Prashant has raised a very interesting point. And one of the more important statements he makes is “… several religions of the world preach that material belongings are unimportant.”
Continue reading “Why, oh why, are they so materialistic?”
Author: Atanu Dey
Economist.
You might be a third-world country if …
I have been writing this blog for a year. I have learnt a bit and I hope that it was not a waste a time for those who visit it occassionally. About 100 unique visitors show up every day on the average, and every day a few write in with comments or an email to me. Thank you all.
On reviewing the archives, I note a glaring omission. The blog needs some humor. Sure the topic is extremely serious. But one can definitely make a serious point with humor. So I want to add a bit of humor occassionally.
Continue reading “You might be a third-world country if …”
The Power of Incentives
It is said that one should not ascribe to malice what can be adequately explained as stupidity. I would go one step further and say that one should not ascribe to malice or stupidity what can be explained by basic self-interest. In other words, the power of incentives. Incentives matter and just like you can explain all sorts of natural phenomena by understanding the law of gravitation, you can explain all sorts of diverse economic puzzles by asking what are the incentives.
Consider this. BBC News on Sept 3rd 2004 carried an item: Solar plan for Indian computers. Some excerpts:
Authorities in the Indian state of Uttar Pradesh have drawn up a pilot project to use solar power to run computers in village schools…
Many have to use kerosene lamps for light and most government-run primary schools have no power at all.
It is hoped the plan will help schools cope with the rural power crisis.
Last year, the Uttar Pradesh Education for All Project Board bought about 1,000 computers for selected primary schools in all 70 districts.
The schools were selected in villages which had no power lines, and teachers were given special training for computer-aided education.
Consider the typical village school in UP: totally strapped for resources, teacher absent most of the year, perhaps not even a blackboard, students unable to afford books and most likely malnourished. Why, one asks incredulously, would anyone be spending money on computers when there are more important needs that are crying out for resources?
The report goes on to say:
A further 1,000 computers are to be purchased this year for village schools, but most of these will not work because there is no power available.
The mind boggles at the waste of resources which a poor state can ill-afford. Funds for rural public education are severely limited and yet they are wasting it buying computers that will serve no apparent purpose. These funds could have been used more effectively in paying teachers living wages, buying supplies such as books and blackboards, perhaps food for the starving students. Why?
Here is my explanation. Some time ago, I had pondered the question of why telephones, radio, and TVs don’t make the conference circuit. The vendors of PCs have an incentive to push their wares and they are a powerful lobby. Couple that with the avarice and corruption of the “authorities” mentioned in the BBC report, and you have the answer. When tens of millions of rupees are spent in bulk purchases of computers, there are kickbacks. The authorities make their pile, never mind that the computers end up being expensive non-functional display items in the villages without power.
But wait, it gets better. No power for computers? No problem: use expensive solar power to power them. And you will find the vendors of solar power panels eagerly getting into the game of rural development. They make hay while the sun shines.
It is disgusting, all things considered. Last Friday I made the mistake of driving about 10 kms on Mumbai roads. It took an hour and a half. We were stuck at a T-junction for about 20 minutes because of a deadlock. Vehicles had moved into the intersection and there was no way any vehicle could move. I had described a similar situation earlier in a post entitled Seduced by ICT:
Recently I came across a news item which said that they are looking at solving Mumbai’s traffic problems by making Mumbai roads “electronic intelligent roads.” I don’t have the slightest doubt that it would involve huge outlays to the tune of millions of dollars and lots of people will make lots of money up and down the line providing expertise and hardware and software for this hi-tech venture. I am also convinced that it will not make the slightest effect on the congested Mumbai roads because it is not the roads that need the intelligence but the people designing the roads that need to be intelligent.
Close to where I live in Kandivali, a suburb in North Mumbai, there is an intersection that is almost always caught in a grid-lock. The intersection is like an “H” with bi-direction flow of traffic along all the sections and it has one traffic signal at one of the points where the horizontal section meets the vertical sections. Traffic gets log-jammed around 300 meters of this intersection and it takes about a half hour to cross this bit every evening. Hundreds of autorickshaws, buses, cars, trucks, two-wheelers, and whatnots spew exhaust fumes and honk continually and people suffer. It is astonishing that the traffic people have not figured out that the simplest thing to do would be to paint some part of this intersection with the “KEEP CLEAR — DO NOT BLOCK” sections and put a couple of traffic cops to teach the people to keep off these sections. It would be a simple effective system which would cost very little compared to the enormous price that everyone pays throughout the day due to the congestion.
