The Grand Unified Theory On The Economics Of Free

from the have-fun-with-it dept

Ok. I'll be the first to admit that I've taken the long way around in going through my series of posts exploring the economics of goods when scarcity is removed. What I had thought would be a series of 5 or 6 posts, turned into something much longer -- but each week people came up with new questions or discussions or objections, and so I tried to spend some time digging down on various pieces of the economics at hand. However, what I haven't done is tie it all together in one single spot. In the last couple of weeks there's been tremendous confusion among people from Scott Adams to CNN to various others that have made it abundantly clear that the one thing I've failed to do is put the whole concept together in a single place. That's resulted in people being confused about what I'm actually saying -- where they only pick up a tiny piece of the argument or confuse it with the arguments made by others. So, while I still think it was important to go through the details, now is as good a time as any to pull the whole theory together (with some links back to the previous articles in the series).

First off, and this is key, none of what I put forth is about defending unauthorized downloads. I don't download unauthorized content (never have) and I certainly don't suggest you do either. You may very well end up in a lawsuit and you may very well end up having to pay a lot of money. It's just not a good idea. This whole series is from the other perspective -- from that of the content creator and hopefully explaining why they should encourage people to get their content for free. That's because of two important, but simple points:
  1. If done correctly, you can increase your market-size greatly.
  2. If you don't, someone else will do it correctly, and your existing business model will be in serious trouble
If that first point is explained clearly, then hopefully the second point becomes self-evident. However, many people immediately ask, how is it possible that giving away a product can guarantee that you've increased your market size? The first thing to understand is that we're never suggesting people just give away content and then hope and pray that some secondary market will grant them money. Giving stuff away for free needs to be part of a complete business model that recognizes the economic realities. We'll get to more details on that in a second.

From a high-level perspective, though, the reason that giving non-scarce products away for free will increase your market size goes back to the same Thomas Jefferson quote that we kicked the series off with:
If nature has made any one thing less susceptible than all others of exclusive property, it is the action of the thinking power called an idea, which an individual may exclusively possess as long as he keeps it to himself; but the moment it is divulged, it forces itself into the possession of every one, and the receiver cannot dispossess himself of it. Its peculiar character, too, is that no one possesses the less, because every other possesses the whole of it. He who receives an idea from me, receives instruction himself without lessening mine; as he who lights his taper at mine, receives light without darkening me.
What Jefferson noted is the wonderful feature of a non-scarce, or infinite, good that it is effectively a free resource. Once created, it costs nothing to give to someone else, and you still retain the original. In fact, economists have finally realized that this is the very key to economic growth and progress. The infinite resource known as an "idea" that improves what was already there is what increases the size of a market. Or, putting it another way, that infinite resource of a new idea makes an existing scarce resource more valuable. It's easy to understand that when it's an idea applied to, say, a machine making it more productive -- but it also applies to any infinite resource appropriately bundled with any scarce resource.

The way it works is actually quite easy and fits in with the same basic economics that's always been in place. Knocking down the barriers of artificial scarcity opens up tremendous new opportunities -- just as knocking down the artificial scarcity known as "protectionism" helps to grow markets by creating new opportunities. In this case, those new opportunities have only increased in number as we've gone digital, making more content infinite in nature. Where some people have trouble is that those new opportunities may be in different places than the existing opportunities -- and those new opportunities may not all be capturable by the creator of the content. Indeed, there will be some externalities created by the free flow of an infinite resource. However, the total amount that any content creator can capture is still much larger than it was before. It's one of those cases where getting 20% of a huge pie is much better than getting 90% of a tiny pie.

You just start by redefining the market based on the benefits of what you're providing, rather than the specific product you're selling. If you're focused on selling the benefits, then discovering a better way to sell those benefits is seen as a good thing, rather than a threat. You then break down the different components that make up those benefits that you're selling -- and you begin to recognize that every bundle of goods and services that make up the benefit you're selling has components that are scare as well as components that are infinite. In fact, if you look closely enough, you realize that any scarce product you buy actually has infinite components while any infinite good you see also tends to have scarce components.

Once you've broken out the components, however, recognizing that the infinite components are what make the scarce components more valuable at no extra cost, you set those free. Not only do you set those free, you have every incentive to create more of them, and encourage more people to get them. You break them into easily accessible bites. You syndicate them. You hand them out. You make them easy to share and embed and distribute and promote. And, yet, all the while, you know exactly what scarce resources those non-scarce goods are tied to, and you're ready to sell those scarce resources, recognizing that the more people who are consuming the infinite goods, the more valuable your scarce resource is.

