The Erosion of Price Due to the Pervasiveness of “Free”

When it comes to any product, there are costs involved in its creation.  For things such as cars or waffles or underpants, part of that cost is purely in raw materials.  Each of these items is a physical good, requiring actual matter to create.  The same is the case for items like DVDs, books, CDs and videogames. The difference in these verus the formerly mentioned physical goods, however, is that the vast majority of their primary value (the reason that someone actually wants them) can be replicated digitally, without raw materials other than those that are typically already possessed by people, such as free space on a hard drive. Their primary value is information, and as such it can be broken down into simple bits and bytes and easily distributed for minimal cost.

The other portion of the cost that both of these types of items have is the cost of actual manpower to create.  There’s someone designing the underpants, just like there’s someone writing and performing the music. This even includes if a waffle was made by some sort of automatic waffle maker – that automatic waffle maker was created by manpower (or the robots that created it were created by people who programmed the robots). Or, if the music is completely computer-generated, someone created the computer program that allowed the music to be created. If a person’s time or talent has value, then creation has a cost.
 
The point I’m trying to make here is that everything has some sort of cost involved in creating it. Nothing is free to create.
 
With this cost come questions for creators. Do I pass any of that cost on to the consumer? What is my purpose for creating?  What is the price of my creation?
 
If any of the reason for the creator is monetary, then there must be some price to be paid by someone for some aspect (no matter how vaguely connected) to your creation.  If it’s not monetary, then what did you create it for?  Was it simply to better the human race?  Perhaps it was to strengthen the acceptance of a cause you feel strongly about. In both of those cases you’re at least charging the cost of a person’s time to consume your creation. There are plenty of creations out there that fall into all of these camps, and a lot more.  As such, there’s a lot of competition out there.
 
The easiest way to compete in business is by offering a lower price. If you are okay with assuming your time, knowledge, talent and effort are worth nothing monetarily, then it’s easy to offer your content for free.  With millions of people creating content today, a percentage of them are willing to offer their creations for free, and that percentage of a lot of people turns out to still be a lot of people. So what we have is a lot of content for free, competing with some content with a price. How does one compete with free?
 
Again, the easiest way to compete is by offering a lower price – and there’s no lower price than free – so instead, many individuals compete with free by offering free, plus something else for free (in an example of an e-book, think of an e-book but with a free bonus podcast).  So what ends up happening is that free competes with free in an effort to increase consumption. To what end that consumption is encouraged is up to the creator or distributor, but the battle right now lies ultimately in consumption.
 
If we back up to the cost of a creative work, however, the vast majority of that cost really is in time, effort, talent, skill and knowledge. Costs exist, but in our previous world where bits and bytes were not free (or nearly free), they cost raw materials to reproduce.  People actually paid for a physical object.  The fact is, however, that what they paid for was much more than the cost of the raw materials – it was the cost of the raw materials, plus all those skills, efforts, hours and smarts (put into an equation of expected sales volume, marketing costs, etc) that made up the price the consumer paid.  The consumer, however, placed their value on the physical product that they paid for, rather than the information or aesthetics that were portrayed via those physical media. When someone paid $15 for a CD, they said they paid $15 for a CD … not $15 for the music that Nirvana recorded and distributed to individual listeners for a cost that was below the actual cost of recording the music but was hopefully made up for (with little left over to pay for food) via volume.
 
Due to this idea of paying for the physical product rather than the creation within, it was easy for us to start viewing the actual media itself as the item with a price.  Therefore, when the media was no longer required and the new distribution options had little cost (I’m already paying for Internet access, why should I pay to access things via my Internet access) it was also easy for us to feel that the creations really weren’t something we should start having to pay for.  We didn’t pay for books before; we paid for the paper they were printed on and the shipping and the store shelf space.
 
The price was nothing. In the world of music, the new digital price actually started as nothing. The music industry wasn’t first to start offering their music online, but instead it was people – people who had been trained to think that the music itself really wasn’t what one paid for. After all, one doesn’t pay for the radio. So what happened was that by distributing music for free from the beginning, an anchor point was set for music to be worth nothing.  The fact that the music industry was very slow to respond with any sort of model on their own only reemphasized this idea.  The price at which music was available online was zero. There was no alternative – or if there was, people didn’t know about it.
 
