The Sexy But Dangerous Economics of Digital (Tech Strategy – Podcast 173)

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This week’s podcast is about digital / information economics.

You can listen to this podcast here, which has the slides and graphics mentioned. Also available at iTunes and Google Podcasts.

If you’re interested in talking digital strategy and transformation for your business, contact us at TechMoat Consulting.

Here are the digital economics concepts:

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Related articles:

From the Concept Library, concepts for this article are:

  • Digital Costs
  • Pricing / Versioning
  • Willingness to Pay / Consumer Surplus

From the Company Library, companies for this article are:

  • n/a

——–transcription below

Welcome, welcome everybody. My name is Jeff Towson and this is the Tech Strategy Podcast where we analyze the best digital businesses of the US, China and Asia. And the topic for today, the sexy but dangerous economics of digital. Now, for those of you who have been listening for let’s say two and a half years, I’ve actually talked about this before but it was about three years ago and it’s super important. And I kind of realized, you know, it’s, you know, maybe you should bring this up again because there’s a whole lot of people that obviously weren’t there two and a half years ago. So I thought about why does the economics of information, it used to be called the economics of information in the 1990s, textbooks about this, blah, blah. And then it sort of became known as the economics of digital. But it’s, you know, basically when your business goes digital, it could be a digital native like e-commerce. It could be a traditional business that’s going digital. which is pretty much all of them, as that happens, the economics of the business start to change. The more it’s about software and bits and bytes as opposed to factories and products, the economics change and then the business models change. And it’s a big deal. This is software eats the world. Okay, well, it’s important to understand how the economics of software are just completely different. And they’re awesome. and they’re also pretty brutal, hence sexy but dangerous. Like you can grow dramatically, which everyone loves, but the truth is most software companies make no money, which is kind of important. So I thought I’d go through basically three to four concepts that if you get these, you got it. You don’t need to read the big textbooks, although they are pretty good. But if you get three to four concepts, you got it. So I’m gonna go through that relatively quickly. And let’s see, also because I’m in a hotel in Paris and I got a check out in about 45 minutes. So that’s probably helpful for me, so I don’t drone on. So anyways, we’ll go through this pretty quick. Let’s see, standard disclaimer, nothing in this podcast or my writing or website is investment advice. The numbers and information for me and any guests may be incorrect. The views and opinions expressed may no longer be relevant or accurate. Overall, investing is risky. This is not investment, legal or tax advice. Do your own research. And actually, I forgot one thing. For those of you who are interested in doing sort of a tech tour in China, we’re ramping the next one up, which is gonna be in November. If you’re interested for that, in that individually or for your company, maybe your management team, go over to Tecmo Consulting. You can see, or just contact me directly and we can talk about it. But yeah, we’ve been doing that this year. It’s absolutely fantastic. That’s coming on the horizon. So if you’re interested, reach out. Okay. Let’s get into the content. Now, as always, we start with a couple concepts. And big surprise, these are about digital economics. So three concepts for today, which are always in the concept library on the web page. Digital costs, at the point of today. Pricing and versioning, big, huge, important topic. And then, let’s say, willingness to pay consumer surplus. So that’s kind of three different concepts. The language is not helpful. They’re kind of vague. A lot of the language in this area is kind of really unhelpful, but you kind of got to know it because it’s important and everyone uses it and there we are. So those are the three concepts for today. And I’m going to put these all in one slide. There’s one JPEG, which is in the show notes on the webpage. And basically all of this is listed there. The one slide has the concepts you need to know. And we can put those into digital costs versus the other stuff, pricing, versioning, willingness to pay, consumer surplus. So we start with digital costs. It’s just software is weird. It’s such a strange thing once you move from things from the physical world to things that are ones and zeros on a screen, it’s just a different world. And the one everybody always talks about, there’s really three to four things to think about in terms of digital costs, digital economics in that sense. The one everyone always talks about is zero marginal production costs. So production