Demand is Convex, Profit is Concave
One can describe most of the world as a series of options between extremes. The question is where the value is on that spectrum - at one end, the other, or somewhere in the middle?
Much of the world has a "bell curve" distribution between extremes. The general idea is there is an average value that is also where the most examples are. For example, the distribution of the heights of human men in a given region is likely to follow a bell curve distribution - more people of modest size than very tall or very short.
The bell curve starts short at one extreme, grows tall in the middle, and shrinks on the other side as we approach the other extreme. One can think of it as a mountain in the middle, with basecamp on either side. I also imagine a parachute pushed up by the air, slowing our fall.
But sometimes, we find that the extremes rule aspects of the world. Nassim Taleb spends a lot of his writing discussing this phenomenon. Black swans are events that come from the extremes and drive a great deal of value - or at least a lot of change. Taleb refers to concave contexts caused by extremes, as "Extremistan," contrasted with the convex "Mediocristan" of the bell curve environment.
Concave environments start tall at the edge and then slope down in the middle before rising to the other edge. A pond or lake is concave - usually deeper in the middle than where one wades in at the shore.
Generally, the demand side of markets is convex - most people like a happy medium. But that's not necessarily where strategic value is.
Early in my career, I heard the story of the bakery business plan: the parable of the cakes. Every year the business planning course at Harvard Business School requires students to assemble and submit a business plan. The professor and assistants evaluate the business plans for grading purposes. One year, they gave all the students the same market profile data: a bakery for a town. The graders then evaluated the submitted business plans as if they implemented them in the same market at once.
One question was how the market responded to cakes that were more or less fudgy or cakey. Some people like fudgy cakes, some preferred cakey cakes, but most preferred something in the middle. The distribution of preferences was a perfect bell curve,
As one might expect, these hungry business students saw money in that big middle and focused their business plans on winning that customer base. As a result, the business plans themselves were less distributed than highly focused on winning that highest point in the market.
At least, most of them were. A few focused on the edges - marketing the fudgiest cake in town and the like. These business plans sacrificed the middle to win the loyalty of people with special interests.
Those going for the middle of the market competed with each other, driving down prices and creating a wonderful experience for their clients. Great cakes at great prices! Sadly, this meant that the various virtual bakeries were bereft of profit. A sea of red ink flowed from this red ocean.
However, those who specialized at the edges won loyal customers whose preferences were close to their offerings. Income flowed from these blue oceans! Without the storm of competition, they captured value through higher prices as well.
The students focusing on the middle were not wrong in their demand analysis - most of the market was there! But the strategic consequences of going to the same segment as everyone else diminished their opportunity for profit.
The lesson to me is clear: finding the market requires more than discovering where demand is. One must anticipate competition and find a source of durable advantage over it. Going where you are strong, and the other fellow is weak is the most elementary strategy - but it works!
There is likely a "measuring the coast" diminishing returns aspect to this kind of segmentation analysis. For example, there will be some disagreement within the population of fudgy cake lovers on which there is another bell curve distribution of opinions. If this sub-market were to become highly competitive, another convex/concave analysis might apply. However, if the market segment is not supply-competitive, just grabbing the middle will maximize absolute returns.
Differentiate your offer to capture more value while the rest of the world fights over the meaty middle. Surviving and serving your target market well will reliably generate excess returns while delighting the customer base. That seems like good business to me.
Image Credit: M. W. Toews, CC BY 2.5, via Wikimedia Commons