The Failings Of Supply and Demand In the New Economy

I am a pretty big follower of what is going on in what is called the new economy. That is businesses that are based around or based on the internet, and often that deal with what is called content, from movies, music, and software all the way to news, information, or opinion sites (like this one). Clearly, the internet is changing things, but not in the ways that existing business theory can explain properly.

One of the most common refrains is that the internet brings infinite distribution, which can be taken a bunch of different ways. The most common ones are that the internet reaches almost everyone, and as such, allows distribution to any of them for electronic goods. With a large percentage of all of the worlds citizens online, even in places like China, there are certainly implications for the distribution models of almost every company and every sort of product that can be moved this way.

The second way of looking at infinite distribution is used by those who support piracy (or just think it inevitable) as a way of explaining why everything should be free. In business school, one of the first things you learn is the basic law of supply and demand, and how that effects price. If the supply is bigger than the demand, then the price goes down. Their theory is that because an infinite number of copies of things can be made, that we thus have a completely endless supply, and so everything from movies to music should effectively be free. They go on about marginal costs (costs to produce one more unit of a given thing) as now being zero, therefore the market price is the same.

In purely technical terms, those who push the idea are correct. If you run the calculations, the price is zero. However, the real world says that this is not a tenable situation, and therefore either the model is incorrect, or it fails at it’s extreme ends, or there is something else missing.

I think it is that something else is missing. When the costs of distribution come down, when the costs of manufacturing reach effectively zero, those things that make up marginal costs no longer count very much towards figuring out the market price of a product, rending the models useless to explain the current marketplace. When it comes to making movies, almost all of the costs are up front. The actual cost of the seat (at the theater) or the shiny plastic disc (DVD or BluRay) that you buy it on is very low. The marginal cost of another piece of plastic (forget digital distribution for the moment) is so small that it all but unimportant. Move it to digital (hello Itunes) and the cost is only the bandwidth costs to move the product. Very close to nothing. We aren’t even talking pennies.

However, the big up front costs are what drives the new market. A movie that costs 50 million to make has to find a way to make that money back. So no matter what the supply and demand curves say for price, the reality is that a chunk of that original cost has to be written into the price of each unit to make it work out. If they expect to push 5 million units, they have to have at least $1 per DVD or movie ticket just to break even. So no matter what supply and demand says, the minimum selling price is still $1.

Now, piracy comes in and pretty much blows it all up. Pirates don’t pay the dollar, but they do shrink the potential market by offering a free alternative to the real thing. Piracy (especially P2P torrent style) has near perfect infinite distribution, and absolutely no up front costs to create the product. So if you look at THIS market, then yes, the product is free. They don’t have to pay to make it, they aren’t paying for distribution or copying (the users do that, and those costs disappear into their monthly ISP bills), and they certainly don’t have to worry about any regulation. They can give it away for free because it doesn’t cost them anything to be there.

Piracy is pretty widespread right now, and if it ever reaches a certain tipping point level, it will very quickly kill off the movie and music industries as we know them. The funny part is that in doing so, they will also kill off the very supply of the material that everyone wants. There are no first year economics formulas to explain shooting yourselves in the foot!