Econ 101: Cost, Price, Value

Hoisted from the comments on my most recent Economics 101:

Why should Anyone (me) pay virtually the same price for an e-book as for a paperback? I get less in terms of ownership rights, ie resale, or lending to friends and family, and apparently Amazon can take the damn thing back at any time without permission. I do have an e-reader , not a Kindle and I love it, I don't love the way publishers have diminished my rights of ownership.

I believe that this comment demonstrates a common conflation: value, price, and (covertly) cost. Let's unpack it and see.

Value is an intangible, subjective thing. It is the judgement, by an individual, of what something (an iPad, say) is worth to them. Market value is an accumulation of individual judgements of value.

Price is a tangible, objective thing. It is the statement, by the owner of a thing, of how much it would cost to purchase that thing (from them).

Cost is a tangible, objective (but different to calculate) thing. It is the accumulation of what had to be spent to create or acquire a thing. In a value chain, the cost of an item will vary as it passes through the chain. If we imagine a physical book, for example:

• The cost of the book to the publisher includes: cost to acquire the book rights; cost to have each copy of the book printed; cost to store and ship those books; pro-rata overhead costs attributed to the book; etc...
• The cost of the book to a wholesaler who purchases the book directly from the publisher is whatever the publisher charges them per book plus: accumulated costs to store and ship the books; cost to advertise the book in trade publications and sales/marketing materials; pro-rata overhead costs attributed to the book; and so on...
• The cost of the book to a medium-sized chain bookstore that purchases directly from the wholesaler above is whatever the wholesaler charges them per book plus: costs to store and ship the books; cost to advertise the book in local publications; print and place signage in and around their stores; pro-rata overhead costs attributed to the book; etc...
• The cost of the book to an end-user who buys it from the medium-sized chain is whatever the chain charged them plus: cost to drive to the chain store and park; cost of the coffee and cookie they bought because they were in the bookstore; etc...

As demonstrated above, there are many possible definitions for cost. Whenever you use the term cost you have to be careful to make sure to specify what cost you're dealing with.

In order to make a profit and stay in business over the long term, price has to be higher then cost. At each step of the value chain, the buyer is going to spend more for the item than the seller paid for it. Ultimately, each buyer must decide that the value of the item is higher than its cost. For anyone who is planning to re-sell an item, the value is easily set as the price for which it will be sold (with some allowance for shrinkage and the reality that not all of something will sell).

Economists assume that users make internally consistent and rational choices about the value of items. They don't, but economists like to assume that. So in any transaction, the buyer has decided that the value of the item is more than its cost (which is the price plus attendant costs to acquire), while the seller has decided that the value of the item is less than its price. Mathematically:

Which clearly shows that there must be a difference between Vb (value to the buyer) and Vs (value to the seller).

This is the essence of a market transaction.

With respect to physical books and eBooks, the question arises: is the price set according to the cost or the value? From a publishing/warehousing/distribution/retail perspective, costs set a floor on price. From a consumer's perspective, value sets a ceiling on price. If a book producer cannot create a book which has sufficient (average) value which is higher than the cost to produce, they can't stay in business.

The question a consumer asks themselves isn't "do you feel lucky?", it's what is the relative value to me of an eBook and a physical book? Some people say an eBook has lower value because of DRM (if we're talking about a Kindle book), limited capability to lend the book, requirement for batteries to read, or inability to recoup residual value (i.e. re-sell the book). Some people say an eBook has higher value because it occupies less volume, has less mass, or can be read in the dark. The point is that eBook value is idiosyncratic. Just like value is for everything.

Personally, I value the virtual volume and mass of eBooks. I have 100 banker's boxes of books in the garage. I buy eBooks and keep them on hard drives -- even Kindle books, which can be downloaded onto the computer and transferred to the Kindle via USB. I have several thousand eBooks (in various formats). I love the fact that they fit onto a hard drive instead of requiring more boxes in the garage (where they are inaccessible), more bookshelves, more house to hold those bookshelves and boxes (perhaps 20% of my house is dedicated to books and other media which could be reduced to bits upon hard drives).

