The zero marginal cost of digital products

My tenth post, halfway to 20! This was the hardest topic yet to write about and I will likely update my views and formulations of the points below in the future.

One of the two fundamental properties of digital products, that I believe make them different, is the zero (or near zero) marginal cost of producing them. In this post I expand on this concept and aim to show how this property affects competition and strategic planning. 

Marginal cost is the cost associated with producing an additional copy of a good. For in every industry (until digital products) this cost was:

  1. Larger than zero
  2. Decreasing with increasing cumulative volumes

In traditional industries this was the foundation to the “economies of scale” of large companies. I.e. large companies could in theory do everything a smaller company could but thanks to its scale do it to a lower price. In an industry where almost identical products can have very different prices customers will focus on price in their purchase decisions and, most other things being equal, choose the cheaper alternative.

Contrast this to digital products. How different would the competitive landscape of digital products be if a small company would have a marginal cost of $100 for each new customer whereas a large company would only have a cost of $10. The though is almost absurd but think how much harder it would have been for companies like Slack to compete with Microsoft Teams if each new Slack user incurred a cost 10X that of Microsoft’s. Microsoft would in this scenario likely be able to out-price Slack just by virtue of its size. It’s reasonable to assume that Slack could not have provided its services for free if such a marginal cost were in affect.

This matters for strategy. In a world where price per unit is a driver for customer volumes, planning for lower prices becomes an integral part of strategy. Detailed planning is done on whether to build another factory this year to increase volumes and lower prices or to not invest and instead return more to shareholders. These strategic choices are mostly internal and thus more controllable. Strategy is in the environment rightly thought of as a game of chess where the grand-master could think one more step ahead (i.e. have a more detailed business case) than his competitor.

In a world where the marginal cost is zero however, prices will quickly be competed away as a factor and customer will therefore look for other factors. These factors are usually external to the company that provides the services and therefore less controllable. They can range from: “How usable is to product?”, “Does it solve my particular need?” etc. I believe there are actually very few factors that affects a customer’s decision to use a digital product that the company can control by focusing only on internal processes. Strategy therefore becomes much more of the poker game I’ve described earlier: instead of doing detailed business cases to justify large investment we make many small investments and see them as experiments to learn more about what our customers actually want.

As I wrote in the introduction, this is a tricky topic. One could, for example, argue that consumer brands for ages has used customer knowledge to build differentiated products and move away from price as a factor in purchase decision. This is true but I believe the zero marginal cost makes this even more important in digital products. However, zero marginal cost might not have been enough as a single property. I believe it’s the combination of the the zero marginal cost with the high malleability of digital products that ultimately makes it necessary for companies in this industry to approach strategy in different way.

In the next post we’ll look into malleability and how this beneficial property though competition can start to dictate how we see strategy.