Living Economics

The High-Tech Treadmill
The profit of New Economy business firms that have very high R&D fixed costs and very low marginal costs is brutally squeezed in economic downturn.

In some East Asian countries, you can buy a CD with all the major pirated Adobe software for about $5 - $10. And for that matter, lots of popular hit songs on a CD for about the same price. Yet it has cost the software companies and record labels millions of dollars to develop the digital masters of these pirated products.

These digital products that have low marginal cost of duplication and high R&D costs are typical of many New Economy products. Having huge R&D costs, a new product has huge fixed costs to recoup. To make the product affordable, the R&D costs must be spread over large sales volume through expensive marketing. Once a mass market is created, however, the low marginal cost of duplication ensures huge profits.

But when sales drop, all hell breaks loose. In businesses where most of the costs are variable, costs can be more flexibly adjusted to sales volume without hurting the long-term health of the firms. But in New Economy businesses, most of the R&D costs are fixed. They are fixed in two senses. First, unrecovered past R&D costs for current products must be carried forward. Second, R&D costs for future products in the pipeline must be paid for. These costs cannot be reduced without harming the long-term health of the firm. Unrecovered past R&D costs cannot even be retroactively reduced. And lowering R&D costs for future products to match lower current sales would improve the current bottom line only at the expense of future viability if the product pipeline were depleted. Faced with such huge fixed costs, lower sales (at the same or lower price) would quickly increase the average total costs (consisting mostly of fixed costs) per item. Such a profit squeeze can be extremely brutal.

Inktomi corp., a software company based in Foster city, California, spent more than $10 million to develop its software for delivering and managing Web content. After reporting a profit of $1 million in 2000, the company, yet another victim of the now declining US economy, reported a loss of $58 million for the first quarter of 2001 alone.

References:
  • Ip, G. "Blame the Profit Drive Onů" The Wall Street Journal, 5/16/2001.
  • Mandel, M. "The New Business Cycle" (Cover Story) Business Week, 3/16/1997.
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