When Blockbuster, the huge video-rental chain, set up a mail-delivery service in the summer of 2004, rival Netflix watched its stock price tumble. Netflix had invented the business in the late '90s, and already survived one competitive scare after Wal-Mart began dabbling in DVD rentals. By 2004, Wal-Mart was backing out, having decided that video rentals weren't part of its core business. But Blockbuster, the nation's largest video-rental chain, was a much bigger threat. Video rentals were its entire business. Its very survival depended on conquering Netflix.

Six years later, Blockbuster is in tatters, leaving Netflix as the undisputed winner in the DVD-by-mail business. Blockbuster's long-anticipated bankruptcy filing is clear proof that the company clung far too long to an outdated strategy and failed to understand changes that others eagerly exploited. Blockbuster plans to reorganize and continue to operate its online rental service and its 3,000 retail stores while it comes up with a new strategy. But even writing off $1 billion in debt won't make Blockbuster competitive, and the chain's downfall reflects the huge risk any firm faces today by just standing still. "Legacy investments create a legacy mindset," says Vijay Govindarajan, a professor at Dartmouth's Tuck School of Business and co-author of The Other Side of Innovation. "Blockbuster got stuck in the box. They never changed their business model."

Blockbuster was an upstart itself when it was formed in 1985 as a small, flashy video-rental chain in Florida. Businessman Wayne Huizenga bought the company in 1987 and began a series of acquisitions that eventually made Blockbuster the world's biggest video-rental company. While swelling in size, however, Blockbuster began to alienate customers with strict late fees and unimaginative, warehouse-style stores. It also overlooked e-commerce while sticking to its long-held retail strategy, even looking into buying the defunct Circuit City in 2009. Blockbuster's cardinal sin, says Govindarajan, was maintaining its commitment to a vast retail network, even when that was no longer the way movie renters wanted to shop.

Netflix was founded in 1997 as a more convenient way to rent movies—and to take advantage of lightweight DVDs that would be much cheaper to mail than bulky videocassettes. But the new firm's first idea flopped. Netflix originally charged a set fee for each movie rented, just like Blockbuster, which didn't catch on. Then CEO Reed Hastings decided to change the business to a subscription model that allowed customers to pay a flat monthly fee and rent as many movies as they wanted—with no late fees. That got traction.

As Netflix became successful, competitors emerged because its business model seemed simple: Simply keep DVDs in a warehouse and mail them out when orders came in. But Netflix's business is anything but simple, and that's why the competition has faltered. Quick delivery, for example, depends on having regional distribution centers in just the right places, and in its early days Netflix suffered from many complaints about slow delivery. It took several years for Netflix to get its distribution layout right. Managing a huge inventory of movies is another challenge. Ensuring quick delivery means stocking thousands of titles and having plenty of copies of the most popular films. That can get expensive. But a slim inventory that leaves customers waiting for movies would drive business away.

Then there is Netflix's secret sauce: Algorithms that allow users to rate movies and then receive recommendations for other films they might like, including some they may never had heard of. This kind of technology is common today, as sites like Pandora and Amazon make it a routine part of their users' experience. But Netflix was an early innovator, and Hastings seems to have understood that enhancing customers' experience would build brand loyalty that's crucial in such a cutthroat industry. "Most people think you should be riveted on the competition," says Andy Rachleff, a Stanford Business School professor and Silicon Valley venture capitalist who has known Hastings for years. "Absolutely not. Be riveted on delighting your customer. If you do that all they can do is follow you. That's why Netflix is so far ahead of Blockbuster. They're focused on delighting the customer."

Netflix, of course, hasn't been Blockbuster's only competition. In 2004, Redbox began offering video rentals for $1 a night through vending machines at fast-food restaurants, grocery stores, and other retail outlets, stealing Blockbuster customers with practically none of the overhead that comes from running actual stores. Redbox now has 24,000 kiosks nationwide, eight times as many locations as Blockbuster. Apple is now in the movie-rental business, offering movie downloads for many popular devices. Cable and phone companies have also started offering video-on-demand straight to their customers' TVs, a service that suffers from a limited supply of movies but obviously offers the ultimate convenience. Netflix, for one, saw this coming, and has been aggressively developing its own on-demand offerings for subscribers, including converters that allow streaming straight to the TV.

Blockbuster has copied moves like these, but it has also been consistently late to the game with no real innovations of its own. Meanwhile, it has been burning cash over the last few years, stuck between a costly commitment to retail real estate and fast-moving competitors with no such baggage. That left Blockbuster struggling to get more revenue from fees without alienating consumers. The recession sealed the deal, as business declined and Blockbuster was finally unable to make its debt payments, resulting in bankruptcy.