Approaching perfect competition? Thoughts on the limitations of digital content pricing

From Why the Web will gut paid e-books and apps, and why free can pay for authors and publishers:

Selling digital content at any price above zero is not sustainable: the Web is cheaper for readers, cheaper for writers and publishers, and far more discoverable and shareable than the squabbling hermit kingdoms of e-books and apps.  For both authors and publishers, the best strategy is to distribute for free and find another way to pay the bills.

This post got me thinking a little bit about the pricing of ebooks. Essentially, the author’s argument is that, since the marginal cost of ebook production is nil, market forces will (eventually) force publishers to give away ebook content for free. That is, publishers who do charge for content will not survive due to the barrage of free content providers with alternate revenue schemes.

This is thought provoking, but not entirely correct. I believe the post goes astray by confusing price with economic profit. If the post were to argue that publishers will be forced to earn zero economic profit, I might agree more.

Let me qualify that. “Economic” profit is not “accounting” profit (i.e. total revenue minus total cost). Economic profit refers to any profits earned in addition to those that are needed to offset the opportunity cost of the primary stakeholders. So if you are exactly covering your costs, and making exactly enough to live, you have zero economic profit. If you could do better spending your efforts elsewhere, you are in the red. The textbook example of an industry where each firm earns zero economic profit (referred to as an industry in “perfect competition“) is hay farming. Hay is a homogeneous product, and any hay farmer can sell as much hay as they would like at the prevailing market price but no single farmer can affect that price. If the price goes up, economic profits may be earned in the short term, but the higher price draws more competitors to the industry until economic profits again fall to zero in the long run.

Of course, digital content is nothing like hay–it is far from homogenous. If an individual hay farmer attempts to sell his hay at $6/bail when the market price is $4, he will sell zero bails. This is not true for a publisher, who has different styles and qualities of content that cannot be provided by other firms, and thus has some market power. And so the publishing industry can be characterized as what economists call “monopolistic competition”–an industry with heterogeneous products for which there are many substitutes. Depending on which type of content you provide, there can be relatively few or many substitutes for your product, and your content may be more or less distinctive from other products.

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Industry modeling has limitations, but nonetheless can provide insight to how goods and services are priced. The key factor in this model is the uniqueness of content. For example, a news website that offers more or less the same quality and information as a thousand other sites will not be able to command a high subscription fee (if it can charge a fee at all). Conversely, The Economist can charge a higher price because it is more specialized, branded, and well-reputed. Customers across all industries pay for things like specialized products, brand name, and good reputation. The implication is the wider the availability of similar products, the lower margin any firm can feasibly ask for.

The post I mentioned above argues that neither of these firms will be able to charge for their content. In the long-run, all content must be given away. Au contraire. While run-of-the-mill content or perhaps new authors might be best suited by allowing free content downloads, publishers with higher quality, more specialized products will certainly be able to command a positive price margin–as long as there is a market for their products.

But the question is, how high of a margin might they charge? Too high of a margin will draw new competitors into the market, and too low of a margin and all of a sudden you’re going under.

And now we’re coming full circle. Patokallio (the author of the post) argues that free content from the internet will “gut” paid ebooks and apps. This is certainly true–for the ebooks and apps that have many substitutes and offer more or less homogenous content. As the availability of free content on the web increases, this tier of publishing will start to rely on other revenue streams to keep going. Publishers will have to find a way to cover the costs (advertising, associated product merchandising, etc), but will probably only earn a very low margin–or, in other words, zero economic profit. The “perfect competition” model provides insight here.

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But now the margin on specialized sales is being driven down too, to the point where they may begin to resemble perfect competition as well. The downward-driving force is piracy. I can tell you from real life experience on a college campus that bootleg etextbooks are definitely available. Computer software is the same deal. Of course, not everyone is willing to be a pirate. Many people willingly pay. But it is intuitively easy to see that the higher margin publishers charge, the more people will resort to piracy. Thus, piracy exhibits downward pressure on price-cost margin, even in specialized niche markets.

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So, again, the ultimate balancing act is, what margin can I charge for content? The answer is, a higher margin for content with fewer substitutes, and a lower margin for content with more substitutes. Our dilemma here, aptly pointed out by the aforementioned post, and expanded upon slightly in this post, is that margins are being driven down across the board–regardless of the level of heterogeneity! This is a big problem for publishers, who once enjoyed some degree of monopoly power over their content, and are now being driven to a level of the barest subsistence–zero economic profit!

