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
    Darryl, 14 Jun 2010 @ 9:50pm

    Its NOT all about PRICE - Price is way down the list - U dont know that ?

    Mike you basing your assumptions on wrong facts, that is probably why you ommited any examples to support your claims.

    Your first mistake is the assume, the value of something is based on the cost of it, and its scarcity. That price alone is the only motivation for competition.

    What industries, have been forced by competition to sell their product at margin ?

    Does Nike have lots of competition, massive pressure from competition in fact, yet Nike shoes are very expensive, and popular, and not scarce.

    Clothes, same deal, huge competition and price is not the primary factor, and product is sold high above margin.

    So competing itself means you may compete on quality, price, value, support, good will, social standing, availability, form, function, innovation, look, feel the list is endless.

    Usually price is somewhere down the list of the most important thing when making a purchase, the first thing you decide is "is it going to do what I want it too", do I trust the people I buy it from, will there be someone to call if something goes wrong, and so on.

    May by price is a factor, but its NOT the primary factor, if it was everyone would only purchase the very cheapest of anything available, so it would be the cheapest car, cheapest house, computer, phone whatever.

    But they dont, do they. You know people will buy the best they can afford, that does what they want.

    Next to me here is my $2000 canon EOS 450D digital camera kit, I could have purchased a much cheaper camera, even a much more common camera, but price was not the deciding factor for my purchase, it was quality, functionality, support, and compatibility. Sure, I could have purchased a no name $50 digital camera, still takes pictures.

    But it would be NOTHING like my EOS 450D.

    For most purchases people make, its not price that determines their purchase, therefore its not price that companies compete on, its function, quality, support and so on.

    And in the case of "file sharing" its what you are willing to pay for the legal copy of the movie, book and so on and the value is not in the price of the data, but the quality of the data (good movie or song).

    People dont desire things that are cheap, they desire things that do what they want them to do, and that actually work, and has a quality and security of purchase from a known source (good will). (ie, i trust canon more than I trust 'jo_backyard_reverseengineering.)

    So your entire argument is based on a false premise, that markets are purly price driven, when clearly that is not the case, (and practically not the case).

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