World After Capital: Digital Technology (Zero Marginal Cost)

NOTE: Last week’s blog post was the current introduction to my book World After Capital. Today’s post covers the first half of the chapter on Digital Technology, which discusses how zero marginal cost is unlike anything found in the analog world.

Digital Technology

The invention of agriculture expanded the space of the possible by dramatically increasing the food density of land. This allowed humanity to have surplus food, which provided the basis for increased population density and hierarchical societies that developed standing armies, specialization of labor and writing [5].

The Enlightenment and subsequent Industrial Revolution further expanded the space of the possible by substituting human power for machine power and increasing our understanding of, and control over, chemical and physical transformations of matter. This allowed humanity to make extraordinary material progress on the basis of innovations in energy, manufacturing, transportation and communication [6].

Digital technologies provide the third expansion of the space of the possible. This seems like a bold claim, and many have derided digital technologies such as Twitter, arguing that they are inconsequential compared to, say, the invention of vaccines.

Yet we can already see the disruptiveness of digital technologies. For instance, many previously well established businesses, such as newspapers and retailers, are struggling, while companies that deal only in information, such as Google and Facebook, are among the world’s most highly valued [7].

There are two characteristics of digital technology that expand the space of the possible, and both are important: the first is zero marginal cost and the second is the universality of digital computation.

Zero Marginal Cost

Once a piece of information is on the Internet, it can be accessed from anywhere on the network for no additional cost. As more and more people around the world are connected to the Internet, “anywhere on the network” increasingly means anywhere in the world. The servers are already running. The network connections and end user devices are already in place and powered up. Making one extra digital copy of the information and delivering it across the network is therefore free. In the language of economics: the “marginal cost” of a digital copy is zero. That doesn’t mean there aren’t people trying to charge you, in many cases there are. Zero marginal cost is a statement about cost, not about prices.

Zero marginal cost is radically different from anything that has come before it in the analog world, and it makes possible some pretty amazing things. To illustrate, imagine you own a pizzeria. You pay rent for your store, you pay for your equipment, and you pay salaries for your staff (and yourself). All of these are so-called “fixed costs.” They don’t change at all with the number of pizzas you bake. “Variable costs,” on the other hand, depend on the number of pizzas you make. For a pizzeria, these include the cost of the water, flour, and other ingredients used in making pizzas. Variable cost also includes the energy you need to heat your oven. If you make more pizzas, your variable cost goes up. If you make fewer, your variable cost goes down.

So what is marginal cost? Well, let’s say you are up and running making 100 pizzas every day. The marginal cost is the additional cost to make the 101st pizza. Assuming the oven is already hot and has room in it for one more pizza, then the additional cost for that 101st pizza is just the cost of the ingredients, which is likely relatively low. Imagine now that the oven has already cooled off, then the marginal cost of the 101st pizza would include the energy cost required for re-heating the oven. In that case the marginal cost could be quite high.

From a business perspective, you would want to make that 101st pizza as long as you can sell it for more than its marginal cost. Every cent above marginal cost makes a contribution towards fixed cost, helping to pay for rent and salaries. If you have already covered all your fixed cost from the previous pizzas sold, then every cent above marginal cost for the 101st pizza is profit.

Marginal cost also matters from a social perspective. As long as a customer is willing to pay more than the marginal cost for that pizza, then everyone is better off. You’re better off because you get extra contribution towards your fixed cost or your profit. Your customer is better off because, well, they just ate a pizza they wanted! Even if the customer paid exactly the marginal cost you wouldn’t be any worse off and the customer would still be better off.

Let’s consider what happens as marginal cost falls from an initially high level. Imagine for a moment that your key ingredient is an exceedingly rare and expensive truffle and therefore the marginal cost of your pizzas is $1,000 per pizza. Clearly you won’t be selling a lot of pizzas. You decide to switch to cheaper ingredients and start to bring down your marginal cost to where a larger number of customers are willing to pay more than your marginal cost. In New York City, where I live, that seems to be around $25 per pizza. So you start selling quite a few pizzas. As you bring down the marginal cost of your pizza even further through additional process and product improvements (e.g., a thinner crust, economies of scale, etc.), you can start selling even more pizzas.

Now imagine that through a magical new invention you can make additional pizzas at close to zero marginal cost (say one cent per additional pizza), including nearly instantaneous (say one second) shipment to anywhere in the world. What would happen then? Well, for starters you would be able to sell an exceedingly large number of pizzas. And if you charged even just two cents per pizza you would be making one cent of contribution or profit for every additional pizza you sell.

At such low marginal cost you would probably be the only pizza seller in the world (a monopoly—more on that later). From a social welfare standpoint, anyone in the world who was hungry and who wanted pizza and could afford at least one cent would ideally be getting one of your pizzas. This means that the best price of your pizza from a social point of view would be one cent (your marginal cost). Why not two cents? Because if someone was hungry but could only afford one cent and you sold them a pizza at that price, then the world as a whole would still be better off. The hungry person was fed and you covered the marginal cost of making the pizza.

Let’s recap: When your marginal cost was extremely high, you had very few customers. As your marginal cost dropped you started to be able to sell more. And as your marginal cost approached zero, you eventually started to feed the world! This is exactly where we are with digital technology. We can now feed the world with information. That additional YouTube video view? Marginal cost of zero. Additional access to Wikipedia? Marginal cost of zero. Additional traffic report delivered by Waze? Marginal cost of zero.

This means we should expect certain digital “pizza-making operations” to be huge and span the globe in near monopoly positions (i.e., they are much larger than anyone else, having nearly the entire market to themselves). This is exactly what we are seeing with companies such as Google and Facebook. But—and this is critical to the idea of the Knowledge Age—it also means, from a social perspective, that the price for marginal usage should be zero.

Why prevent someone from accessing YouTube, Wikipedia or Waze, either by cutting them off from the system altogether or charging a price they can’t afford? This would always constitute a loss to society. With zero marginal cost, any given individual might receive some benefit, which would be a benefit greater than the marginal cost. And best of all, they might use what they learn to create something that they share and that in turn winds up delivering extraordinary enjoyment or a scientific breakthrough to the world.

We are not used to zero marginal cost. Most of economics assumes non-zero marginal cost. You can think of zero marginal cost as an economic singularity: dividing by zero is undefined, and as you approach zero marginal cost, strange things happen. We are already observing these strange things in the world today, including digital near monopolies and a power law distribution of income and wealth. We are now rapidly approaching this zero marginal cost singularity in many industries, including finance and education.

So the first characteristic of digital technology that expands the space of the possible is zero marginal cost. This space includes digital monopolies, but it also includes access for all of humanity to all the world’s knowledge (a term I will define more precisely later).