A little while ago, I read Cory Doctorow’s “Down and Out in the Magic Kingdom” (on DailyLit of course).  In the book, he has the concept of Whuffie, a reputation-based currency that has replaced traditional money in a world of abundance.  Since then I have been thinking about whether we might possibly be headed towards a scenario in which we have so much of everything that we can choose to or maybe even have to use mechanisms other than traditional monetary cost/price for making decisions.

I believe it is worth spending more time thinking about this for two reasons.  First, when it comes to digital goods, we have essentially reached a state of negligible marginal cost (the cost of making and distributing an additional copy).  This is already driving some profound changes.  For instance, the current confusion over how to price something like the news is more than a failure of imagination.  Second, even in the world of physical goods we are currently seeing declining prices.  Now the latter could easily be dismissed as being purely the result of the current deep and global recession, but I am not so sure because of two divergent trends.  Global population growth has slowed to about 1.2% annually in each of the last three years.  At the same time technological progress has been accelerating.  For instance even a crude measure such as global labor productivity has been growing at least 2% annually and in some years significantly more than that.  I should be quick to point out that the benefits of this divergence are extremely unevenly distributed across the world population, but it is not inconceivable that we can eventually bring the marginal cost of products below their marginal benefit for many categories (the marginal benefit being the benefit derived when someone who does not yet have the product receives it).

Such a future has also been referred to as the “post-scarcity economy,” but I don’t like that term because there is still likely to be significant fixed cost involved (even for digital goods) and some things are likely to be scarce for a very long time, such as the environment (there is only one earth for us to live on) and people’s attention.  So what I want to focus on instead is what happens as marginal cost falls below marginal benefit.  Consider a picture somewhat like the following:

Instead of the traditional demand curve picture which simply ends in mid-air, eventually the population of possible customers is exhausted.  At that point even a further reduction in the price of the product will not result in an increase in demand (or as economists would put it, demand becomes perfectly inelastic).  In such a situation the social optimum is achieved by everyone having the product.

Interestingly, any price below P* and above Pmin in the chart will accomplish this social optimum.  Prices between Pmin and P* no longer act to allocate the product among possible consumers (everyone gets the product) but act solely as a transfer between consumers and producers (I am using these terms because they are the traditional economics terms).  So here we have our first indication how we might get to a point where price is not necessarily needed to achieve an efficient allocation, or where a range of different prices can sustain the optimal allocation.  But price plays a second important role and that is it affects the distribution of surplus.

The area in the chart above the price line and below the demand curve is referred to as the “consumer surplus” – this is the net benefit accruing to consumers, i.e. how much more they value the product than they pay for it.  The area below the price line and above the supply curve is the “producer surplus” – which captures the total contribution towards fixed cost.   Shifting the price around between Pmin and P* changes the distribution of surplus between consumers and producers but leaves everything else unchanged.  In order for the system to be sustainable, the price needs to be such that the producer surplus, i.e. the total contribution, covers the fixed costs of production.

It is easy to see how if fixed costs are high, there may not be a price that makes the social optimum possible.  In fact, here is the picture redrawn for a digital good (credit to Mike Speiser’s closely related post which also uses hand-drawn diagrams but gets the digital good case slightly wrong.

The supply curve is now completely flat at price zero and the marginal benefit is also zero (no vertical portion of the demand curve).  The argument for the latter is that the demand for most digital goods is smaller than the total population and in fact you eventually get to folks who would have negative benefit from consumption (e.g. listening to a song they don’t like). The social optimum is clearly at price zero and all net benefit occurs in the form of consumer surplus.  But at price zero there is no contribution towards fixed cost.  This is the dilemma that we are already facing with many digital goods such as music and news today.

Creating an artificial price for such a good, for instance by forming a news oligopoly, would move us away from the social optimum.  Yet we need to figure out as a society how to cover the fixed cost of news and music production or we will have less of it than would be optimal.

The historic experiments to date of trying to produce goods for everyone and not relying on price for allocation were of course largely a failure, e.g. the Soviet Union.  Two of the key issues are what happens to incentives for innovation and who decides what to produce among the many possible things that could be produced (keeping in mind that there are still fixed cost).  So what alternatives exist?

One important alternative that is not receiving nearly enough attention is to stop charging the same price to everyone.  In economics this is know as “price discrimination” and there is an extensive literature on when and how it is possible.   For instance, with so-called “perfect” price discrimination everyone would pay exactly what the good is worth to them.  The outcome would be efficient but in this case all the surplus would accumulate to producers.  Because digital goods are so easy to redistribute they don’t meet the traditional criteria which would allow for price discrimination.  But somewhat surprisingly it turns out to be possible to have voluntary different prices as was shown for example by Radiohead’s pick-your-price experiment.

I hope that the logic above shows at a minimum why and how the traditional price mechanism breaks down for abundant and digital goods. There is a lot more that follows from the economics of supply and demand than makes sense to explore in a single blog post.  Stay tuned for more posts exploring both the physical goods and the digital goods cases further.