Saying You Can't Compete With Free Is Saying You Can't Compete Period
from the a-little-explanation dept
Getting back to my series of posts on understanding economics when scarcity is removed from some goods, I wanted to address the ridiculousness of the "can't compete with free" statements that people love to throw out. If we break down the statement carefully, anyone who says that is really saying that they can't compete at all. The free part is actually meaningless -- but the zero is blinding everyone.
To explain this, it helps to go back to your basic economics class and recognize that, in a competitive market, the price of a good is always going to get pushed towards its marginal cost. That actually makes a lot of sense. As competition continues, it puts pressure on profits, but producers aren't willing (or can't for very long) keep selling goods at a direct loss. Sunk (or fixed) costs don't matter, because they've already been paid -- so everything gets pushed to marginal cost. That's pretty well accepted by most folks -- but it's still misinterpreted by many. They tend to look at it and say that if price equals marginal cost, then no one would ever produce anything. That's a misconception that is at the heart of this whole debate. The problem is that they don't add in the element of time, and the idea that what drives innovation is the constant efforts by the producers in the space to add fleeting competitive advantages (what some economists have annoyingly called "monopolistic competition," a name that I think is misleading). In other words, companies look to add some value to the goods that makes their goods better than the competition in some way -- and that unique value helps them command a profit. But, the nature of the competitive market is that it's always shifting, so that everyone needs to keep on innovating, or any innovation will be matched (and usually surpassed) by competitors. That's good for everyone. It keeps a market dynamic and growing and helps out everyone.
So, let's go back to the "can't compete with free" statement. Anyone who says that is effectively saying that they can't figure out a way to add value that will make someone buy something above marginal cost -- but it's no different if the good is free or at a cost. Let's take a simple example. Say I own a factory that cost me $100 million to build (fixed cost) and it produces cars that each cost $20,000 to build (marginal cost). If the market is perfectly competitive, then eventually I'm going to be forced to sell those cars at $20,000 -- leaving no profit. Now, let's look at a different situation. Let's say that I want to make a movie. It costs me $100 million to make the movie (fixed cost) and copies of that movie each cost me $0 (marginal cost -- assuming digital distribution and that bandwidth and computing power are also fixed costs). Now, again, if the market is competitive and I'm forced to price at marginal cost, then the scenario is identical to the automobile factory. My net outlay is $100 million. My profit is zero. Every new item I make brings back in cash exactly what it costs to make the copy -- so the net result is the same. It's no different that the good is priced at $0 or $20,000 -- so long as the market is competitive.
So why aren't the same people who insist that you can't compete with free whining about any other competitive market situation? Because they know that, left unfettered, the market adjusts. The makers of automobiles keep trying to adjust and differentiate their cars through real and perceived benefits (such as brand) -- and that lets them add value in a way that they can make money and not have to worry about having products priced at marginal cost. If a company can't do that, it goes out of business -- and most people consider that a good thing. If you can't compete, you should go out of business. But, when it comes to goods with a $0 marginal cost, even though the net result is identical to goods with a higher marginal cost, suddenly people think that you can't compete? The $0 price makes no difference. All that matters is the difference in price you can charge to the marginal cost. Everyone else learns to differentiate -- why can't those who produce infinite goods do the same?
The answer is that they already do -- even if they don't realize it. Why do movies still cost more than $0? Because there's additional value bundled with the movie itself. People don't buy "a movie." They buy the experience of going to the theater. People like to go out to the movies. They like the experience. Or people buy the convenience of a DVD (which is another feature bundled with the movie). They like to buy DVDs (or rent them) in order to get the more convenient delivery mechanism and the extra features that come with DVDs. In other words, they like the differentiated value they can get from bundled goods and services that helps justify a price that's more than $0. Just as people are willing to pay more than the marginal cost (in some cases a lot more) to get that car they want, they're willing to pay more for a bundled good or service with content -- if only the makers of that content would realize it.
So the next time someone says "you can't compete with free" ask them why? Every company that's in business today competes with those who aim to undercut the price of their product -- and the situation is absolutely no different when it's free. It's just that people get blinded by the zero and forget that the absolute price is meaningless compared to the marginal cost.
If you're looking to catch up on the posts in the series, I've listed them out below:
Economics Of Abundance Getting Some Well Deserved Attention
The Importance Of Zero In Destroying The Scarcity Myth Of Economics
The Economics Of Abundance Is Not A Moral Issue
A Lack Of Scarcity Has (Almost) Nothing To Do With Piracy
A Lack Of Scarcity Feeds The Long Tail By Increasing The Pie
Why The Lack Of Scarcity In Economics Is Getting More Important Now
History Repeats Itself: How The RIAA Is Like 17th Century French Button-Makers
Infinity Is Your Friend In Economics
Step One To Embracing A Lack Of Scarcity: Recognize What Market You're Really In
Why I Hope The RIAA Succeeds
Reader Comments (rss)
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Love this series
I have really been enjoying this series on scarcity. I know very little about economics but you break it down in a way that I can understand it, and overlap the subjects of your posts just enough to drill the concepts in. Very education and interesting. Thanks!
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Not really
Your movie analogy is invalid. The production company is the factory, the movie is the car. The cost of making a movie is a marginal cost.
With all due respect, you misunderstand the idea of it all going toward marginal cost. Technically, it will never reach it, even in perfect competition which is highly theoretical and hard to define. It will get closer and closer to 0 as volume increases.
At least this is what I was taught, I would love to see some resources that say otherwise; would really change the outlook.
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Re: Not really
The production company is the factory, the movie is the car. The cost of making a movie is a marginal cost.
Yes, that's true before the movie is made. Once it's made, however, the marginal cost of making a copy is zero.
With all due respect, you misunderstand the idea of it all going toward marginal cost. Technically, it will never reach it, even in perfect competition which is highly theoretical and hard to define. It will get closer and closer to 0 as volume increases.
I'm not sure why you think I've misunderstood price moving towards marginal cost. I agree that perfect competition is hard to define, but that doesn't actually matter. The point is that as you move towards more competition, the price moves towards marginal cost, and that's the incentive that companies have to innovate and offer something new and different that helps drive the price higher than marginal cost.
