The Media versus Marginal Cost

If you have two companies producing the same product then, over time, the price to the consumer will eventually start to hover just above the incremental price of each additional product.

Not the price it costs to produce products — but the price it takes to produce one more product.

Say, for example, you have two newspapers in the same town producing almost indistinguishable products.

And it costs, say, $1 dollar to print and distribute one additional newspaper.

The newspapers charge $2 for the papers — $1 goes to cover the marginal costs, and the rest is divided between fixed costs and profit. By fixed costs, in this context, I mean the money it costs to produce the first copy of the newspaper — the salaries of the editors and reporters, the rent of the newspaper building, the capital costs of the printing presses.

At some point, one of the two newspapers will decide to try to grab market share from the other one and lower its prices. Say it drops its price to $1.50 while the other newspaper doesn’t. If the two have equivalent content — and readers don’t have any particular loyalty to one over the other — everyone will switch over and the $2 paper will go out of business. To keep that from happening, the $2 paper will also lower its price to $1.50.

In a free market, the two newspapers will continue to lower their prices until they can’t go any further without losing money or making the profits so low that it’s not worth the effort.

In practice, of course, one newspaper will buy out the other and enjoy monopoly pricing — it can decide how much to charge so as to maximize revenues from its geographical area of coverage.

So what happens when there is no additional cost to produce a new copy of an item?

One example of this that we’re all familiar with is television and radio broadcast.

If you’re living within the coverage area of a television station, it doesn’t cost the station anything extra to beam the program to you. Cable television companies have to lay new cable. But not broadcast stations. They put up the antenna, and everyone within range can listen in.

Radio and television stations could, if they wanted, charge their audience members. They could encrypt their broadcasts and sell decryption boxes to individual subscribers.

Say one station charged its viewers $10. Another station, with equivalent content, charges only $5. After all, it’s already paid for the antennas and the journalists. Either the other station matches the price cut or it goes out of business as everyone switches over to the cheaper one.

The two stations will continue to lower their prices until they’re just above the marginal cost of each new subscriber — but that marginal cost is zero.

And, in practice, terrestrial radio and television stations give away their programming for free, and use advertising to offset their fixed costs of production.

So what about online media?

The incremental cost of each new website visitor is pretty close to zero. There are fixed overhead costs — servers, content, staff.

If two websites offer equivalent content, then traffic will inevitably flow to the one that charges less money, since customers aren’t total idiots. Eventually one of these websites will figure out how to bring in enough advertising revenues to cover its fixed costs, and give away content for free, as radio and television stations have done for decades. The for-pay websites will have to do the same or go out of business.

The main exception to this, of course, is monopoly content. If, for example, mine is the only website to offer Dilbert cartoons, and the public really wants Dilbert cartoons, then I can charge whatever people can afford to pay. But this is only as long as I maintain the monopoly. The minute I start allowing other sites to reprint Dilbert cartoons for, say, a fixed licensing fee, then those other sites can lower their prices and we’re back in a competitive landscape.

Apple is able to charge more than its marginal costs for its products because it controls the distribution network for a very popular product with unique content. As soon as that content is available elsewhere — say, through Android-based alternatives to the iPad — it will quickly start losing market share to lower-priced alternatives.

Music, software, books, and movies are three types of content that used to have marginal costs. It cost money to print DVDs and books. It cost money to get them into stores. It cost money to hire clerks to sell them. With electronic distribution, the marginal costs of these goods are zero.

We’re already seeing out-of-copyright works available legally, for free, on electronic distribution networks.

Movies and music are already available for free on television and radio and to a limited extent on the Web. This will only grow as licensing deals spread and companies figure how to how to use advertising revenues to offset fixed licensing costs so that they can get the content to the biggest audience.

I predict that we will soon see free, ad-supported electronic books, starting with the publishers’ back catalogs and out-of-print titles.

Software is already moving to a free model, with enterprise products like Google Apps, and free-to-play games that make money from selling in-world virtual goods.

Any company in the business of producing virtual goods has to think about either offering hot, in-demand monopoly content, or finding out a way to distribute it free.