How much extra would you pay for an iPod that has unlimited access to all the music on iTunes?

Personally, I think I’d be willing to pay up to 50% more than the price of the iPod alone. I reckon this could be a pretty successful business model. Unfortunately, I recently bought a new iPod. If this rumour is true, I hope they offer an upgrade for existing iPods as well as selling it with new ones.

A friend of mine was complaining about having too many choices for lunch. Go to a salad bar, and you have to make ten decisions about the ingredients of your salad. Sure, you can get close to your perfect custom-made salad, but only at a significant cognitive/transaction cost.

Yet, we do not see many ‘Soviet’ salad bars offering only two or three pre-set choices. Instead we seem to see the opposite — increasing tendency towards more choices (Subway; a million different kinds of coffee).

I wonder if this is because people’s tastes in terms of salad are sufficiently different that any transaction cost savings of offering fewer choices are swamped by the dissatisfaction of getting something that’s too far away from your ideal preference?

Ask.com tried to compete with Google as an all-purpose search engine, but found that it can’t. So instead of being generic, they’ve gone for a pretty narrow niche:

In a dramatic about-face, Ask.com is abandoning its effort to outshine Internet search leader Google Inc. and will instead focus on a narrower market consisting of married women looking for help managing their lives.

Once you get over your shock at this dramatic change, it actually doesn’t sound like a bad idea. They almost certainly have a better chance of making money out of that niche than competing head-to-head with Google. Just because a niche sounds a little weird doesn’t mean it’s not profitable.

This article in Wired has a great account of the contest for the Netflix Prize. In late 2006, Netflix offered a US$1m prize for anyone who could come up with a movie recommendation algorithm that performed 10% better than its own. So far, the prize is unclaimed, although the leaders are close on aroud 8.75%.

The Wired article is mainly a profile of one of the contestants, Gavin Potter, who was a solo late entrant and quickly beat some of the bigger teams. He’s currently ranked eighth with an 8.14% improvement. He makes an insightful comment:

“The 20th century was about sorting out supply,” Potter says. “The 21st is going to be about sorting out demand.” The Internet makes everything available, but mere availability is meaningless if the products remain unknown to potential buyers.

I’ve said the same thing before, although far less eloquently.

What Potter is saying is that in the past few decades, quite a lot of business progress was made on the supply side of things — just in time, outsourcing, supply chain management etc. Now the Internet has released shelf-space constraints and opened up the fabled long tail of demand. However it’s not enough just to have a million products in your catalogue, you also have to have a way to match consumers with products as effectively as possible. This matching is a crucial aspect of a business like Netflix, and is the reason why they’re willing to pay a million dollars for a ‘mere’ 10% improvement in matching quality.

(HT: Seth Godin)

Chris Anderson’s latest article in Wired is titled Free! Why $0.00 is the Future of Business. As I’ve talked about before, Chris’s basic argument is that marginal costs in IT are so low and dropping so fast that giving stuff away for free can make sense as a business model.

As he says, many costs in Internet markets look like fixed costs rather than marginal costs. So the marginal cost to Google of providing an extra web search is practically nil. But there are still massive fixed costs. Google runs thousands of servers in gigantic data centers. They use so much electricity that they’re investing in new electricity generation technologies, and they use so much bandwidth that they’re investing in a new trans-Pacific fiber-optic cable.

Anderson paints the trend towards free as being wonderful for consumers, and it is wonderful that I can do Google searches for free. However, when all costs are fixed and none are variable, we have a classic case of economies of scale. The big guy has the lowest average cost, and it’s hard for smaller guys to compete. Lack of competition is bad for consumers. In the search market, searchers don’t pay, but advertisers do. When we take the welfare of advertisers into account, it’s not clear that the economic outcomes in the search market are so wonderful after all. [However, Hal Varian disagrees that economies of scale are the source of Google’s high market share in search.]

Chris also has some wacky economic logic at some points. Check out this quote:

Two of the main scarcity functions of traditional economics — the marginal costs of manufacturing and distribution — are rushing headlong to zip. … Surely economics has something to say about that? It does. The word is externalities, a concept that holds that money is not the only scarcity in the world. Chief among the others are your time and respect, two factors that we’ve always known about but have only recently been able to measure properly.

Money is not a resource, money is just an illusion that we use to trade things. The concept of externalities is not that other things are scarce, but that people’s private actions often have effects on others which they don’t take into account. What I think Chris is really trying to say is that attention and reputation are scarce (I agree), and firms that give something away for free are not competing in price but rather in these other dimensions. Google and the other search engines compete in terms of reputation and attention on the searcher side of the market, and compete in price on the advertiser side of the market.

I’m not saying that Free! is totally wrong. I’m just saying that Free! makes for a great headline, but I don’t see anything intrinsically ‘good’ about it. Having all costs fixed and none variable does not necessarily generate an efficient market structure. And it could be that free web searchers with paid advertising is not the socially optimal pricing structure, once we take all welfare sources into account.