Relevant Cost – Do Not Ignore Opportunity Costs

In a talk  at Haas Alumni Luncheon Mr. Chris Anderson, the  author of The Long Tail and Free, talked about his new book Free. First few minutes into the talk he talked about his previous work, The Long Tail, and how the marginal cost of shelf space.  He said how physical goods (what he calls atoms) have a marginal cost to produce, store and sell and how information goods (what he calls bits) have declining marginal cost that approaches zero.

I will set aside my previous arguments on why costs do not matter with pricing and focus  on just what is marginal cost.  According to  Mr. Anderson, the definition of marginal cost is simply the cost to produce, store and sell one widget. That is the right definition if there are no opportunity costs. In his example he talks about how there is a marginal shelf cost to selling physical goods through Wal Mart. Why is there a charge? Because Wal Mart is looking at opportunity cost of storing your wares vs. someone else wares. If you look closely all shelf costs are sunk for Wal Mart, but still it charges a marketer a fee because of this opportunity cost.

Marginal cost is not about the widget you sell, it is the “relevant cost of serving one additional customer”. It is the higher of either the cost to produce/store/sell the widget and the opportunity cost of serving that additional customer.  The definition is easy to see for physical goods. For digital goods, for example music, the marginal cost is not zero (as Mr.Anderson says regarding digital music just because there are no CDs) but the revenue lost by selling this music vs. another or the future revenue lost by setting a very low reference price in the minds of customers.

Once you consider the opportunity costs you can see the deficiency in the definition and argument based on marginal cost being zero.