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One common misconception in this area is that the marginal cost of making and distributing a digital good is $0. That is not true at all. While the cost is a lot lower than making and distributing a physical good, it is still not $0. This is especially true in the 'record' business, where a cut of every download sold goes to the artist or other rights holder.
There are two big problems in the market right now that are keeping things from heading towards the normal scenario you describe.
1) There are not good tools available (or executives aren't using them well) to determine what the marginal cost is. This should hopefully change soon, and fixing it will be a natural result of fixing #2, which is:
2) The current competition level is not very good. Your choices are Apple, 'piracy', or some other much smaller competitor that has to base their price negotiation with record labels on what Apple has been able to do. And Apple, at least for the moment, doesn't really have to compete with them, at least on price, and is happy with the status quo.
Because of this, and because the labels form a cartel to avoid competing with each other on price (Oh, you want 65 cents per song? Ok, but I was able to get 55 from BMG, so all their songs will be 10 cents cheaper at the store). Once that situation every improves, then we can start talking about pricing songs near marginal cost.
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never thought of it like that
Wow. I hadn't thought of it in terms of profit instead of absolute price, which makes sense. Profits matter, and through differentiation, value is created, so even if marginal costs are theoretically $0, there is still a value proposition of greater than $0 for making a profit.
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Re: Not really
But you don't have to pay $100 million dollars to make the movie every time you sell a copy of it, so how is the movie the "car" in this analogy? The .avi file or the dvd is the car!
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"All that matters is the difference in price you can charge to the marginal cost. Everyone else learns to differentiate -- why can't those who produce infinite goods do the same?"
Are you saying that a marginal cost of zero is the same as free? In you example the marginal cost of the movie is $0, but it still costs me $8.5 to see the movie, so it's not free. What is there for the producer to get if the difference in price is absolutely nothing? No revenue = no inovation = no competition
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Misconceptions of a misconception
"One common misconception in this area is that the marginal cost of making and distributing a digital good is $0."
No, I don't think that's been a misconception. As others like Some Guy seems to not understand, you derive the idea that competitive pressures drive prices towards marginal costs from the theoretical example of having a $0 marginal cost (or $100 marginal cost - the actual number doesn't matter). No one is saying that we live in a theoretical world and that there actually is a $0 marginal cost on digital goods. What's being said is that prices are driven towards marginal costs, and for all intents and purposes, digital goods have a marginal cost of $0, but that doesn't change the profit outlook of that good as seen in Mike's example of two $100MM investments. Whether the marginal cost is $0 or not, your profits are derived from your ability to innovate and differentiate, and has no relation to the actual marginal cost even if that may or may not be $0.
So, while prices are driven down to marginal costs, there are always ways to create profit no matter the marginal cost.
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Re: Not really
the price of a good is not what it is sold at, but what consumers are willing to pay for it. a BMW costs more than hyundai because people are willing to pay more for BMW. BMW charges what they do, and the keep getting away with it... hence the street price for a BMW.
companies increase (or stop losing) profits two ways: 1) raising prices 2) lowering costs.
if i hand make cars in my garage, they will cost me way more to produce (per unit) than a $100 million dollar automated factory will be able to produce them for. that's the ecconomy of scale.
the point at which net profit in sales (sale price minus marginal costs) is equal to fixed costs is the break even point.
natually, reducing marginal and fixed costs at a greater rate than reducing the sales price will help you hit the break even point faster.
mike's point is that with digital content and digital distribution, all costs are fixed costs. the price of producing the film is paid at production time, and then the film itself can sell and sell and sell until the break even point is reached. at which point, all sales are pure profit.
long tail ecconomics means that a given work has unlimited time to generate profits so long as the cost of distribution is near enough to zero, which digital distribution makes possible.
how long will it take for a $2 download to offset the cost of a $100 million movie? probably a long time.
it will take a lot less time than the sale of a $20 dvd that costs $18 to press, package and seal, haul across the country in trucks, and sit on a store shelf for 6 months before going in the bargain bin to be sold for $10.
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Small problem
When competitors have different marginal costs for the exact same product, and not because of 'manufacturing' differences (which a free market should fix), there exists an insurmountable advantage for one of them.
Say iTunes and AllOfMP3.com.
IMS pays royalty fees, which drives up the marginal cost of each song download, whereas AOMP3 does not. That would be like, in your car analogy, one company using slave labor while the other pays market wages. No matter how much they refine their manufacturing process, they can't compete without breaking the law.
So since neither IMS nor AOMP3 are the original producers of their product, they just resell it, the fact that one company licenses the product contractually and legally creates a huge competitive advantage for the company that doesn't.
Also, there's a much larger problem:
The market forces the price toward the marginal cost over time. There's no business in the world that doesn't include recovering the cost of the initial investment into its products' pricing. After enough sales, the price drops toward the marginal cost, but if somebody else can skip the initial investment recovery period entirely, and head straight for the marginal costing strategy (as in the case of digital distribution), the model really is broken.
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Re: Re: Not really
I see what you mean by moving towards marginal cost Mike, and I wholeheartedly agree that is what happens as a market matures. An excellent example is the PC market, from computers with a thousand times the computing power selling for a quarter of what they used to 10 years ago.
My point, which I now see is not as eloquent as I hoped, is that moving toward 0will always happen, but it will never get there. In fact many times it will take a step back. An example of this which is pretty appropriate is movie theatre ticket prices. The market has highly matured, many theatres being bought to make a huge chain. Mom and pop theatres are quickly becoming no more. Yet prices have almost doubled in the last 10 years.
The movie cost is a sunk cost once the movie is made, and a per user selling basing would be the cost of the DVD. But a big hole in the "toward 0" theory is large competition. The automobile market is huge, competition is large, and price is a major differentiation.
For movies, no matter what the cost, it will cost you the same at the theatre, and a DVD price will generally be in the same scope as one another regardless of the budget (maybe a 5-10 dollar difference at most). There just isn't enough competiton, and some could easily argue that they are not meeting the market need. Demand is high, supply is low, price goes up.
