Chapter Three

Digital Goods and Services

Dr. Ibrahim Elatroush
 Introduction
Explain the concepts of marginal cost, exclusivity,
commodities, and transaction costs for digital services.
 Explain why some digital goods and services can be
offered free of charge.
Understand why service bundling is particularly simple
for digital goods and services.

2
 1. Definitions
Definition1: A digital good is a networked zero marginal
cost virtual object having value for some individuals or
organizations.
A digital good has the following properties:
①The virtual object is intangible but can be stored as data
on a digital medium, e.g., the consumer’s hard disk or
smartphone or in the cloud.

3
 1. Definitions
②The virtual object can be simulated without any incurred
cost: the marginal production cost of the object is zero.
③ The format of the virtual object must be such that it can be
delivered to consumers over the Internet, or in other words,
the virtual object is networked.
④ The virtual object must have financial, psychological, or
other value for consumers (individuals or organizations).
Virtual objects without value for anyone are not included in
the definition.
4
 1. Definitions
Examples of digital goods satisfying this definition include
Microsoft Word documents, Internet webpages, iPhone apps,
Wikipedia, e-mails, stored data on electronic bank accounts.
These goods are virtual objects; they have value for someone;
they can be replicated without cost and can be delivered to
consumers over the Internet. Examples of non-digital goods
are computers and cell phones. These goods have value for
someone, but none of them are virtual objects; they have non-
zero marginal cost and cannot be sent over the Internet.
5
 1. Definitions
Definition2: A digital service is a networked zero
marginal cost service that has value for individuals or
organization.
Services are intangible by nature. Digital services
include posting news on social media, electronic
banking, Internet access, multiplayer online gaming, web
browsing, and composing and sending e-mails. The
difference between a digital good and a digital service is
somewhat blurry. 6
 1. Definitions
This is illustrated by two examples. The data on a
Facebook account is a digital good, while the use of
Facebook for any purpose is a digital service. Music
tracks stored on Spotify’s servers are digital goods, while
the use of Spotify to listen to music is a digital service.
 Network access and transmission of data over fixed and
mobile networks, as well as data storage and data
processing, are also digital services.
7
 1. Definitions
 Moreover, the providers of digital goods and services
usually benefit from the enabling technologies without
investing directly in them. For example, Facebook uses
the worldwide Internet to support its value proposition
but has not contributed to the development and
management of the Internet as such.
 Offering and enabling services as a commercial product
has become a new business arena referred to as Anything
as a Service (XaaS), also known as cloud computing. 8
Examples of XaaS. From on-premises systems where everything is self
managed (left) to SaaS where only data is self managed.
 2. Zero Marginal Cost
Definition 3: Marginal cost is the cost of producing one
additional unit of a good or service. Digital goods and services
have zero marginal cost.
Let us estimate the cost of producing one additional copy of an
app. If the app has been downloaded and installed 10,000 times
on different smartphones, what is the cost of the next download?
 we again conclude that the costs of processing an extra trade
transaction on Amazon, posting a new message on Facebook,
or downloading a video on YouTube are zero.
12
 2. Zero Marginal Cost
Conversely, the marginal cost is not zero for physical
goods. The cost of production then includes the cost of
raw materials , workforce, and logistics.
Note that some e-commerce businesses selling physical
products online, such as Amazon, do not have zero
marginal cost because of the shipping of the physical
goods. However, the marginal cost of the digital trade
transaction is zero.
13
 2. Zero Marginal Cost
Digital goods may have high fixed costs since some of them
are expensive to develop, build, and operate. Software
development may cost millions dollars require development
teams and take several years from idea to the end. Grand
Theft Auto V computer game (released 2013) development
cost $265 million, while Star Wars (released 2011) cost
more than $200 million.
Yet, some digital goods costs; iPhone or Android apps have
low fixed. Some of them have simple digital services that are
developed by single person over fairly brief time frame. 14
 2. Zero Marginal Cost
High fixed costs don’t mean that the consumer must pay for
the good. This depends on business model of the company.
The running costs of Facebook and Google are very high.
These costs are not covered by direct payments from
consumers but, indirectly, by selling advertisement space.
This is made possible by collecting huge amounts of
personal data from users and selling these data to marketers
for targeting advertisements or to other data processing
corporations using them for other purposes. Such business
practices are subject to clear privacy concerns. 15
 2. Zero Marginal Cost
The relative gap between fixed and marginal costs is
descriptive for digital goods. For example, the major cost of
an app is the development of the app. The time taken to
develop an app can be anything from few days to several
years. As seen, the marginal cost of a digital good ( the app)
is zero so that the cost of installing the app is also zero, and
every new sale of the app contributes directly to revenues.
Copies of app can even be distributed for free without any
financial loss for developer. When total sales matched the
costs of developing the app, remaining sales are pure profit.16
2. Zero Marginal Cost

