a frightening game, especially when some of the

players are as yet out of view. By subjecting the sources of disruption to
systematic analysis solidly based on the fundamentals of supply and demand,
executives can better understand the threats they confront in the digital
spaceand search more proactively for their own opportunities.
Angus Dawson is a director in McKinseys Sydney office, Martin Hirt is a director in the Taipei
office, and Jay Scanlan is a principal in the London office.
The authors would like to thank Chris Bradley, Jacques Bughin, Dilip Wagle, and Chris Wigley for
their valuable contributions to this article.
Copyright 2016 McKinsey & Company. All rights reserved.

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