Monday, July 19, 2010

Zero marginal cost and Microsoft Office

In my last post, I made the case that a la carte cable wouldn't necessarily save consumers' money: instead, the price of each individual channel would skyrocket, the market would unravel, and consumers would find themselves paying a similar amount of money for a far less impressive set of choices.

This results from a feature common to most kinds of electronic content: zero marginal cost. When you're buying a bundle of cable channels, you're not paying for the cost of distributing each channel to you—as long as cable is already installed, that's virtually zero. Instead, you're supporting the fixed costs of creating the content in the first place. If a la carte cable leads each consumer to subscribe to only 10% of channels, each channel will be forced to raise its price to support the cost of programming (and quite possibly go out of business in the process). In the end, the funding for the content has to come from somewhere, and a thinner base of subscribers means either less content or higher fees for the same content.

To better understand the economics of zero marginal cost, it's useful to look at another example: the software industry. In the age of the Internet, software is virtually free to distribute—it's a classic case of zero marginal cost. Yet commercial software certainly isn't free. Software makers need to recoup their costs somehow, and the obvious way is to charge consumers for using the product. What happens, then, when a company offers multiple related products, each with a large share of the market? It could bill consumers a la carte, pricing each piece of software separately. Or it could bundle the software, charging a single price for a large package.

Microsoft Office springs to mind. As it turns out, Microsoft offers the different components of its Office suite both individually and as a bundle. The prices, however, are quite revealing. Buying Word 2010 standalone costs $150, which is the same as the price for the entire Office Home and Student 2010 suite, including Word, Excel, PowerPoint, and OneNote.

Why doesn't Microsoft offer a cheaper version of Word for home use? Because it has nothing to gain. Many home consumers, presumably, are only really interested in Word. If Microsoft charged less for Word alone, these consumers would happily snap up the option. But it doesn't cost anything for Microsoft to throw in Excel, PowerPoint and OneNote as well, and even the consumers who mainly want Word will be happier with access to every program.

In fact, the only reason Microsoft sells different bundles at all—rather than offering every conceivable feature in one version of Microsoft Office—is that it wants to price discriminate, especially between home users, small businesses, and high-powered business clients. Sophisticated businesses are willing to pay much more for Microsoft Office than home users. Hence Microsoft sets aside one cheap version restricted to home users by the terms of its license, and also differentiates between "Microsoft Office Home and Business" and "Microsoft Office Professional" to extract revenue from the businesses who are most willing to pay. But while it offers these different tiers of software, it never provides each individual program as a cheap a-la-carte option. The individual prices always add up to far more than the price of the bundle.

Advocates for a-la-carte cable almost always use the same basic argument: why should I have to pay for channels I don't watch? You could just as easily adapt this rhetoric to apply to Microsoft Office: why should I have to pay for programs I don't use? Why doesn't Microsoft offer a home version of Word for less than the price of Office? But if you understand the economics of zero marginal cost, you'll realize the fallacy. Offering an additional channel to a cable subscriber doesn't cost a network anything. Including more programs doesn't cost Microsoft anything. By bundling, they're able to deliver more content for the same price—and that's great for consumers.

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