But all companies will abide by the general pricing rule (price scaling omitted such as DVD vs. Theatre) of:
Price = (Overhead/(Expected # sold) -Cost) + demanded profit/(Expected # sold).
The demand being high will drive demanded profit up, and the supply being low will up the expected sold. So the price being high speaks that there is poor competition, and low volume. The demanded profit has the luxery of being higher for a theatre.
I hope I was more cleare this time around. Regardless, I do agree that the argument of "can't compete with free" is silly. You have to compete with free in everything. Cars companies even consider walking to work as competition, and they are doing just fine.
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What hes saying
Mike isn't saying that the item should be sold for $0. He's saying that if the production price is $0 (Or at lease so close that there really is no difference) than the only thing that anyone should be looking at is the added value, like the movie or music itself. There is no reason to have the price set at what it was when the margin was higher. And with downloads the margin price douse drop to $0. (I am not counting the server, internet connections, or web development prices since they are investments not cost. Plus they would still be an insignifigent price in the long run.) All that's left to bring up the price is the added value of the object being downloaded.
I believe I have that correct.
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I think I get what you're saying...
Ford designs a car that costs $20k to make. Each car from that design has $20k worth of parts in it. In order for them to compete with a car by Chevy that also costs $20k per car Ford has to add some unique value to their car to pull customers away from Chevy. Let's say that both Ford and Chevy each spent $2mil in labor (paying the R&D departments), testing, etc. to come up with their designs.
MGM makes that cost them $100mil to make. Each DVD does not cost $100mil but in fact only costs perhaps $2.
It would seem that part of the confusion in this is that Ford and Chevy are spending $20k for each and every car they produce whereas MGM is only spending $1 for each and every DVD they produce and people are trying to compare MGM's $100mil cost to Ford's $20k. I'll have to ponder this some more.
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Thoughts
While I've really liked your articles, I do have a few issues with this one. Sunk and Fixed Costs are different things. To quote Wikipedia, which words it far better then me:
--Fixed costs are expenses whose total does not change in proportion to the activity of a business, within the relevant time period or scale of production.
--Sunk costs are costs that have already been incurred and which cannot be recovered to any significant degree.
So for example (mine):
--Research is a sunk cost; you can’t recover it, and when you think about whether or not to continue to develop the product, an NPV should not factor it in.
--Factory leases are a fixed cost; they don’t vary no matter how much you produce.
So how is something priced? A product has a price and value – on the value exceeds the price, you have a potential transaction. Now someone keeps that delta between price and value; market forces generally dictate who (the seller or buyer) extracts what percent of that value. In a perfectly competitive market, the buyer generally extracts all the value. Monopoly situations are different (at outside the scope of what we are talking about).
A perfectively competitive situation DOES NOT drive the price down to the marginal cost. For example, you factory costs you $10,000 a year in leases, and a $1,000 a car. In a perfectively competitive market, if the price was driven to $1,000, you wouldn't cover the $10,000 lease, and go out of business. Therefore, a perfectively competitive market covers MC+(FC/units). If unit sales are infinite, then FC would go to zero, but this is never the case.
Additionally, sunk costs are a red herring. Sunk costs are useful in decision making, as they cannot be recovered. But they can often be thought of a fixed cost (just convert them to a perpetuity fixed cost). If not, then someone is eating this loss. Therefore, if someone is forcing you to sell at zero, you are eating all fixed costs.
I'm not an economist, so please, any comments would be great on my analysis.
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long tail economics
As a clarification, long tail economics has little to do with the original producer. Amazon and Netflix are examples of the long tail at work. They can make tons of money off of non-blockbuster items by selling 100 million $1 items compared to instead selling 1 million $100 items. In the first situation, those 100 million are still grabbing a small % for themselves, and not necessarily benefiting as greatly from the economics of the long tail as the distributor is doing. The long tail is about opening up offerings at the bottom end of the spectrum, and some smaller distributors or content creators will be able to set out on their own for more profits by connecting with their markets better than they could before, but in general, the long tail is referring to the larger distributors that open the access to the small creators.
"companies increase (or stop losing) profits two ways: 1) raising prices 2) lowering costs."
Companies increase long-term profits in one way: innovation. Raising prices and lowering costs are driven by the market and less by a company as industries tend to rely on the same suppliers, so overtime (and without innovation), competitors are working off of the same manufacturing costs, and the only way to raise prices when faced with the same competing product is by producing something different of value that people are willing to pay more for.
"Price = (Overhead/(Expected # sold) -Cost) + demanded profit/(Expected # sold)."
On an individual company level this is true, but not on a market level. Price is set by the competitive forces, and overtime, that is the marginal cost. Movie companies are competing with new industries that aren't as mature yet. I actually prefer independent productions online over the standard junk out there. For instance I"m a huge fan of the DRM free - no limits after downloading - "Long Way Round" movie store, which has far far better prices than a $10 movie, and more value to me. However, smaller creators and distributors like these aren't able to put substantial competitive pressure on the large companies yet. Still, that doesn't mean that over time they won't, and that's what Mike has been getting at in this thread of articles. The current movie/music companies are fighting a basic market trend, and if they realize this, then they have a chance to change their business models and benefit us all. Instead we get lawsuits on grandmothers and fans.
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correction
"A perfectively competitive situation DOES NOT drive the price down to the marginal cost."
This is wrong, and you're example only shows a company that has failed to be profitable. They're unprofitable because their competition has driven them out of business (kinda like what's happening to Ford). There is no guarantee of profits on any investment, so when your marginal costs are higher than the market's marginal costs, you go out of business from price competition. That doesn't mean that a perfectly competitive market doesn't drive prices to marginal costs.
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Re:
One common misconception in this area is that the marginal cost of making and distributing a digital good is $0. That is not true at all. While the cost is a lot lower than making and distributing a physical good, it is still not $0. This is especially true in the 'record' business, where a cut of every download sold goes to the artist or other rights holder.
