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

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  1. identicon
    James Stevens, 20 Feb 2007 @ 9:59pm

    Missing the point...

    Crosbie, you seem to be missing a very important point of Mike's whole series (I hope it's safe to say that).

    You say that the movie producers either stop making movies or they'll collectively agree on ways to get funding. This is simply not true. If there's a demand for movies, there will be suppliers who rise to the occasion to deliver because there's potential for large profit involved.

    Let's say Movie Producer A decides to stop making movies because they can't make any money using an out-dated business model. They decide to completely pull out of a huge market and stop making movies (this seems highly improbable to me). At this point, as long as there's a demand for new movies, other companies use this as an opportunity to become a major player in the industry. They design new business models that make sense for the current/future situation and new movies WILL be created, because that demand is still there.

    On the flip-side, you say if they don't stop making movies, they collectively agree on funding or whatever. Movie Producer A better not use their current business model or they'll be replaced from a profit standpoint by someone else who actually understands the nature of today's content economics. Simple really. They don't catch on, they lose. Someone else wins.

    So it really doesn't matter if the industry stops making movies or does whatever it thinks will help them keep things the way they want them... what's supposed to happen according to economics will happen no matter what, cuz that's the way business works.

    As far as your argument for goodwill goes, I'm not sure you're even on the right track. I don't think we're talking too much about brand recognition and goodwill with this. It's more on the reality that basic economics in certain industries are undergoing change; things are just different than they used to be. Content can be infinitely duplicated and the very basis on which these company's business models was built has changed entirely. Now it's time for the industry's companies to stop dragging their feet and adapt to the change.

    Let's open up an online gambling site and start taking bets for how long it'll be until the Big 4 in music ditch their old business models and realize that this is 2007 and there's this thing called the Internet that makes many things abundant. Go all in with your money and receive double payout by betting on Universal going out of business before they change anything. Now this is good idea, someone better set a site up. But make sure you do it somewhere else besides the USA where horse racing is MUCH, MUCH different than betting on sports. Is horse racing a sport?

    Or who's up for a parody site mocking Universal? We can stress how important it is to include DRM on our CDs so that our customers are happy that they can only burn 3 copies of their CD. And we can even have a section dedicated to sucking up to the RIAA... how file-sharing must be stopped, how Limewire as a program is illegal, how to tell the public they can't do something and then go ahead and do it yourself, a special section demonstrating how to create a double-standard... you know all that bull. Oh wait, we might wanna be careful with this though since we might get sent a DMCA take-down notice even though parody is legal. Still, we might get sued and then be another victim of extortion courtesy of the RIAA.

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