There’s a new system of exchange of goods and services that threatens to rock the economic system and it’s not some new form of derivatives. Digital goods and services are growing larger and larger, but economics has not yet caught up. This is scary because more and more of our economy is based upon digital goods. In order to understand why I’m raising a fuss about this, we have to do a quick review of economics 101.

Our system of economics is based on the law of supply and demand. This does not work perfectly in the real world due to friction in entering the market and government interventions (both good and bad). Basically it is easily illustrated in a story. Company A starts selling a new product. They figure out the costs to create their product and reap whatever profits they think they can earn from buyers. This becomes the cost for the product. Now there are many possible outcomes. Let’s say it’s too expensive – in other words, people are not willing to pay that much for the product. As long as the price is higher than the cost to produce it, they’ll lower the price. Eventually they’ll get customers.

At that point, as long as they have enough customers to keep their business going, they never have to lower the price. Unfortunately for them (but great for customers), Company B notices that Company A is making a lot of profit on the product. So they start making it. This causes Companies A and B to enter into a price war to gain customers. (Ignoring human tendencies to have brand loyalty or to perceive Company B’s product as a knock-off) Eventually they must lower the price until they are no longer making a profit. The price they charge is the price to make the next item of product. Consumers win because we’re now paying the minimum price for the product. Alternatively, if either company wants to charge more money, they add more features –also a win for customers.

The point is that the economy finds the right price for the item. It is the price to produce the next one. With digital goods, this system is broken. The cost to make the next item is $0. So everything online should be free! Yay! Wait a minute, although people will still produce content without getting paid for it (look at all the people out there who create free literature, movies, and music out on the Internet), our society has made the judgment that culture will be enriched by paying people to produce content. So now how do we price e-books, downloaded videogames, and MP3s?

This is a huge dilemma because, throughout history, whenever humans have tried to dictate the prices of things, we have gotten it horrible wrong. (See communist Russia) So how do we find the answer? As of now, we’ve just priced these goods at slightly less than the cost of the book, CD, DVD, etc. But we’re not using any physical objects at all, so the cost of those materials is irrelevant. So is the cost of shipping them to stores.

Several recent developments got me thinking about this. One was how publishers have been trying to keep Amazon from pricing ebooks cheaper and cheaper. And yet, the true price of the book should be the cost to create the ideas and write them plus a tiny percentage for Amazon. So it should not cost the same as books in the bookstore. Also, there’s no longer any such thing as a premium for hardcovers vs softcovers.

Really, the answer is in my previous paragraph. We basically have to come up with a way of saying how much we’re willing to pay authors, bands, programmers, etc for their time. Then they develop their products within some set amount of time and that determines what the book needs to cost.

The other thing that got me thinking about this topic was my experiences this weekend. At Borders I browsed the clearance aisles. Books such as Anathem, which had retailed for $30 were selling for $5. Why were they doing this? Because in the physical world Borders needs to make room for new books. They only want to carry enough copies of any particular book so that if you walk in you will find it instead of going to Amazon. So for new books they need lots of copies. For older books, they need to get rid of them so they have more shelf space. So the books go on sale. This happens with everything everywhere — it’s why clothes go on sale after they’re out of season. It’s why old video games sell for $20 instead of $60.

One place where they don’t need to make room for new stock is with digital goods. Amazon has an infinite number of copies available for any song while only needing to store one copy on its servers. So you would expect that there would never be sales with digital goods. After all, they don’t need to make space on the servers in the same way. And this sucks because there are many people like me who just don’t have the money to buy everything at full price. So we wait until everyone else has a Playstation 3 so we can get it at $300 instead of $600. It seems we will now be forced to pay full price for everything from now on.

Yet, this weekend, Steam was selling every Civilization IV game for $10. No physical store is selling these games at so heavy a discount. And they do this every weekend for some set of games they want to promote. It’s not announced ahead of time so it doesn’t cannibalize full price purchases (except for those prone to gambling — waiting for the right price to appear on any game). Amazon also routinely has albums for sale for $5 instead of $ 10. So why do Steam and Amazon do this? And, more importantly, is this captured by economic theory?

I think there are three possible wins for Valve (owner of Steam) and Amazon. First of all, they are building brand loyalty to using them for content distribution. Once you buy an album for $5 at Amazon, you may be more likely to buy full price items there because you found the experience easy and convenient. (Same thing with Steam) The second possibility is that Steam typically does this with games that have been out for a long time. So they may figure that everyone who bought the game at the usual price has already done so. So if you’ve made all the money you can and no one else is out there who would normally pay $50 for a game, the rational thing to do is lower the price and get everyone else. After all, before you made $0 and now you make $100 by selling 20 games at $5. You can’t look at it as if you would have made $1000 (hello Recording Industry! Not everyone who gets a song for $0 would have paid $1 if they were completely unable to obtain it free). Finally, both in the case of games and music, perhaps they’re hoping that you will blog, tweet, etc about the new purchase you made and draw others to buy it at full price. They would have bought it at full price before, but they just didn’t know about it.

So all this is exciting and new and perhaps too new for me to learn about it when I took econ in the early 2000s. But I hope there are economists studying this stuff and getting it to the latest econ majors because more and more of our content is going this way and we need their expertise.