The paper describes major aspects of the “New Economy” to understand the situation in this global and interlinked sector, which favors intangible things. The focus of the paper lies on an analysis of the “Freeconomy” phenomenon implementing microeconomic concepts as well as models from behavioral economics to observe demand side tendencies towards free information goods. The final purpose lies in illustrating appropriate competitive business strategies to face the “gratis culture”.
Table of Contents
Abstract
Table of Contents
Table of Figures
Table of Abbreviations
Table of Mathematical Variables
1. Introduction
1.1. Development of a “New Market” in Germany
1.2. Classification of information goods
2. Freeconomics
2.1. Definition
2.2. Why can online businesses offer goods for free?
2.3. The paradoxon of information goods
3. Free from the demand-side perspective
3.1. Microeconomic aspects of free
3.1.1. Utility function and determinants of demand
3.1.3. The free rider concept and piracy
3.2. Free in Behavioral economics
3.2.1. Anchoring
3.2.2. Focusing effect
4. Who pays wages in a Freeconomy
4.1.1. Cross Product Subsidy Models
4.1.2. Cross Customer Subsidy Models
4.1.3. Cross Time Subsidy Models
5. Conclusion
References
Table of Figures
Figure 1: Classification of information goods
Figure 2: Demand curve with and without network effects
Figure 3: Demand curves in a multi-sided market
Table of Abbreviations
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Table of Mathematical Variables
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1. Introduction
This working paper provides a report on a topic which is a trend in the economy of the 21st century, particularly recognizable in the digital economy. There are different nomenclatures like “Freeconomics”[2], “gratis culture”[3] or “demonetization”[4]. They all show the tendency of potential consumers and users to discriminate pay-offers of information goods and substitute them by using free alternatives or by obtaining them illegally. Business sectors distributing news, software or entertainment goods including music, movies and computer games are primarily affected by this development in a relatively new market which caused a hype at the German stock exchange.
1.1. Development of a “New Market” in Germany
An economy being highly innovative, making possible an expeditious technological progress had its beginning in the 1980s when personal computers slowly started to become affordable to private households. Moore’s law of increasing microchips performance combined with decreasing production costs, published in 1965 in the magazine „Electronics“[5], proved to be correct. The resulting diffusion of computers enabled a global network and new forms of business. Alan Greenspan, chairman of the Federal Reserve was convinced of a new business cycle[6] and Kelly even preached an „emerging new economic order“[7].
Many German economists propagated enthusiastically a similar change of society and economy. A new stock index called “New Market Index” (later “NEMAX”) was introduced at the German stock exchange in1997. Start-up firms in the IT sector experienced high investment. In 2000 the dot com bubble burst in Germany. “NEMAX” started to drop tending to zero leading to the close-down of the index in June 2003 due to the massive image loss it had caused to the German stock exchange. Until then many firms of “NEMAX” had filed for insolvency.[8] Ironically most firms of “NEMAX” providing free content or services are still successful firms or mergers. For example “Freenet AG” or “Web.de AG” as part of the “United Internet AG” are now listed in the “TecDax”, the German stock index replacing “NEMAX”. It is important to understand that the business models in the digital economy are very heterogeneous and the often cited ICT sector is only a part of a whole complex. The BVDW (German association of the digital economy) classifies the three main segments in the digital economy as service access, applications and services as well as end user interaction.[9] Most firms affected by the bursting of the “dot com bubble” in Germany were part of the service access segment including providers of technological infrastructure and consumer electronics. Examples are “Gigabell”, “SZ Testsysteme”, “Bintec Communications” and “MetaBox”.
So the gratis mentality and information goods for free were not the root of failing business models in the “NEMAX”. By amplifying goods and services distributed by the internet the economic impact on the German economy grew steadily. The digital economy became a “growth engine for the German economy”[10]. The positive development is shown in a recently published report of the BVDW which reveals average turnover growth rates of approximately nine percent since 2008 and it forecasts a turnover of about 120 billion Euros in the digital market.[11] Nevertheless it is obvious that by browsing the web you can use many websites and their services for free, and if you search for a new movie you will probably find a source to download it for free illegally. Do information goods favor an economy where you can obtain valuable goods for free?
