Digital Economics: The Zero Marginal Cost Economy

This is a multipart series on digital economics. More here.

The economics of digital products are odd because once you’ve produced the product the cost of making copies is nearly zero. For example it may cost some fixed money up front to record a song, but once you’ve got the final track it’s nearly zero added cost to make duplicates. These odd economics are becoming the norm as digitization takes over larger and larger parts of the economy. So let’s cover this odd zero marginal cost world before digging into particular industries, like movies or newspapers, which will come in later in this series.

Let’s baseline on the economics of traditional factory manufacturing. For example, making nails. You have an up front cost of building the factory. And so the first nail you make has a very high average cost. But as you manufacture more and more nails in your factory, the cost per nail comes down because the sunk cost of the factory and labor are averaged over more and more nails. But also note at some point the cost of making extra nails will start to go back up again. This is because now you’ll have to run the factory at night and pay overtime, or pay extra for supplies that cost a bit more. So the marginal cost to produce an extra nail starts high, drops down, and then rises again as you push the limits. So you get the classic marginal cost curve as below.

For this type of product, the market (barring monopolies) will tend towards pricing the product at it’s marginal cost. If you need a refresher here’s some wikipedia links on marginal cost and perfect competition.

But for digital products the marginal cost decreases indefinitely. Making more and more copies just gets easier and easier with scale. And in this situation market competition the market will tend to drive prices to zero. This is the world we live in now for movies, newspapers, music, software. They all now have this odd economic property of the markets naturally push pricing to zero.

Now if the prices really do go to zero, then of course companies will go out of business. So companies are trying a variety of tricks to make money, even though the core economics tend to push prices ever downward.

There’s really only a couple of ways to deal with this situation:

1. Give up/ecosystem play – give up and make your product free. This only works if your company is part of a larger ecosystem where the free product makes your larger set of products in your product suite more valuable so the cost of subsidizing the free product is worth it. For example the GPS market used to be a normal business where customers paid good money to get a GPS device to use in their car. But Google and Apple have decided to give away free GPS apps on phones to enhance the value to their larger smartphone ecosystems. So this means the stand alone GPS devices are dying out. To the extent they survive they’ll be bundled with the car or with phones.
2. Bundling – in this case you take a package of what by themselves might be very low marginal cost items and sell them together as a bundled unit to make money. Netflix is an example of this, where the convenience of getting a whole package of shows and movies makes the service worth paying for, even though individually the marginal cost of any particular movie or show is close to zero.
3. Freemium/tiered pricing – give away some core product free, then charge extra to hard core users for extras. Tiered pricing has been around a long time of course. Coupons are the classic example of making customers who want to bother pay less, while still charging higher prices to non-sensitive customers. But the freemium model of giving the base product away as the bottom tier was uncommon until digitization. Examples are the NY Times giving articles away for free until you hit a limit per month, at which point you have to buy a subscription to see more. Or apps being free, but you have to buy in-app purchases to get the full usage and benefit of the app.
4. Minimal pricing – the music industry is doing this with 99 cents songs. Just price your product at a low enough cost that for most people that nominal cost is better than piracy. In some sense this is collusion in the industry, but this is such an act of desperation it’s unlikely to trigger anti-trust action. Most phone apps are priced this way as well. At a dollar or two.
5. Advertising – this is a classic, used by radio and TV for decades. The product is free, but you have to listen to ads. The difficulty here is this model is not nearly as valuable on the internet as it was in older media. For example newspapers used to make 80% of their money from advertising, but that’s fallen to 20%.

This post is similar to the “hollow middle” post in that it’s a shopping list, this time of ways to deal with zero marginal cost products. Like I said, we need this baseline before diving into particular industries. So we’ll do that next post, where I think movies are the farthest along the digital path so we can cover them first.

This is a multipart series on digital economics. More here.