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Why does marginal cost matter?

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One of our regular discussion points is the importance of recognizing the marginal cost of a good in determining the competitive forces that will impact pricing.  Why is marginal cost so important to understand?  Why isn't total or average cost as important?
initiated May 17, 2011 in Economics by Mike Masnick (22,930 points)   59 99 160

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Marginal cost is especially important in today's technological landscape because the marginal cost of digital data is precisely $0. This is why it is economically unwise to build a business model around the assumption that you can charge people for no-value-added digital data that can be duplicated perfectly at zero cost (i.e. pirated).

It's not impossible to make money doing it, but it's difficult and unpredictable because it requires you to convince people that a $0-marginal-cost copy is actually worth more than $0.

It is far more prudent to build a business model that relies on other value-added services which cannot be duplicated at zero cost. There are a whole host of ways to do this, depending on what you're trying to sell and who your market is, but the core idea is to create something unique and finite to add real value to your products.

If your business will fail unless piracy is stopped, then you need to rethink your business model. Depending on arbitrary IP laws to bend fundamental rules of economics in your favor is not a recipe for success.


response added Oct 12, 2011 by Jeff Rowberg (270 points)   1 1 4
@jrowberg Sometimes the added value may not be where you think it is.

A chap on an ebook oriented website I'm involved in talked about his usage.  He uses an Amazon Kindle to purchase and read ebooks.  He's tech savvy, and knows where to look for pirated versions of the books he wants to read.  He doesn't bother.  Using the Kindle, he can browse Amazon's extensive catalog, select a book, make a purchase, download a copy and begin reading immediately in a couple of minutes with a couple of keystrokes.  Getting a pirated copy would involve searching for one, finding what is hopefully decent quality version, downloading from a questionable source, and quite possibly having to do a format conversion to get something he can read on his device.

He places a value on his *time*.  The value add from Amazon is the incredible convenience, and he's willing to pay for it.
@dmccunney That's a good point; convenience can have a tremendous value for a lot of people, since it saves time and effort. Amazon, Apple, and Netflix all provide extremely valuable convenience that would allow them to make some money even if books, music, and movies were legally free.

However, as technology improves and bandwidth and storage costs fall, the perceived value of that convenience will drop. It won't disappear, but it will make it harder to compete with piracy. It won't always be as difficult as it is now to find some particular book, song, or movie online. Once we reach or cross the point where average consumers feel like finding a free pirated version is no harder than using legitimate paid channels, then we'll still have to find ways to provide something unique and scarce along with the infinite component of the product in order to expect a profit.
@jrowberg I think the basic question is how you perceive the market.  Zero marginal cost for the producer does not mean zero value for the consumer.  

The consumer wants something badly enough to go looking for it.  It has value to her.  I may be a starry eyed optimist, but I happen to think the market will pay for value.

I've been involved in discussions elsewhere about the value  of Digital Rights Management in preventing piracy.  I see it as having *no* value.  I have seen no DRM scheme that wasn't cracked immediately after release, and once a copy has been liberated, the horse is out of the barn.  (And Amazon's DRM scheme isn't about preventing piracy - it's about locking you into Amazon as the vendor.)

You successfully sell and make money in the digital marketplace by *providing* value, pricing appropriately, and making it as easy as possible for the consumer to find you and give you money.

Providing value requires knowing your market, and what is valuable to it.  So does pricing appropriately.

But ultimately, piracy is a nuisance, not a disaster.  I worked in retail a long time ago, and we had the issue of stuff that disappeared from shelves without a sales receipt to account for it.  We called it shrinkage, and we did what we could to limit it, but somehow we survived and even prospered.  I think the same will hold true for piracy.  We'll see.
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Marginal cost matters because it defines the competitive landscape.  That is, if the market is competitive, price will get driven to marginal cost, because it makes economically rational sense to get there.

For example, if you make pizzas that cost $8 to make, but you normally sell for $20, if someone else starts selling equivalent pizzas at $12, you wil likely be pressured to drop your price to at least $12, or below if you want to beat the competitor.  The competitor then will need to drop prices to stay competitive as well.  The equilibrium price if the market is competitive will then be at the marginal cost: in this case $8.

Of course, the complaint against this is that it is an unprofitable state.  If you're selling at marginal cost, you don't make any money and you don't cover your fixed costs.  And, that's true if the discussion ends there.  But it does not.

There are a variety of ways to deal with this situation, and the simplest answer is that you seek out areas in the market where things are no longer competitive.  One way to do this is to decrease your marginal costs.  Thus, if you can now make pizzas for $6 and your competitor still has to make them for $8, you can sell your pizzas at $7.99, still profit, and your competitor can't compete.

Another option is to increase value and differentiate your offering.  Perhaps you can invest a little in improving the ambiance of your restaurant, such that the competition is no longer direct.  The overall benefit to consumers is such that they're willing to pay a premium.

A third option (related to the second) is to figure out ways to bundle solutions.  Sure, the pizza may be priced at marginal cost, but perhaps you can also sell drinks at above marginal cost, and can bundle the two in compelling ways such that you profit on the overall bundle.

The real issue in understanding the marginal cost issue is so that you recognize where there's a true competitive market, and recognizing what will happen to prices in that market, and using that to seek out ancillary markets where you have some sort of competitive advantage and can profit.

response added May 17, 2011 by Mike Masnick (22,930 points)   59 99 160

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