1.2. Classification of information goods
In literature there is confusion about how to define goods and services which can be transformed into binary code. The terms “information goods” and “digital goods” are often considered to be the same.
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Tab. 1: Definitions of information goods
It is important to notice, that information goods do not necessarily have to be available digitally. Since information goods are very heterogeneous it is necessary to classify them as part of tangible and intangible goods (see figure 1). Some information can only be accessed by using a physical medium, without the possibility to reutilize this medium to hold any other information (e.g. books, non-rewritable CDs/DVDs). The carrier medium leads to the excludability of non-payers. If the same information is accessible digitally it is very difficult to create excludability because the reproduction is very cheap and easy. The only requirement is the binary code which represents a digital information good. Take books for instance. If you have a book of 350 pages, copying it will be time-consuming, it requires physical resources and it probably results in a reduction of quality whereas an ebook as the digital counterpart of the physical information good book will be copied and pasted in another hard drive by simply using a two button combination on your keyboard.
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Figure 1: Classification of information goods[13]
If an information good is only available on a tangible medium without digital substitute it underlies the same principles of scarcity and excludability as other goods due to physical limitations. But if it is possible to create a digital counterpart, consumers may attribute the abundance of bits and bytes to the physical version which normally leads to a reduction of willingness for payment. Therefore a question arose concerning information goods. Is free a new business model which is about to innovate the economic theory?
2. Freeconomics
2.1. Definition
The term freeconomics was defined in an article by Chris Anderson, Chief editor of the US magazine “Wired”. It was published in 2008 as the basis of a book which was about to follow in 2009.[14] The term is made up of two words, free and economics. Free is defined as “without cost or payment“[15] In the context of an economic model free means that one can access, use and possess a tangible or intangible entity without a monetary compensation or equivalents. A 19th century economist called Andrew Marshall stated that “economics is a study of mankind in the ordinary business life”.[16] This simple 19th century definition was verified by Mankiw, professor of economics in his 2006 book, where he says that it is “as true today as it was in 1890.”[17] So the term freeconomics could be defined as the study of human behavior in a business world of abundant information goods which are available without monetary costs or payment.
2.2. Why can online businesses offer goods for free?
Anderson argues that marginal costs are dropping with a trend to zero because of almost zero bandwidth, storage and processing costs.[18] According to him the so called first copy costs which are necessary to create an information good and make it available, are the only considerable costs in the economy of internet. In an offline economy physical goods and services involve higher marginal costs due to the scarce factors of human labor and natural resources. In the online economy once an information good is created associated with scarce factors it has no further cost. This argument leads him to the conclusion that information goods available in abundance should be free, since there is no scarcity of input and output and people in a business world would not be willing to pay for abundant goods.[19] His suggestion is “giving away one thing to create demand for another.[20] He considers this radical strategy to be highly important in an online economy where information is abundant and attention is scarce because it is driven by the limited time of a human being.
If you give away a good without monetary compensation what compensation do you get from user or customer of a free good? You get a part of scarce attention which can be converted to money although more difficult. Nevertheless many online businesses use attention as main performance figure. The CTR (Click-Through-Rate) which shows the number of clicks per impressions on a result page is calculated to measure performance in search engines and unique visitors are indicators of success. The monetary dimension is sometimes forgotten since attention will probably convert into future money.
There are different forms of free goods. One form is free giveaways as marketing tool to stimulate the demand for the very same or complementary products. The aim is to convince consumers, who can experience and evaluate a good. By that it’s also possible to create demand for another product because the free good is either useless without the paid good or it directly increases the need for some entirely different good, like free beer would increase appetite. Another form of free is to give a product away as gift. This happens to attract attention, increase reputation or of mere altruism. Piracy of information goods is a form of imposed free.[21] Information goods piracy is possible due to the same principles of distributing non-pirated content on the internet. If you upload a pirated version of an information good it is easy to spread it (almost) without costs across the whole globe.
