Thursday, January 10, 2008

#FREE - is Marginal Cost relevant?

I was dusting off a few old economics textbooks this weekend to try and get my head around this idea of Marginal Cost Pricing - where the next unit of a good is priced at its Marginal Cost.

In the dismal science that is Economics, Marginal Cost (MC) is what it costs to produce one more widget. So if making one widget costs you $20 but making two costs you $25, the MC of the second widget is $5. In perfectly competitive markets with beautiful supply an demand curves, the market price of that second widget is also $5.

This is all well and good. And I can understand the basic rationale behind the model (Wikipedia has a page in it here). However, it seems destined to run into problems in the digital world.

Back when Marginal Cost pricing was theorized, products had physical inputs - it was ALWAYS going to cost you x to produce an EXTRA unit. In the digital world, the short run MC of a good is always zero. It costs almost NOTHING to reproduce ones and zeros.

Using this model, as Chris Anderson does in explaining FREE, all digital goods should be priced at $0 (or close to it). Not too sure if I buy this. I don't think you can take a theory based very much in the physical world and declare it valid in the digital one. You've just ripped the entire manufacturing and production process out of the system and replaced it with.... nothing.

It will be interesting to see if he (or others) address this issue as his book idea unfolds.

Personally, I prefer the arguments around abundance driving price low rather than Marginal Cost. Marginal Cost is heavily distorted in a digital market. Especially when the cost of reproduction to the CONSUMER is also zero. Things just get too messy.

Imagine a world where all Marginal Costs were zero and consumers could replicate all goods for nothing? You wouldn't have any incentive to produce anything. I wonder if that's how some music artists feel?

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