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Economic models of the traditional and well-known sense usually describe either manufactured physical goods or services performed, both of which are scarce resources: only so much grain can be grown, for instance—or widgets churned out of an industrial plant, or pipes plumbed by professionals. Short of espionage, even the market for Information1 was tied to the cost of materials and availability of produced goods such as printed books, pressed records, or spooled movies. In other words, though the Information was created once and itself remained unchanged, the marginal cost of creating copies of that Information was the sum of the materials, labor, and transportation costs used the produce, package, and ship the finished physical good to a store or warehouse.

Since the copyright on these forms of Information lasts for so long2, it is more useful to look at the patent system as an economic model of the fixed costs of producing or selling Information. In the pharmaceutical industry, as has been the case for some time, companies can and routinely do spend a billion dollars on the research and development of a new drug (Moran, 2003, p. 25); the protection of a patent, however, is only good for 20 years from the filing date, so the company must attempt to recoup its expenses and produce a profit while it has a monopoly on the particular drug in question. The cost of manufacturing the drug is often vanishingly small, but the medication is priced well above marginal cost—it must be—because its fixed costs are so high, regardless of how many units of the drug it actually sells.

The accelerating migration from the analog storage of Information in the form of printed books or newspapers, pressed records or compacts discs, or boxed movies, to a form of digital storage and networked transmission which can operate independent of a central producer, has not only brought up ethical dilemmas with respect to copyright and media “piracy,” but also hauled into the spotlight the economic model wherein price is set so high above the marginal cost, since this now applies to virtually every good available for purchase (or, for that matter, available for pirating) on the Internet. Of particular concern is digital music, whose placed in the zeitgeist began with Napster in 1999 and remains today with the Apple iTunes Store. As well, “e-book” readers such as Amazon’s Kindle are now bringing the same controversy over marginal cost to the book market, heretofore largely untouched by the move to digital media, the same of which cannot be said for their counterparts in the periodical industry.

In a perfectly competitive economy, price falls toward marginal cost. Since digital goods have a marginal cost near to 0 (as distinct from the cost of the first unit), traditional economic wisdom would indicate that the price of such goods should fall dramatically, taking into account the additional cost of transmission and storage. In “Free!” Chris Anderson asserts that each piece of equipment “does more and more for less and less, bringing the marginal costs of technology in the units that we individuals consume closer to zero” (2008).

Apologists for software and other media piracy, along with more pragmatic technologists with an economic bent, often quote writer Stewart Brand, who once famously opined “Information wants to be free”. Less frequently mentioned is the entire quotation, which is “On the one hand information wants to be expensive, because it’s so valuable. The right information in the right place just changes your life. On the other hand, information wants to be free, because the cost of getting it out is getting lower and lower all the time. So you have these two fighting against each other” (1985, p. 49). In other words, the economic cost of Information is not equal to its marginal cost, but this is not a revelation: no other industry in the world has enjoyed a configuration such as that. Anderson himself admits that attempting to offer a good at a price equal to its marginal cost cannot make (and will likely lose) money in a two-party market system. Only new synergies or “cross-subsidies” can generate an economic profit if these digital products are priced at their marginal cost (2008).

From Edison to Jobs

Though the indisputable leader in digital music sales is iTunes, having sold more than 2 billion songs since 2003, its smaller competitors number in the hundreds, and now include among their number such industry giants as Amazon.com (Feng, Guo, & Chiang, 2009, p. 243). Apple’s decision to charge a flat fee of $0.99 per downloaded song essentially set consumer expectation for price; Amazon, effectively a price-taker when it entered into the market, charges the same (though it offers a slight discount for purchasing whole albums as opposed to individual tracks), if only because attempting to charge any more would virtually guarantee the venture fails.

The low price charged doesn’t necessarily reflect the low marginal cost of producing the digital content in question. In all likelihood, the price point is set to attract those who would otherwise acquire the content illegally—that is, for a price of $0 (Smith, 2005). The ethical aspects of piracy and its causes and effects within the new economics of digital media are well beyond the purview of this paper, but it is clear that consumers who would never steal a physical good from a brick and mortar store are more than happy to acquire digital music without compensating the label or the artist. There exists the possibility that this phenomenon is a strange moral quirk, but more than likely it is a subversive economic reaction to the perceived low marginal cost of the goods. The consumer’s ease in acquiring the good, after all, is some reflection of the publisher’s ease in creating or duplicating the good. RIAA-funded reports to the contrary (which treat each illegal download as a lost sale), there is no good evidence that a consumer willing to “pirate” a song would also be willing to pay for it at any price point, be it $0.99 for a song from iTunes or $20 for an entire physical album. Paradoxically, however, there is evidence that people who illegally download music already spend more on legal music purchases than average (Shields, 2009), which would indicate that the rise of music piracy is simply what happens when the marginal utility of a track is less than the price set by its controlling firm. In the pre-digital era, this would have indicated a non-sale, but now demand for this kind of good can be independent of its price, since supply is effectively infinite.

