Ethically Appropriate Business Models

-- By AlexeySokolin - 17 Oct 2011

Introduction

On the horizon is a world where cultural goods are distributed freely and quickly to everyone who wants them. But, even if society may be in transition to a system without private property in ideas, transitional stages are important. It matters how we move from intellectual property regimes of today. What then are ethical business approaches to do so?

Economic Axioms

Digital goods such as software, music, video and text have a marginal cost of zero. It costs nothing to duplicate and transfer an mp3 or ebook file. Digital goods do not have zero fixed cost. This non-zero fixed cost includes the cost of financing which is a function of the risk of the venture. Higher-risk ventures involve a higher cost of equity.

Many such goods are cultural goods and enrich the lives of those that consume them. Cultural goods exist in varying quality (Bach vs. Limp Bizkit, Harry Potter vs. Picasso), which is independent from popularity. Such goods also differ in fixed cost, the time it takes for fixed costs to be recovered, which in turn depends on the number of consumers that pay and do not pay for the good.

Ethical Axioms

We pick two principles that define an “ethical” approach to business. The first is Rawlsian “veil of ignorance,” which implies a set of preferred rules regardless of position in the genetic and geographic lottery. We also rely on Kant’s second formulation of the categorical imperative, which holds that no person can be used as a means to an end.

From behind the veil of ignorance it is clear that MC=0 goods should be free. We want access to music and the internet if born in New York or India. Less clear is how much access we want—perhaps there is a line to be drawn between necessary cultural goods (learning the classics) and luxury cultural goods (StarCraft? ). One empowers, lifts people from their station into the flow of human progress; the other entertains and distracts. The two are not synonymous in function and moral weight. The problem encountered in this distinction is who decides, and how.

Kant’s categorical imperative has several restrictive implications. We may not use information on users without their express permission. Advertising and data mining are prohibited unless consented to a priori. We postulate that few people would opt-in even if this funds the consumption of their favorite media junk food. Second, a business may not charge one set of users for one thing, and then arbitrarily give that thing away for free to everyone thereafter. Such a scheme would use one set of people as a means for others.

Onto Business

Goods with marginal costs of zero are pubic goods. They are nonrival, non-excludable, and subject to free ridership. While some cultural public goods may indeed be emergent (e.g., music, literature), others require significant capital investment and equity returns. Examples of such goods are blockbuster movies (Harry Potter), high-end video games (Blizzard), and professional software (Adobe Photoshop). These goods cost nothing to distribute, but they do need large sums of money to build initially, requiring employees, office buildings and financing.

We can make money from public goods by turning them into “club goods,” meaning layering on top of them a power to exclude others. Venture Capital firms look to invest in such endeavors, focusing on building barriers to entry, platforms to keep value, monopolistic potential and long-term profitability above normal returns. This is insurance against the chance of failure, which in a software context can be quite high. On average, VCs achieve normal or below normal returns, which may justify the types of businesses they invest in. The economic rents Facebook extracts is a subsidy for all the Facebooks that failed. Without this insurance aspect, financing may be much more expensive.

Still, this breaches our ethical compass, at least for cultural necessities. It may not breach our ethics in the case of superfluous goods—it is one thing to provide Chinese students with textbooks, and quite another to give them movies that costs millions of dollars to produce.

But, we cannot coerce businesses to generate cultural goods without covering fixed costs and financing costs. Arbitrarily charging those first in line and distributing for free to the rest of the world is unethical. If advertising and data-mining are unethical as well, we must fund the product by user contributions and bifurcate paying users from non-paying users. There must be enough paying users to get the product to the point where MC=0. Two ethical models have emerged: (1) auction, and (2) freemium.

In the auction set-up, people self-discriminate and bid up to their willingness to pay. For some this is zero, for others it is a positive value. Successful examples are Radiohead’s “In Rainbows” (1.2 million downloads), Nine Inch Nails ($1.6 million in one week), and Kickstarter ($75 million raised). Inherent in the auction model is a utility so positive that people pay as expression of gratitude. The creator must be particularly good at signaling the differentiation of the good from a commodity such that price does not equal marginal cost.

The second approach emphasizes marketing and tiering value. Technology commentators advocate connecting with fans and generating a reason to buy with value separate from that of the free product. That value is either a superior experience that deserves compensation by choice, or comes bundled with physical items whose MC is not equal to zero (e.g., signed limited edition prints, t-shirts). Similarly, many technology start-ups use a freemium model to charge for upgraded service and provide the core service for free, allowing users to self-discriminate.

These models do not guarantee that fixed costs are covered, especially for capital intensive, experimental projects. In that case, we need public subsidy to offset the innovator’s temptation to build club goods. A hybrid solution could involve indication of private interest (via Kickstarter), a significant public subsidy once a goal is reached, and a Creative Commons license on the final good produced.

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