Freeconomics

A wonderful article written by

Chris Anderson: editor-in-chief, Wired magazine; author of “The Long Tail”

In 1954, at the dawn of nuclear power, Lewis Strauss, the head of the Atomic Energy Commission, promised that we were entering an age when electricity would be “too cheap to meter”. That did not happen, mostly because the risks of nuclear energy hugely increased its costs. But what if electricity had in fact become virtually free?

The answer is that everything that electricity touched—which is to say nearly everything—would have been transformed. We would be using electricity for as many things as we could—we would waste it, because it was so cheap that it wasn’t worth worrying about efficiency.

All buildings would be electrically heated. We would all be driving electric cars. Desalination plants would turn sea water into all the fresh water anyone could want, irrigating vast inland swathes and turning deserts into fertile acres, many of them making biofuels. Compared with free electrons, fossil fuels would be seen as ludicrously expensive and dirty, and so carbon emissions would plummet. The phrase “global warming” would never enter the language.

Unlikely? Just such a transformation is already under way, but not in electricity. What is getting too cheap to meter is processing power, storage, bandwidth and all the other enabling technologies of the digital revolution. Thanks to the exponential doublings of Moore’s Law and its equivalents for hard drives and communications, the cost of a given unit of computation, storage or transmission is inexorably dropping towards zero.

One of the first to notice this and consider its implications was a Caltech professor named Carver Mead. In the late 1970s he was reflecting on the amazing learning curve that the combination of quantum mechanics and information science had started on the surface of silicon wafers. Like Moore before him, he could see that the 18-month doublings in performance would continue to stretch out as far as anyone could see. But he went one step further to consider what that implied about computers. He realised that we should start “wasting” them.

Waste is a dirty word, and no more so than in the 1970s and 1980s. An entire generation of computer professionals had come to power doing just the opposite. In the glass-walled computer facilities of the mainframe era, they exercised their power in deciding whose programs should be allowed to run on the expensive computing machines.

Among Mead’s disciples was Alan Kay, working at Xerox’s Palo Alto Research Centre. Rather than conserve transistors for core processing functions, he developed a computer that would frivolously throw them at such silly things as drawing icons, windows, pointers and even animations on the screen. The point of this profligate eye candy? It was ease of use for regular folks, a previously neglected market. Kay’s work became the inspiration for the Apple Macintosh, which changed the world by opening computing to the rest of us.

Today the same is happening in everything from bandwidth to storage. The learning curves of technology cut prices at a rate never before seen. The cost of storing or transmitting a kilobyte of data really is now too cheap to meter. Soon the same will be true for a megabyte, and then soon after that a terabyte. And the internet touches nearly as much of our economy as electricity did when Lewis Strauss issued his prediction.

Creative disruption

Bandwidth too cheap to meter brought us YouTube, which is revolutionising (and possibly destroying) the traditional television industry, and Skype, which is hollowing out the phone industry. Storage too cheap to meter brought us Gmail, which in 2004 upended the webmail market by increasing—free—the capacity available to all by a factor of 1,000, to say nothing of the huge free photo capacity of Flickr or MySpace’s invitation to put anything on your personal page for no cost.

Before the iPod, people weren’t asking to carry their entire music collection in their pockets. But Steve Jobs and a few others at Apple understood the economics of storage abundance. They could see that disk drives were gaining capacity for the same price even faster than computer processors were. Demand for massive music collections wasn’t driving this—physics and engineering were. Anyone could extrapolate the curves and see what was around the corner, but only the Apple engineers “listened to the technology”, to use Mead’s phrase, and saw that putting 10,000 songs on a drive smaller than a deck of playing cards was going to be possible by 2001.

The dominant business model on the internet today is making money by giving things away. Much of that is merely the traditional media model of using free content to build audiences and selling access to them to advertisers. But an increasing amount of it falls into the free-sample model: because it is so cheap to offer digital services online, it doesn’t matter if 99% of your customers are using the free version of your services so long as 1% are paying for the “premium version”. After all, 1% of a big number can also be a big number.