Well, that's only true in the case where you do have to pay the rights holder -- which is putting in place artificial costs. I'm saying the actual marginal costs are extremely close to zero if not zero.
1) There are not good tools available (or executives aren't using them well) to determine what the marginal cost is. This should hopefully change soon, and fixing it will be a natural result of fixing #2, which is:
Honestly, it doesn't matter what the marginal cost is as long as you realize that a competitive market will push the price in that direction.
2) The current competition level is not very good. Your choices are Apple, 'piracy', or some other much smaller competitor that has to base their price negotiation with record labels on what Apple has been able to do. And Apple, at least for the moment, doesn't really have to compete with them, at least on price, and is happy with the status quo.
Yes, this is absolutely true, but I think it's a market anomaly that will be corrected over time. It just presents too big an opportunity.
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Re:
Are you saying that a marginal cost of zero is the same as free?
No. I'm saying that when the marginal cost is zero, the pressure will always be towards pricing the good at zero.
In you example the marginal cost of the movie is $0, but it still costs me $8.5 to see the movie, so it's not free.
Right. I explained that in the post. Because the movie theater can present additional value (the experience of going to see the movie), they can charge a higher rate.
What is there for the producer to get if the difference in price is absolutely nothing? No revenue = no inovation = no competition
Revenue is meaningless here, as the example in the post showed. All that matters is profit. And as the post explains, companies compete to differentiate themselves (making their product better or making the cost of making it cheaper) and that drives innovation.
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Re: Re: Not really
the price of a good is not what it is sold at, but what consumers are willing to pay for it.
No, that's not quite true. It's true in the absence of everything else, but if there's perfect competition, then those competitors will seek to offer the same good at a lower price -- and eventually it will end up at marginal cost.
a BMW costs more than hyundai because people are willing to pay more for BMW. BMW charges what they do, and the keep getting away with it... hence the street price for a BMW.
Right... but that's different. What's happened there is that BMW has provided a benefit above and beyond the commodity level car (in this case, a Hyundai). Some of that value is real (it's just a better car) and some of it is perceived (the BMW brand). That's exactly the point I made in the article. The way you compete is by adding value and differentiating.
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Re: Small problem
When competitors have different marginal costs for the exact same product, and not because of 'manufacturing' differences (which a free market should fix), there exists an insurmountable advantage for one of them.
Why is it insurmountable? If anything it should be a challenge.
As I said, the way companies profit is by differentiating -- and one good way of differentiating is decreasing the costs of production for yourself. However, if you can do it, so can someone else eventually. That's what progress is all about.
The market forces the price toward the marginal cost over time. There's no business in the world that doesn't include recovering the cost of the initial investment into its products' pricing. After enough sales, the price drops toward the marginal cost, but if somebody else can skip the initial investment recovery period entirely, and head straight for the marginal costing strategy (as in the case of digital distribution), the model really is broken.
Not so. The market isn't broken at all. And, you're wrong to say that "after enough sales, the price drops toward the marginal cost." The number of sales has nothing to do with it. What you describe only is true in a static market -- but markets are dynamic. So the profit is made by continually differentiating and adding value. The profit is made by being able to convince people that there's more value in your product and making them willing to pay for it.
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Re: Re: Re: Not really
My point, which I now see is not as eloquent as I hoped, is that moving toward 0will always happen, but it will never get there. In fact many times it will take a step back.
The only way it "steps back" is if there isn't enough competition or if the companies continue to differentiate.
An example of this which is pretty appropriate is movie theatre ticket prices. The market has highly matured, many theatres being bought to make a huge chain. Mom and pop theatres are quickly becoming no more. Yet prices have almost doubled in the last 10 years.
Right. The consolidation of movie theaters has actually reduced competition greatly -- hence a big part of the increase in costs. Also, there are marginal costs involved in running a movie theater -- and some of those costs have gotten more expensive over time which helps explain the rising cost of tickets -- but still fits with the model I'm describing.
But all companies will abide by the general pricing rule (price scaling omitted such as DVD vs. Theatre) of:
Price = (Overhead/(Expected # sold) -Cost) + demanded profit/(Expected # sold).
Not if there's real competition it won't. And, competition doesn't just need to be other movie theaters, but could be DVDs, the internet, other entertainment options (concerts, plays, video games, TV, etc.). Why do you think movie chains are struggling these days? They haven't been able to compete effectively against all of those other things.
So, we're not disagreeing here -- you're just pointing to examples that still support the model, not disagree with it.
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Re: Thoughts
While I've really liked your articles, I do have a few issues with this one. Sunk and Fixed Costs are different things.
Jamil, you're absolutely right. I was simplifying by lumping fixed and sunk costs together -- because it was easier to explain that way, but they are different (though, sometimes overlap). However, for the sake of the model I was describing, the sunk costs and the fixed costs were nearly identical. That's not always true, as you point out.
A perfectively competitive situation DOES NOT drive the price down to the marginal cost. For example, you factory costs you $10,000 a year in leases, and a $1,000 a car. In a perfectively competitive market, if the price was driven to $1,000, you wouldn't cover the $10,000 lease, and go out of business. Therefore, a perfectively competitive market covers MC+(FC/units). If unit sales are infinite, then FC would go to zero, but this is never the case.
I think you're mixing up a few concepts here. Perfect competition absolutely does drive price to marginal cost. In the example I gave in the post I was assuming that all of the fixed costs were sunk -- that there was no lease to pay, just it was all paid up front. But in your example, you get the basics right, but miss the overall point. If the lease costs a certain amount and there is perfect competition then YES, the company will go out of business. But that's exactly what the model says will happen.
The way to avoid going out of business isn't to just "price the product at some price higher than marginal cost, but less than value," it's to add value to the product such that you can do so. If you are just selling a commodity offering, you won't be able to increase the price much above marginal cost because you'll have no differentiating value. So in the example you're using, what happens is the factory works on differentiating its offer to justify the higher price.