Instead, the Mumbai municipal corporation is investigating ways of using electronics. Why not better road markings and so on? Because there is not much money involved in a simpler but more effective system. Simpler may be better but there is not much profit in it. A blackboard, a teacher, and a dozen slates and some chalk may be simpler and better for adult education, but there is not as much profit as in putting PCs with literacy programs to teach adults how to read in rural areas.
That is all there is to it. Expensive solutions are proposed because those in control of the spending benefit. This is a universal phenomena, not restricted to poor overpopulated corruption ridden third-world people. Doctors in the US freely sometimes recommend unnecessary heart-bypass surgeries instead of recommending life-style changes. They make more money performing by-passes and don’t make any money if the patient changes his life-style.
The power of incentives is awesome. Look carefully at the roots of persistent poverty and you will see that someone makes money and therefore it is in the interests of the person to perpetuate that poverty. This is not even limited to the economic sphere alone, of course. Mother Teresa’s goal was religious glory and her incentive was therefore perpetuation of overpopulation because people are the fodder that the church feeds on. Is there a way out? I think there is. Stay tuned.
Pondering Outsourcing: Part Duh
I was pondering outsourcing yesterday and ran out of pondering time. Now that I have some pondering time, I thought I would continue with my pondering of outsourcing. {“ponder”: interesting word, isn’t it? Perhaps I should look it up… Here is what one source on the web says:
To weigh in the mind; to view with deliberation; to examine carefully; to consider attentively.
Syn: To Ponder, Consider, Muse.
Usage: To consider means to view or contemplate with fixed thought. To ponder is to dwell upon with long and anxious attention, with a view to some practical result or decision. To muse is simply to think upon continuously with no definite object, or for the pleasure it gives. We consider any subject which is fairly brought before us; we ponder a concern involving great interests; we muse on the events of childhood.
End of digression.}
First one point of clarification. Yesterday I wrote
Fun fact #2: Trade occurs only among two dissimilar entities. If I have an excess of peanut butter and you have an excess of bread, then we can trade and both end up enjoying peanut butter sandwiches. But if both of us have exactly the same ratio of peanut butter to bread to start off with, then we could not trade.
The point was that the two trading entities have to be dissimilar. That dissimilarity could be intrinsic or extrinsic. If they are intrinsically dissimilar, then even if their endowments are the same, trade can still take place. For instance, we may start off with the same ratio of peanut butter and bread, but you may have a strong preference for only bread and I may have a strong preference for only peanut butter. In that case, we can trade and end up happier. If we are instrinsically similar — our preferences match — then we cannot trade unless our endowments are different. End of digression number two.
Continuing with the list of fun facts, here is another. Fun fact #5: The world is moving towards increasing specialization since the stone age. Speciation is what happens in the natural world where life evolved in some primal soup and since then from the earliest protozoan to the present day different species have emerged. Evolution is a fact. The theory which explains the mechanism of evolution was given credence through the diligent and brilliant work of Charles Darwin (1809-1882). Darwin got the germ of his idea upon reading Thomas Malthus’ (1766-1834) Essay on the Principle of Population. No doubt Darwin pondered that issue long and hard and then it struck him that speciation occurs through competition for resources and those that are less fit are doomed and this process he called “natural selection”. Darwin explained the mechanism that underlies the question how did all the diversity of life originate.
It is easy to see that specialization in the economic world is a close analog of speciation in the natural world. Once upon a time you used to have people who were jacks of all trades and masters of none. Now you have programmers and playwrites, prostitutes and politicians (ok, I repeat myself), pharmacists and paleontologists. The more advanced the society, the more specialization of its work force.
