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. icon
    Mike (profile), 15 Feb 2007 @ 3:01pm

    Re: Thoughts

    While I've really liked your articles, I do have a few issues with this one. Sunk and Fixed Costs are different things.

    Jamil, you're absolutely right. I was simplifying by lumping fixed and sunk costs together -- because it was easier to explain that way, but they are different (though, sometimes overlap). However, for the sake of the model I was describing, the sunk costs and the fixed costs were nearly identical. That's not always true, as you point out.

    A perfectively competitive situation DOES NOT drive the price down to the marginal cost. For example, you factory costs you $10,000 a year in leases, and a $1,000 a car. In a perfectively competitive market, if the price was driven to $1,000, you wouldn't cover the $10,000 lease, and go out of business. Therefore, a perfectively competitive market covers MC+(FC/units). If unit sales are infinite, then FC would go to zero, but this is never the case.

    I think you're mixing up a few concepts here. Perfect competition absolutely does drive price to marginal cost. In the example I gave in the post I was assuming that all of the fixed costs were sunk -- that there was no lease to pay, just it was all paid up front. But in your example, you get the basics right, but miss the overall point. If the lease costs a certain amount and there is perfect competition then YES, the company will go out of business. But that's exactly what the model says will happen.

    The way to avoid going out of business isn't to just "price the product at some price higher than marginal cost, but less than value," it's to add value to the product such that you can do so. If you are just selling a commodity offering, you won't be able to increase the price much above marginal cost because you'll have no differentiating value. So in the example you're using, what happens is the factory works on differentiating its offer to justify the higher price.

    Additionally, sunk costs are a red herring. Sunk costs are useful in decision making, as they cannot be recovered. But they can often be thought of a fixed cost (just convert them to a perpetuity fixed cost). If not, then someone is eating this loss. Therefore, if someone is forcing you to sell at zero, you are eating all fixed costs.

    No, you're getting confused again by assuming perfect competition is an absolute. It's not. It's a force, but the whole point of this article is that companies continually innovate to differentiate away from a perfectly competitive market -- and that's where the value (and money) is. So you don't eat all the fixed costs because you come up with other ways to differentiate and that's where you earn back the fixed costs.

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