Additionally, sunk costs are a red herring. Sunk costs are useful in decision making, as they cannot be recovered. But they can often be thought of a fixed cost (just convert them to a perpetuity fixed cost). If not, then someone is eating this loss. Therefore, if someone is forcing you to sell at zero, you are eating all fixed costs.
No, you're getting confused again by assuming perfect competition is an absolute. It's not. It's a force, but the whole point of this article is that companies continually innovate to differentiate away from a perfectly competitive market -- and that's where the value (and money) is. So you don't eat all the fixed costs because you come up with other ways to differentiate and that's where you earn back the fixed costs.
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Red Hat makes a lot of money off of a free operating system. It seems you can compete with free.
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Not so fast...
Net outlay is $100 million.
The first copy published gifts $100 million dollars worth of movie to the public (and every single trader who fancies adding value to a copy at $0 marginal cost).
Adding $5 of brand value onto $0 of marginal cost does not get you off the hook, because you have to compete with people adding their own $5 brand value and/or $5 of convenience to $0 of marginal cost.
By the time the producer has recouped $100 million, all competitors have also made a profit of $100 million. This means the producer has broken even, and their competitors are each up $100 million (and very thankful for the altruistic investment on the part of the producer).
++ DOES NOT COMPUTE ++
The producer MUST sell the movie for at least $100 million to the audience interested in seeing it (or middlemen interested in adding value).
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Mixed up
Mike,
You are right, I was mixed up on a few things, and I spoke to my step-father about the economics on this (he's a retired very senior level economist). I will try to repeat what he said, but understand sometimes things get lost.
Perfectly competitive does drive to MC, and if there are FC, then the equilibrium as when MC=AC [MC=margin cost, FC=fixed cost, AC=average cost], as MC generally does not have an elasticity of zero. However, this breaks down when MC has an elasticity of zero, because MC will never equal AC (which is where I was getting mixed up). His statement is that when MC equals zero, and there are FC in a perfectly competitive market, you have no private entry, and you have a public good.
I understand (and agree with you) that the trick then is to move away from perfectly competitive markets, and your argument is you do that by differentiating yourself.
My question then becomes -- if one of your basic inputs then is this MC=0 good with some fixed costs, who produces this basic input? Is your argument that you must provide a value proposition high enough to subsidize this "public" input? Or that the market in general must provide such a value proposition? Or are you saying that you must move the basic input away from a perfectly competitive market?
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RE Mixed up - Jamil
Actually, the end result to what he's saying is that "perfect" markets don't exist. Further, music and books and movies aren't commodities (e.g. one is no different from another).
Argue fixed vs. sunk vs. production costs all you want, but if the consumer ultimately pays less than those costs then the producer will stop incurring them. However, you'll never reach that point, because, one way or another, consumers will pay those costs, if only to ensure that they have a choice.
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There is one difference at 0
An excellent series, and this one is especially fascinating.
It seems there is one difference at 0 price: The vendor can no longer differentiate on price. So differentiation has to be functionality, branding, service, etc. (i.e. components of perceived value).
I guess you could go to negative price (pay people to take it) but this model has not been very successful in most situations. An example: radio stations that run lotteries.
Another point: Some commenters said the marginal cost of copies is not 0. You don't need to argue about fixed costs here. The relevant cost is the cost to the vendor. Using bittorrent, etc. most or all of the copying costs are borne by the customer, not the vendor, so the vendors' marginal cost is truly 0.
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Re: Mixed up
His statement is that when MC equals zero, and there are FC in a perfectly competitive market, you have no private entry, and you have a public good.
This is what has traditionally considered true in economics, but it's not quite true -- and it's a somewhat subtle change that I've been trying to get at here. While it does have many characteristics of a public good, it's not quite the same. I think this is part of the problem that many economists had in trying to figure this out over the past 50 years or so.
My question then becomes -- if one of your basic inputs then is this MC=0 good with some fixed costs, who produces this basic input? Is your argument that you must provide a value proposition high enough to subsidize this "public" input? Or that the market in general must provide such a value proposition? Or are you saying that you must move the basic input away from a perfectly competitive market?
I'm saying that anyone can start producing that basic input if they recognize the larger market they're in (see the article in this series on "recognizing what market you're in"). In that case, you start to recognize the zero marginal cost good as an input or a resource into a larger offering, and, in fact, the infinite good becomes the differentiator for those other products... Companies will produce those goods because they realize that, while the direct return may be zero, the indirect return in having an infinite resource with which to differentiate other goods is huge.
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Re: There is one difference at 0
It seems there is one difference at 0 price: The vendor can no longer differentiate on price. So differentiation has to be functionality, branding, service, etc. (i.e. components of perceived value).
Yes, that's a very good point, that I definitely did not make clear enough. Thanks!
The relevant cost is the cost to the vendor. Using bittorrent, etc. most or all of the copying costs are borne by the customer, not the vendor, so the vendors' marginal cost is truly 0.
Another excellent point.
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Real l example
I was travelling in South East Asia where pirated copies of movies can be found everywhere. You could buy a cheap VCD on a blank CD for about fifty cents, a labled one for maybe a dollar. DVDs can be had for a couple bucks on a cruddy looking disk, a buck or two more for a nice disk and jewel case. Shoppers were happy to pay a LOT more for the same movie in a box with some text wrapped around it.
Go figure.
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wow
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Re: Re: Mixed up
I hope I'm not being obtuse, and we can certainly move on, but something still doesn't ring right here for me. I'm curious what characteristics you are saying are different from a public good. If I remember correctly, a public good has no scarcity and no exclusivity, and derives it's properties from that. But more to the point, I've been doing some more thinking and maybe this (admittedly silly example) will clarify. Take for example crossing a river where there existed a bridge lane with infinite (but closed) lanes built by the government, and you could open/take one for free. You could take a lane and charge a toll and make money. However, someone would come in and open another lane, and undercut you, and so forth until someone opens one that was free. At this point, charging your toll to cross the river would be competing with free, and you would be out of business. So you had better realizing that you are not in the business of crossing the river, but rather you could make your lane prettier or have radio and then charge a toll, because you have something other people can't do. Other can imitate, but now you are competing on something differentiating. If this is your point about people complaining about competing against free, I totally agree. However, I would submit that many people envision a different scenario when they talk about competing with free (vis-a-vis copyrights). Suppose instead of the government building the bridge, YOU had to build the infinite lane bridge at some cost. And then anyone could come in an open up a lane and do what they want with it. So now you are competing just like before, except for you are massively in the whole with your start-up costs. This second scenario is what I think people mean about having trouble competing with free. This is the problem I was trying to raise with "who creates the public good?"
