Microsoft (Nasdaq: MSFT) is watching Google (Nasdaq: GOOG) and Apple (Nasdaq: AAPL) make rookie mistakes in the burgeoning digital media market. It's easy to sit on the sidelines, point, and laugh -- but the software giant wants to do more than that.

Reuters reports that Microsoft is in "early talks" with media companies to lay the groundwork for the company's own foray into the digital infotainment markets. And Microsoft is nothing if not flexible this time: Among the options on the table, you'll find a subscription service for the Xbox game console, an Xbox media catalog linked to the consumer's existing cable TV account, and even an a la carte menu of individual TV channels from which customers could build their own virtual cable packages.

It's still early days in these discussions, and Reuters' sources say that it could take another 12 months to come up with a real product. Knowing the foot-dragging tendencies of our media giants, I'm thinking that's actually an optimistic estimate. And this is where things get interesting.

We don't wanna!
You see, neither Apple nor Google seems to have a lot of friends in Hollywood or around Rockefeller Plaza yet. In Apple's case, the original Apple TV has almost three years of history in the rearview mirror, and the iTunes store has offered video materials longer than that. Google's effort is younger but still is gaining a head start on Microsoft. The difference in lead times between these contestants for the same market space makes all the difference.

The market for long-form online videos has been a chicken-and-egg phenomenon from the start. From News Corp (NYSE: NWS) to Walt Disney (NYSE: DIS), the studios are among the most risk-averse businesses I know. Jumping aboard the digital bandwagon means abandoning decades-old traditions and business models, and change is bad when you're the incumbent. So digital media could never be a success until someone fed it with a respectable content catalog, and Hollywood wouldn't provide the necessary rights and licenses until there was a proven success story going on.

Hatching the egg or raising the chicken?
At long last, Netflix (Nasdaq: NFLX) has broken that logjam by proving that a business model based on digital streams can provide the following benefits:

  • It works for consumers, as evidenced by the dramatic uptick in new subscribers as the Netflix service moves away from the old DVD-mailing model. People want this stuff.
  • It works as a business model. The licensing costs are fixed, at least in the short term, so rapid subscriber growth leads to greater profits. The cost of delivering a movie online is orders of magnitude smaller than two-way postage charges.
  • It even helps the movie studios make money, which is really the crux of the matter. Rather than paying out the nose for delivery of the product, Netflix spends a lot of money on media licenses, which become a high-margin revenue stream for the studios. There are no manufacturing, shipping, or handling costs involved -- just provide a digital copy to Netflix and start counting your money. Also, with certain concessions like delaying new releases, the studios have been able maintain old-school DVD sales, which provides their old model support while the companies transition into a new model for selling content.

Whether Netflix is the chicken or the egg, the paradox has been smashed to bits by the company's groundbreaking work. The next question is, was Microsoft crazy for staying on the sidelines for so long and letting the other guys build their media relationships much faster -- or crazy as a fox for letting other people blaze a trail through the digital wilderness?

The fast and the furious
Either way, I'm pretty sure it's in Mr. Softy's best interest to put the pedal to the metal. Neither Apple TV nor Google TV have run away with the media center market yet, and no underdog upstart has shown up with a legit alternative, either. But the window of opportunity will close eventually, and perhaps before Microsoft's 12-month talks have run their course.

With 17 million subscribers under its belt, Netflix is rapidly gaining on Comcast (Nasdaq: CMCSA) and can wield a hefty amount of leverage in its content licensing talks. Whosoever wishes to become the preferred hardware and software platform where content aggregators like Netflix can display their wares had better build up a similar customer base in a hurry.

Microsoft's enormous installed base of Xbox consoles is a strong card in this game, but is it good enough to overcome its rivals' lengthy head starts? I think the company is setting itself up to fail with this too-relaxed attitude. Add Microsoft to your Foolish watchlist to keep an eye on this project, then vent your own spleen in the comments below.

Fool contributor Anders Bylund holds no position in any of the companies discussed here. Walt Disney, Google, and Microsoft are Motley Fool Inside Value choices. Google is a Motley Fool Rule Breakers selection. Apple, Walt Disney, and Netflix are Motley Fool Stock Advisor recommendations. The Fool owns shares of Apple, Google, and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. You can check out Anders' holdings and a concise bio if you like, and The Motley Fool is investors writing for investors.