Microeconomics of the Consumer Web

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The marginal cost of delivering web-based content is approaching zero, so while some publishers continue to charge for it, they are the exception and not the rule. This has led to the reliance on advertising as a revenue model by most consumer web publishers. But if the marginal cost of a page of content is zero, isn’t the marginal cost of a page of ads zero, too? This assumption, coupled with the financial crisis, has many people questioning the viability of advertising as a long-term revenue strategy. So is advertising dead?

Most web publishers have optimized their products to produce page views because that’s what they think they’re paid to provide. Given that the online advertising pricing model is still largely based on the cost per thousand page views (CPM), such a focus is easy to understand. But since the number of people on the planet and their consumption is finite, advertising should work as the primary revenue model on the consumer web. The key is to focus on the right objective — driving measurable revenue for your advertisers.

Economics 101: Allocative Efficiency

Figure 1 shows the model of perfect competition — the point at which the supply and demand curves intersect and yield maximum aggregate surplus (consumer + producer surplus). Economists define a consumer surplus as the value consumers would pay above actual market price (the blue area under the demand curve). Producer surplus is the value above the marginal cost of production (the pink area above the supply curve). The point at which these two curves intersect is the equilibrium point, which is also known as “perfect competition” and is generally held up — by economists, anyway — as the goal for all markets.

Figure 1: Traditional Supply and Demand Curve

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Moore’s Law and “The Audience” Supply Curve

The canonical example of a supply curve illustrated in Figure 1 assumes that the marginal cost per unit of supply increases with respect to quantity.

What if marginal cost approaches zero? That is, what if the supply curve approaches zero, as I have depicted in Figure 2? While the variable cost of software distribution is clearly near zero, people are often quick to point out the economic maxim of “In the long run, all costs are variable.” In other words, fixed costs (like buying and running servers and storage, hiring people to write code and owning buildings where employees to do their work) should really be amortized and added to variable costs, in which case marginal cost is far from zero. But Moore’s Law, open-source software, and globalization are driving the fixed costs of operating and capital expenses (on a unit-amortized basis) to zero, too. In the race between mankind’s ability to consume online content and Moore’s Law, Moore’s Law wins hands-down.

Figure 2: The Audience Supply and Demand Curve

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In Figure 2, the supply curve favors gravity over traditional economic logic and approaches zero as quantity approaches infinity. This explains not only why it’s so hard to charge a consumer for web services, but the dominance of advertising-supported services for information-based web properties — and why it appears as if 100 percent of the surplus accrues to consumers (blue area under the demand curve).

What About the Advertising Supply Curve?

Isn’t the logical conclusion, then, that advertising pricing will also approach zero? If advertisers pay based on page views and the marginal cost of an ad view is near zero, how can companies charge $10, $20 or $50 for 1,000 views?

Advertisers ultimately seek profit and use advertising to accomplish the following objectives:

1. Drive near-term purchases.

2. Drive “considered” purchases, like the purchase of a car, by influencing the consumer’s perception with repeated messages over long periods of time.

3. Increase a consumer’s willingness to pay a premium above marginal cost to improve profit margins.

It’s extremely difficult to measure goals two and three. Brand advertisers often aim to achieve all three goals and have various (unscientific) ways to measure performance. The majority of firms that can afford the luxury of spending without actually knowing whether there is a positive ROI are very large firms with large discretionary marketing budgets, a very small percentage of the roughly 40 million businesses out there.

Direct advertisers wouldn’t mind achieving goals two and three, but focus the vast majority of their measurement and optimization on the first objective. These firms can reinvest profits from marketing in more marketing until acquisition costs equal profit because their spend is measurable. Consequently, performance-based advertising is self-funding, which helps to explain the rise of search marketing (and Google).

Until there is a better way to measure the ROI of all three objectives articulated above, the big winners in online advertising will be those that have the capacity to generate a massive quantity of high-quality leads at a low cost.

Display vs. Search Advertising

In an effort to compare the efficiency of lead generation, let’s compare Google’s price and cost per lead to a very rough guesstimate of Yahoo’s non-search business. Please note, however, that I can’t find the data I need to do this well, so this is a back-of-the-envelope analysis that is surely way off. It should only be used for illustrative purposes — nothing more.

According to a recent Morgan Stanley research report, Google generated 11.3 billion paid leads in the first quarter of 2009; according to a recent blog post from Yahoo, that company generates 180 billion page views per month. Let’s assume that all of these pages have one display ad (excludes the very efficient Yahoo Search), that the average click-through rate for Yahoo display is 0.10 percent, and that all costs go against display.

In Table 1, I’ve estimated Google’s cost per lead vs. Yahoo’s non-search cost per lead. Note that Google earns revenue of only 49 cents per lead vs. my estimate of $2.93 for Yahoo’s display advertising. More importantly, the fully amortized cost to Google of providing a lead is 30 cents vs. roughly $2.17 for Yahoo. As the supply of leads increases, prices will likely experience a dramatic aggregate decline. When that happens, anyone who can’t produce supply for a cost under market price will obviously find himself in a bad place. The low-cost provider will expand market share as volume increases and high-cost providers fade away.

Table 1: Back-of-the-Envelope Comparison of Direct vs. Display Price and Cost Position

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One of these days someone will figure out how to measure the impact online advertising has on offline purchases, considered purchases, and a consumer’s willingness to pay. When that happens, some publishers will earn an order of magnitude more from advertising, while others will experience massive price deterioration. In the meantime, my money is on lead generation as the best way to build a consumer web content business.

Mike Speiser is a Managing Director at Sutter Hill Ventures. His thoughts on technology, economics and entrepreneurship will appear at this time every week.

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