Divide By Zero

Last time we examined how the same companies that sell basic software that is necessary for any computer to perform its most common functions market their software to businesses the same way they market to consumers: By maximising network effects in order to portray their software as the only viable choice, in fact a necessary purchase, for any computer use.

However, we also looked at a distinct difference between businesses as software consumers and individuals as software consumers: Businesses are more readily prepared to pay directly for software. This is not really a hard and fast rule, but it is true by degrees. This is evidenced by the plethora of software products that are aimed squarely at businesses, and the many successful companies behind them. Contrast this to the handful of software companies that make a living selling to consumers, almost all of them doing so indirectly, by bundling their software with hardware through OEM sales.

In addition to the usual suspects that sell operating systems, these companies provide two basic categories of software: The first is the kind that runs on your desktop PC. The most well-known example of these is Adobe Photoshop, the de facto standard for processing photographs and other bitmap images. There isn't a professional photographer, designer, publisher or even web designer that doesn't own a copy of Photoshop, and possibly the entire suite of Adobe design applications. It's interesting to note the price of this software; the Master Collection version of Adobe Creative Suite 4 is priced at $2,500. The amazing thing is, it sells like hotcakes. The same illustrator or advertiser that has never spent a cent on software for his home computer has no qualms against dropping a four-figure sum on a piece of software he perceives as necessary in order to do his job.

Economic theory tells us that if they are overcharging for their software, a competitor would soon come up with a cheaper product and force them to compete. The reality is that the network effects reinforcing their monopoly make this next to impossible. If I came up with a better Photoshop tomorrow, nobody would buy it. On top of the usual business inertia and Adobe's huge global sales and marketing operations, I'd have to convince users that my software would be able to unerringly exchange files with the majority of people still using Photoshop - something we've already shown to be next to impossible, and something Adobe can very easily make harder for me. In the end, people buy Photoshop because it's the standard, and Adobe has to exert only the minimum amount of effort to be able to continue to charge exorbitant prices to the professionals that absolutely must purchase their software in order to get their job done, with no threat of competition. In fact, Adobe's primary incentive to add new features to its software is not to stave off competition but actually to give its users an incentive to upgrade on a regular basis.

Does this reflect the relative value and utility of these two products? The answer is, who knows? Both of these products stand alone with a truly staggering market share in their respective fields. For various reasons, they have no real competition, and because of the network effects we've been talking about, it's highly unlikely that they ever will. What's more, they've become absolutely essential for businesses to operate (in Adobe's case, any business that is related to design; in Microsoft's case, any business, anywhere). The companies can, and do, set the price they want, and the price they want is the one at the absolute upper limit of what the market will bear.

Let me take a break here and note that this is not me trying to do some of the usual pandering to anti-commercial sentiment, ever so prevalent in our current economic conditions. The management teams of Adobe and Microsoft have a legal obligation to their stockholders to maximise their profits. Of course, they also have an obligation, under anti-trust laws enacted in most of the countries they operate in, to not use their monopoly position unfairly. Microsoft in particular has repeatedly been found guilty of engaging in such illegal behaviour in both US and European courts, and has been fined truly staggering amounts of money because of it. The amazing thing is, however, that even though Microsoft has curbed its most blatant monopolistic practises and now seems to be operating within the law, the network effects are still there, and only need the slightest prod or nudge to keep any and all competition squarely at bay.

Now I'd like to return to the issue of price. The most expensive, full-featured version of Microsoft Office retails for $499.95, just one fifth of the price of Adobe CS4. Even comparing more normal configurations, Microsoft Office "Home and Student" edition retails for $149.95, while the cheapest Adobe CS4 version is a whopping $1,699. Even the regular, non-Extended version of Photoshop alone costs $699. That's right, the cheapest stand-alone version of Photoshop costs significantly more than the most expensive version of Office.

Returning to the discussion of price and its reflection of value in a market which naturally stifles competition,
is this in any way a fair representation of the cost of providing this software to users? This turns out to be a very hard question to answer. From a technical point of view, there's not much difference of the scale of effort involved in producing the two software suites. I have no exact numbers, but I would hazard an educated guess (it's my business to know these things!) that the development costs for Adobe Creative Suite and Microsoft Office are roughly at the same level. Why does one cost more than the other?

Of course, I am asking the wrong question. The cost of a copy of either of these products is almost zero. Even in physical form, etched on optical discs and wrapped in cardboard and cellophane and airlifted halfway around the world, the cost of the copy itself is measured in cents, not thousands of dollars. Almost the entirety of the cost of producing software is in designing it. This one-time, up-front development cost will then have to be recouped - and hopefully, profited from - through a limitless amount of copies that will be sold.

So let's ask ourselves this question: Adobe knows it has a lock-in for most design professionals for Photoshop, but the digital camera revolution of the past decade has led to an explosion in the number of amateur photographers, many of whom may be a potential market for Adobe but are scared off by the steep price tag. If Adobe decided to sell Photoshop for $100 instead of $700, how much more would it sell? Would it sell seven times more, as every amateur with a brand spanking new camera buys a copy of Photoshop to retouch his holiday snaps? Whether it could or not is not important; what is important is that if it could, it would make no difference to its bottom line.

Adobe most probably could sell Photoshop for $10 a copy, but get it installed on just about every other computer in the world at that price. The most important thing to note, however, is that it could be making the same amount of money, in fact it could be making more; because the cost in producing a sale is zero, any reduction in price up to and including the point were you've exhausted your target market leads to more, profitable shipments. There is no cost line under which the price cannot drop while profitability is maintained. As long as the price is not $0.00 and there are enough sales to recoup development costs, Adobe is making a profit on every sale.

This is why Microsoft Office only costs a fraction of what Adobe Creative Suite does. This is why Adobe offers a version of Photoshop called Photoshop Elements, stripped of some advanced functionality but retaining the expensive-to-develop rendering core of the full version, for $99. This is why the cheapest version of Windows Vista costs $99 and the most expensive version costs $339.99 even though 90% of the code - and the costs to Microsoft to write it - is identical.

If you're selling cars, or telephones, or tables, or in fact anything physical, tangible, there is a production cost, a unit cost, involved in making a sale. In almost all of these examples, the unit cost is a significant portion of the price; most of what you pay for when you buy a car is metal, plastic, rubber and fabric, the energy cost to put them together and get them to your local dealer's showroom, the wages for the people who make this possible. A small percentage goes to recoup the design and development costs, and the rest is profit - squeezed to the bare minimum by the invisible hand of the market.

With software, the unit cost is zero, or as close to zero as it could possibly matter. If it costs me $1,000 to design and develop a software program, I can sell 10 copies at $100, 100 copies at $10, one copy for $1,000 or any other similar combination and I've covered my cost; every single sale from now on is pure profit.

With tangible, physical products in an open market, the price reflects the cost of production. With software, with its near-zero unit cost and its natural monopolies, the price reflects whatever the vendor estimates will maximise their profits.