That's a conscious decision on my part, that virtual mass and volume has value. I recognize the potential for losing a subset of my eBooks to: DRM; format changes; hard drive failure; or unforeseen issues. Just as I recognize the potential for losing a subset of my physical books to: theft; flood; vermin; physical loss; shrinkage; or unforeseen issues.

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Econ 101: Capital vs. Consumable

From Have we seen the end of the $9.99 eBook? at The Unofficial Apple Weblog:

Amazon currently charges $9.99 for most books, which, according to AppleInsider, means that Amazon is losing $4.50 per book to keep its leadership position in the eBook market and keep Kindles selling. This strategy is similar to the loss-leader marketing popularized by Gillette who sold razors at a loss in the hopes of more than making up for it in the sales of blades.

Uh, no. That strategy is, in some sense, the opposite of selling razors at a loss and making it up in the sale of blades.

In order to understand this apparently complex system, you need to understand one way of dividing objects into two categories: capital, or consumable.

Capital is something which makes value, or enables making value. As a rule, it is a relatively fixed cost which is paid regardless of the amount of production. For example: manufacturing equipment is capital. The Gillette razor is, conceptually, capital -- because its cost does not vary with the number of shaves.

The opposite of Capital (in this simplistic view) is Consumable. Consumables are used (and generally used up) in the creation of value. The raw materials converted by Capital into value (and used up in the process) are Consumables. In the Gillette example, blades are consumables because the total cost of blades varies directly with the number of shaves. EBooks are a Consumable.

So let's go back and take a look at that quote again, with my inserts in italics:

Amazon currently charges $9.99 for most books (consumables), which, according to AppleInsider, means that Amazon is losing $4.50 per book to keep its leadership position in the eBook market and keep Kindles (capital) selling. This strategy is similar to the loss-leader marketing popularized by Gillette who sold razors (capital) at a loss in the hopes of more than making up for it in the sales of blades (consumables).

In other words, selling consumables at a loss to keep selling capital is the same as selling capital at a loss in order to sell consumables.

Riiiiiiiight.

Let's start again: what Amazon does, presumably, is price the consumables (eBooks) low so that it will drive sales of the capital device (Kindle). What Gillette did was price the capital device (the razor) low to lock users into purchases of relatively expensive consumables (blades).

Those are not the same thing. Amazon is (probably) trying to gain market share for the Kindle regardless of profitability so they can sell eBooks at a loss in hopes that they can seize the market and make it profitable later. Gillette was trying to gain market share for the razor so they could sell blades at a tremendous markup and be profitable now.

Clear?

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iPad, therefore i...Read?

(in my mind, at Adobe, 1998)

A tablet-type device, 8"x10" (that's a 12-13" diagonal screen) or so, capable of displaying PDF, would be worth $1000. As this is pre-widespread wireless network, no thought of connectivity enters into the picture.

(in my mind, last week)

I don't know what the mythical Apple Tablet is going to be, but I would be happy with a device twice the size of the iPhone, which screen would be about 4x6, so long as I can:

1. read Kindle books and PDFs on it;
2. attach a keyboard in order to be able to type;
3. run some large subset of either iPhone or Mac apps, or perhaps both

I would consider paying $800, possibly $1000 for such a device, depending upon battery life, CPU power, connectivity, etc.

But that would be a very prosaic device to be shipped by Apple as a paradigm shifting device. I find it difficult to believe that Apple would do something that ... straightforward.

(San Francisco, 2010.01.27)

Apple introduced a new computing device today, the Apple iPad. It is an attempt to find a sweet spot as "a third device" between the smartphone and a notebook. Since the smartphone itself is really an Apple invention (that is, the iPhone is the standard by which other smartphones are judged, as evidenced by the fact that every new iPhone is an "iPhone killer"), this is Apple attempting to extend their portable device domination* up the computer power ladder toward notebook computers.

I will start by saying that I find the name "iPad" completely uninspiring. As has been pointed out, it sounds like a feminine hygiene product. It's also easily confusable with iPod, and it's owned by Fujitsu in the USA.