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Oops, sorry about the lack of formatting in the previous posting. New to this :)
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usemonoply... not a right over every copy
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Re: Re: Re: Mixed up
I'm curious what characteristics you are saying are different from a public good. If I remember correctly, a public good has no scarcity and no exclusivity, and derives it's properties from that.
You can see some of the reasoning here:
http://www.compilerpress.atfreeweb.com/Anno%20Romer%20Why,%20Indeed,%20in%20America%20Theor y,%20History,%20and%20the%20Origins%20of%20Modern%20AER%201996.htm
in Paul Romer's discussion of how technology isn't clearly a public good the way many think it is.
However, I would submit that many people envision a different scenario when they talk about competing with free (vis-a-vis copyrights). Suppose instead of the government building the bridge, YOU had to build the infinite lane bridge at some cost. And then anyone could come in an open up a lane and do what they want with it. So now you are competing just like before, except for you are massively in the whole with your start-up costs. This second scenario is what I think people mean about having trouble competing with free. This is the problem I was trying to raise with "who creates the public good?"
Ah. I had tried to explain this, but I guess it wasn't clear. The point is that there is still demand to get across the river, right? Therefore, it is in someone's best interest to build that bridge -- but they need to realize that they won't profit directly from the bridge, but from additional services. And, even if others can take a lane for free and copy, the originator can still do quite well just by being the first and having the associated brand.
For example, when the 9/11 report came out it wasn't copyrighted, since it's a government document. However, the government gave the initial printing rights to one publishing company who came out with a purchaseable version before anyone else. Others followed -- but the company that came out with the original version still outsold the competitors by a wide margin because people associated the report with them. In other words, there was "perceived" benefit in going with them (this example is used by economist David Levine).
Alternatively, the bridge builder could find someone who greatly needs the bridge -- and get them to help finance it. Say it's a trucking company and the trucking company recognizes they'd save $20 million in having a bridge. They may be willing to give you $19 million to build it -- and then you can advertise their brand on it.
That's just a simple example, but the point is that if the product is needed, there will always be a business model that can be designed to make it worthwhile to build that initial resource -- and then to set it free.
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Club goods
Jamil, I wouldn't classify digital goods as public good, but as club goods. That being that they are non-rivalrous, but still excludable. Non-rival because "consuming" a digital good doesn't take away from the whole, but I could still be excluded from buying a Beatles album for instance if the owner so chose.
So, using your lane analogy, if a person uses a lane it doesn't take away from another person being able to use that same lane. However, you might choose to block people with SUVs from using your lane, which could be of value, or you might do something else to add value, and charge a toll to use your lane (listen to your music, or watch your movie). There is still a cost in production, but a sunk cost because the lane has to be built first, but the marginal cost of people using the lane is $0.
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resource for club goods
I'll admit that I haven't read this one in full (maybe tomorrow after some sleep), but it looks like the best resource out there, and includes things such as movie theaters in at least one reference as a club good.
http://www-1.mtk.ut.ee/doc/Sepp_Klubiteooria.pdf [PDF]
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Adding value to copies is a secondary market
There are two markets:
1) Production and sale of a public good to interested members of the public
2) Production and sale of added value copies
You can have producers competing with each other to provide similar movies to similar audiences. However, the movie gets financed for sale to its interested audience (consequently becoming a public good).
It is only after this transaction (producer recouping their costs + profit) that the secondary market occurs, and the producer and anyone else can compete to add value to copies (packaging, etc.).
A $100m dollar movie is produced because there are 10m members of the public who'd pay $10 each to see it released.
Once released people can download copies for $0, or buy copies in the shops for $5.
1) Art for money, money for art.
2) Copies for free. Copies+value for money.
I'm continually mystified as to why people think that without copyright it's impossible to sell a digital work to a large audience.
Don't sell copies, sell the original!
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But!
Thanks for the link, Mike, and I'll take a look at your link when I get a chance (work calls soon).
"Jamil, I wouldn't classify digital goods as public good, but as club goods. That being that they are non-rivalrous, but still excludable."
Matt, I agree with you 100% on the Club Goods, and I believe that is an appropriate model for thinking about digital goods with MC=0. However, my understanding was that this whole thought exercise was about removing scarcity. Adding exclusivity adds scarcity, which truly changes the game.
"For example, when the 9/11 report came out it wasn't copyrighted, since it's a government document. However, the government gave the initial printing rights to one publishing company who came out with a purchaseable version before anyone else."
Mike, in this example, you have also introduced some initial scarcity into the problem, and allowed someone to gain an initial brand, which changes the dynamics of the problem.
But, let me back up, and say I think there are multiple issues going on here. Mike, I think your initial point is that competitive pressures drive excess profits (I think that's the right economic term) down. The firm’s goal is to drive them up. It doesn't matter if at perfect competition the price is being driven to zero or not, it's the fact that in all situations the excess profits are being driven to zero (with perfect competition). No quibbles there.
I think the relevant question – the question being implicitly posed with “I can’t compete with zero” is does there exit a market when MC=0 and scarcity is removed? They key assumption I’ve been working on (given this series) is that scarcity has been removed– no exclusivity, no exhaustion. I believe there are two different scenarios:
1) Secondary market -- When you are taking a good that currently exits with no scarcity and no MC, then you must add value to the good to realize excess profits. What you are essentially doing is creating a secondary good (with your added value) that has scarcity. Example – as mentioned earlier, Red Hat takes Linux and adds value with technical know-how that not everyone has. No question a market exists.
