The Human Condition:

Supply and Demand in a Digital Market – April 8, 2012

A tenet of free markets says that the value of any good or service—and therefore its price in the marketplace—is set by the mechanism of supply and demand. If the supply of something is limited and the demand for it among potential buyers is great, then the price goes up. If the supply is great and the demand is limited, the price goes down. This may not be exactly what producers and consumers want to hear at any one point in time, but it’s pretty much the way things work.1

Why are diamonds so expensive? Because, in addition to being pretty and desirable, they are also rare, being formed under extreme geological conditions that don’t occur very often. Everyone who wants a diamond has to bid against others who want one too, in a market with relatively few diamonds available.

Rareness by itself does not automatically confer high value, however. Surviving, functioning Model A Fords are relatively rare, too. There were only so many produced—about 4,300,000 all told—between 1927 and 1931. In the market composed of antique automobile aficionados, they command a good but not a spectacular price. A deluxe model in excellent restored condition will fetch up to about $17,0002—equivalent to a small, inexpensive, bottom-of-the-line car in today’s market. That’s because Model A’s are not very practical to drive as cars and are bought mainly as love objects for a certain kind of romantic or fanatic.

Neither does desirability itself command value. People desire wheat as a staple ingredient to all kinds of food—bread, pasta, cakes, pastries. Every person has to eat regularly, which makes a basic food item like wheat one of the most desirable objects on the planet. But wheat is not rare or hard to grow. Only when supplies are disrupted by drought, disease, or some other mechanism does the price tend to rise. And it can just as quickly fall back to the previous “market level.”

Producers and consumers have tried to get around the free market and the principle of supply and demand for years, probably forever. Cartels of producers have formed to limit supply and drive up the price. The most notable recent example is the Organization of Petroleum Exporting Countries in the 1970s. They drove the price of oil up for a while, but then greed always sets in, and several producer decided they could sell more than their allotted share by dropping the price a bit. They broke ranks, and consumers flocked to their pipelines. And then the high prices spurred new exploration in difficult fields and new technical developments—like processing tar sands and shale oil for liquid petroleum—and the oil supply rose, driving prices down to a new equilibrium

Consumers also lobby their government to set the price of a good or service at a “reasonable” level. During the same OPEC rise in oil prices, the U.S. government stepped in and tried to control the price of gasoline. Refiners, caught between a high cost of their basic input and relatively lower price for their basic output, went idle rather than produce at a loss. Then everyone blamed them for wanting to make “windfall profits.” Whenever a government has tried to set a “reasonable” price on a commodity that is in limited supply but has high demand—whether you’re talking about gasoline, wheat, or two-bedroom apartments—the result has always been scarcity. Not because oil producers, farmers, or landlords are basically greedy, but because they won’t have their pockets picked. And no one has successfully nailed their feet to the floor so that they have to stand still for the picking.

But what happens when something desirable is available in unlimited supply? How is the price set then? That is the situation the market for digital media is facing right now—whether you’re talking about songs in MP3 format, streaming movies in MPEG-4, or novels as epubs—and, so far, no one has a good answer.

Not everyone who owns an iPod, iPhone, or iPad wants the latest Lady Gaga song, the latest Leonardo DiCaprio movie, or the latest Elmore Leonard novel. But if they did, there would be no question of limited supply in the available electronic formats. Bits and bytes are infinitely copyable. If a billion Chinese peasants each owned an iPad and each wanted the latest movie by streaming video, the only problem would be the bandwidth to deliver it. Replicating the data itself into a million memory chips would never be an issue.

So why aren’t all these digital products virtually free? That would make a lot of consumers happy. That would also please the Electronic Frontier Foundation people, who oppose patents and copyrights and other systems that limit access to intellectual property. All those bits and bytes want to go to a new home on your iPad. Where’s the problem?

One of the issues is that supply is limited by an entry barrier. Although the bits and bytes that constitute a digital song, movie, or book are not rare, they don’t exist in nature like diamonds or beach sand. Someone has to write the song, make an appointment with Lady Gaga to sing it, hire and pay a band to back her, set up a recording studio, and make the event come together so that sound can be captured as bytes. Someone has to hire actors, a couple of cameras, a sound stage—or work with a group of computer graphic artists—to make the images that will be captured in the movie. Someone has to think up the words and the press down the keys in order to create the book text. These are entry levels of effort, so many hours of time put in by performers, artists, and writers, before the finished product is ready for encoding.

After that, the bytes may be free in infinite amounts. But until that effort goes in, there are no worthwhile bytes to download.3

Another issue is that, in today’s media marketplace, consumers want variability and novelty. They don’t just want any Lady Gaga song, but the latest song. Yes, people may still buy and download the old Beatles albums out of nostalgia or because they are young, new to the market, and discovering the Beatles for the first time. That’s how classical music has remained popular, even though Bach, Beethoven, and Brahms haven’t written anything new in a hundred years or more. But the mass market is driven by novelty, not nostalgia. Nobody’s iPad has all the songs, movies, books they ever expect to enjoy. We all anticipate finding new favorite performers, actors, and authors tomorrow, next year, or a decade from now.

Pricing a song, a movie, or an ebook download under these conditions can be difficult. First, how to establish the worth of the creator or performer? Based on popularity, the time an Elmore Leonard spends pushing down all those keys required to create a novel is worth a lot more than the comparable amount time that a Tom Thomas spends on the writing process. More people are interested in and eager to read Leonard’s books than care about mine. But does some kind of threshold apply? What is Leonard’s price to write a book? He certainly won’t drive himself to the appropriate level of creative energy and investment for a return of only $10 or $100. How about $10,000, or $100,000? At some point it becomes worth his while to sit down, write, and finish a book.

