Immovable Object versus Unstoppable Force: Capex and the Marginal Cost of Production
One of the courses I study in the Farmyard Podcast University is economics. I like making sense of the world, and sometimes economics help make sense of the world. Sometimes. Sometimes it seems flatly contradictory. Here is one of those cases.
The theory of production states that in a competitive market, prices will stabilize at the marginal cost of production. That is, if I am a farmer with a bunch of wheat, I will be willing to sell my next kilo at the cost to raise that additional kilo. If seed, fertilizer, and diesel cost me $10 for that kilo, I will rationally take anything more than $10 for it. Since lots of other farmers are also competing to sell wheat, the price will fall to $10. I would be a chump to insist on a higher price and risk not selling at all. I would be a chump to sell for less than my cost of production. Price = marginal cost of production.
The theory or production is used to “logically” justify a price of $0 for information. Since the marginal cost of production (the amount to distribute the next download) is essentially zero, so the story goes, the price for information will tend to zero.
This theory takes a very narrow view of economics. Somebody has to pay for the tractor and the land. In this model, such costs get paid for out of an irrelevantly small slice of the price.
Businesses divide the money they spend in to capital expenditure, CAPEX, and operational expenditure, OPEX. CAPEX is money spent in anticipation of future gain, like buying a new tractor or writing a programming tool. OPEX is money spent in anticipation of immediate gain, like buying seed or paying this month’s bandwidth bill. The distinction between CAPEX and OPEX is important for tax reasons and because balancing the two in various ways can offer different business models.
OPEX is really our friend the marginal cost of production by a different name. Bringing CAPEX into the picture highlights the absurdity of the “price = marginal cost of production” theory as OPEX trends to zero. That little “capital tax” added to every price becomes increasingly significant. What happens when price = marginal cost = $0? Like quantum effects, once you reach a certain scale the rules change. The Newtonian economics of “price = marginal cost of production” are overwhelmed by the need to finance the upfront capital. The form of solution to this has yet to emerge.
Is This Really a Problem?
One of the factors that has kept this dilemma from being a problem to date is increasing capital efficiency. A programmer today can produce software for much, much less than he would have required for the same functionality even ten years ago. In fields like journalism or music, the cost of doing an okay job has likewise fallen dramatically.
The word “okay” is important in that last sentence. There is a difference between an article written by Malcolm Gladwell (on this very topic) and one written by, well, me. But if his costs money and mine is free and you don’t care enough about the difference, he can’t charge for his. I don’t care about charging for mine, because I make my money on, on, on… I’ll get back to you on that.
Cracks are appearing in the system. One of my pressing needs is an efficient environment for collaborating in real-time on code. Many projects have started to provide such functionality, but most (all in the Eclipse world) have stalled short of solving the problem. Increasing capital efficiency in this case can’t overcome the size of the task of solving a difficult programming problem. The capital just isn’t there to solve the whole problem. A group of smart, poor graduate students can’t muster the capital necessary to solve it and a VC would have to be crazy to invest in it, given that no one will pay for a solution. And so a socially, economically significant problem goes unsolved.
I don’t have a resolution of this dilemma. CAPEX is immovable but the pressure for “price = marginal cost of production” is unstoppable. One argument was that in a world of abundance, things that couldn’t be replicated easily, like one’s own physical presence, would increase in value. I am not finding that to be true, but I’m experimenting with selling a remote pair programming session. I’ll get back to you on how it works. In the meantime I have some good ideas waiting for capital, I just can’t promise any payoff. I know I’m not alone.