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Is Our Future Really $0?

May 13, 2008

Tags The EntrepreneurFree MarketsValue and Exchange

[An MP3 version of this article is available for free download.]

Chris Anderson, editor-in-chief of Wired magazine, is a well-known business guru in the world of online commerce. His reputation has its source in the classic article, "The Long Tail," and in a book developing the same idea.

It should not be surprising, then, that a more recent article by Anderson (another article destined to become a book) has been received with great interest by the Internet community.

This new piece is provocatively entitled "Free! Why $0.00 Is the Future of Business." Its main idea can be summarized as follows:

  1. The marginal costs of the underlying technologies of the Internet — storage capacity, process capacity, and bandwidth — tend toward zero.

  2. In a competitive market, prices equal marginal costs, and there exists no market more competitive than the Internet.

  3. Consequently, prices of Internet services will tend towards marginal costs, and eventually be zero, that is, free for the users.

  4. As more and more industries are entangled in the Internet, this trend will pervade the economy.

Starting from this main idea, Anderson elaborates a taxonomy of "free," in which he identifies six categories of business model:

  • "Freemium": It is the traditional free-sample model, with the difference that, in the digital world, the cost of providing free samples is virtually nil.

    In the freemium model, that means for every user who pays for the premium version of the site, 99 others get the basic free version. The reason this works is that the cost of serving the 99 percent is close enough to zero to call it nothing.

  • Advertising: an audience is built by supplying free content; access to this audience is then sold to advertisers. It's the usual model for broadcast television and radio, but with vast new possibilities on the Internet.

  • Cross-subsidies: A product is sold at a price below its costs, and then this loss is compensated with sales of products complementary to it, e.g., free parking at the supermarket.

  • Zero marginal cost: for those goods which can be freely distributed through the Internet, like music or software.

  • Labor exchange: the user receives something free in exchange for completing some tasks for the provider. Anderson's examples of this model include the rating of stories on Digg and voting on Yahoo! Answers.

  • Gift economy: in Anderson's words, "we are discovering that money isn't the only motivator.… In a sense, zero-cost distribution has turned sharing into an industry."

Unfortunately, a proper economic analysis of Anderson's ideas does not allow us to share his optimism regarding the future — at least, not on this issue.

Prices and Marginal Costs

Again, the starting point for Anderson is this: in a competitive industry, prices tend towards marginal costs. Of course, this is not true.

Firstly, as James Buchanan shows, the tendency is just the opposite: it's the marginal costs that are made equal with the prices by adjustment of the supply.

Only prices have objective, empirical content; neither the marginal evaluations of the demanders nor the marginal costs of the suppliers can be employed as a basis for determining prices. The reason is that these are both brought into equality with prices by behavioral adjustments on both sides of the market.

But, secondly, this equalization would only happen in the long term, and provided that everything remains the same. That is, there can be changes neither in technology nor in the preferences of consumers. These are the conditions to achieve the "evenly rotating economy" that Austrian economists refer to in order to better understand the functioning of certain economic aspects. In the long run, it may well be that prices and marginal costs are equal, but only if there are no changes whatsoever during the process. That seems quite unlikely in the case of the Internet.

In the short term, price exclusively depends on the preferences of individuals and on the available stock; there is no dependence on costs. So, there is no direct relationship between the price of a good and its marginal cost.

But, finally, even if we were to accept that prices have converged to marginal cost, it must be noted that this cost is of no relevance to the decisions of the capitalist. Anderson himself refers to this:

But tell that to the poor CIO who just shelled out six figures to buy another rack of servers. Technology sure doesn't feel free when you're buying it by the gross.

Of course, the marginal cost of one megabyte of hard disk may be very low. The problem is that storage is not sold in one-megabyte chunks, but in much larger units, which, in the end, amount to big investments. Goods are not infinitely divisible, and so it does not make much sense to talk about marginal costs as a guide for pricing.

Entrepreneurs providing storage or process capacity on the Internet are not able to buy marginal units; they have to make big investments in order to provide those resources. And if they do not recover those outlays, they will have to leave the market, sooner than later.

So Why Are Storage, Process Capacity, and Bandwidth Given Away for Free on the Internet?