A really simple explanation of the way pricing works is as follows: Costs are determined and volume is estimated. A profit goal is set. The minimum price should be equal to your total cost + your total profit goal, divided by volume (or units). Or, as a mathematical equation:
 
(Total Cost + Total Profit Goal) / Units = Price Per Unit
 
In today’s world of a digital economy, however, one can easily be led to believe that volume is potentially unlimited. Since the costs are only up-front for a creation that is distributed digitally (that is, the only costs are those costs to create the work in the first place – replication has no cost), and volume is unlimited, price can be set almost to zero and the profit goal can still be met, even as the profit goal reaches infinity. But if the profit goal is zero, and a lot of people have no profit goal (or if they do, they are assuming they can make a profit through another channel, perhaps through speaking engagements, branded automatic waffle makers, etc.), they can easily set their price to zero.
 
So when the monetary costs of raw materials are virtually zero, and one is willing to value their own time and work monetarily at zero, we end up with creations that are priced at zero. With a small percentage of a lot of people doing this, we end up with a lot of people pricing their content at zero.  There are also a lot of people pricing their content at prices much higher than zero. But regular people (consumers) are seeing a lot of stuff priced at zero. They then ask, “what’s with these people asking for monetary compensation?”
 
What happens is a product or service is set at a price, and if enough items are priced at that level for a long enough time, people accept that price as the price of the item. For example, if a pair of pants typically costs $70 at Banana Republic, one then assumes that a pair of pants at Banana Republic is worth $70. When the pants are on clearance for just $40, it’s a great deal – even though a pair of pants at JC Penny might only cost $40 normally.  By JC Penny setting their price at $40 normally they’ve set the value of their pants at $40 – so for their pants to be a great deal, even if they’re exactly the same as the ones at Banana Republic (in this example let’s just pretend they’re the same), they need to drop the price considerably. 
 
The same was the case with CDs – when they cost $18 at Sam Goody and Best Buy started offering them for $12, Best Buy had the better deal. Suddenly $12 was a great deal – but over time, $12 started to become normal (the anchor point) and $18 seemed overpriced.
 
When music was offered for free online, an anchor was set. Other media, such as books or movies, was also susceptible, but didn’t catch on at the speed music did.  By the time the music industry was ready to compete they had to deal with this anchor, as well as the anchors they had set via the physical model.  A digital download of a song had some value, they argued, but that value was also less than the cost of a CD divided by the number of songs on it, since a CD also had physical raw material costs involved. As such, $.99 sounded like a fair price.
 
Still, more and more music is being offered for free – but this time it’s being offered for free by the bands, labels, etc. This is because, as I stated earlier, the easiest way to compete is by setting your price to free. By doing so you have set no barrier to entry other than the time it takes the user to download, the time it takes the user to listen (if they even do is another question) and the tiny bit of space it might take up on their hard drive if they save the song (which nowadays they don’t, since streaming is ubiquitous).
 
Of course, this phenomenon is not unique to music, but has expanded into all realms of content that can be recreated and distributed digitally. What’s happening though is that with more and more creations being set to a price of zero, the anchors are moving as well. Over time, the expected price for most creations will be zero.  This is the issue that the newspaper industry is battling now – and it’s the reason that Rupert Murdoch is setting up a pay wall for the Wall Street Journal. He has decided that his content has value – the work his journalists do has a cost – and their knowledge and expertise is actually worth something. This is why he’s charging – he’s attempting to reset the placement of the anchor.
 
Where anchors are set is purely subjective. Anchors are a battle of what creators want to be compensated versus what other creators are willing to sacrifice for their work. They’re a battle of what goals the creators are attempting to accomplish – is it to make money or to make a difference? Where they end up being set is ultimately a choice left to those who create, and what their goals are.
 
Whether consumers are willing to pay the prices asked is really a question of whether or not they have a cheaper alternative with a perceived value higher than the cost they paid.
 
But remember: the easiest way to compete is by offering a lower price. It doesn’t mean you’ll win the competition.
For further reading on the topic, check out this article by Monica Valentinelli. 

This is a cross-posting from William F. Aicher‘s site.

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