In 2008, the year of free, Yahoo! will go one better than Google and expand its free webmail to infinity. More music labels will give away music as a promotion for concerts, following Prince’s free distribution of his album in Britain’s Daily Mail in 2007 and Radiohead’s offer to let fans choose their price—free, if they want—when they download the latest album. And more newspapers will publish their content free on the internet.

All this marks a pattern. When the cost of serving a single customer is trending to zero, smart companies will charge nothing. Today, the disrupter’s motto is “Be the first to give away what others charge for”. If you listen to the technology, it makes sense.

The truth in advertising

Everybody's free

Amazing song which talks about Life...

Highs and Lows

Is the narcotics industry in trouble?

For decades business has been booming. Over the years rival operators have found ways to lift production, they have devised inventive supply chains that reach across the globe and have expanded markets so that they supply loyal consumers in almost every country. Estimates are hard to confirm, not least because enterprises have been reluctant to open their accounts to public scrutiny, but the industry was thought to claim global annual sales of some $320 billion in 2005 (tax free). And although some better-known trade bodies (the Medellin and Cali cocaine cartels, for example) have been forced to close shop, largely as a result of tough state regulation, the industry as a whole remains in rude health.

But are the heady days coming to an end? A UN report released on June 26th 2007 suggests that prospects for expansion in parts of the industry are dim. Although 5% of adults are thought to have taken illicit drugs of some sort over the past year, the use of softer brands such as cannabis and amphetamines has apparently reached a peak. In America, for example, cannabis use was highest in 1979 when more than 16% of the general population took it. By 2005 that had declined to just 10.4% of the population.

As troubling for the industry, many consumers in the extremely important American market are turning up their noses at cocaine. By 2005 cocaine use in America was down to 2.3% of the general population, more than 50% lower than the rate two decades ago. Compounding woes in that sector producers of coca (the raw material for cocaine) have seen cultivation decline in recent years. At its peak in 2000 some 221,300 hectares were under coca cultivation in Latin America. Last year that had dropped to just 159,600 hectares.

Stagnant growth in these sectors is troubling for the industry. As great a concern, however, may be logistics. The supply chain is coming under greater scrutiny from regulators who wield powers that are the envy of watchdogs in other industries. Fiercer regulation by law-enforcement agencies and, increasingly, by armies and navies, is deterring some producers and sellers, for example those coca-growers in Latin America. The UN report suggests that, globally, seizures of cocaine and heroin have leapt since 1999. In some quarters, programmes to persuade impoverished farmers to switch to legal crops have curbed supplies of raw materials.
One part of the industry, however, seems to be blossoming as never before. The heroin sector is enjoying a consumer boom in many countries, coinciding with record production in Afghanistan. In 2006 the global output of opium which is used to make heroin, the hardest of drugs, reached an all-time-high, with producers in Afghanistan dominating the market (see chart). In the 1980s the country produced just 30% of the world’s opium supply, but it has since—despite years of war—boosted output significantly and now accounts for 92% of world supply. A single province, Helmand, is said to have 70,000 hectares of opium under cultivation. In Afghanistan, at least, efforts to persuade farmers to turn to legal but less profitable crops have had no effect whatsoever.

But heroin producers and traders aside, enterprises within the illegal industry may now seek alternative ways to keep profits up. If the drugs business is indeed slowing, then the gangs, such as the Mafia, may have to compete more fiercely, perhaps engaging in hostile takeovers. Crime bosses battling for a bigger share of a slow-growing market is likely to mean much blood on the carpet. An alternative approach could be to diversify, with enterprises using their talents and infrastructure to peddle other forms of contraband such as cigarettes, pharmaceutical drugs, endangered animals, or human slaves. The UN report suggests such diversification is already underway.

The smartest entrepreneurs, however, may seek a way out of the illegal industry all together. Despite those profits, it is a tough world in which to operate. Asserting property rights is often a question of gaining and maintaining a reputation for the utmost brutality. Secrecy restricts the pool from which bosses can draw the kind of talented and pitiless managers they need. As for the consumers, quality control and service is in the hands of suppliers of dubious merit. Now the opportunities for growth—heroin aside—seem limited in the industry.To counter the problems, crime gangs now seem a lot more decentralised than in the past says to the report. Perhaps this is the shift in management style that will help them to survive.