From Gutenburg to Bezos

Though a relatively recent phenomenon, the rise of e-books is precipitous. Spencer Ante reports that Amazon sold more digital books than printed books last Christmas, which for Amazon entails a relatively small digital download to an electronic reading device that the customer already owns (2010, p. 50). At current prices, publishers net the same profit on both digital and printed books, but economic gravity is already dragging some prices down; in Amazon’s case, some new or best-selling e-books are $8, compared to as much as $35 for the hardback version of the very same Information. Though some of that price difference has to do with the larger marginal costs of the bound book, it’s long been common knowledge that publishers, like record labels and movie studies, exercise heavy price discrimination on new materials. Those willing to pay $35 for a new book do so because they are willing to pay that high amount either for the physical quality of the book or the privilege of reading it now instead of a year later, when the paperback edition is released. Libraries, too, will usually buy their initial stock of the books at an inflated price, quieting cries of alarm that the free use of books will ruin profits. For this reason, publishers such as Harper-Collins are delaying the publication of e-books for several months after a new hardcover’s release. Jeffrey Trachtenberg (2009, p. B2) notes that threat of competition from cheap digital media is a very real one for book publishers; however, this trend appears to be nothing more than market forces at work.

Amazon appears to pay publishers about half the cost of the new hardcover, regardless of which edition was solid: at first glance, this seems like a losing proposition in the case of digital downloads (Ante, 2010, p. 51). However, while the cost of Amazon’s “supply” of e-books may be close to the marginal revenue of selling them, the company also has little fixed costs associated with storing or shipping the data. As well, in Amazon’s case, the company is receiving revenue from the not-inexpensive Kindle e-book reader. This, then, might be an inverted instance of Chris Anderson’s Gillette-inspired bundling concept (2008). Rather than use cheap hardware and expensive data, Amazon sells expensive hardware and data as close to inexpensive as current economic models will allow.

Books and periodicals, like music, may benefit from an old but upward-trending concept known as bundling. Given a large product pool with a small but non-zero marginal cost of production, they can maximize profit as Hitt and Pei-yu describe in “Bundling with Customer Self-Selection” (2005, p 1481, 1491), citing the well-known marketing schemes of Colombia House as well as the newer pricing models of Netflix. In the case of technical book publisher O’Reilly, the bundling or subscription model has raised profits by about 20% (Ante, 2010, p. 51).

From Scarcity to Abundance

Traditional publishing models are predicated upon the idea that all of its aspects are essentially scarce resources: the physical media upon which Information is disseminated is itself scarce or at least costly, and the Information itself is a scarce resource which, because of its ostensible uniqueness3, has no likely substitute good. Digital media not only reduces the marginal cost of goods to near zero, but it also raises the supply to near infinite. Whereas once record labels and publishing imprints decided who or what appeared on the scarce shelf space of stores, these same companies now essentially compete against independent artists or authors who have more power to self-publish, and for lower prices, than ever before. In fact, the lower prices apparent in the digital economy may to some degree reflect the new, more intense competition that has become its hallmark.

The situation now resembles or is coming to resemble a case of monopolistic competition, albeit one in a state of extreme transformation. The number of producers in the market is now effectively infinite (taking traditional firms and self-publishing individuals together, and implying that individuals can act as multiple producing and consuming agents both alone and as organizations), and though some firms are currently exercising their market dominance (such as Apple setting a standard $0.99-per-track price), the ever-present threat of piracy ensures that prices will tend to be set low. A low marginal cost of production and surplus of human creativity insures that market entry and exit are easy. Finally, though it is true that specific songs by specific artists are technically unique, they are ultimately unique in brand, but substitute goods in genre. A consumer looking to purchase ten rock songs may have his or her need met by any ten in a thousand songs available. The result is that consumers discount more heavily when substitute goods are available but not when purchasing unfamiliar products, according to Clemons (2008, p. 13).

Yet another character of monopolistic competition that was impossible ten years ago is now rapidly becoming more realistic: perfect information, wherein consumers know all goods being sold, their differences, their prices, and even what profit a firm makes from them, could not have existed for such a wide array of goods in the years before the Internet generally and powerful search engines specifically. While traditional firms have relied on the popular 20% of products sold (market “fat spots”) to subsidize the less profitable 80%, this latter “long tail” is now the focus of considerable economic and marketing attention, and is the center of Anderson’s argument regard low-margin economies. More to the point, it is also the focus of more consumer attention, now that better information availability has improved access to the long tail.

