How Geeks Misunderstand Economics and Marketing

by Nick Tuesday, December 30, 2008 3:53 PM

As high quality technologists (which I assume all my readers are ;) ), most of us are usually fairly specialized in our field.  In other words, we're very good at what we do for a living, and that often comes at a price at not knowing other things, even if they have some importance on our business.  For instance, we may be very good at programming in C#, Java, etc. and can tell you the classes in the BCL by heart, or list off the GoF patterns from memory, but couldn't figure out how to make money selling software if we tried.  I quickly thought of that as I was reading this article in the New York Times on the cost of text messaging vs. what we are charged:

TEXT messaging is a wonderful business to be in: about 2.5 trillion messages will have been sent from cellphones worldwide this year. The public assumes that the wireless carriers’ costs are far higher than they actually are, and profit margins are concealed by a heavy curtain.
...
Professor Keshav said that once a carrier invests in the centralized storage equipment — storing a terabyte now costs only $100 and is dropping - and the staff to maintain it, its costs are basically covered. "Operating costs are relatively insensitive to volume,” he said. “It doesn’t cost the carrier much more to transmit a hundred million messages than a million."

Once one understands that a text message travels wirelessly as a stowaway within a control channel, one sees the carriers’ pricing plans in an entirely new light. The most profitable plan for the carriers will be the one that collects the most revenue from the customer: unlimited messaging, for which AT&T and Sprint charge $20 a month and T-Mobile, $15.

The entire premise of the article is in essence to say, you the consumer are being ripped off, because text messages cost nearly nothing to transmit, while it costs you the consumer significantly more to actually send them.  There is even a reference to an investigation spurred on by Sen. Herb Kohl.  Clearly, the intent is to suggest that we're being "gouged".  Unfortunately, this perpetuates the myth that the price of a good or service needs to somehow be directly related to the cost of production, and that charging more than some percentage higher than the cost is somehow wrong or illegal.  Worse yet is when these improper assumptions lead to regulation which then hamper the ability of businesses to market in new and innovative ways.  But I'm being too generic here.  Let's look at specifics.

If I write some software package and offer to send it to you on a CD for $50 (plus S&H), is that justified?  After all, it costs less than a dollar (maybe even a quarter) to actually burn a CD these days.  Worse yet, what if I charge you the same for an electronic download which cost even less to distribute?  You and I know that there is nothing wrong with that, because we naturally think of all the time and effort it took to actually write the software itself.  Part of what we charge reimburses us for our initial time, when we weren't making any money on the yet completed software.

Look at a different example, in the gaming industry.  Companies charge $50 - $60 a copy for games on the Xbox 360, PS3 and Wii.  A significant amount of that cost is actually wrapped up in licensing fees that go to the console maker (Microsoft, Sony and Nintendo).  Are those licensing fees too excessive?  At first glance, it may seem so.  However, when you look at the business as a whole, you see that its simply a marketing technique.  That's because the console maker actually take a significant loss on each of the consoles it makes in order to get enough gamers in the market.  They then try to recoup that money through licensing fees on the games themselves.  In other words, the higher cost of the games is used to subsidize the console.  You can't separate the cost of the game from the cost of the console.  If they charge less for games, then the consoles would have to be more expensive.

Many people want to demand "a la carte" pricing from cable companies, but that too would come at a price.  Many channels are simply not watched enough to pay for themselves if they were priced on their own.  They only exist because they can be bundled with more popular channels in a package.  Cable companies are able to offer a wider variety of channels for smaller niche audiences because they charge more money than normal for popular ones.

Similarly, it is unfair to look at the cost of text messaging on its own.  In fact, cell phone companies work similarly to game console manufacturers in that they actually take a hit on the phone itself, in exchange for your cell phone contract.  Text messaging is likewise used a constant overall revenue stream, while the companies take losses in other areas.  Looking at text messaging as a whole ignores other areas of the business that may take a loss, or a much smaller profit.  If you force companies to charge less for text messaging, then other services may be made more expensive in order to make up the difference in profitability.  Worse yet, some services that are offered at a loss may be eliminated because people would be unwilling to pay their true cost, which might cost customers.

Of course, the real problem, once again, is the view that the price charged for a good or service needs to be directly related to the cost in providing it.  However, the reality is that the cost of a service is only limited to the willingness for people to pay for it.  There is nothing wrong with that.  It merely places a value on your desire for a service.  As soon as a company starts charging more than you value the service, you simply stop paying for it.  The actual cost in providing it is only relevant so long as the company can charge enough to stay in business.

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Nick Schweitzer Nick Schweitzer
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I'm a Software Consultant in the Milwaukee area. Among various geeky pursuits, I'm also an amateur triathlete, and enjoy rock climbing. I also like to think I'm a political pundit. ... Full Bio

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