Why Your Boss Is Overpaid

It is a typical "Dilbert" strip. The boss announces, "Our CEO has voluntarily slashed his pay from $6 million per year to $4 million. In a written statement, he said he wants to 'share the pain.' Do you feel better now?" A downtrodden intern replies, "I make my underpants from sandwich bags."

But that's office life, is it not? Bosses make obscene sums of money, while downtrodden cubicle slaves toil almost without reward. It might seem insane, but economists have a surprise for us: The insanity reflects nothing more than cool economic logic. There is method in the madness.

The ugly truth is that your boss is probably overpaid--and it's for your benefit, not his. Why? It might be because he isn't being paid for the work he does but, rather, to inspire you. In other words, we work our socks off in underpaying jobs in the hope that one day we'll win the rat race and become overpaid fat cats ourselves. Economists call this "tournament theory."

After all, managers find it hard to spot an excellent performance. It is a rare job where workers can be fairly paid according to some objective criteria.

There are some exceptions, of course. Critics and audiences may disagree about the literary merits of Dan Brown's best seller, The Da Vinci Code. Yet from a business point of view, the success is easy to measure. He has sold about 40 million books and is rewarded with a payment for each one.

Another superstar, tennis champion Roger Federer, has qualities that cannot be so easily calibrated. So instead of trying to measure his performance in objective terms, as Dan Brown's is measured, we measure it in relative terms. If Federer beats Andy Roddick in the final of the U.S. Open, he has succeeded.

Federer is not paid to try hard, nor to produce objectively brilliant tennis. He is paid for beating other players. Yet that is enough to get the best out of him. It is likely that employers have long since noticed that paying for relative performance can be just as good as trying to pay for absolute performance.

The economists Edward Lazear (recently appointed to chair the Council of Economic Advisors) and the late Sherwin Rosen argued, in a hugely influential paper published 25 years ago, that tournaments are an integral and often invisible part of the workplace. Workers are frequently ranked relative to each other and promoted not for being good at their jobs but for being better than their rivals. It is a natural response to the difficulty of true performance pay.

Tournaments also help protect workers against risks they cannot control. Companies can be affected by recessions, unexpected competition and hurricanes. As long as every worker is equally affected, the incentives to try hard remain the same. Trying to encourage performance through, say, stock options would unnecessarily expose workers to risks without really encouraging them to work harder.

Promotion tournaments sound sensible: Good workers are promoted, less capable workers are not. Yet the widespread use of tournaments also goes a long way toward explaining the frustrations of office life.

First, one way for you to win is for your colleagues to lose. Companies that rely too heavily on competition to determine promotions may find that their employees discover that the most efficient way of winning a promotion is by sabotaging the efforts of their rivals. You don't need economic theory to spot that risk.

The second, and more counterintuitive, prediction of tournament theory is that the more luck is involved in work, the larger the pay gaps should be between the winners and the losers. If Jack's promotion is 90% luck and 10% effort, Jack may be inclined to goof off--unless, of course, the rewards for promotion are absolutely astronomical. And they sometimes are.

Tournaments also demand increasingly absurd pay packages as workers get higher up the hierarchy. At the lowest level, a promotion may not need to carry much of a pay increase, because it opens up the possibility of future, lucrative promotions. Nearer the end of your career, only a fat check is likely to spur you on.

Finally, tournament theory also helps to explain why insiders, not outsiders, get cushy jobs. You thought it was all about the old-boy network, but in fact, the logical reason for promoting insiders is clear: These jobs are designed to keep your workforce motivated.

Lazear and Rozen's tournament theory has stood the test of time and been supported by many subsequent pieces of empirical research. It also passes the smell test: The more grotesque your boss's pay and the less he has to do to earn it, the bigger the motivation for you to work for a promotion. As Lazear wrote in his book, Personnel Economics for Managers, "The salary of the vice president acts not so much as motivation for the vice president as it does as motivation for the assistant vice presidents."

Economists don't even pretend that your boss deserves his salary. Suddenly, everything is clear.