Digital content and related businesses such as data transport and access often face profitability issues because of marginal cost pricing, in a broad sense. Marginal cost pricing is the practice setting the price of a product to equal the extra cost of producing an extra unit of output.
Of course, digital goods are prime examples. What is the additional cost of delivering one more song, one more text message, one more email, one more web page, one more megabyte, one more voice conversation? What is the marginal cost of one more compute cycle, one more gigabyte of storage, one more transaction?
Note that entities often use marginal cost pricing during recessions or in highly-competitive markets where price matters. Marginal cost pricing also happens in zero-sum markets, where a unit sold by one supplier must come at the expense of some other supplier.
In essence, marginal cost pricing is the underlying theory behind the offering of discounts. Once a production line is started, once a network or product is built, there often is little additional cost to sell the next unit. If marginal cost is $1, and retail price is $2, any sale above $1 represents a net profit gain.
Of course, price wars often result, changing expected market prices in a downward direction.
But marginal cost pricing has a flaw: it only recovers the cost of producing the next unit. It does not aid in the recovery of sunk and capital costs. Sustainable entities must recoup their full costs, including capital and other sunk costs, not simply their cost to produce and sell one more unit.
So the core problem with pricing at marginal cost (the cost to produce the next unit), or close to it, is that the actual recovery of sunk costs does not happen. Sometimes we are tempted to think the problem is commoditization, or low perceived value, and that also can be an issue.
One arguably sees this problem in wide area data transport and internet transit pricing, for example.
Software suppliers have an advantage, compared to producers of physical products, as the marginal costs to replicate one more instance are quite low, compared to the cost of adding another production line or facility; the cost of building additional access networks or devices. \\A company that is looking to maximize its profits will produce “up to the point where marginal cost equals marginal revenue.” In a business with economies of scale, increasing scale tends to reduce marginal costs. Digital businesses, in particular, have marginal costs quite close to zero.
The practical result is a drop in retail pricing, such as music streaming average revenue per account, mobile service average revenue per user, the cost of phone calls, sending text, email or multimedia messages, the cost of videoconferencing or price of products sold on exchanges and marketplaces.
Of course, there are other drivers of cost, and therefore pricing. Marketing, advertising, power costs, transportation and logistics, personnel and other overhead do matter as well. But most of those are essentially sunk costs. Many of those costs do not change as one incremental unit is produced and sold.
Which is why some argue the price of digital goods tends toward zero, considering only production costs. Most of the other price drivers for digital goods might not be related directly to production cost, however. Competition, brand investments and bargaining power can be big influences as well.
Still, marginal cost pricing is a major reason why digital goods prices can face huge pricing pressure.
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