2) Primary market – When you must create the good that will be available with no scarcity, no MC, but does have a Fixed Cost, then in order for their to be a market, there must be a “secondary market” (maybe not the right word) that the producer of in primary market can extract enough excess profits to cover the FC of creating this primary market. Example – I create music and release it free to the world knowing that I can make enough money from my own concerts to cover my music writing costs, because no one else is me. So the critical point here is that the market exists only if the excess profits in the secondary market will cover the fixed costs of the creation of the primary market >for the creator
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>cont
end got chopped off, sorry.
So the critical point here is that the market exists only if the excess profits in the secondary market will cover the fixed costs of the creation of the primary market >for the creator
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sorry again.
formating thing... with my brackets. was trying to stress the creator.
So the critical point here is that the market exists only if the excess profits in the secondary market will cover the fixed costs of the creation of the primary market for the creator. Potential a market exists. And that is where the question, “can I compete with zero” has valence.
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quality can compete with free
Bottled Water, Anti-Virus programs, Firewall programs, condoms, Television programs, Internet, Operating Systems. These are just a few quick things that compete with free, and not only compete, but are million and billion dollar industries.
Any company can easily compete with free, if they make a quality product that people want to buy.
The problem is the music industry is to lazy to make a quality product and so they want to just sue every one who doesn't want to pay for a crap product. Just fade away into nothing music labels, you are no longer needed. I think it's been long enough that you've thrived leeching off the hard work and talent of musicians.
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scarcity
"Matt, I agree with you 100% on the Club Goods, and I believe that is an appropriate model for thinking about digital goods with MC=0. However, my understanding was that this whole thought exercise was about removing scarcity. Adding exclusivity adds scarcity, which truly changes the game."
Ah, true. So, to kind of restate, the current situation is that of a club good, however, the proper state for these goods, arguably, is that of public goods. Because there is little technical reason why these couldn't be public goods as for digital goods there's no inherent consumption cost for the producer, and exclusivity is artificially induced by copyright, and since the good essentially has an AC or MC=0 (MC is just the first derivative of AC, so it doesn't matter which you talk about), there is still theoretically a $0 cost for digital good. Since MC=0 removes price differentiation (not that price differentiation has ever exists with music), profits should be derived from a secondary market of added value.
This is really the essence of why the copyright was created. Because past content creators realized that books and music were as good as public goods, but inducing an amount of exclusivity for a time period has the potential to encourage creators to create. However, we've become so accustomed to copyright that it now seems the proper state of such goods instead of their natural state as being a public good. There are of course other way to induce exclusivity such as with added value of an exclude able good, so really, copyright isn't needed except for an easy way into business.
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Real-life experience
I have a degree in economics and own an on-line publishing company, so I can put a real-life spin onMike's argument, as that's how I run my business. I incur a fixed cost to develop market research reports which I then sell off my website. Essentially my marginal costs are close to zero. Not really, because I have variable costs such as rent, bandwidth, etc... But effectively, given the volume we sell. I price my reports based on what my competitors are charging for similar offerings, past experience, and what customers are willing to pay. Essentially all my reports cost the same to produce, but they are all priced differently. If one doesn't sell at the inital price, I keep lowering it until it does sell. To get a high price for my reports, I have to add value. I pick markets that others have ignored which gives me exclusivity. I target the format of my reports to meet the needs of my target customer.
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Re: Re: Mixed up
There are no perfectly competitive markets, so MC never quite equals 0. But regardless, there seems to be some confusion with MC and Price. Just because MC=0, doesn't mean price = 0. In addition, its a fallacy that companies won't enter a business with MC=0. They will if they believe they can get a price over 0. Look at eBay as an example. What is their MC? It's got to be pretty close to 0. Yet their price is above 0 and there are plenty of other companies doing online auctions.
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markets exist with value
"So the critical point here is that the market exists only if..."
Markets exist where there is value, but no one acknowledges those markets until a profit is made. For instance, the OLPC market is there. Poorer countries will derive value from laptops, but no one has yet to find a way to make money off of that market. Negroponte will hopefully both establish the market through a cheaper and more affordable laptop for those countries, but also play a charitable role in doing so. There is a market for charitability, but few acknowledge it because most charities are either a lose or neutral based on costs. Still, I wouldn't say there isn't a market there because there is value. It just has yet to become massively profitable.
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price driven towards MC
"But regardless, there seems to be some confusion with MC and Price..."
It's not so much that price will be zero with an MC=0, but that with competitive pressures, the market will drive the price toward MC, which is theoretically 0 for digital goods. So, unless you do what you've done in your publishing business by adding exclusivity of added value, there argument that copyright should supply the full added value is ludicrous (IMO), which is really what these articles by Mike have been getting at in a way.
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Re: sorry again.
So the critical point here is that the market exists only if the excess profits in the secondary market will cover the fixed costs of the creation of the primary market for the creator. Potential a market exists. And that is where the question, “can I compete with zero” has valence.
Yes, but the point I'm getting to is that by using the primary market as promotion for the secondary market, there will always be ways to make sure that the fixed costs of the "primary" market are covered. I think the terms "primary market" and "secondary market," while useful in picturing things, later cloud the picture -- because the primary market is no market at all, but rather a resource to promote the secondary market.
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Some clarifications
Hey,
First of all, the reasona movie sells for less than $0 is not that it adds "value". Value is encompassed inthe price itself- when you say that something costs $0, you are saying it's value is $0.
What's really the key here is that movies will never be perfectly competitive. The reality is that movies aren't perfect substitutes for one another. This is because, if I wanted to see Will Ferrel make an idiopt of himself in Talldega Nights, I'd have to buy THAT movie from one studio and ONE studio only- so in essesnce, it's a monopoly. Or at least, monopolistic competition.
So that's a bad example.
In addition, remember that marginal cost includes the salaries of everyone who works for a company- so everyone gets paid, has jobs, and makes money. The COMPANY turns no net profit.
In addition, remember that marginal cost also has the component of opportunity cost in it. If you don't keep this in mind, you'll make the mistake of thinking that actual proft goes to $0- it doesn't. What goes to zero is the profit above and beyond opportuinty costs. Otherwise, everyone would leave a $0 profit industry for more profitable ones. Things should move to an equilibrium...