costs, what does it cost you to build a digital good or a chair? Or if it’s a service, what does it cost you to cut someone’s hair? Production costs. And then you think about the marginal production costs, which is… What does the next one cost you? Often setting things up for the first time, the initial production cost can be significant, making a movie, but the marginal production costs, making a second copy can be very, very low. And in digital, it’s basically zero most of the time. So you spend $200 million to make the Avengers movie. You make the first copies, $200 million, and then to make the second copy, it’s literally zero. It’s Control C, Control V, you got another copy. Now, there’s nothing else in the world like that in software. If you make tables and you got to make another table, it costs you some money, it takes you time and effort and labor and blah, blah. Services, same thing, you cut someone’s hair, you diagnose, it’s all… But once you move into software and economics, digital information… The zero marginal production cost is just this strange, strange thing. And it’s a big deal. And usually what you need to think about is the initial, what’s the cost of the first version, the first product, and then what’s the cost of the second one. And even the first one gets a little complicated because you think, oh, you spent $200 million to make the first copy of the Avengers. True, but in most cases, not most cases, in a lot of cases, digital goods and services, people kind of do it for free. So yes, in some cases, you’re actually writing big checks, but if it’s someone just writing a book on their laptop, they’re not really… So even often the first one can be close to zero depending what it is. If you’re coding in a… in a dorm room like Facebook, okay there was a cost to the first version of Facebook but was there really or was it just a couple people in a dorm room writing? So even that’s not totally clear. And then you think, okay what happens after you make the first version, then the second one, the third one, the fourth one, the cost there is zero but you have to factor in the initial cost. But even that, people don’t do that, because often once you’ve paid for the first version, they view it as a sunk cost. So that’s kind of mentally erased anyways. So across the board, it tends to be close to zero for a lot of digital goods. Most apps on your phone, that’s why they’re free. So there’s that idea. So even when you think about the marginal cost, it’s important, but when you think about the first one, and then you think, okay, who made the first one? Was it made by an individual in a dorm room? Was it a studio writing big checks? Or was it created by the cloud? Or the crowd, let’s say, the wisdom? Is it a bunch of people just writing on Wikipedia for free? So even that first cause can be very strange. Now the best of all business models, well not the best of all, a great business model, is if you can capture the value. of the second and third cost, but avoid the first cost. Which is really what Facebook does, right? They don’t produce content, the first step, but they share the content. They do the Control C, Control V. So the newspapers and the magazines spend all this time and money writing articles and making videos, and Facebook avoids the first step. But when it’s shared and shared and shared and shared, the marginal, zero marginal productions, they capture the value there. It’s really pretty awesome. So, anyways, think about that. That’s kind of the first one everyone talks about with software. The other one, oh the other point to make here real quick. I’m talking about bits and bytes, software, digital goods, a copy of a movie, a copy of a book. That’s not the same as all digital goods. When you move into AI, what you realize that there are new costs that we don’t have in what is traditionally software. You write a piece of software, maybe you update it every year, you blast it out. originally on CDs, now you download it. AI as a service is much more labor intensive on an ongoing basis. You can’t just deploy the model and leave it. You have to keep retraining it. You have to keep cleaning the data, tagging the data. When it starts to deteriorate, you have to fix and retrain. So there’s a lot more labor costs in AI than say traditional software. I’m talking about traditional software. That’s point number one. Next sort of idea under digital costs is the low cost of distribution. People like to say there’s zero distribution cost with digital. Hey, you can just put your book up on your webpage and anyone can download it. Zero distribution cost. Not really true. This is one of these ones where like the word distribution is really about the physical world. So there’s cost to putting things in warehouses and then getting them to store shelves and putting them on trucks, distribution goes. The whole concept of distribution doesn’t really make sense online. So I don’t think it’s the right way to look at it. I look at it more like consumer connection or customer connection. Like you have to actually create a connection with a customer