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
    Lejacquelope, 28 Jun 2016 @ 4:07am

    We're now entering into a new era that may turn all this on its head.

    It's now 2016 and the fundamentals behind this article's argument are changing significantly. We're approaching the age of frugality-driven "performance over flash." People are seeing through the scams that plague the concept of "value adding."

    "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."

    Actually, the existence of movie piracy does signal a sea change in the conditions that support the assumption of "additional value".

    Take movies. More people do just "consume" a movie. In many cases people just go to the movie theater because that is where they will first get a chance to watch a movie. If they could watch it at home on Day 1, they would. This is why movie theaters fear the idea of simultaneous streaming and theatrical releases: they'd lose huge percentages of what few customers they still have.

    Worse yet they're also hobbled by a lack of convenience. Quite a few consumers out there would be happy to get download movie for free and pop their own popcorn for less money, get a $0.79 two liter bottle of soda compared to $3+ for a 32 ounce theater drink, sit in seats they trust to be clean, and where they can pause the movie to deal with a crying baby, answer their cell phone or go to the bathroom. So they're not only vulnerable to being defeated by "free" but also by its faithful companion animal, "freedom." See, putting a price on something also often comes with the right to control how it is consumed: this especially becomes obvious with non-scarce media goods.

    But there is also a bigger picture. The no-frills market is growing in popularity with Millennials. Actually, it started with Gen-X'ers. And not just in America. See: Tata motors, Dollar Tree, and other ultra cheap no-frills market entities that are thriving. Then there's Amazon which and ebay which are just happy to ditch the entire brick and mortar experience and send you a product, with zero frills, for barely above (or sometimes below) its production cost. The concept of adding value is irrelevant to an increasing number of people - the value is in the product doing what it says it does. This is why people generic medicines are increasingly popular and why name brands and no-name brands alike get more equally (but not totally equally yet) lauded or outright dragged in myriads of customer review sites because of their known performance. Also take note of the rise of lower-priced store-brand goods in supermarkets, and their increasing competitive standing against name brand equivalents.

    Then take Linux. Microsoft, indeed, has done remarkably well in competing against free and open source Linux, but only in the desktop PC market. Linux has decimated (many times over, no less) Microsoft in the server market, and Microsoft's presumed plan to make its Internet Explorer web browser a for-pay software like MS Office, was killed early by free software. Then there's the mobile market, which is now dominated by iOS but also its competitor, Android, which is free. Admittedly the market for the hardware that uses Android has done well in defending itself against FREE: Samsung and its name brand competitors are going strong. (Let's see how that goes, though, when 3D printing makes knockoffs far cheaper to produce.) In the operating system market, competing against free has quite often proven to be a disaster.

    And, devastatingly, nowhere is this more obvious than in the world of employment. Cheap labor is winning out over expensive labor. Hence our astronomical manufacturing sector trade deficit. And even that is giving way to free-per-unit labor aka automation. Wait until people at home can 3D print cars (no doubt more than 50 years in the future) - it will devastate the most popular name brand manufacturers of the day. Free will cut deep into the profitability of non-free as 3D printing matures in efficiency and quality. Even clothing, which is remarkably resistant to "free", will not be immune to 3D printing. 3D printing and open source designs will totally capsize (though not totally sink) the concept of adding extrinsic value to a product for the purpose of higher than marginal prices.

    Make no mistake, adding perceived value to a product will always be profitable to some degree. Mostly the rich will cling to this concept as will those who wish to "keep up with the Joneses". Then there's the status-hungry kids who will want the "coolest" shoes, etc. But as they mature into working class adults, reality will force them to consider frugality and frugality favors free over value-added upselling. People are now increasingly skeptical of the value of brands. More people are aware of the psychological manipulations involved in consumer culture, more people are eco-conscious, and more people want their money to go further. The future calls for "adding value" to be defined as "product Y works better than product X and it costs less too", not "your friends all love product X, you should, too!"

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