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AI and The Offline Moat

In a world of abundant content, businesses that control physical touchpoints have a unique advantage. But they also carry unique risks.

Dror Poleg
Dror Poleg
8 min read
AI and The Offline Moat

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Generative AI is flooding the world with content. It is also threatening to upend a variety of jobs and professions. What does it mean for physical assets — buildings, cities, and devices?

No one knows. But there are theories. A popular one posits that digital abundance will create physical scarcity. Ben Thompson alluded to it in a recent  interview (🔒):

In a world of abundance... It’s actual investment in the real world that has a meaningful moat, that is actually scarce. To actually experience something is going to be the greatest value going forward because digital’s going to be everything. It’s going to be like... when AI is generating content for everything, you’ll get any experience you want virtually, but it’s going to be valueless because it’s not special.

Ben's comments highlight an important paradox: As technology advances, it's cheaper and easier to create new content, and, as a result, the digital experience becomes commoditized. If you want something unique, you'll have to go offline.

This doesn't mean that all digital destinations will be worthless. Quite the opposite, the more content there is, the more value will accrue to a handful of gateways that aggregate and curate content. We've already seen this dynamic play out over the past three decades: Google built a massive business by helping us figure out which page to go to, Spotify recommends the right songs out of millions of options, Airbnb helps sift through houses, etc.

In addition, there is an opening for physical gateways to become valuable. But these gateways have to satisfy an important condition. Per Thompson:  

There’s real value, I think, generally in being in the physical world. Everything tech is digital, digital with all the scalability, but it’s also the fact that everyone benefits from scalability and the competition is infinite. So you have a company like Amazon spending billions and billions of dollars on logistics, that’s a moat, right? You have these cloud companies spending billions and billions of dollars, that’s a moat. Apple is actually building phones. And these aren’t actually tech companies from the perspective we were discussing earlier, as they’re not the zero marginal cost sort of thing.

The folks that benefit are the ones that facilitate the zero marginal cost world without necessarily participating in it themselves...

Let's unpack that last sentence. Thompson is referring to the unique economics of tech. As he explained elsewhere, a key characteristic of the economics of tech is the ability to turn high upfront investments in R&D into products that can be sold at zero marginal costs. For example, Microsoft can spend $1b on a new version of Word, but once Word goes on sale, the cost of every new copy is basically zero. Whether a hundred thousand or 100 million people use Word, the cost to Microsoft is (almost) the same — thus, the product becomes more profitable with every new unit sold. In theory, the profit margin for tech products can reach as high as 99.9%. In contrast, the margin for the billionth car sold by Toyota is limited because the costs of producing and shipping every new car remain significant.

So, is physical bad, digital good? Not necessarily. Physical assets are scarce. And as Thompson points out, digital abundance can enhance physical scarcity if the physical asset facilitates digital abundance. Sounds complicated?

Think of an Amazon Warehouse. It's a physical asset, but it enables Amazon to offer an abundance of products on its website. An Amazon data center enables other companies to "rent" computing power and digital storage. As such, the (scarce) data center becomes more valuable as online abundance increases. Thompson also mentions Disney and its theme parks. Disney controls valuable intellectual property (Star Wars, Marvel, etc.) that drives people to its offline theme parks, which offer unique experiences. So, the more widely Disney's content can spread, the more valuable the physical experiences it offers.

You can extrapolate this theory to your relevant market and asset type. A few years ago, some thought it applied to offices as well. As the Internet and tech grew, the production of software and content concentrated in a handful of neighborhoods in a handful of cities. The assumption was that those cities would continue to benefit from the growth of software and digital media.

But that's not what happened. Tech turned out to be a double-edged sword. The same innovations that pushed people into urban cores were also the ones that ultimately enabled them to work from wherever they wanted. This process is still unfolding, so we do not know what the final equilibrium looks like — or whether there's a new equilibrium at all. (I'm writing a whole book about this).  For now, it is clear that the old assumptions were at least partly wrong.

At the moment, it's hard to say how warehouses and data centers can be upended. But it was equally hard to see the office apocalypse coming. We assumed the Internet was only a problem for retail real estate (and before that, we assumed it would only affect bookshops).

As we contemplate the future of physical assets, there are three things to keep in mind:

  • AI can provide unique experiences at scale.
  • Digital abundance makes offline investment riskier.
  • Online growth drives up offline costs.

A recent announcement from Disney helps illustrate these points. A year ago, Disney opened a Star Wars-themed hotel in Florida. In theory, this was a sure winner. Disney could market this unique offline experience to its large base of digital-content consumers. After the opening, Disney's CEOs said the company was projecting the hotel would be at “100 percent utilization” in the coming months.

