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
    out_of_the_blue, 23 Sep 2013 @ 8:48am

    Re: Re: Classic Mikeness! COMMENTERS BEWARE!

    @ Mike: what you say up there is:
    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.
    As I've said often, you put up a huge "IF" and re-inforce it last sentence. The market for movies is NOT competitive NOR have "sunk (or fixed) costs" already been recovered: that's your totally artifical condition never found in reality, so NONE of what you wrote there holds true! OBVIOUSLY you cannot recoup the $100 million AT ALL! In practice, you can't recoup a $100 million ten cents at a time, either: even if your "sunk (or fixed) costs" are zero, you just simply can't get enough people to watch! And yet Mike holds this illustrates some great principle!

    Visitors, read this again slowly; Mike sez: "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" -- The KEY point is that Mike has already made the $100 million of "sunk (or fixed) costs" just VANISH so that he can focus on marginal costs! Nothing to do with price, he says, let alone needs to be recovered. Just read from #53.

    Another key LIE is that Mike treats physical goods the same as digital distributed movies (his "infinite goods notion), as if the costs for those are at all comparable. Bear that in mind when reading, because Mike always squirms away when I've pointed out the misleading juxtaposition: his notions don't apply to physical goods. (THOUGH, he's tried telling me that because Wal-Mart gives away free manufacturer's samples, it proves his notions apply to real goods too...)

    Mike's latest counter is trivially stupid in saying that all movie tickets are priced alike, when they're not, even for initial showings, and further, MOST of the "box office" take AT a movie theater goes TO the theater itself, which pays a probably FIXED RENT for the movie TO its distributors.

    Mike now sez: "The cost to make the movie does not factor into the pricing of the ticket." -- YES, that's because theaters don't just hand over ticket sales to distributors: theaters take a RISK on every movie and keep any excess (after their own "sunk (or fixed) costs". That's where the flexibility is.

    AND then there's the follow-on market, where one can rent the movie from local store or off Netflix. -- Whether ticket prices at a theater are fixed is irrelevant!

    You've only constructed another deliberately misleading example because leaves out key facts like where most of the ticket price goes.

    I'm not the only making these objections, MIke. Anyone who troubles to read all here finds plenty of objections and NO answer from you except more hedging and assertions of authority. #53 begins a crucial weakness that you've let lay since Feb 16th, 2007, where you wrote:
    I disagree. I hope that soon I'll be able to show why there will always be the opportunity to recover the fixed costs (though, it still depends on execution, which doesn't always happen).

    SOON, Mike? IT'S BEEN SIX AND A HALF YEARS! You CANNOT patch up the MAJOR HOLES in your assertions!

    [By the way, is it any wonder that I'm RUDE to Mike? He's just dodged with more Classic Mikeness! I assume he didn't expect me to check here again..]

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