Prices are tools for underdogs
i. The parable of the lemonade stand
Suppose you’re broke and you need to earn some money. You decide to sell lemonade. Unfortunately for you, you are bad at lemonade. No one buys your crummy lemonade at the going price of $1 per cup. They all prefer the tastier lemonade from the 20-year-old stand down the street.
You have two options to make your lemonade sell better.
Option #1: Spend years experimenting with lemonade recipes, throwing each result down the drain, until you have a recipe as good as the 20-year-old lemonade stand down the street. (This option costs money that you don’t have, so if you try it, you’ll stay broke and never sell any lemonade.)
Option #2: Price your crummy lemonade at 50% off, get some sales, learn by doing, and over the years incrementally improve your recipe. Unlike option 1, this option doesn’t risk vast quantities of startup capital and it provides a sustainable path to catching up to the other lemonade stand with its 20-year headstart.
Essential to Option #2 is the fact that (a) prices exist and (b) prices are flexible. In a world without prices, no one would ever buy your crummy lemonade (unless maybe the other stand ran out or had a long line). Without prices, you’re pretty much stuck with Option #1, which is an expensive non-starter.
The moral of the story: Prices are tools for underdogs.
As I understand it, this is what happened to China over the past 30 years. In 1990, per capita GDP in China was around $300, less than a dollar a day. Hundreds of millions were in poverty. Chinese-manufactured goods were crummier compared to the goods manufactured by the experienced and well-capitalized firms in America and Europe. China was a serious underdog.
But as an underdog, China used the one advantage it had. They were willing to work harder for less. They offered a lower price.
As a result, labor-intensive manufacturing was gradually outsourced to China. And as more and more was outsourced to China, China began to develop advantages other than price. Workers learned to build products and factories better. Supply chains became shorter and denser. Quality went up. Designs got better.
None of this would have been possible without bootstrapping. If instead, China had decreed in 1990 that they were going to make their manufacturing better than the US/Europe/Japan and then put it out on the market at the same price, this would have been disaster. They would not have had the resources. But because they had business from their low prices, they got money and experience that allowed this to eventually happen.
This story is one of the brightest moments of the past 100 years, and of overall human history. Hundreds of millions pulled themselves out of poverty.
And it only happened because China could catch up by offering lowering prices.
iii. When can you not compete on price?
It is not always possible or effective to compete on price directly.
One case is when your superior competitor is willing to work hard for very little. This is the Amazon playbook. As Jeff Bezos says, “Your margin is my opportunity.” By tolerating small profit margins in online shopping, Amazon makes it very difficult for another online shopping company to get started by temporarily accepting even lower margins. (At that point, they literally might have to subsidize purchases.)
A second case when it is difficult to compete on price is when the market has economies of scale.
If the lemonade stand down the street is a giant industrial factory, then perhaps their lemonade is going to be better and cheaper than your hand-mixed lemonade. In these situations, there is no real way to enter the market by undercutting on price.
However, all hope is not lost. In these situations, there can still be a path to success. If you can differentiate your product, by, say, selling spicy lemonade, then you can still bootstrap your way up. You sell your crummy spicy lemonade, get a few sales from people who like spicy lemonade, and use that money and experience to eventually scale up to the point where you can compete with the industrial lemonade factory.
This is the classic story of technological disruption, where you gain a foothold in a small adjacent market before technological shifts cause it to take over the big market.
This is how low-cost steel minimills eventually displaced integrated mills. They started making crummy rebar, but eventually used their learnings and profit to figure out how to expand into higher quality steel, and now minimills produce almost all steel.
(Of course, disruption can also come from higher prices, like how Tesla got a foothold by selling the expensive and not-so-practical Roadster before selling the cheaper and more practical Model 3. This is what solid-state hard drive manufacturers did selling expensive SSDs, until eventually they learned how to make them cheap enough to take the magnetic hard drive market head-on. Ditto for digital cameras and pretty much every new expensive technology.)
Economies of scale make it difficult to enter a market by competing on price.
Last, there is a third situation where it is difficult to compete on price. And this might be the most difficult of all. It’s when your competitor offers their product for free. Consider Facebook. Facebook doesn’t charge users (except perhaps by ad load). So if you want to build a social network to win those users, there is only one way. You have to win on quality. There is no path to winning on price, and then letting the quality come later as you figure things out and grow. On day 1, your quality needs to be as high as Facebook. That is a tall, tall order. Imagine demanding a Chinese factory in 1990 to build a cost-effective iPhone. The skills and supply chain and scale were just not ready yet.
Of course, if a product is free, is is strictly true that you cannot compete on price? What if you enter the market by charging a negative price?
iv. Google’s lemonade
In 2009, Microsoft launched Bing. They knew that Google was dominating search, but they also knew that no monopoly lasts forever. Although Google’s quality was higher than Bing’s, Microsoft they might be able to enter the market by competing on price. Within a year, they launched Bing Rewards, which literally paid people to search on Bing. The price of Bing searches was now negative. And did it work?
‘Free’ is a very sticky price. There is a big jump from $0.01 to $0.00. But there seems not to be a big jump from $0.00 to -$0.01.
Today, Google still dominates web search. It seems like difficult to imagine anyone ever displacing them from web search in the next 10-20 years.
The only way they lose, I think, is if web search becomes less important.
v. My main point
This brings me to my main point. Digital technology has stronger economies of scale than anything ever. As a result of the near-zero marginal costs, for most products a price of $0 is optimal. But when the price of a product is $0, it becomes difficult to displace. Would-be innovators cannot bootstrap their way to success by feeding off of price-sensitive consumers. No new lemonade stands enter the market. Innovation slows. The poor lose some ability to catch up to the rich.
Is there a solution? I see none.
Fundamentally, it comes from the cost structure of semiconductors and software. And they are what they are.