Hand in hand with the specialization of the work force, we have the specialization of the firms that operate in the society. Firms that used to do all things in a particular sphere (vertically integrated firms) no longer do so. They ‘outsource’. For instance, take a car manufacterer. Once upon a time, at one end steel, rubber, and glass would go in and at the other end of the factory you would have cars rolling out of the assembly lines. All the raw materials would be transformed inside that one plant into cars. That was then. Now a car manufacturer assembles cars from components that are manufactured by other firms. So a firm that manufactures engines will supply these intermediate goods to a host of firms.
{Advanced industrialized countries (or developed countries) trade a lot amongst themselves. Much of that trade is in intermediate goods. Given that, it is hard to tell where something is really manufactured these days. For instance, ponder a complex creature such as a Boeing 777. Engines could come from Europe, parts of the fuselage from Japan, avionics from the US, … by the time you are done enumerating, you would find that practically the whole world was somehow involved in the manufacture of the plane. End of aside #18.}
That is what outsourcing is all about. You don’t do all the stuff that needs to be done. Get someone else to do it because they have a comparative advantage in doing that bit. I outsource ‘jhadu-pocha-bartan’. American firms outsource much of what they need done and a part of that outsourcing happens to be done abroad and of that work done abroad, India has a small share.
So now let’s ponder outsourcing and India. I will ponder outsourcing and the US later because I am fast running out of pondering time.
India appears to be a destination for a specific kind of outsourcing. Business processes and software development. The sort of work that does not require hard infrastructure such as roads and ports and water and power. You just need some kind of connectivity, a bunch of English-speaking graduates who can be easily trained, and a bunch of entreprenuers who would start BPO and software firms to do the ‘jhadu-pocha-bartan’ equivalent for the US firms.
From all indications, the whole business works quite well. India has a huge population. Out of that billion+ population, India graduates around a million every year. Some of these graduates can speak English and of them some are trainable. Firms that initially went into the BPO and software business had an easy time. Lots of unemployed and underemployed graduates to choose from and they had a party. Will the party continue? As more and more firms get into the game, it will become increasingly difficult to find graduates that are trainable and can speak English. Given increase in demand without significant changes in the supply, prices will get bid up. That will drive up the costs of BPO and software in India. India’s competitive advantage in the sector will deteriorate.
So how does one go about avoiding the fate that I just outlined? Simple: increase the supply. India should see that more of the million graduates it produces are capable of being trained and speak English.
For the record, I should state that while I feel happy for the people who get the BPO and software jobs, I do not feel very happy about the fact that India has to be the preferred provider of ‘jhadu-pocha-bartan’ to the Americans.
Is Outsourcing Good for the Universe
Via Rajesh Jain, I came to know of NY Times report on Paul Samuelson’s essay in an upcoming issue of JEP. I am probably one of the very few who have not read Samuelson’s celebrated book on introductory economics. That is so because I never studied undergraduate economics. My introduction to economics was at the graduate level and the first books on economics I read were Hal Varian’s Microeconomic Analysis and Bhagwati and Srinivasan’s Lectures on International Trade. I learnt undergraduate economics later while teaching undergraduate classes. OK, enough of this biographical aside.
The issue of outsourcing appears to be a very hot topic. Here is how I think about it. I go back to the basic facts.
Fun fact #1: Trade is good. Whether between two people on eBay or between two countries across an ocean, trade increases welfare. While that is true in general, there are well-known conditions under which trade can be harmful and decreases welfare. If any of those conditions exist, then you need to take corrective measures which may include the extreme measure of banning the trade.
Fun fact #2: Trade occurs only among two dissimilar entities. If I have an excess of peanut butter and you have an excess of bread, then we can trade and both end up enjoying peanut butter sandwiches. But if both of us have exactly the same ratio of peanut butter to bread to start off with, then we could not trade.
Fun fact #3: Increasing the supply of any good or service (all other things being equal) reduces its price. This is not rocket science but the ignorance of this fact is as widespread as the ignorance of rocket science.
Fun fact #4: Most change gives rise to winners and losers. Walmart in your neighborhood helps you and hurts the little stores in your neighborhood. Imported Chinese junk helps the consumers of junk but hurts the domestic manufacturers of junk. Basically, lower prices help those who consume the good or service but hurt those who produce it.