Clemons (2008) speaks to the changes being wrought by increased access to information. Citing online price-comparison engines, he argues that these services essentially “discover” the correct market price for a good (as opposed to a producer setting it), much like the NYSE (p. 15). The kind and quality of product offerings will also change to reflect the more perfect consumer information. His summary of pricing changes is clear:

[C]onsumers’ willingness to pay is a function of the competition discount, the compromise discount, and the uncertainty discount, all of which have changed because of change in consumers’ informedness. Margins on most commodity offerings have collapsed[.] Pricing strategy has been transformed, and consumer behavior in the presence of informedness has been the principal driver (p. 33).

The implications are large for both consumers and producers alike. In the long term, technology of this sort will change how firms do business; just as the Industrial Revolution radically transformed the developed world from an agrarian economy to an industrial one in a minimal span of years, so too will the move to a digital economy of Information both fast and transformative. Regardless of high fixed costs, lower marginal costs due to improved technological will lower price, especially when products now compete against a growing niche market of goods that are given away for free. Anderson (2008) suggests that pricing in the digital economy will dip drastically low for Information and increase the cost of physical goods. A summer blockbuster movie, for example, may cost pennies, but popcorn will cost as much as ever—until that science-fictionalized day comes when technology gives us an unlimited supply of physical resources, as well. The net effect will be two separate but cross-synergizing economies, one for traditional physical goods with non-negligible marginal cost, and one for digital Information which, once expressed, automatically creates an effectively infinite supply of itself.

References

  • Anderson, C. (2008). Free! Why $0.00 Is the Future of Business. Wired, 16, 3. Retrieved March 5, 2010, from http://www.wired.com/techbiz/it/magazine/16-03/ff_free
  • Ante, S. E. (2010, January 11). Trying to Avert a Digital Horror Story. BusinessWeek, 50-52. Retrieved April 2, 2010, from Business Source Elite (47279438).
  • Brand, S. (1985, May). Keep Designing. Whole Earth Review, 44-57.
  • Clemons, E. K. (2008). How Information Changes Consumer Behavior and How Consumer Behavior Determines Corporate Strategy. Journal of Management Information Systems, 25, 2, 13-40. Retrieved April 3, 2010, from Business Source Elite (34879420).
  • Feng, Y., Guo, Z., & Chiang, W. K. (2009). Optimal Digital Content Distribution Strategy in the Presence of the Consumer-to-Consumer Channel. Journal of Management Information Systems, 25(4), 241-270. Retrieved April 2, 2010, from Business Source Elite (38419436).
  • Hitt, L. M., & Pei-yu, C. (2005). Bundling with Customer Self-Selection: A Simple Approach to Bundling Low-Marginal-Cost Goods. Management Science, 51(10), 1481-1493. Retrieved April 2, 2010, from Business Source Elite (18676603).
  • Moran, M. (2003). Cost of Bringing New Drugs To Market Rising Rapidly. Psychiatric News, 38(15), 25. Retrieved April 2, 2010
  • Shields, R. (2009, November 1). Illegal downloaders ‘spend the most on music’, says poll. The Independent. Retrieved April 2, 2010, from http://www.independent.co.uk/news/uk/crime/illegal-downloaders-spend-the-most-on-music-says-poll-1812776.html
  • Smith, T. (2005, September 20). Apple CEO blasts ‘greedy’ music labels. The Register. Retrieved April 2, 2010, from http://www.theregister.co.uk/2005/09/20/apple_jobs_piracy_pricing/
  • Trachtenberg, J. A. (2009). Harper-Collins Delays E-Books. Wall Street Journal, 254(137), B2. Retrieved April 2, 2010, from Business Source Elite (47053417).
  1. Information as a proper noun is hereinafter used to refer explicitly to any form of information or data, in this case salable, as distinct from a generalized term for “knowledge”. Specifically, Information in the digital age is anything for which a reasonable facsimile can be made in the form of binary digits—the 1s and 0s which form the basis for all electronic storage and transmission.[]
  2. As of this writing, works created after 1978 are copyrighted as long as 70 years after the death of the creator.[]
  3. By way of example: if one is looking to purchase a copy of Tolstoy’s War and Peace, one is unlikely to purchase Dan Brown’s The Da Vinci Code if the price of the former is too high.[]
§5294 · April 27, 2010 · Tags: , , ·

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