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
    MyNameIsMatt, 16 Feb 2007 @ 11:00am

    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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