OK, so here is the story about outsourcing, the US, and India. India and US are dissimilar. Wages are lower in India as compared to the US. Why? Because wages depend on the average productivity of the country. India is a low productivity country. Why that is so is another story that we will not go into right now. Because Indian labor is cheap, producers who can use Indian labor will have an incentive to use them. If you are producing goods, you can get the goods produced abroad and sell them in the home country. Winner: the domestic consumers. Losers: the domestic workers who were replaced by cheaper labor. While labor is immobile internationally (immigration laws and all that), labor is said to be embodied in the goods that are produced abroad. Think of it as if the worker is virtually present in the US and is working for a wage much lower than the domestic worker would demand.
In the past, India supplied some goods to the US, mostly commodities. Then when communications technology improved, services could be exported. It was as if a couple of million Indians moved to the US. Increased supply immediately translates into lower prices. Basic economic logic, not rocket science at all. Lower prices help the consumers and hurt those who worked in that sector before the supply of labor increased. Globally, that movement of labor (virtual movement, of course) is welfare improving. It is undoubtedly good for India because the average wage of those workers increases and since Indians are in general not consumers of the stuff these workers produce, Indian consumers are not hurt. But is it good for the US?
What is good for GM is good for America is only true if all Americans work for GM, otherwise it is an open question. So also, if the US workers displaced by the virtual migration of Indian labor move on to more productive jobs, then the change is an unmitigated good for the US. Then of course, one has to consider the question from the temporal angle as well and distinguish between the short- and long-term impact of the change.
In the long-term (not the real long term, of course, in which we are all dead as Keynes astutely observed), Heckscher-Ohlin’s factor price equalization theorem takes effect. Here is a definition from About.com:
Factor price equalization is an effect observed in models of international trade — that the prices of inputs to (“factors of”) production in different countries, like wages, are driven towards equality in the absence of barriers to trade. This happens among other reasons because price incentives cause countries to choose to specialize in the production of goods whose factors of production are abundant there, which raises the prices of the factors towards equality with the prices in countries where those factors are not abundant. Shocks to factor availability in a country would cause only a temporary departure from factor price equality.
The basic theorem of this kind is attributed to Samuelson (1948) by Hanson and Slaughter (1999) who also cite Blackorby, Schworm, and Venables (1993). The context of the theorem is a Heckscher-Ohlin model.
Programmers and call center operators are a factor in the production of many goods and services in today’s global economy. Since barriers to trade have come down both due to free trade agreements and to technological advances in telecommunications, it has led to a “mobile” labor market for those workers. Increased supply implies lower prices for that sort of labor. Lower prices implies winners and losers, as argued earlier.
So is it good for the US and if not, could the US do something about it and if it could, should the US do something about it? Good question. The answer is forthcoming. What we have to remember when it comes to change is the good old theory of the second best which Bhagwati had written about years ago and which I believe throws light on the present debate.
The magic that is the internet
The internet is huge. It is bigger than one can imagine. We are fortunate that we have access to the internet. And I feel for those who do not have access to this astounding wealth of information and possible source of wonder, amazement, delight, instruction, and possibly enlightenment.
Take for instance a website such as number27. You can spend so much time getting informed and getting entertained at the same time. Check it out sometime. [Thanks to
Readings: “How to Win the Nobel Prize”
A friend of mine, who was a fellow grad student at UC Berkeley, gave me as a gift Michael Bishop’s How to Win the Nobel Prize [Harvad Univ Press 2003]. “In 1989 Micheal Bishop and Harold Varmus were awarded the Nobel Prize for their discovery tha normal genes under certain conditions can cause cancer”. I’d like to quote from the chapter, People and Pestilence, because it is relevant to my obsession with India’s population problem. Continue reading “Readings: “How to Win the Nobel Prize””
“GPS for the common man”
Every now and then, I screw up enough courage to read the newspapers. I am faint of heart and avoid newspapers because they generally report such stuff that nightmares are made of, such as Islamic terrorism killing a few hundred in Russia (recently but around the world with sickening regularity.) But occasionally they report news from a surreal world and my morbid curiosity wins over my basic distaste of horror stories. A few days ago, I came across an item that gladdened my heart: Sibal plans GPS project to help common man reported the Times News Network on September 3rd.