Conversely, there are some writers—especially those whose books are not highly valued in the marketplace—who will find that creative energy simply for the love of writing. They will produce books even if there is no return. In fact, they will put up money from their day jobs to facilitate writing and producing a book.4

Once we establish a threshold cost, how should it be apportioned among the buyers, who are actually paying for a string of infinitely reproducible bits? First come, first served? That is, the first buyers will pay some fraction of that threshold expense, and later buyers get the bytes for free? If so, how many first buyers? What fraction of the expense? The devil is in those details. Or is it possible to wait until we can identify everyone who might want to buy the book—perhaps through some kind of pre-sale signup—and then divide the threshold cost by the number of buyers? But then, what about people who come later, learn about the book from friends, and also want a copy?

In the world of physically printed books, this early-adopter/later-adopter situation is covered by the publisher establishing a press run for the first edition. First editions become rare items. Hardcover editions eventually sell out and are replaced by later editions in paperback. Still, at no time does the availability of printed books, though they might be plentiful, become “virtually unlimited.” And after all the printing presses have stopped, there are only a finite number of printed copies in the world, just as there was a finite production run of Model A Fords.

The issue of novelty has traditionally been handled—although, admittedly, not very well—by the mechanism of copyright. Copyright used to be some fixed number of years, based upon the then-current law. For example, works published before 1978 were covered for 28 years and then, with a renewal, for another 28 years before entering public domain. Now copyright extends to 70 years after the author’s death, or 95 years after the date of publication, or 120 years after the date of creation. Since no author, or his or her immediate family, really has to worry about losing control of the work for the foreseeable future, copyright is not a good mechanism for valuing works against the churn of public taste and desire for novelty.

We have no way to say that songs, movies, or books that are older—by a year or two, or by a decade—than their initial reception should be priced less expensively than the latest releases. Elderly divas, aging movie directors and actors, and flagging authors might choose to bring down the price of their works to maintain an income stream in the face of declining popularity and interest, but that is a personal choice. No supply-and-demand formula works to enforce it in an environment of infinitely replicable bits. And certain old classics—like the Beatles or Brahms—still can command current prices.

The fly in this ointment, of course, is the nature of the digital medium. With no physical disk or binding to represent the inventory of albums, movies, or books, there is no record of how many copies have been taken. Even songs and movies that were originally released on CDs and DVDs, once they are copied onto a hard drive somewhere, become an infinitely replicable stream of bytes. They can be downloaded from the disk—or from the server farms supporting a music-sharing website or a digital pirating operation—without showing an accounting record, making a hole in the physical inventory, or leaving any trace at all.

These days, the value of the bitstream is established by the whim of the publisher in an environment set largely by tradition and customer expectations. And these traditions and expectations are now in flux. People “expect” to pay about $15 for an album CD or a single-movie DVD, and more for a collection or a boxed set. This gives them a physical object that they can own, play as many times and as long as they want, and lend to friends if they wish. Right now, as bitstreams available on iTunes for downloading to their iPads, customers will pay equivalent prices for the bitstream alone. Getting a plastic disk in the bargain doesn’t add significantly to the price. All of this is accepted as traditional and meets the buyer’s expectations—although customers usually can’t loan the bitstream to friends as they can a disk, and in some cases rental arrangements and play limits keep the customer from listening to or viewing the bitstream in perpetuity as if it was on a medium he or she owned.5

In the digital books market, print publishers who control the digital rights to the books they’ve produced are trying to set their ebook prices on a par with the printed books. With hardcover prices remaining somewhere north of $25 per book, that puts the price of the ebook version higher than the paperback. Publishers cling to this model because they still produce expensive, physical books that have to be bound, stored, inventoried, taxed, shipped out, shelved, shipped back, and pulped. They fear that a much less expensive ebook will undercut the price of their print books. And they’re right—not because ebooks are too cheap, but because the list price of a print book at $27 or $35 is unrealistically high. It would drive most readers away if they had to pay that full price, but luckily most booksellers discount the price deeply through sales and store credits.

Where all this will go is anyone’s guess. But in ten years or twenty, when the physical object of limited availability—the CD, DVD, or bound book—has become just a memory, and when songs, movies, and books are generally available as infinitely copyable bitstreams, then the producer’s traditions and customer’s expectations will have to change. And if the law of supply and demand has anything to say about it, the result will be a lower price for the music, the movie, or the reading experience.

After all, even Lady Gaga’s not coughing up diamonds here.

1. It’s called a law, like the law of gravity, and over the long haul it works almost as inflexibly.

2. See the pricing guide on the website “Model A Trader.”

3. So, after all, the consumer is not just downloading bytes, but certain bytes put together in a certain order. Would anyone take the time to download a whole string of zeroes, a null program, naughts? Would anyone download random noise, static, unintelligible garble? You wouldn’t pay for the memory chips to hold white noise or spend the effort to get it and catalogue it.

4. In the old days, this might be an investment on the order of $10,000 to print their books. Now, despite the ease with which book text can be coded as epubs and uploaded on a service like those supporting the Kindle or Nook, there are still costs involved with obtaining cover art, acquiring an International Standard Book Number (ISBN), paying copyright fees, and buying support services.

5. Except for those who believe “data wants to be free” and so resort to piracy.