to deliver the good to them. And while there’s no cost in the distribution aspect of shipping it or emailing it, there is significant cost in accessing customers, in getting their attention, in getting past gatekeepers. So there is actual cost there. If you’re going to distribute digital books, sell digital books, guess what? You’re going to pay 30% to Amazon. Actually, it’s more than 30% because they keep, they really sort of keep raising the rates with all these little tricks. on Amazon. It’s not cheap to distribute books on Amazon anymore. But there is an aspect of distribution connecting with the customer online which is inherently different. It’s like publishing. The concept of publishing doesn’t really make sense in the digital world. It made sense when you actually had printing presses and you worked and you figured out the type, let’s say a newspaper, and then you physically publish it. There’s no real publishing in the digital world. You just click upload. That’s published. So same with distribution. The concept doesn’t really work in the digital world very well. But people talk about it all the time, so I put it on there. A third bit here, cheap and fast scalability without real capacity limits that you can, businesses, goods, services based on digital economics, bits and bytes, not people, not… molecules and physical things, you can grow really easily, cheaply, quickly. You know, there is no difference between selling your book to 10 people, your digital book, and selling it to a million people. There’s literally no difference. That’s pretty unusual. So everyone who’s in software wants to go for growth. And the other aspect of that that’s important is you don’t have a capacity limit. In everything else in life, business-wise, if you’re going to triple your production of chairs, your factory is going to run out of capacity and you’re going to have to build another one. If you’re doing consulting and you want to do ten times as many projects, you’re going to need to hire more people. There’s no real capacity limits for a lot of digital stuff. You may have to buy more servers at a certain point if you’re doing something like cloud or video which takes more storage, but you know, most software is not really the case. You know, usually companies, as soon as they go into digital, they get very excited about two things in terms of the economics. They get excited about, hey, let’s get bigger margins because we don’t have any costs. Okay, and then let’s grow really fast because we don’t have any costs there for growth. So, you know, no production costs plus easy scalability, people get excited about that. And it almost never happens in practice, almost never, which I’ll talk about. Third concept, and this is the weird language, rival versus non-rival goods. You’ll hear this all the time by economists, rival versus non-rival. I don’t really like this term, but you gotta know it. Non-rival goods means multiple people can use the same product or service at the same time. You can watch the Avengers and I can watch the Avengers at the same time. If I buy a seat on an airplane, you can’t sit on that seat for that trip. It’s a rival. If I’m eating an apple, you can’t eat the same apple. But we can both use the same software, we can both watch the same video, so companies like TikTok and Netflix, that’s a real benefit as opposed to people who grow apples. They have to grow the apple, it can only be used by one person and it can only be used one time. You make a movie on Netflix, everybody can watch it at the same time, perpetually. That’s not unimportant as a factor, it’s a pretty big deal. Life is a lot easier when you have… you can create something once. You make one hit pop song in 1995 and people listen to it for 20 years. That used to be a pretty good business model now, it’s not so good. Okay, when you think about all these things, I think that’s enough for this. Yeah, so in terms of digital costs, four concepts to think about, zero marginal production costs, low distribution costs, cheap and fast scalability without capacity limits, and non-rival goods. That’s pretty much what you need to know. And I did a podcast a month or so ago about intangible assets, which I think about all the time. Whenever I look at companies and I look at the balance sheet, I mentally try to think about what are the intangible assets that aren’t listed there that are important, because all of those have digital economics. Right, if you’ve got a bunch of IP. that has basically digital economics. It’s considered information, now we call it digital. So that’s worth thinking about when you wonder how important this is. So that’s kind of, I think the first bit, a lot of that is attractive. It’s very sexy, people get excited about it. And then they, you know, they do it software and they do digital businesses and most people don’t make money. That’s the dangerous part. And so, I used to ask students all the time, why are things on the internet free? Because as far as I know, in the rest of life, you don’t get stuff free. When I walk down the street, people don’t walk