Can’t find your way around in a metropolis? Don’t know how many bus stops are there in your town? Want to know the exact size of your farm? Geo-technology may give you the answers.
The science and technology ministry has embarked upon some major projects which it claims could change a common man’s life. By 2005, the ministry is planning to provide global positioning system (GPS) for motor vehicles in Delhi, Mumbai, Chennai, Hyderabad, Bangalore and Kolkata.
A central server will be set up by the ministry that can be accessed by GPS screens installed in cars. “Most sedans have GPS technology, but car owners who don’t have it can get it installed and access the service,” said science and technology minister Kapil Sibal.
This system would allow drivers to know their location and the directions to reach their destination,” he said.
The concern that the policy makers in Delhi feel for the common man is nothing if not touching. Their passion for the commonweal is awe inspiring. Imagine, if you will, the horrors that the common man faces as he drives his car looking for an address in an unfamiliar neighborhood. But the common man need not worry anymore. Science and technology (and the passion of the Indian policy makers for the common man) will solve this incredibly complex and terribly urgent problem.
Some time ago, I had written in a piece called It’s the small stuff, stupid:
I just went out to lunch in the neighborhood of where I work. A passerby stopped me to ask me where a certain company was. I said I don’t know but if he had an address, I could perhaps direct him. He only knew that it was close to the ‘Empire Building’. We spent some time trying to locate it and then finally gave up. I don’t know how long he spent walking around in the noon-day sun trying to get where he wanted to go. Perhaps he just wasted an hour, a lot of shoe leather, sweated in the heat, and when he arrived, he was tired. The opportunity cost of his trying to find a place is small but non-zero. He could have spent more time with his family or done some productive work. Add the cost of millions of people spending non-productive time searching, and soon you get a significant amount of loss.
That streets should have a name and locations along a street should have a number is a concept that should be evident to the meanest intelligence, one would expect considering that it is not exactly rocket science and that many parts of the world have had that innovation for generations, if not centuries. Yet it is a rare exception when you can find a place in India without an algorithmic description of how to get to it.
“GPS for the common man” should rightfully be listed under the LET THEM EAT CAKE category. Other items in that set: One computer in every village. Never mind that most villages lack a teacher who comes somewhat regularly to teach the children, and electricity is almost non-existent.
Deva, deva!
Want a gmail account?
I have a bunch of gmail invites. Email me at atanudey at gmail dot com if you want one. I am sorry that I will not send a gmail invite in reply to a comment.
Even though I say very clearly that one has to email me and NOT post a comment asking for a gmail account, about twice a week people post comments asking for an account. Clearly these people lack basic reading and comprehension skills.
The Economics of Software
“The time has come,” the Walrus said,
“To talk of many things:
Of shoe–and ships–and sealing wax–
Of cabbages–and kings–
And why the sea is boiling hot–
And whether pigs have wings.”
An item titled the economics of software caught my eye on Rajesh Jain’s blog. Rajesh quotes from an article by Bryan Cantrill which begins with:
Software is like nothing else in the history of human endeavor unlike everything else we have ever built, software costs nothing to manufacture, and it never wears out. Yet these magical properties are arguably overshadowed by the ugly truth that software remains incredibly expensive to build. This gives rise to some strange economic properties: software’s fixed costs are high (very high — too high), but its variable costs are zero…
Clearly, Mr Cantrill is out of his depths when it comes to basic economics, and consequently his analysis of the economics of software is fundamentally flawed. Ignorance of basic economics is bad enough when one takes on the task of explaining the economics of software but what is worse is that he is mistaken about some facts as well. For instance, he asks rhetorically, “… doesn’t it strike you as odd that your operating system is essentially free, but your database is still costing you forty grand per CPU?”
Which planet are you on?
One wonders if he has heard of that obscure little company called Microsoft which makes a decent living out of selling operating systems. As far as I can tell, they don’t give them away for free. And I suppose that he has not heard of MySQL which is database software and for which you have to pay a lot less than forty grand — zero, to be precise.