Specs:

7.5" x 9.5" x .5"

16, 32, or 64 GB of flash memory

WiFi and optional 3G connectivity, Bluetooth 2.1

1.5 - 1.6 pounds

1024 x 768 pixel display @ 132 ppi IPS (in-plane switching) Multi-Touch Screen

1 GHz Apple A4 custom SOC (system on a chip)

Accelerometer, Ambient Light Sensor, Digital Compass, GPS

Microphone, Speakers, Headphone Jack

On-screen keyboard

Dock for charging, optional video out, optional physical keyboard

iPhone OS 3.2 (currently in Beta)

10h Claimed Battery Capacity

Notably Missing:

Cellular Voice capability

Camera & Flash

SDHC slot for expanded memory

Front-facing Camera for Video Conferencing

Multitasking (apparently)

RAM capacity unannounced so far as I can tell, but I assume 256MB or above.

Support Structure:

iBooks store

Pricing:

WiFi Only: $500 - $700

WiFi + 3G: $630 - $830

The Obvious

The basic specs are nice, although IMO the jury is still out on the 1GHz SOC CPU/GPU combination. No one seems to have much of a grip on just how powerful this chip is compared to what's in the iPhone 3G or 3GS, although it is presumably at least 2/3 faster than the 3GS chip (which runs at 600 Mhz). This is an iPhone on steroids, less the cellular voice capability (it would appear to retain at least the potential for VOIP via WiFi and/or 3G), minus the camera. Alternately, it's an iPod Touch on steroids, plus optional 3G data capability.

The Price

Personally, I found the price surprisingly low, and the suggested data plans very reasonable. I would have paid more for this system, but I'm not Apple's target market. I think at $500 this is a very attractive alternative to a netbook, assuming the text input system works well. With a top end of $830 for the 64GB WiFi+3G model (plus another assumed $100 for the keyboard doc and keyboard or a dock and Bluetooth keyboard combination) you have a new, cheaper, lighter, more portable way to have the elegance of an Apple product as your primary portable computing system.**

Books are the new Music?

Apple also announced a reader application called iBook and the new iBook store. Partnering with five major publishing houses (HarperCollins, Penguin, Simon & Shuster, Macmillian, and Hachette Book Group), books will be presented in the ePub format, an existing open standard for publishing based upon XML. The iBook app looks a lot like Delicious Library and will connect directly to the IBook store. There is brief mention of a partnership with Amazon [@ 10:54], but no details, so I don't know if that is correct or not.

Regardless of their relationship with Amazon, I think it perfectly likely that the Kindle app will continue to work on iPad, making it even more possible for people to buy Kindle books from Amazon. ePub does support optional DRM, making it possible for iBooks to be difficult to copy and opening the door for Kindle to support iBooks and possibly for iBook to support Kindle volumes.

It seems clear that Apple is attempting to disrupt the print publishing world in more or less the same way they disrupted the music publishing world with the iTunes Music Store. Despite Steve Jobs' famous assertion that "people don't read anymore", the iPad and iBook ecosystem is clearly intended to make reading paper a thing of the past if at all possible. Given that 3-5% of the books published today are eBooks, there's clearly a lot of room for growth. Since a lot of the cost of a book is the physical medium on which it's delivered, there's clearly a lot of room for cost savings in the publishing pipeline by switching to lower-cost digital media.

Which raises the question: what do print publishers bring to the party? In an effort to cut costs, book publishers have all but abandoned the secondary services they used to provide authors: copy editing, proofing, and type and layout design. They have become merely infrastructure to turn digital files into physical books, distribute those books, collect money for them, and arrange for the disposal of the excess volumes. Most of those steps are unnecessary in a digital world, and it will be interesting to see how book publishers morph in the face of a potential industry-wide disruption of this scale. When you and I can publish simply by creating a digital manuscript and offering it to the iBook store (or the Kindle store), the major publishers become nothing more than marketing machines and will have to reinvent themselves as such or face increasing irrelevancy. Amazon and Kindle started the process. If the iPad and iBook ecosystem becomes as popular as the iPhone, Apple and iPad may finish it.