As explained, prices depend on individual preferences and on the available stock. With regard to the referred goods, it can arguably be conceded that supply on the Internet is nearly infinite, at least relative to the current demand.

In those conditions, price is bound to be very low, even negligible, so that it may not make sense to try to charge for services. Transaction costs might exceed revenues.

Now the question is, of course, why there is such a surplus of these goods associated with the Internet that their price has been driven to nil. Have Google, Yahoo!, and their shareholders gone mad?

This excessive stock is precisely the result of the business models carried out by these firms. The analysis of their structure of production reveals that it is neither storage nor process capacity nor bandwidth that they sell, but something completely different for which a price can be charged and collected.

Google offers us free use of their search engine and other web applications. Why? Because that is how Google attracts our attention to its advertisements. Google doesn't sell its online services to us; it sells an audience to its actual costumers, the advertisers. Google is buying our time and selling it wholesale. As time is a scarce resource, and time (and attention) demand is increasing as a result of fierce competition on the Internet, Google has to pay us ever more, according to the law of diminishing returns. This payment is made not in terms of money, but as storage and process capacity. That's why Google keeps increasing its "free" offering to us, its providers, in terms of, e.g., storage capacity for e-mail accounts.

If this does not prove to be enough, it is likely that these firms may start paying money in exchange for our time. According to Anderson's economic analysis, this would mean that marginal cost is now below zero, which is completely absurd.

Anderson's intuition is right when he refers to "news scarcities," the ones of attention and reputation. As has just been explained, it is precisely the competition for these resources that seems to explain this trend to "free" services in some Internet business models, and not the existence of marginal costs reducing to zero. (But one can hardly refer to the scarcity of time as something new: time has always been a scarce resource, and will stay this way until humans become immortal.)

One last comment: Anderson seems to think that the lowering of prices for Internet technologies is a natural phenomenon driven by technology or by researchers, e.g., Moore's Law. On the contrary, it is the market drawing on current technology. It is the competition for offering more storage and processing in the fight for our time that propels the technological advance, not the other way around.

On the Taxonomy of "Free"

Some of the business models identified by Anderson in his taxonomy deserve further assessment, because they hide economic fallacies.

For example, "labor exchange" is clearly not free. One individual performs some work in exchange for some service. There is a barter payment for that work, but still, there is a payment. In this exchange, money is not involved, but that does not make it free.

Regarding "marginal cost zero," Anderson refers only to distribution costs and completely forgets about production costs. It may well be the case that the outlay for distributing a song or a film through the Internet is nearly zero. But it will still have to be produced. How are the composers to recoup the resources (time, ideas) invested in developing the product?

If, as Anderson says, "music is not a moneymaking business, it's something [musicians] do for other reasons, from fun to creative expression," it is certainly grim for the future of the music industry. A musician cannot devote resources to his music just because online distribution is free.

Of course, music may be offered for free through the Internet (it is already happening), but this is not because of distribution cost being equal to zero. Most likely, it will be a case of "freemium" or cross-subsidies.

The "gift economy" of Anderson is neither new nor surprising. In the theory of exchange, the revenues and costs to be considered are psychic revenues and costs, not cash. Gifts can easily be explained by taking this into account. If the satisfaction of giving something away is higher than the actual revenue provided by direct use (i.e., the cost), the individual will proceed to donate it. Of course, for an outside observer, this cannot be explained just by looking at the cash flows.

Final Remarks

In summary, there is no such thing as a "free market" as envisaged by Chris Anderson when he concludes, "zero is one market and any other price is another." If the price in a particular market seems to be zero, we are looking at the wrong side of the market.

It has been shown that price only equals marginal cost in the unlikely "evenly rotating economy," in which no changes happen. Moreover, the concept of marginal cost is not relevant when making investment decisions, because these are not infinitely divisible.

The reason why some goods are given away for free in some markets has no relation to any hypothetical notion of "marginal costs tending to zero." In fact, those supposed free goods are "given" to us in exchange for our time and attention. As time is an increasingly scarce resource, its value is steadily rising, in terms of storage, processing, and bandwidth.

With time rightly identified as a scarce resource, economic theory is needed to understand the interchange process. And there is no place for the "freeconomics" of Chris Anderson. Better luck next time.

 


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