Sorry, Mr Cantrill, but it will take us too long to fix all the bugs in your analysis. So I will just write the analysis from scratch. Here is a short introduction to the economics of what is called “information goods” to which class computer software belongs.
Of goods and services and information
To start at the top, there are things called goods and there are things called services. Services are things such as haircuts, transportation, heart surgeries, operas, and psychoanalysis. Goods are stuff such as cd players, cars, toasters, shirts, and books. Most goods are ‘hard’ in that they are kickable. Then there are goods that are not kickable. An idea or a thought or a receipe is not kickable because it is not made up of matter. Note however that to convey, store, transmit, and use the idea or receipe, it has to be incorporated into some physical medium which is kickable. But the information good itself is not a material entity unlike a car or a desk.
The distinction between the information good itself and the material object used to store, retrieve, transmit and use it is vitally important. The idea or the receipe is ‘software’ while the stone tablet or book or the cd in which it is found is the ‘hardware’. The cost and economics of hardware follow the usual economics of kickable goods. So it may be good to review those basics quickly before we look at the economics of software.
Costs — fixed, marginal, and average
To produce stuff (hardware), you need labor, capital, and other stuff. Let’s say we need to make a car. We need to buy some humongous machines, make parts, put them together and we get a car after some time and cost. Even before we get one car out of the shop, we have to spend money — put the factory up and pay people to design the car, etc. Those are fixed costs. For every car we produce after we have paid the fixed costs, it costs some money. That is the variable cost. The more the number of cars, the higher the variable costs because you need more parts. The difference in the total cost of producing n+1 cars and n cars is called the marginal cost of producing that n+1th car. Finally, the total cost (sum of the fixed and variable costs) divided by the number of cars gives us the average cost.
Supply and demand
Usually, the marginal cost decreases as the number of units produced increases, and at some point it starts rising for reasons that need not detain us now. The upward sloping supply curve is actually the rising part of the marginal cost curve and it represents the fact that as you produce more and more of some good, it costs more to produce the next unit than to produce the current unit. This is true for most kickable goods but not so in all cases and definitely not so for software as we shall see.
Then there is a demand curve which is usually downward sloping (on a price-quantity graph where the y-axis is used for the price and the x-axis is used for quantity). This is so because of a number of reasons. For a consumer, each additional unit of a good delivers diminishing additional utility. This diminishing marginal utility or benefit implies diminishing willingness to pay. So the demand curve is a marginal utility curve or a marginal benefit curve.
Markets
If you draw the marginal benefit curve (aka demand curve) and the marginal cost curve (aka supply curve) on the same price-quantity space, they may intersect and if they do that point of intersection is called the equilibrium which represents a market-clearing price and quantity. The equilibrium condition is that the marginal cost equals the marginal benefit. Markets determine this equilibrium and under idealized conditions (which do not obtain in the real world but are realized approximately in many instances), this is welfare maximizing.
Which brings us to a very important point that is relevant to our goal of understanding the economics of software. We have to know something about competitive markets and how they maximize welfare and under which conditions. Markets are competitive if a bunch of conditions are met which include, among others, (1) zero fixed costs (implying no scale economies), (2) no externalities, (3) perfect information, (4) no public goods, and so on. In a competitive market, the price determined is welfare maximizing and the price is equal to the marginal cost of production. Whether real world markets achieve efficiency, that is, whether they arrive at this welfare maximizing price or not, depends on whether the conditions for competitive markets are met or not.
Marginal Cost Pricing
One last thing we need to keep in mind before we continue on. For economic efficiency (in other words, for maximizing social welfare), price has to equal marginal cost. That is, the additional cost of producing the marginal unit (that is, the next unit) has to equal the marginal benefit from the consumption of that unit. So if the marginal cost of production is zero, the economically efficient price is zero. But here is the catch. You could have zero marginal cost of production but have a very high fixed cost. In which case, you still have a positive average cost. Granted, this average cost decreases as the total number of units produced grows. But pricing the good at marginal cost will leave you unable to recover the fixed cost. You could of course price the good at that average cost but then it will not be maximally efficient — it will lead to dead weight losses. Alternatively, you could have the government or your rich uncle subsidize the fixed cost component and price your good at the marginal cost of zero.