out and say, hey, would you like to have this for free? Maybe they give you a sample to try and tease you in, but they don’t just give you services for free. Maybe the government and public goods and there’s parks, okay, there’s a little bit, but generally that was a very weird, but most things on the internet, it’s like, hey, it’s free. And not just once, free. This software that I’m using to record this is called Adacity. I have never paid them anything. Like I’ve been using it for three years. I have yet to pay them. I spent more on coffee this morning than I did on this company over the last three years. That’s crazy. Most apps on your phone, you didn’t pay for. The clock, the notes. Now you could say some of that’s baked into Apple or whatever, most things in the app store are free. at some level. So how do you make money in life if you’re charging things for free, being profitable and capturing big margins, how is that supposed to happen? And that’s sort of the problem. That’s why I call this talk sort of, it’s sexy but it’s dangerous. Anyways, that’s sort of the next point which I’ll get to and that’ll lead us to the other two concepts which are pricing and versioning and then willingness to pay in consumer surplus. So that’s kind of the next topic. Okay, now standard economics is when you think about the price of a good or a service, you generally look at the marginal production cost. You kind of look at two factors. You look at what your competitors are charging, what’s the market price for this, and then you look at your marginal production cost. What does it cost for me to make one more apple? Not what I, no, not what did I spend. on the factory and the farm 10 years ago. No, the price pretty much stays close to the marginal production cost. This next Apple cost me a dollar. My competitors are charging a dollar 15, I’ll charge a dollar 12. And that’s usually it. In simple products and goods anyways. Okay, fine. But I just kind of said, look, the marginal production cost for digital stuff is zero. So if the marginal production cost is zero, what’s the right price? It’s supposed to be close to that. And it kind of turns out, yeah, that the right price for most digital goods and services is zero or very close to it because that’s the thing. And then on top of that, you know, you get price wars. People who create software, they perceive it as a sunk cost, so they’re willing to sell it for an extra nothing. A lot of this stuff is commodity. So when you start to try and price software, digital goods, content, videos, you can’t really do cost-based pricing or you don’t want to really. So you look at competition, well, that’s bad too because everybody and their brother can write a book on their laptop now. So there’s a sea of competition for books and videos and all of that. So that’s bad as well. And what you end up having to do is, okay, you either accept that you’re not going to be able to make any money off your digital goods and services, which is fine. That’s a good strategy, actually, I think. And so maybe you do YouTube videos and you pair that with an e-commerce site. And this is more marketing and reach and customer acquisition in your digital side. And then the e-commerce business where you sell physical goods and stuff, that’s where you make your money. You know. I do consulting, that’s where I would earn money, but podcasts and things, I don’t even look to make money on a lot of this, some, but not very much. Okay, so you can accept that this is a zero margin activity, a zero profit activity, because the price is basically close to zero. Or you try to price based on the perceived value to the customer, and then you’ve got to have a competitive advantage. So there is a perceived value that I can measure or assess by the customer, and then I have to have some sort of barrier so that I am not exposed to competition that’s gonna naturally drive this down to pretty much zero. So that’s what you need. So, how do you sort of assess perceived value? Usually people talk about willingness to pay. They like Photoshop. They think it’s cool, but a lot of people aren’t willing to pay for it, but there’s a select group of people, like professional photographers and content creators, who are willing to pay for it. Generally you’ve got to look at willingness to pay. That’s kind of the number that matters, but that’s assessment of perceived value. And then you try and… there and your cost structure is gonna be significantly lower and that will work as long as you have a competitive advantage. You never want to be in anything digital, software or whatever, without a moat because it’s gonna drive to zero. That’s why almost all the apps on your phone can’t charge anything. And I’ve heard Silicon Valley people talk about this all the time like don’t do anything in software without a moat. Just don’t do it. You can look at sort of famous software companies and like Microsoft was always 50% of the profits. So you have this sea of companies doing software but only a handful of companies were making all the profit because everyone else was getting pushed