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
    Jamil, 16 Feb 2007 @ 7:46am

    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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