17
 2. Zero Marginal Cost

Figure 3. The average cost as a function of the of units produced 18

 2. Zero Marginal Cost
Economies of scale are the cost advantages that companies
obtain as the number of units produced increases. This is so
because the fixed cost per unit decreases as the production
volume increases as shown in Fig. 3 and may tend to zero if
the number of units produced is large.
 Companies producing physical goods benefit from cost
advantages as the number of units produced increases only
up to a certain point.

19
 2. Zero Marginal Cost
Moreover, expanding the production beyond a certain edge
may also necessitate that more production infrastructure
must be built, thereby increasing the cost of administration
and support-functions so that the benefits from economies of
scale are marginalized.
This is different in digital economy as MC is zero. Thus,
there is no limit to the number of units that can be produced
without increasing fixed costs. Hence, the cost per unit
produced will be zero regardless production volume. This is
why firms produce digital goods & services get so big. 20
 3. Classification of Digital Goods
Goods can, in general, be classified either as private goods,
public goods, club goods, or common-pool resources
(Stiglitz, 2015). This classification depends on whether a
certain good is rival/non-rival or excludable/nonexcludable.
 From these characteristics, four different types of goods
can be defined as in Table1. Digital goods are non-rival by
nature—the consumption of a digital good by a user does
not reduce quantity available to other users of the same
digital good.
21
3. Classification of Digital Goods
Table 1. Different types of goods
 3. Classification of Digital Goods
For example, a user reading a webpage does not reduce the
availability of that webpage for other users. A user
accessing the Internet does not reduce the availability of the
Internet for other users.
The latter is true with some limitations since webservers
and the Internet have a maximum capacity. However, most
communication systems today are provisioned to handle
high demands. Thus, digital goods and services are assumed
to be non-rival in most practical cases.
23
 3. Classification of Digital Goods
Digital goods can either be excludable or nonexcludable.
Excludability means that access to the good can be regulated.
Conversely, if a good is nonexcludable, a user cannot be denied
access to the good. Widespread digital goods are non-excludable.
Ex; free music, news, and free web pages. Restricted Digital
goods are excludable. Ex; copyrighted music and movies, and
licensed software. Excludable goods can be accessed by a paid
subscription plan or a club membership. The illegal copying of
copyrighted material might result in excludable content becoming
nonexcludable. 24
Figure 4. Classification of digital goods 25
 4. Zero Average Revenue per User
Average revenue per user (ARPU) is an important financial
indicator in economics. The ARPU states how much revenue
an average user is generating over a specific period of time. For
instance, the monthly ARPU for mobile subscribers in the USA
is about $40. Total revenue for a mobile service provider is the
ARPU multiplied by the number of subscribers. The mobile
service provider will focus on increasing its total revenue by
increasing both the ARPU and the number of subscribers.

26
 4. Zero Average Revenue per User
In the digital economy, several companies operate with zero
average return per user, in which case the company does not
receive any revenue from consumers at all. Since MC is zero,
the cost to attach users is also zero.
This applies to all competitors offering the same service so
that, to compete, goods are offered for free to the consumer by
all of them.
 Suppliers do not compete on price but on user experience. In
this economy, supply-demand curves are meaningless.
27
 4. Zero Average Revenue per User
The main challenge for many companies in the digital
economy is, therefore, to get revenue for its operations from
sources other than consumers. A few companies have
succeeded in this effort, for example, Facebook, Google, and
Twitter. Their main source of revenue is advertisements: the
more they know about their consumers, the more attractive
they are as marketing channels.
Note that ARPU = 0 is not a universal rule applicable to all
digital services. Netflix, for example, has an ARPU >0 because
consumers pay to access the service. 28
 4. Zero Average Revenue per User
How is it possible for
Facebook to reach
such a financial
position when it does
not earn anything from
its users?

