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Predictions

by Mike Masnick




The Importance Of Zero In Destroying The Scarcity Myth Of Economics

from the let's-go-back-to-basic-math dept

A couple weeks ago, I wrote about all the well-deserved attention being placed on the idea of the economics of abundance. The discussion around that topic, both in the comments and in a series of emails has been quite interesting. Not everyone agrees with the concept, and that presents something of a challenge. It always interests me to figure out what the points of disagreement are in various intellectual debates. Larry Lessig recently quoted Al Gore in talking about the importance of "removing blocks." Basically, the idea is that, when people disagree with you, look closely at the points on which they disagree, and try to figure out why that disagreement is occurring. You can often learn some very interesting things, while challenging your own opinion on things. I am planning a series of posts on this topic, to see if we might be able to clear out the blocks concerning the economics of digital content. To start it off, I'm going to recap the talk (and the reasoning behind it) I gave back in April.

When Jim Harper of the Cato Institute kindly invited me to be on a panel discussion about copyrights at Cato in their Washington DC office, I had a lot of trouble figuring out what I was going to talk about. I had been spending a lot of time trying to understand why there was such a split among folks who prided themselves on having a "free market" or libertarian view of the world -- but who seemed to completely disagree on the economics of content. It bothered me that people who started with the same fundamental toolbox ("the free market is good") would end up at such widely divergent views. On the one side were folks like the Progress & Freedom Foundation, who felt that strong intellectual property laws (including things like stronger protections of DRM) were necessary to build an economy around content. On the other, were folks like myself, Tim Lee and David Levine, who saw that these intellectual property laws were basically government granted monopolies that could hold back economic progress.

As I mentioned in my recap to the panel discussion, I had my "Eureka!" moment on the airplane to DC. While I'd been reading through a bunch of text books on the economics of intellectual property, the history of intellectual property and the history of economics -- none seemed to answer the question of where the breakdown occurred. So I gave it all up, and decided to reread a book I'd picked up at a used book sale a few years back, called "Zero: The Biography of a Dangerous Idea" which is a fascinating history of the number zero -- and the fact that not only did it take societies ages to even recognize the number zero, it was considered heretical in some areas for a while. Zero caused all sorts of problems in that it didn't work like other numbers. It isn't a number. It's the absence of a number, and that screws up a lot of things. For thousands of years, it held back progress. You can't have advanced math or physics without an understanding of zero -- and the difficulty in accepting it was a real problem.

Of course, for all of us who learned about zero in elementary school, this seems laughable. How could zero be such a difficult concept to understand? Except, as I read the book, it occurred to me that it's the exact same problem that was causing this breakdown in the discussion. It's incredibly easy to misunderstand zero in economics. That's because economics, we're often taught, is the "science of scarcity" or understanding resource allocation in the presence of scarcity. All too often, economics itself is defined by scarcity. The "zero" changes all of that. Plugging a zero into an equation that expects a non-zero sends it haywire (think of what happens when you divide by zero) -- and that leads people to think that the equation must be broken. So, for example, basic economics tells you that a free market will push prices towards their marginal costs. If their marginal costs are zero (as is the case with digital goods and intellectual property), then it says that price will get pushed towards zero. However, this makes people upset, and makes them suggest the model is broken when a zero is applied. They see a result where there is no scarcity, and it doesn't make sense to them since they've always understood economics in the context of scarcity.

However, the point is that if you understand the zero, there's nothing to worry about and the model works perfectly. It just requires a recognition that the scarcity doesn't exist. Instead, you have abundance. You can have as much content as you need -- and in that world, it makes perfect sense that there's no costs, because without scarcity there need not be a cost. Supply is infinite, and price is zero. That does not mean, however, that there's no business. Instead, it just means you need to flip the equation and use the zero to your advantage. Instead of thinking of it as forcing a "price" of zero, you think of it as being a "cost" of zero. Suddenly, you've lowered the cost of making something to nothing -- and you should then try to use as much of it as you can. One simple example of this is to use that item that "costs" zero as a promotional good for something that does not have a zero marginal cost. When you realize how zero factors in, you realize that there's nothing new or radical here at all. It's just coming to terms with the idea that free market economics still works in the face of zero (in fact, it thrives) and there's no reason to put in place government-sanctioned barriers to shape the market.

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  1. identicon
    Bruce, 21 Feb 2007 @ 9:15am

    The fallacy of zero

    If you ignore expenses, the marginal cost of everything is zero. So everything should be free. Yeah! Let's sell everything for free. What we lose on individual sales we'll make up in volume. Not.

    Now let's get realistic. Say it costs me $10,000 to produce a record. The cost of the first CD is $10,000 and all others are $1. So what I should do is wait until someone comes along willing to pay $10,000 for that first one so I can recover the cost and then sell subsequent ones for $1. That sounds like a great business model.

    Let's try again. I'll sell all the records for $1. How do I recover the $9,999 in initial expenses? I'll do concerts. Yeah, that's the ticket. It costs me $1000 to rent the hall and I can fit 100 fans. Of course, my competition which only does concerts just charges the fans the marginal cost of the concert, so I have to do that to stay competitive. So I have charge $10 a ticket. Hmm, not only is that not a way to recover my costs, I'm working harder and still not making any money.

    Maybe I'll sell the CDs for $1 and make the CD expire so you have to buy a new copy from me after 30 days. That won't work either. I sell more CDs but I still never recover my initial investment.

    How about I sell accessories that enhance the value of the CD? But I can't price them above my marginal cost (zero again) so that's not a good way to make money either. Selling service plans to help you open that annoying CD packaging won't work either.

    There is a system that works. Amortize the cost of the so-called fixed expenses. Say I buy a CD burner. It has an expected lifetime. It can burn a million CDs before it needs to be replaced. Divide the cost of the burner by one million and that's the cost per CD. If you divide by infinity, you get zero. But infinity is a fiction in this context. Not only is there no infinite supply of anything, there's no infinite demand.

    There's one other thing wrong with the arguments. IP is not a commodity market. Not all CDs are equal. I'll leave that analysis for someone else.

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