to zero. Okay, so you focus on willingness to pay perceived value, that’s how you determine price. And then the concept that goes right along with that. is versioning. Because what is the perceived value to me versus someone else of a company like Audacity, this software for recording podcasts? Well, it’s very different. What is the perceived value of watching the Avengers movie the weekend it comes out versus six months later on streaming or whatever? Well, it depends on the person. This is perception based. segment customers based on their different perception of value and willingness to pay. And you can’t really do that with shampoo because you’re not going to make a thousand different types of shampoo but you can do that in software. So pricing and versioning go hand in hand. We should create multiple different versions of this digital good or service and then by offering multiple versions the customers will self segment. based on their willingness to pay. The power user who’s a professional photographer, we wanna create one version of Photoshop for them and price it at $120 a month. But the students who use Photoshop for whatever, we wanna make it cheap or free because they have a different willingness. So if we create multiple versions of software, which turns out it’s easy to do, you can optimize against various willingness to pay and that’s what companies do. You kind of want to maximize pricing for each version against each user segment. And then hopefully that works out. And this is nothing new, it’s just much more robust in digital because it’s easier. There’s always been hardcover books versus paperback books. Which is kind of a BS thing. Hardcover books is a really stupid idea. Why would you care that the cover is hard? How is that valuable at all? Really, what customers actually care about is can I buy the book when it first comes out? Harry Potter just got released or am I willing to wait three months and buy it later? And when all the new books when they’re released, they make them hardcover. Not because people care about the thickness of a cover, but because they want to buy it immediately versus those that are willing to wait. So it’s just a way of distinguishing new release, you know, buy it today versus buy it in two months. See it in the theater. versus get the DVD later. So hardcover’s kind of made up. But once you move into software, you can do this all over the place because it’s really easy to make lots and lots of versions of things. And you can vary all sorts of features within software, digital goods, digital service. Delay is a common one, which is the idea of see it in the theater this weekend, or see it later, hardcover, softcover books. Convenience. How many devices can you watch Netflix on? Three devices, 10 devices. Comprehensiveness, you know, you can go on the New York Times and you can, if you have a certain type of subscription, which is more expensive, you can see all their past articles going back hundreds of years. Manipulation, you know, can I manipulate this graphic or can I use Canva and store and copy and print and do different qualities of So your ability to interact and your ability to manipulate what you’re working on can be power user versus basic. Access to community forums, sometimes people charge you for that. Annoyance, this one has ads, this one doesn’t have ads. Speed, if you’re doing video editing you can do more powerful rendering. Data processing. depending which version you buy is gonna have different types of features and sort of more powerful data processing. Image resolution, if you go to Getty Images and you wanna buy a stock photo or a professional photo, you know, the 1080p version is cheaper than the 10-megabyte version, because one you could use in a print magazine and one you could only use sort of online. Support desk, can you make calls, can you do it or not? So anyways, you can… You can version all of this stuff. And I think we’re all kind of used to that for software. What’s interesting is when a traditional business starts creating software as well. So let’s say you make power tools, which that’s traditionally just a product. It’s hardware. But as those power tools start to have software and connectivity into them, you can start to offer versioning in something that used to be, we have five different types of drills you can use. as a contractor, you can go down to the store and buy them. And they might have different prices. But now once those drills are becoming smart and connected, you can create all types of versioning in its functionality. So it opens up a lot of spectrum for goods. And as soon as you see a traditional company start to go digital, you start to look at pricing and versioning and new types of services you can layer on top. It tends to be fairly powerful. It tends to help you differentiate from your customers and then the pricing is obviously a big, big deal. Last thing for today. So, okay, I think I’ve sort of gone through that. You think about pricing, you think about versioning, and then this last idea is sort of willingness to pay versus consumer