The Missing

Let's reprise that list of things "Notably Missing" from the iPad:

1. Cellular Voice capability
2. Camera & Flash
3. SDHC slot for expanded memory
4. Front-facing Camera for Video Conferencing
5. Multitasking (apparently)

1. Cellular Voice: I don't think this is a big deal one way or the other. VOIP will be an option (at least over WiFi, and possibly over 3G depending up carrier -- Apple will not be able to claim that VOIP apps are impinging upon the base phone capability in this device). Using a Bluetooth headset is increasingly required by law when driving, so using a hands-free device with the iPad doesn't seem like a big stretch, so the argument that "you can't put a device that big up to your ear to make a phone call" falls by the wayside. That said, adding voice capability might have increased the cost of the device and would have definitely increased the complexity of the pricing.

2. Camera and flash: I am a heretic in this matter -- I believe in carrying dedicated cameras for specific purposes. I do use the camera in my iPhone on occasion because it is the only camera I carry all the time. When I expect to be doing casual photography, I carry one of two different small point-and-shoot digital cameras, and when I expect to do serious photography, I carry a digital SLR and way too much glass. The iPad is not appropriately sized to use as a camera, even casually, and I don't see the point of saddling it with camera circuitry, battery draining flash, and the software to deal with them for the minor gain of having an inferior photography experience.

3. SDHC (or other removable media) for expansion: 64GB ought to be enough for anybody :-). With reasonably constant network access and USB 2.0 connectivity, I don't feel that expanded capacity is that big a deal -- it hasn't been for the iPhone, hasn't been for the (much more limited) Kindle 2, and I don't see why this should be different. The Macbook Air has less capacity and is doing just fine.

That said, I would have appreciated a CF or SDHC slot for photographic media, like I have in my MacBook Pro. I anticipate an add-on reader and accept that my needs may not match the needs of the majority.

4. Front Facing Camera for Video Conferencing: I think this is a matter of positioning more than anything else. The iPad is clearly intended as a media device, playing music, video, and text. If it were positioned as a business device I think the lack of a front facing camera would be much more egregious.

5. Multitasking: depending upon the power of the CPU/GPU this may be a temporary omission. I think Apple has decided that the simplicity and robustness of a (largely) single-app-at-a-time OS trumps multitasking. It simplifies the user experience, simplifies the programming experience, and makes the system more reliable in a resource limited platform. As a geek, I do rather miss multitasking, but I don't think most users will. At all. Especially if switching between apps is a fast as it can be with a faster CPU with more RAM.

Ultimately, the feeding frenzy of rumours inflated the expectations of a lot of people. A device with all the bells and whistles suggested by the rumourmongers (some of them, I'm sure, planted by Apple deliberately) would have been the hardware equivalent of Microsoft Word: big, slow, expensive, and full of features that few people want. It's a truism that most users use 10% of available features, and it's the overlap of those 10%s which create monsters like Word. Apple is as much about paring down features to the required elegant minimum as they are about discovering new critical features which no one else imagined.

I think the iPad sounds like a good balance. Depending upon its power (which is a bit of a mystery) and its battery life (which must always be seen in context of a specific use profile) and its text input capabilities (and I think I trust that Apple nailed this one -- one way or another), it may create that "third device" category Jobs talked about during the unveiling. Does it have the potential to be a world-changer (like the iPhone)? I believe it does. Might it be the second coming of Newton? It could be, but I doubt it. If it is, I think I will be one of those people still using it a decade or more later, just because it's so cool.

There's a lot more to say, but I think this is enough for now. The iPad obviously has huge potential for vertical markets (especially healthcare) and the ease of programming it (presumably) inherits from the iPhone makes it a more nimble platform than anything Windows based. These (and more) are subjects for a different time.

*Yes, iPhones comprise only 30% of the smartphone market, and smartphones are only a bit over 10% of the worldwide market, making iPhones total penetration a mere 3%. But that 3% is making Apple more money than Nokia's 40% market penetration, and is absorbing 50% of the portable network bandwidth.

** Ultimately, this configuration is cheaper than either a subsidized or unsubsidized iPhone. With the larger display and faster CPU/GPU, it is very probably a more capable computing platform.

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