Figure 5 Facebook revenue and market cap 2012 - 2020 29

 5. Digital Commodities
Commoditization is the process by which digital goods end up
being indistinguishable from a consumer’s point of view.
Competing goods will look the same to the user—it is
impossible to differentiate between the goods even though they
are produced by different manufacturers.
The only distinguishing factor for a commoditized good is the
price. It is, for example, impossible for consumers to
distinguish between lubrication oils from different refineries or
electricity produced by different power plants—only the price
can be used as a distinguishing factor 30
 5. Digital Commodities
Several digital goods have been commoditized. Examples of
digital commodities are Internet access and transport of bits,
storage of data, processing of data, international news bulletins,
and, to some extent, certain types of software products (e.g.,
word editing and spreadsheet software).
 Digital goods that have been commoditized compete only on
price. A fierce competition among companies providing digital
commodities tends to push the price to zero because of the
zero-marginal cost property of digital goods. Standard
microeconomic theory on perfect markets predicts this outcome
31
 5. Digital Commodities
However, at price equal to zero, it is a challenge for companies
to be profitable. Most of them will run out of business as
revenues decrease and profits turn negative. This is a strategic
dilemma for several companies in the digital economy.
 To avoid a price war resulting in zero revenue, companies
may differentiate their goods from competitors by making them
unique for customers, for example, newspapers offering
customized news alerts. Newspaper may generate revenue from
these customers. Another option is to apply creative business
models that operate under condition that the service is provided
for free while revenues are obtained from other sources. 32
 6. Transaction Costs
Transaction cost is the cost associated with the process of
selling & buying. Transaction costs is divided into 3 categories:
1. Search and information costs are the costs of searching for a
particular good and determining its price and properties.
2. Bargaining costs are the collective costs for the consumer and
the provider to agree on the terms of the contract. This includes
the price and delivery conditions of the good.
3. Policing and enforcement costs are the costs of sticking to the
agreement and taking appropriate action if the agreement is not
upheld by either party.
33
 6. Transaction Costs
An example is trading of physical goods on eBay. Buyers first
search for products they want to buy among offers made by
various sellers (search and information costs). This is done on
eBay’s website. When the buyer has decided which item to
buy, buyer and seller will negotiate price & delivery conditions
(bargaining costs). If something is wrong with received
product, the buyer will enforce contractual rights by contact
with seller (policing and enforcement costs). eBay may also be
involved in the dispute if the buyer and seller do not agree.
Amazon, eBay, and Alibaba lower the transaction costs by
offering efficient search processes using web or mobile apps. 34
 7. Bundling
Product or service bundling means that several products or
services are combined and offered for sale as a single package.
One example is the Microsoft Office 365 package. This
package contains digital services Word, Excel, PowerPoint,
OneNote, Outlook, Publisher, and Access.
Another example is cable television subscriptions where the
user may subscribe to various bundles of television channels.
The cable television provider may also extend the package to
include audio broadcasting, streaming of movies and music,
broadband Internet access over Wi-Fi, and VoIP. This is
exemplified in Figure 6. 35
 7. Bundling

Figure 6 Examples of a bundle of the services Netflix, Spotify, and Network access

36
 7. Bundling
Pure bundling means that consumers can only buy bundled
package without the opportunity to buy the single products or
services in the package. Mixed bundling means that a
consumer has the option to buy the package as well as single
products or services constituting the package. In general, the
bundle price is lower than the sum of the price of the individual
services constituting the package.
 Bundling is a strategy for providers to increase sales. In the
digital economy, bundling is particularly efficient because of
zero marginal cost property—it does not cost provider anything
adding another service it already owns to the package. 37
 7. Bundling
The consumer may find this business model attractive since
an additional service in the bundle contributes to increased value
for the consumer and, hence, an increased willingness to pay for
the bundle.
Digital economy has also enabled the unbundling of previously
bundled goods and services. Unbundling has become common
in music industry. Apple iTunes unbundles CD albums offering
each music track as an independent product. Customer may
then buy a single track rather than buying a complete album. It
also allows the consumer to build their own personal playing
lists containing songs from several albums. 38
 8. Conclusions
The most important characteristics of digital goods and
services are summarized as follows:
‒ The marginal cost of production and distribution of digital
goods and services is zero.
‒ Digital goods and services are non-rival; that is, the
availability is not reduced by consumption and usage.
‒ Digital goods and services may be excludable or non-
excludable depending on commercial conditions of usage.

39
 8. Conclusions
‒ Several, but not all, digital goods and services are
commodities; that is, they can only be distinguished by price.
In some market segments, the price for the product is zero, and
price cannot be used as differentiating factor.
‒ It is easy to bundle digital goods and services in flexible
packets. If the provider owns all components of the bundle and
all components are digital goods, then the cost of bundling is
zero. In this case, the customers may create their own bundles,
for example, playing lists for music and collection of television
channels.
40