This seems obvious, but physical and digital goods have very different cost structures.
That said, it still warrants further examination and explanation for the layman. Today, I’d like to address distribution and production costs.
Distribution costs get your product to market. For physical goods, the marginal cost of selling one more unit are high. Physical products have higher marginal costs as they involve real world “frictions” such as shipping, storage, and retail / placement fees given the physical limits of warehouse and shelf space.
These costs can decline as a business gets larger. In other words, as you ship, store, and sell more products, costs should decline from Scale Economies. Eventually, these costs will reach some point at which they don’t decline anymore. This is know as diminishing marginal returns.
Now, consider digital goods. Examples of a digital good include an e-book, a software product, or a Netflix subscription. These goods have lower marginal costs of distribution. Typical distribution costs for digital products include website hosting fees and platform fees.
Website hosting fees are fixed and platform fees run about 30% of the retail price. Some think that 30% is high and that is why Epic Games has gone to war with Apple over this fee charged in the App Store. Ben Thompson has written a great article on Rethinking the App Store that I recommend you read.
The key here is marginal costs. Website hosting fees and platform fees can be very high in the aggregate, but low at the margin. In other words, variable distribution costs are higher for physical products than they are for digital products.
Like distribution costs, production costs differ for physical and digital goods. Physical goods are comprised of raw material inputs. To sell more products, you need more raw materials. This expense is variable. Variable costs change with output and fixed costs do not.
For physical products, the production process involves some mix of machines and people. These costs are actually semi-fixed in that they are fixed within ranges of output and variable between ranges of output. As a business grows its volumes, these costs will increase in steps. Just to recap, physical goods incur a mix of variable and semi-fixed costs to get the product through production.
Digital products do not incur variable production costs. They can be duplicated at essentially no marginal production cost. Digital products are developed by people such as software engineers or authors in the case of an e-book. There is a cost for sure, but this cost is fixed. The fixed costs of production may be higher for digital goods, but there is very little in the way of marginal costs.
Above, we have described how the cost structure of both distribution and production is different for digital goods. The composition of the cost structure has changed and resulted in much higher fixed costs and much lower variable costs.
Companies have more operating leverage than ever before. It is easier to get larger and there is more incentive to do so.
This is how and why technology companies get so big. It is simply much easier to scale. Lower marginal costs have spawned bundling strategies and made them feasible and possible. Bundling allows companies to leverage the cost structure we allude to above of high fixed costs and low marginal costs. Bundling also allows companies to accommodate heterogeneous tastes and customer acquisition costs. Amazon Prime is a “super bundle” of physical and digital products.
Economic policy decisions often face a trade-off between “enlarging or shrinking the pie” and “splitting the pie”. Technology companies face a similar trade-off with many decisions. Consider the Apple and Epic situation mentioned above. With low marginal costs, decisions to enlarge the pie will almost always be better than decisions about increasing your slice of it. Why? Because your dollars of profit will always be greater. The cost setup we mentioned above makes this trade-off easier than ever before.