Competition, Profit Rates, and Freeness

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Having read some excerpts (e.g.) from Chris Anderson’s Free and also Malcolm Gladwell’s takedown review, I think the whole subject could stand to benefit from a little less good writing and a bit more plodding distinction-drawing. There’s a basic valid point underlying what Anderson is talking about. In a competitive market, the price of a good ought to converge toward its marginal cost of production. And in a digital universal, the marginal cost of production is close to zero. In other words, there are fixed costs involved in creating a blog post or a song or a film or a piece of software, but the cost at the margin of distributing the good to a new consumer is almost zero. Anderson adds to this shopworn piece of economic knowledge, the insight from behavioral psychology that while people react similarly to a price of $10.15 and $10.25, human behavior when faced with a price of free is quite different from human behavior when faced with a price of ten cents. Consequently, when market competition starts pushing prices down to nearly zero, someone will realize they can gain a huge competitive advantage by pricing the good at free.

Where Anderson goes off the rails is in his suggestion that this “give it away” business model is actually a promising business model. Gladwell demolishes some of Anderson’s examples, but the problem with Anderson’s argument is completely theoretical. The convergence to marginal cost of production is predicated on the idea that you’re operating in a highly competitive marketplace. But the thing about operating in a highly competitive marketplace is that it’s impossible to make tons of money by doing this. That fact tends to get obscured in popular discussion of business in the United States, because we (or, perhaps I should say, because journalists who want to make money getting corporate speaking gigs) are very invested in a heroic model of capitalism in which wealthy entrepreneurs get rich through their competitive awesomeness. In reality, the reason that competition is good for customers is that it destroys profits. The way you make real money is by getting into situations where you’re insulated from competition. A license to operate a bar in Adams-Morgan is like a license to print money—no new bars are allowed to operate, and restaurants that make too much money off booze are getting shut down. On a grander scale, Microsoft has been able to entrench its position through “network effects” and price key software way above its marginal cost.

As sectors turn to a Free business model, they’re just going to become way less lucrative. That doesn’t mean the sectors will vanish. Nobody makes a fortune running a dry cleaning business, precisely because dry cleaners operate in a highly competitive marketplace. But dry cleaning services are very widespread, and customers benefit greatly from the fact that it’s relatively cheap. But the mere fact that dry cleaning is very successful as a technique doesn’t mean that the dry cleaning business is a good business to be in. Consider the case of YouTube, which Anderson labels a quintessential example of Free. Gladwell points out that YouTube actually loses money—it’s a terrible business. But what’s really noteworthy about YouTube, to me, is that as it exists it’s actually competing with several other, also Free, also money-losing video services. But since Google as a whole can easily afford to cover YouTube’s losses, it’s hard to see the percentage for Google management in shutting down a market-leader, or in destroying its position by trying to charge people to use it. But conceivably YouTube will just operate indefinitely as a money-losing subsidiary of a large profitable firm. And since it’s there losing money but not going out of business, it will probably be impossible for any competitors to ever beat it. And if YouTube does go out of business some new money-losing free video site will become the market leader as long as there’s some investor out there somewhere who believes, wrongly, that he’s smart enough to figure out a way to make money out of this thing. Meanwhile, as the underlying technology gets cheaper the scale of the losses should get smaller, making it ever-more-realistic to run the business at a loss and thus ever-less-likely that the money-losers will be driven out of the market and create the possibility for monopoly rents.

That’s the real lesson of Free. The combination of competition, the near-zero marginal cost of production, and the psychological significance of the zero bound means that the market-leader in video is bound to lose money. To win the market, you need to make your product Free. But while your marginal cost is near-zero, it’s not actually zero, so you’re losing money.