So, the simple bulletpoint version:
  1. Redefine the market based on the benefits
  2. Break the benefits down into scarce and infinite components.
  3. Set the infinite components free, syndicate them, make them easy to get -- all to increase the value of the scarce components
  4. Charge for the scarce components that are tied to infinite components
You can apply this to almost any market (though, in some it's more complex than others). Since this post is already way too long, we'll just take an easy example of the recording industry:
  1. Redefine the market: The benefit is musical enjoyment
  2. Break the benefits down (not a complete list...): Infinite components: the music itself. Scarce components: access to the musicians, concert tickets, merchandise, creation of new songs, CDs, private concerts, backstage passes, time, anyone's attention, etc. etc. etc.
  3. Set the infinite components free: Put them on websites, file sharing networks, BitTorrent, social network sites wherever you can, while promoting the free songs and getting more publicity for the band itself -- all of which increases the value for the final step
  4. Charge for the scarce components: Concert tickets are more valuable. Access to the band is more valuable. Getting the band to write a special song (sponsorship?) is more valuable. Merchandise is more valuable.
What the band has done in this case is use the infinite good to increase the value of everything else they have to offer. They've increased their marketsize by recognizing how they can use the infinite goods as a free promotional resource and made the value of the overall ecosystem around them more valuable. Rather than playing small shows in tiny clubs that don't pay very well, they get to play large venues with bigger covers. It's certainly true that there are some externalities -- where some people will enjoy the music for free without ever taking part in paying for the scarce components. But, when done right, you've increased your market so much that it more than covers the difference. Compare this solution to that of a band that sticks to the old way: they are then limited in the audience that will hear them -- especially as more and more bands give their music away for free. Fewer people will be interested in going to their concerts or buying their merchandise or joining their fan clubs -- when the benefits are so much greater for following other artists that actually give their music away for free. The end result really is a much bigger market with much greater benefit by expanding the market by using infinite goods to make the scarce goods more valuable.

So there you have it. After many months, one single summary of the economics of "free" and how it can be used to anyone's advantage. It's not about defending unauthorized downloads. It's not even about getting rid of copyright -- just recognizing that copyright holders can actually be better off ignoring their own copyrights. It's very much about showing the key trends that are impacting all infinite goods -- and pointing out a clear path to benefiting from it (while making life more difficult on those who refuse to give up their old business models). And we're giving it to you all... for free. So, enjoy.

If you're looking to catch up on the posts in the series, I've listed them out below:

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  1. icon
    Mike (profile), 3 May 2007 @ 10:48pm

    Re: Re: Re: Some Problems with Mike's Model

    Mike, you are so far out from reality that it is hard to figure out where to begin to pull you back from Never Never Land

    Well, I appreciate you trying, though, dropping to the level of insults seems like an odd teaching technique.

    This is not 1998, Mike. Your BS does not hold water anymore.

    Weird. The business model I'm discussing goes back well before 1998. It's really basic economics. The same that Adam Smith taught... Do you actually think that protectionism is a better policy than the free market?

    But the most basic hole in your whole theory centers around your basic misunderstanding of economics and business:

    Ok. I'm willing to learn where I'm wrong.

    Trust me on this, Mike. I have a Masters degree in economics from a good university and I have worked in the field and in business research for 15 years, for companies big and small. I was a student in the second graduate level course in existence on the economics of the Internet. I have worked on websites and marketing them and their digital products and services since 1994.

    Thanks for posting your resume. That, alone, of course, doesn't mean that you're right.

    Fixed cost DO matter.

    Wait, wait, wait. I never said that fixed costs don't *matter*. I said that they're not involved in pricing pressure. In your graduate level economics courses they must have taught you that at some point. Marginal cost is what influences price. This makes sense if you think about it logically. If the market is competitive, then there will be pricing pressure. You either differentiate or you lower price -- and you're always willing to lower price down to marginal cost eventually, because you can still make some money on each sale up to that point.

    Of course, where many people (even those trained in economics) get confused, is they view this as a static, rather than dynamic market. What's happening all the time is that the producer is trying to differentiate, perhaps even by making production cheaper (lowering the marginal cost). However, with infinite goods, you simply can't lower the marginal cost, so focusing on selling that particular item is going to get you into trouble eventually. What I'm describing is a way to get around that problem, and to use the zero marginal cost aspect as a *resource*. That is, it's about using it to your advantage.

    What I think you're trying to say (and I agree) is that you have to come up with a business model that will later account for recovering the fixed costs. I don't disagree with that and I'm sorry if you thought I said to totally ignore fixed costs.

    That's not what my model is intended to say. What it's saying is that the pricing pressure on infinite goods is going to be pressured to zero -- and it's as simple as the basic P = MC equation you must have learned at some point in your life.

    But, you obviously still want to recoup the FC, and you do that by differentiation. Right, that's how any business makes money, by basically creating a *temporary* monopoly. That allows you to charge above MC for the time being. What I'm saying with this series is that you use the *free* infinite good to create that monopoly for the scarce goods. That's how you profit and that's how you make up returns that are greater than the fixed cost. In fact, because you're using the free good to enlarge the market, it makes it even easier to recover the fixed costs (and more).

    But you have to recognize the fundamental market that you're dealing with.

    I can point to at least 200 examples of companies that used your basic model in the 1990's and tanked.

    Really? I don't think there are that many. There were a bunch of companies in the 90s that used "free" things, but they didn't fully embrace this model. They didn't know which things should be free and which should be charged for. In fact, most of the "free" companies that I remember got the model ass-backwards, giving away the scarce things for free and trying to charge for the non-scarce.

    So, please tell me which companies focused on the model?

    God, I hope I have never invested in any company that has listened to you!

    I'm sorry you feel that way, though I'll also note that you didn't respond to any of my other points earlier. Each point you made that supposedly disproved my model didn't actually do so. You seemed to confuse the scarce components with the infinite.

    Anyway, you don't have to believe that my model works, but if you only invest in companies that fight the tide, then I would suggest your companies are going to face a lot of challenges. But, that's something we'll discover eventually.

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