Economics of Software
Now let us move to software. First order of business, what is software as used in this analysis. I define software as anything that is an organized collection of information. Examples of software: receipes, stories, driving direction, computer programs, population statistics, exam results, poems, instructions on how to achieve enlightenment, a movie script, and such. Let us lump these in the generic group called information goods (IG). Every IG requires some amount of intellectual effort and unlike the production of hard goods (HG), the cost of production is totally front-loaded and the cost of producing additional copies of an IG is zero. In other words, the cost of producing one IG is the same as the cost of producing a billion copies of the IG.
Distribution Costs
Note however that merely producing something is not enough; you have to distribute the stuff before you can use it. The cost of distribution is an important and significant component of the total cost of IG. This is distinct from the case for HGs. To take an example, producing a car costs say $100 million, producing each additional unit costs (marginal cost) say $20,000, and the cost of distribution for each car through a dealer network is $1,000. The distribution cost is therefore only 5% of the marginal cost of production.
Now consider IGs. Take the case of an operating system or a database system. It costs umpteen hundred million dollars to produce the first unit, if you are a Microsoft, but it costs next to nothing if you are an open source collaborative project. So the range of fixed costs of production extends from very high to practically zero. Marginal costs in any case for IGs is always zero. Then comes the distribution costs. If you were to distribute your software on punched paper tape or cards, you have to hire a fleet of 18-wheeler tractor trailers to deliver one copy of Microsoft Windows XP to one customer and it will cost you $19,500. If you were to use a set of floppy discs and mail it to the customer, it will need a shoebox-full of floppies and your distribution costs will be $40 per customer. Not as bad as the fleet of tractor trailers, but still not as good as using a few cds and cutting your distribution costs to $4. And it gets really sweet when you can just have your customer download it from your site for about $0.04 total cost to you. (But the sweetest thing of all is when you can charge your customer $300 for the download.)
Summary
To sum up the discussion so far, depending upon the size and complexity of what a software program does, you have to employ a bunch of programmers and have some computers for them to do their stuff on. That is the fixed cost of producing the software program. That fixed is high in the case of operating systems and huge database programs if you have to pay programmers fat salaries. If you got a whole bunch of people to collaborate and produce software for free, then you have low fixed costs. The latter is what mostly happened in the case of Linux while the former is what happens in a commercial shop like Microsoft.
Once you have produced the software program with whatever fixed costs — high, low, or intermediate — you then make a certain number of copies. Depending on the cost of the medium you use to distribute the software, your variable costs (and therefore the marginal costs of distribution) is determined. If you use punched cards or paper, marginal cost of distribution is high; if you use cds, it is low; it is lowest so far if you send it over electronically by wires or wirelessly. Because electronic distribution of software is so cheap over the internet, you can say that the marginal cost of production as well as distribution comes pretty close to zero.
Is software really different?
Information goods are essentially different from material goods. That is so because of two reasons. First, the nature of information goods itself. And second, the cost of production of IGs. IGs have public goods characteristics, they have externalities, and have high fixed costs. All these are deviations from the conditions required for competitive markets. Thus markets will not deliver the social welfare maximizing outcome. All sorts of distortions will result such as the presense of monopolies. Monopolies, like everyone and his brother, maximize profits and since they have market power, they can charge whatever suits their fancy. So they can price an operating system at $300 a pop which is way above the marginal cost of production (exactly $0) and the marginal cost of distribution (nearly $0).
So is the economics of software essentially different from the economics of other goods? Not really. There are differences in their associated costs (fixed, marginal, average) and the ways in which they deviate from the conditions required for a competitive market. But the fact remains that there is nothing surprising about the way the market for software behaves if one were to understand the nature of software and the nature of markets. Like shoes and ships and sealing wax, they follow predictable pathways in the marketplace. Pigs don’t have wings and the sea is never boiling hot.
In the concluding bit of this piece, I will explore some of the issues that follow from this preliminary analysis. Later, alligator.
Atanu Dey : Life is a Random Draw 