Supply And Demand in The Age Of Infinite Supply

The following appears courtesy of The Music Void. See all of Ted Cohen’s Digital Diatribe columns for The Music Void at TheMusicVoid.com.

Lately, there’s been renewed chatter about the price of a digital download and just where, exactly, is the “sweet spot” for the industry and consumers. Last week, producer/professor/entrepreneur/thinker Sandy Pearlman again broached his theory of the five-cent download. Yesterday, 7digital announced its long-awaited launch in the US, and plans to compete on price by selling MP3s at $0.77 and whole albums for $7.77. This alone is a big shift from the current trend of raising the price of downloads to $1.29.

The thinking behind the five-cent download is, well, that there is no thinking. At five cents, consumers won’t give a second thought to the purchase decision – even if the song sucks, it’s only a nickel, right? For five cents, it’s far easier to get the real (high quality) track from a legitimate source, complete with accurate meta data, album art, and even lyrics, than play roulette with illegal services and risk downloading crap. According to Pearlman’s research, the breaking point here is ten cents; as soon as you hit double digits, people start to think twice.

Let’s pause for a second to take in a basic lesson in economics – that of supply and demand. If supply is low and demand is high, the optimum pricing strategy is to price the product extremely high – surely you’ll find a few suckers willing to vastly overpay, since there are only a few available. In the music industry, think concerts – you can only fit so many people into the venue, so if you want to see U2, you’ve gotta pay the price. If demand is low and supply is high, it’s a buyer’s market and prices plummet – everybody’s desperate for a sale. These days, think CD sales. Market forces cause supply and demand to even out over time (at some level), called equilibrium. Of course, sometimes equilibrium falls at a point with a price below cost, and everybody ends up with nothing, but that’s normal.

But what happens if there is infinite supply? You can’t manufacture less. Incremental production costs in the digital world are basically zero. The biggest cost of a digital download (other than licensing, of course) is the transaction cost. We know, based on illegal downloading, that demand for music is incredibly high. Ideally, we want to meet that demand (legally), and economically, the best way to do that is to lower the price.

In 2003, Listen.com and Rhapsody conducted a test to see what would happen if they sold downloads for 49 cents instead of 99. The result? Downloads tripled. It doesn’t take a mathematician to see the dollars; three times the downloads at half the price equals fifty percent more money.

But is that actually reality? On the surface, it looks like a no-brainer; lower the price and watch the cash roll in. But to really understand what happens in these cases, we have to look deeper. In the Rhapsody case, the 49 cent price point was a limited time offer, and was heavily promoted and covered by the media. How many of those purchases can be attributed to good old fashioned marketing? Plus, every other download source was selling music at 99 cents a track; when you’re half the price of your competition, you’re going to lure a lot of customers away from them – so in fact, the experiment may have actually lost money for the industry, if those extra purchases would otherwise have been made at 99 cents at iTunes or elsewhere.

If we go back to Pearlman’s five cent theory, we have to ask a few more questions. At five cents, will sales volumes be twenty times higher? What effect will the increased transaction costs have on net revenue? And perhaps most importantly, is any price greater than zero actually a “sweet spot”?

In 2007, venture capitalist Josh Kopelman wrote about a phenomenon he labeled the “Penny Gap”, whereby demand grew massively when price decreased from $0.01 to free (or, if you’re a glass half empty type, demand dropped by a huge amount when introducing any price). Simply put, there are a huge number of people unwilling to pay anything for most products – and it isn’t hard to see music being one of those. While five cents might seem like the sweet spot, we can be virtually certain that it won’t convert all those music pirates. In fact, it may hardly convert any of them.

So what’s the right answer? At this point, it doesn’t seem clear. However, I recently wrote about the concept of an experimental music license for startups to prove their concepts; perhaps it’s time the industry did some real, long-term experimentation with pricing (both lower and higher) to find out what the true “sweet spot” really is. Until then, we may never know for sure.

Posted by Ted • Wednesday, October 7, 2009 .