surplus. The consumer surplus is, okay, people are willing to pay… I don’t know, let’s say $10 a month for access to YouTube. I mean, if you actually test people, would you pay for YouTube? It turns out people are willing to pay for YouTube because it’s pretty awesome as a service. They might pay $10 a month, $15 a month. That’s their willingness to pay, but the price that YouTube actually uses is zero. The difference between the consumer surplus, sorry, the price people pay and what they are willing to pay is a surplus. consumer surplus. It’s like a benefit to the consumer. We all get YouTube for free even though most of us are willing to pay for it. So they are giving us a very big surplus and then you know the way they’re getting around that is by showing us ads and charging the other side of the platform. But most companies don’t usually price at what people are willing to pay. They usually price below that and give consumers a bit of a surplus which people like. So that sort of consumer surplus is an important thing and companies compete based on that. That kind of go hand in hand with willingness to pay. Anyways, I think that’s pretty much what I wanted to talk about today. This tees up, there’s more advanced versions of this, like people talk about bundling, which if you’ve been reading my books, I talk a lot about bundling. That’s usually digital economics in a way that traditional companies can’t. So that’s why we talk about cross-selling, bundling a lot, because it plays into digital economics. But there’s whole textbooks written about the subject. The guy I read is named Hal Varian, who was, I mean, he was writing the textbooks in the 1990s about information economics. And he started the information masters program at Berkeley. He ended up being like head of information economics at Google. I mean, he’s huge. I mean, just look up Hal Varian. His textbooks are great, they’re huge. I mean, it takes a long time to go through them. But most everything I just said, that would be the first three to four chapters. And then it goes on and on, and then you get into pricing and it becomes really complicated. Pricing for these digital companies, it’s really hard to figure out. So anyways, that’s kind of, I think, basic digital economics 101 for today. And I’m just about on time. I kind of check out in 15 minutes. That worked out pretty well. Yeah, so I hope that’s helpful, the three concepts for today. Digital economics, the cost side, pricing, and versioning, and then think about willingness to pay and consumer surplus. Pretty important stuff. Okay, I’m actually having a pretty spectacular week. I’ve been bouncing around Europe for a month now. Germany, Budapest, Romania, Bulgaria, Serbia, Belgrade. And then the last week I’ve been in Paris working on a project, heading back to Germany and Bangkok in the next 24 hours. So pretty awesome. I’ve had just a spectacular time. I kind of came to a conclusion, like I’ve been thinking about setting up a second home somewhere for a couple of years. It wasn’t urgent or anything, it’s just I thought it would make life better to have a home in Asia and a home somewhere in Europe. So that’s a little bit of what I’ve been doing as I’ve been working and sort of bouncing around checking out cities. That’s a little bit what I’ve been thinking about. I think it’s going to be Paris. I’m just having such a good time and I’m getting so much work done, which is kind of my primary thing. Yeah, so I’m starting to look at apartments, but we’ll see if that sticks. I don’t know. But I think that’s probably where I’m gonna settle. So I guess that’s a little bit of a life decision. I feel good about that. So I mentioned it to my family and suddenly everyone wants to visit. Like, you know, it’s amazing how suddenly, like, hey, we should hang out more. It’s like, yeah, you didn’t wanna hang out with me that much more last week, but apparently the Paris apartment, yeah, I guess that moved it up on the list. So I got, oh, let’s all hang out. Let’s plan a family trip. Like, well, that’s an interesting coincidence. Anyways. That’s it for me. I’m heading back. I’m packing up literally right now, checking out and starting to move towards the airport. That’s it. I hope this is helpful and I will talk to you next week. Bye bye.

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I write, speak and consult about how to win (and not lose) in digital strategy and transformation.

I am the founder of TechMoat Consulting, a boutique consulting firm that helps retailers, brands, and technology companies exploit digital change to grow faster, innovate better and build digital moats. Get in touch here.

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This content (articles, podcasts, website info) is not investment, legal or tax advice. The information and opinions from me and any guests may be incorrect. The numbers and information may be wrong. The views expressed may no longer be relevant or accurate. This is not investment advice. Investing is risky. Do your own research.

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