Sounds like a boatload of bad news. I have two tidbits that might brighten your day, and maybe you already knew them. The first thing is that lower economic profits for firms directly translates to higher consumer surplus for customers. That’s right, at least the customers are benefiting. This might not seem like much consolation to publishers, except that as price margins go down, the substitution effect takes place. Thus, a cheaper price for content means that more people will purchase it, and then publishers have some opportunity to make up for lost price margin with increased volume. In a way, lowering price is like paying for marketing. Profits will probably still decrease, but more people will be reading ebooks, so you might count that as a win!

The other tidbit is that specialized publishers and authors should survive the “web gut” pretty well. Price margins may be driven down by piracy or other free content, but people will always be willing to pay for content they put a high value on. This is good news for the small publishers who serve a more specialized market. The narrower the market, the less price elasticity, and the higher margin that can be charged. Big publishers would also be wise to segregate markets into the smallest parcels possible. Specialization and division of labor–principles dating back to Adam Smith–should be of some use here.

To sum it all up, the equilibrium price for some ebooks and apps will be free, but certainly not for all of them. However, piracy and the availability of substitutes put serious limitations on how much publishers can charge for content. Publishing profits should be shrinking, and volume should be increasing. That’s my prediction for the medium-term.

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6 Comments

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6 responses to “Approaching perfect competition? Thoughts on the limitations of digital content pricing

  1. jpatokal

    Excellent post! Broadly speaking, I agree with what you’re saying: in the short to medium term, there definitely are some authors/brands who can charge money for digital content and get away with it, and that’s why I subscribe to the digital edition of the Economist myself.

    That said, I’m not sure that will stay true in the long term, although this could easily take a generation or more. I’ve “migrated” onto the digital Economist because I’ve been a paid-up reader of the print version for years and it’s comparatively cheaper to get to boot. However, when newsstands and bookshops go away, awareness of printed brands will plummet, and paid online content will be much less discoverable than any free alternative. Traffic and branding power will thus migrate to the free options, and when faced with potential readers who have never paid, the Economist will suddenly have a very uphill battle trying to convince people to upgrade from $0/year to $150/year.

    We’re already seeing a reflection of this with e-books, where the demographics for the average e-book reader (age 44) are much more in tune with the demographics of the average book reader (age 50) than the average blogger (21-30yo). This is why I think it’s in the publisher’s and the author’s best long-term interest to target both audiences and figure out a business model that does not rely on paid content.

    • SamT

      Again, I half agree with you here. It certainly seems as if one day the mass-market pbooks we pay for now will be freebies on an ereader. But paid content will never disappear–not even in the very long run–because authors create content with actual value, and people will trade money for it.
      Consider this: you are extremely interested in something obscure, say, fashion trends of British nobility in the 17th century. There might be a handful of authors EVER who have written on this subject (or maybe more? i am unburdened with that knowledge). Your not likely to find that author in the “free downloads” section of your Kindle–not now, and I’d venture to guess you won’t find it on there 100 years from now. For such a specialized subject (the key point is, there aren’t any substitutes) there will be no alternate revenue scheme like pay-per-click advertising. People will need to pay for highly specialized material, always, because otherwise the market would not exist.
      I like your point about branding power transferring to whatever is free–but again i see it as incomplete. Sure, most people won’t pay for an email account anymore, they just use gmail or yahoo or whatever free service. And these have become the major, mass-market brands for people who could use just about any email system satisfactorily. But just because the majority of people use free services doesn’t mean there is no market for, say, high-security email servers. People who want extra pay extra, and they will always be willing to do so. I gladly hand over $1.50 when I shout ‘put extra bacon on it!’
      The only way I see EVERYTHING becoming free is a mass subsidization of authors. And in that case, call me an author.

      • jpatokal

        In the physical book world, the author writing about an obscure topic like British fashion trends in the 17th century and hoping to get paid for it has only one option: write the book, try to flog it to a publisher, and hope the publisher can find enough paying readers. Needless to say, this is pretty risky for everybody involved.

        In the digital world, there’s a more sensible option: the author can set up a Kickstarter or equivalent to sign up interested people who are willing to pay. Once he has enough funding, he can go ahead and write the book, and once it’s completed the book can be released and distributed for free. Much less risk, better distribution, and the author gets paid.

      • SamT

        I think what you’re describing is a completely viable business model. But the monopolistic competition industry model–which I have argued describes the publishing industry–is characterized by many business models and a diverse array of products. Perhaps the free approach will dominate a certain subsect, but to say that one business model will dominate them all seems apocalyptic.

  2. jpatokal

    Using the word apocalyptic there seems a bit apocalyptic. 😉 But there will be inevitable market pressure away from paid content into free content, and I simply think that succeeding by swimming against the tide will be harder than going with it.

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