This week, Disney announced it is shutting down the hotel. The New York Times reported:

After spending hundreds of millions of dollars to build an immersive “Star Wars”-themed hotel at Walt Disney World, Disney said on Thursday that, amid sweeping corporate cost-cutting, it would close the underperforming attraction in September, only about 18 months after it opened.

Pundits cited several reasons for the hotel's failure. In particular, high prices, high operating costs, and a lack of variety:

Some fans were not shocked by the plans to close Galactic Starcruiser, including Dylan Dickson, who runs the Theme Park Obsession YouTube channel. In a video in response to the closing, he called the hotel’s short run “disappointing” and “a shame” and suggested that the company tried to subtly bury the news...

Mr. Dickson said he thought the exorbitant price brought the hotel “to its demise,” and he argued that Disney fans should instead visit a park abroad for the same cost. He himself never stayed at the hotel, saying in an email that “the price didn’t justify the experience.”

He thought another “big issue” with Galactic Starcruiser was that it only offered one scenario: Guests are recruited to help either the evil First Order or the gutsy Resistance. That, he said, limited any incentive to return.

This story highlights a few important points. The hotel was particularly expensive to operate and run — it was built during a time of high inflation and operated during a tight labor market. Both of these phenomena are related to (or driven directly by) the prevalence of digital tools. As Baumol and Bowen pointed out, when some industries become more productive, other industries necessarily become more expensive. In particular, costs and wages in hospitality and construction have risen over the past few years.

The hotel also offered only one particular "narrative" that guests could "live through." This is the downside of unique physical experiences. They are designed a certain way and are expensive and difficult to change. Users have grown accustomed to an abundance of personalized experiences, and it's tough to convince them to pay a premium for anything else — let alone convince them to return for a second visit. In contrast, one of the incredible things about generative AI is its ability to generate personalized content and digital experiences. These may never be as good as the real thing, but personalization, ease of access, and price might convince a lot of users to stay online rather than fly to Florida.

This is only one piece of anecdotal evidence. Disney failed to design and market the hotel. This should not discredit the future of all physical assets. Perhaps another operator would do a better job one day — in Florida or elsewhere. But that's part of the problem: We live in a noisy world where it's increasingly hard to predict which cultural products will resonate. Online, this problem is solved by producing lots of content and seeing what sticks. Offline, it's much harder to experiment or change course. Every mistake is expensive.  

And then there's another thing about Florida. Disney is shutting down the hotel in the context of a broader beef with Governor Ron DeSantis. This may seem like an external factor that is not relevant to our discussion. But it's not. Disney and DeSantis are at odds following the governor's position on gay rights and, more broadly, his actions and opinions on polarizing political matters, including abortion and race relations.

Both Disney and DeSantis seem to be using the beef to rally their constituents (customers, voters). Each tries to portray the other as a symbol of everything that's wrong with America. For decades, financial interests kept Disney and the relatively conservative state of Florida at peace. But now, political polarization makes it harder to do business without total political alignment. Everything is political, and corporations are expected to put their dollars where their mouth is. Technology platforms played a key role in flaming political polarization to its current level. As such, the intensity of Disney's offline trouble is, to a certain extent, a function of online abundance.

Finally, there is another challenge to keep in mind. Even if the Star Wars hotel had succeeded, the longevity of this success would be in question. The hotel depended on the ongoing popularity of Disney's content. So far, such content has increased in value. As I pointed out in The Vader Paradox, the more new content there is, the more likely we are to consume old content. But it's not clear how this theory will hold in a world of personalized, super-compelling content generated by AI. At any moment, people's attention can be drawn away from Star Wars. In the past, only a giant studio could produce comparable cultural products. Today, anyone with a computer can generate mind-blowing content. I am not predicting Disney's demise, only pointing out the precarity of its position. And what's true for Disney is true for all of us: Whatever you're selling, your business is increasingly dependent on digital algorithms, online crowds, and pure chance.

I'll let ChatGPT write the conclusion of this article:

In conclusion, the intersection of physical assets and digital abundance presents unique opportunities and risks. As generative AI continues to flood the world with content, our values may shift, further magnifying the inherent value in scarce physical experiences. At the same time, the business models of firms leveraging these physical assets need to adapt to an ever-changing consumer base whose expectations are shaped by a digital landscape rich with personalization and convenience.

Moreover, the socio-political fabric and the role of technology in influencing it can't be ignored, as corporations are held accountable for their stance on polarizing issues. In the face of these challenges, businesses need to be agile, making the most of their physical assets while also investing in digital capabilities. And it is a reminder that amidst digital abundance, a deep understanding of the human condition and our yearning for unique experiences is essential.

As we navigate this new landscape, one thing is certain: the era of generative AI will necessitate a profound reimagining of how we value, interact with, and benefit from our physical world.

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