Wednesday, December 12, 2007

Economic Rent

Can the business case for SOA be based on the concept of economic rent? I'd be interested to get some reaction to the following preliminary discussion ...

Economists use the term "rent" to mean something different to the everyday meaning of the term. It is not the rental income generated by renting out an asset (such as land) but the market power associated with a given market position. For example, let's say that an executive would work for $250,000 per year, but manages to negotiate a salary of $1,250,000 per year. The difference between these two figures ($1m) is a measure of his market power, and this is what economists refer to as economic rent. Economic rent is also earned by professionals with some barrier to entry (such as doctors and lawyers) and by celebrity performers (such as musicians and sportsmen).

There are two alternative definitions of economic rent, yielding somewhat different calculations. In classical economics, it is defined as the difference between the actual income and the necessary income. For example, imagine a popular musician who currently earns around £50,000 per concert. If his popularity waned, his earnings might drop to around £10,000 per concert, but he would continue to play. The difference between these two figures is pure excess - economic rent.

Followers of Pareto use a slightly different definition - the difference between the actual income and the next best opportunity. For example, if our musician wasn't playing concerts, his next best activity might be as a session musician at £4000 per week.

John Kay writes: "economic rent arises from differentiation and migrates to wherever in the value chain scarcity is found". Kay illustrates this with The Story of Champagne. Under perfect market competition, there are no clusters of market power, and no economic rent - prices are adjusted until the level of supply exactly equals the level of demand.

With software and services, of course, the potential income sometimes bears no relationship whatsoever to the costs of production. Most of the profits of Google or Microsoft can be regarded as economic rent in this sense. Some people regard these profits as excessive, while others would justify such profits as reward for past risks and initiatives taken; in any case, the continuation of these profits depends on maintaining some exclusive advantage, something that is difficult for others to replicate.

If a service provider is to invest in developing a new service, then this may be done with the expectation of receiving sufficient reward to cover the (mostly front-loaded) costs and risk. The level of value generated by a service depends on its exclusivity and differentiation: if the service would be easy to copy then there is little prospect of economic rent; but if the service gains a strong foothold, then it may be difficult to dislodge, at least in the short term.

It is for this reason that network effects are so important to the economics of SOA. A service with ten million consumers delivers greater value to each consumer than a similar service with only ten thousand consumers. This advantage enables the provider of the more popular service to extract an economic rent.

Another important consideration is the relationship between fixed development costs (sunk costs?) and ongoing operational costs (opportunity costs?). (If I understand the Wikipedia article correctly, this relationship is one of the areas where classical economics and paretian economics diverge.) SOA and other forms of virtualization (including grid) make it easier to shift costs from fixed to variable - but of course this may not deliver the best economic advantage to the service provider.

If you have some market power, how do you calculate the best possible price? There is some tricky mathematics involved here: let's assume that the more you charge, the fewer users you have, and let's assume that there is a non-zero cost of servicing each user. Under certain conditions, the maximum rent is given by a formula known as Hotelling's Rule.

In case you were wondering, Hotelling has nothing to do with hotels. Harold Hotelling was a mathematical statistician, also known for Hotelling's Law ("in many markets it is rational for producers to make their products as similar as possible") and Hotelling's Lemma (relates the supply of a good to the profit of the good's producer).

Wikipedia: Comparative Advantage Economic Rent, Hotelling's Law, Hotelling's Rule

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