And even at that, all this is highly theoretical, and can't really be applied in real life.
Moreover, I think those who support anti-trust legislation know this all too well- they just think that it would be better for people to pay a little extra to spur competition than be driven out by a competitor who is able to offer basement prices.
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Re: Some clarifications
I'm sorry to say this, but I think almost everything you said has something wrong with it.
"when you say that something costs $0, you are saying it's value is $0."
No, when you say something cost $0 it means that it costs $0. There could very well be great value derived from that such as with air or water. What does air cost? $0, but what value does it have to you, infinite value. Prices will be above $0 because those things have value to you above $0, and you can't get that thing anywhere else for even if the cost itself is $0. Price is the representation of the value, not the cost, so you could price something below the cost, like an XBOX 360, and still find profit in that industry from other value offerings.
"What's really the key here is that movies will never be perfectly competitive. The reality is that movies aren't perfect substitutes for one another."
Just because there aren't any perfectly competitive markets doesn't mean that the academic argument doesn't have any application. Also, you're miss using the perfect substitute concept. Computer games are perfect substitutes for movies, and any other entertainment options as well. Movies could be thought of as substitute for other movies, but that's too small of a scale. If you want a Will Ferrel movie, then yes, you can only get a Will Ferrel movie from certain places, but that says nothing about other substitute industries. You're not properly defining what industry movies are in. They're not in the movie business, they're in the entertainment business, which has plenty of perfect substitutes.
"marginal cost includes the salaries of everyone who works for a company...In addition, remember that marginal cost also has the component of opportunity cost in it."
Marginal cost is the derivative of (changing of) total cost / quantity. If quantity approaches infinity such as is theoretically possible with digital goods, then MC approaches 0, or for all intents and purpose, MC=0. So, no matter the actual total cost, there can still be a MC of 0 from the change in cost of producing another good decreases. Also, opportunity cost is not a part of the MC calculation. Indirectly, it could be in considered, but there is no component of MC that includes opportunity cost.
"If you don't keep this in mind, you'll make the mistake of thinking that actual proft goes to $0- it doesn't."
No. The mistake is that profits have no direct relation to costs. Ideally, you want price to exceed cost deriving profit, but there is no guarantee of this situation. Companies go out of business because of this. People leave $0 profit industries because you can't make a profit, but that doesn't mean people leave MC=0 industries.
"And even at that, all this is highly theoretical, and can't really be applied in real life."
This is very theoretical, but logically plausible. Take Steve's real life example of his own publishing company. Theory successfully applied to life. QED, stay in school.
"I think those who support anti-trust legislation know this all too well- they just think that it would be better for people to pay a little extra to spur competition than be driven out by a competitor who is able to offer basement prices."
Anti-trust has nothing to do with being driven out of business by price competition. Anti-trust legislation is about creating fair markets where there may be a market failure. Anti-trusts don't force people to pay more, they penalize companies for creating, inducing, or exploiting failures in markets, which is anti-competitive, but none of that has any direct consequence to this discussion.
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Re: Re: sorry again.
Ahh, now I think I see where I disagree with you. Two places:
'there will always be ways to make sure that the fixed costs of the "primary" market are covered.'
I don't agree that with this statement -- if it were true it would have very resounding policing implications. I think this is a calculation that needs to made and determines entry into the market. I can imagine extremely high fixed costs that cannot be recouped by the secondary market. Perhaps the classic example, National Defense.
"the primary market is no market at all, but rather a resource to promote the secondary market."
I disagree here as well. The primary market MUST be a market, otherwise you have involved scarcity in that resource. It's generally IP rights that make this a resource and not a market.
But it's really the first thing disagreement that I think is the important one -- because it has implications on whether these markets will exist in the first place. It gets to the crux of the problem, can a song be created while being free of IP from the get go by a profit minded individual? Yes, IF the secondary market adds enough value to the creator of the music that will be free. However, the answer to the question is not a clear cut yes.
With that said, your point is well taken: not enough people consider the goods we are discussing as inputs into another good to create value. There is no need to keep splitting fine hairs unless people are particularly interested (except I love intellectual hair splitting -- keeps me from getting dopey). :)
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Re: markets exist with value
My apologies, I may be using the wrong terminology. I was using the term 'market' to imply that someone will produce goods and exchange will occur. So I would argue in the OLPC market, there is value, but there is no 'market' as i am using it because the costs to create a 'market' are higher then the 'value.' Not sure what the right term would be there.
I also agree things like altruism change the way you think about these things, or any kind of non-rational actor. Sometimes I wish I had gone into behavioral economics!
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Re: Re: Re: sorry again.
I don't agree that with this statement -- if it were true it would have very resounding policing implications. I think this is a calculation that needs to made and determines entry into the market. I can imagine extremely high fixed costs that cannot be recouped by the secondary market. Perhaps the classic example, National Defense.
I disagree. I hope that soon I'll be able to show why there will always be the opportunity to recover the fixed costs (though, it still depends on execution, which doesn't always happen).
I think it's even true with National Defense, though there are many other (more important) policy reasons for supporting government-backed national defense. However, if you did want to make it a for profit business, I believe you absolutely could. It would just have other consequences that most people probably would not appreciate. :)
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The primary market seems to be a blind spot here
Why do I get the strange feeling that everyone apart from me has discounted the primary market for digital art into a nonentity?
If you can sell a $100m movie for $150m then that sounds like a viable market to me.
Why is everyone focusing upon whether it's possible to give the $100m movie away for nothing and attempt to make $150m in the secondary market by adding value to copies?
This is like a drug company publishing the formula to a drug they just spent $100m developing - without patent - and then attempting to recoup this money by supplying pills in mahogany boxes at $10 each, in the face of competitors who provide them in shrinkwrap @ $1 each.
Somehow, I think the drug company should attempt to sell their formula to a goodly sized population of folk who fancy they could do with it today, or possibly tomorrow.