2.3. The paradoxon of information goods
Stewart Brand, an US author, stated a sentence which started a probably never-ending discussion about business models for abundant information goods on the internet. The most remembered part of his sentence is “Information wants to be free…” of a whole sentence that, instead of proclaiming a new law for information goods, was meant to show a paradoxon. He said: “On the one hand information wants to be expensive, because it's so valuable. The right information in the right place just changes your life. On the other hand, information wants to be free, because the cost of getting it out is getting lower and lower all the time. So you have these two fighting against each other.”[22] The paradoxon creates contradictions between economists, authors and managers who observe the online information goods sector. Whereas Anderson sees it as a quasi natural law that abundance of information leads to offering it for free “…like water will always flow downhill…”[23], Gladwell, author of the New Yorker, states that “free is just another price …“ and “…information can’t actually want anything…”[24]. In an interview Brand said that this information goods “…paradox is constantly restating its opposite”[25], that’s what a paradoxon always does.
3. Free from the demand-side perspective
3.1. Microeconomic aspects of free
The model of homo economicus is very popular in neoclassic economics. It emphasizes the complete rationality of economic agents. On the supply-side the main focus lies on maximizing profit while the demand side maximizes utility.[26] In this model it is possible to predict the decision an economic agent would make if he had to choose between goods and its attributes which represent utility. The model states that all economic agents are fully informed about quality and prices and act totally rational.[27] They try to maximize utility or profit with a given amount of limited monetary and non-monetary resources, including opportunity costs such as time and attention. In this paper the focus lies on illustrating demand-side tendencies concerning free goods. It is therefore important to have a closer look on how utility functions influence an economic decision and which demand curves result from rational behavior concerning digital information goods connected to free.
3.1.1. Utility function and determinants of demand
A utility function reflects the decision of consumers which bundle of goods they should consume as optimum of given limitations.[28] We consider and to be two different information goods with the same benefit. A most simplistic utility function where a consumer would be indifferent about which good to consume is . The theory expects the economic agent to choose the combination with the maximum utility, whereas demand is limited by scarce resource factors ( ), such as money, time, attention etc. We assume all resources to be sufficient in this model. For information goods it is not expedient to assume that the utility increases by an additional information good which offers the same benefit, because if you possess an information it is useless to consume a further entity of the same one.[29] So the outcome is either a consumption of one or the other.
[...]
[1]: See Kelly (1998), p. 2
[2]: Anderson (2007)
[3]: Translated from Picot (2009), p. 654
[4]: Anderson (2009), p. 119
[5]: See Moore (1965)
[6]: Greenspan (1998)
[7]: Kelly (2001), p. 9
[8]: See Von Kalckreuth; Silbermann (2010), p.2
[9]: BVDW (2011), p. 3
[10]: BVDW (2011), p.3
[11]: BVDW (2011), p.4
[12]: translated from German
[13]: Based on Luxem (2001), p. 20
[14]: Anderson C. in Wired Magazine (2008)
[15]: Oxford Dictionary
[16]: Mankiw N. G. (2011), preface
[17]: Mankiw N. G. (2011), preface
[18]: Anderson C. (2009), p.241
[19]: See Anderson C. (2009)
[20]: Anderson C. (2009), p.10
[21]: Anderson (2009), p.71
[22]: Brand (1987), p. 202
[23]: Anderson (2009), p.52
[24]: Gladwell (2009)
[25]: Brand (2009)
[26]: See Kirchgässner (2008), p. 60
[27]: Kirchgässner (2000), p. 64
[28]: Varian (2000), p. 89 ff
[29]: Linde (2005), p. 73