Artificial Scarcity Is Not The Solution

In the digital space, putting a price on non-physical goods has been a challenge at least since the rise of the internet. The market mechanisms of the physical world do not translate well because of one simple missing ingredient: Scarcity.

A craftsman creating a table can easily put a price tag on that table because this table is not easy to replicate. This is not the case with digital art, music, or data. Once a digital good is out there, it is easy to copy.

There have been several attempts that tried to solve the problem by creating artificial scarcity. DRM was one such attempt. A more recent example is NFTs. It has been shown exhaustively that NFTs do not actually achieve this goal (see also my earlier article on what Blockchains actually solve). Nevertheless, for the purposes of this article, I would like to assume that there was a reliable system to create artificial scarcity in the digital realm. That would raise the question of whether we should make use of such a technology. In my opinion, the answer is a resounding no as there are much better alternatives available.

Let us first consider the problem that artificial scarcity solves: Many markets for physical goods have the property that the buyer of a good cannot, without significant investment, replicate that good. If you could replicate a table that you bought at 500€ without further investment, you could buy one and sell an identical copy for 499€. This property drives down the price of the good to zero as supply is effectively infinite.

However, a price of 0€ does not compensate for the initial creation of a good. When you buy a table at 500€, fixed- and upfront costs are a risk that the seller has taken and they are compensated through the sale of the item. Therefore, without scarcity, there seems to be no more incentive for creation.

Introducing artificial scarcity on digital goods is a way of modeling the economics of the digital world after the rules of the markets for physical goods.

The problem with this mechanism is that it imposes a drag on the economics of a society. The overall welfare of the entire population is lowered: To see this, note that every participant i in a society values a digital good at a value U_i. If scarcity leads to the good being offered at a price P, only rational market participants with U_i > P will exchange money for the good. In the very restrictive example of exclusive ownership, only the market participant with the maximum utility U_i will receive access to the good meaning the overall welfare generated is W = U_i - C where C is the cost of producing the good.

In the other extreme, if the digital good were made freely available, the entire population would receive their respective utility making the overall welfare W = \sum\left(U_i\right) - C. While this version achieves maximal social welfare, it is not a mechanism that any seller would engage in. Any reasonable mechanism needs to at the very least compensate a creator for their costs – at least as long as the value of their creation surpasses this cost.

How can we make sure that creators receive fair compensation for their value creation without introducing artificial scarcity?

Note that while it is difficult to price the digital good itself, the work that went into the creation of a digital good has a real value and is furthermore an asset in limited supply. No market participant receives any utility as long as the creation has not yet taken place – and everyone benefits once it is out in the world.

The most straightforward economic model is thus to price the act of creation directly instead of pricing the result. In theory, the market should have an interest in compensating a creator for their work before this work exists. There are different systems based on this idea:

The Kickstarter Model

Platforms like Kickstarter or Indiegogo are quite straightforward implementations of this idea. They also suffer from some of the most central problems of this system which is why it is interesting to consider them first.

In the Kickstarter model, a creator would create a campaign before starting their work. They describe the project and the desired outcome and provide a funding goal which is the amount they would need to execute the proposal. As the digital good does not yet exist, every market participant that would benefit from the existence of the good should have an incentive for contributing an amount proportional to the utility they expect.

If the funding goal is reached, the creator gets paid out and the project is a go. If the funding goal is not reached, backers will be reimbursed.

The biggest problem of the Kickstarter model is that the value of the creation is difficult to predict before it exists. Once they have received the full amount, what incentive does the creator have to go the extra mile? What guarantees do backers have that they will receive what was promised?

Compared to the craftsman creating a table, the Kickstarter setup reverses the risk: The carpenter invests time and material upfront. The buyer can inspect the table in all detail and get a sense of its stability before committing. If no one buys the table, the carpenter loses their investment. A Kickstarter backer, on the other hand, takes on all the risk once they decide to back the project.

This opens the door to marketing-heavy projects and scams. Both of these categories are quite prominently present on Kickstarter and similar platforms.

The Patronage Model

Patronage is another interesting solution, that has been implemented on the Patreon platform. Arts patronage in the historical sense describes a tradition of wealthy individuals to finance artists, allowing them to exercise their craft.

The Patreon platform collectivizes this system, allowing a community of people to support a creator through recurring payments.

Note how this model also finances the act of creation rather than the product itself: The creations of a podcaster funded through Patreon will likely be freely available. My interest in financing the creator through monthly contributions is to enable them to keep releasing episodes in the future.

The Patronage model solves the value prediction problem of the Kickstarter model by tying the patronage to the creator’s reputation: I have access to their past portfolio and I can make an educated prediction that future work will follow the same quality standard.

Furthermore, value creation is broken into smaller packages – if the utility I receive from the creator’s work was to decline, I can simply withdraw my patronage going forward.

A downside of the patronage model is that it suffers from a version of the tragedy of the commons: Every participant might wonder if there aren’t already enough people contributing to keep the creator above water, and if so, why should they be the ones contributing? The funding goal system of Kickstarter resolves this issue by giving a clear indication that my contribution is required if I want the creation to be realized.

However, I don’t see a reason why the granular and reputation-driven system of Patreon could not be combined with the funding-goals system of Kickstarter. (e.g. “If you want my next podcast to be about the life of platypuses during the middle ages, direct your patronage funds here…”)

Customization and Personalisation

Other models that rely on the service aspect of the creation process could make use of the fact that a piece of art that has a personalized aspect provides a unique value to the buyer. A portrait would be a classic example. A creator that sells beautifully rendered maps can create a version of the buyer’s hometown. A creator that makes music can adapt the lyrics to the buyer’s circumstances. A podcaster can curate the topics based on the buyer’s preferences.

This solves the prediction problem as there are other instances of the product out there that are not yet personalized but which allow me to get an assessment of the value of the service. It can be a scaleable business for the creator as long as the cost of personalizing a creation is lower by a substantial margin than the price that a buyer is willing to pay.

This model also shares the risk more fairly than the Kickstarter approach: The artist carries the initial investment in a non-personalized example, and the buyer takes on the remaining risk of the customization not living up to expectations.

Conclusion

Solutions like NFTs try to solve the problem of value in a digital economy by creating scarcity. This is a step back. Instead of using the unique benefits of the digital space, this solution tries to squeeze the digital space in the restrictive mold of a 20th-century economy, inheriting all of its disadvantages in the process.

I do not think that this reactionary thinking is helpful for value creation in the digital world. As long as creation has value, we will be able to create market mechanisms that encourage such value creation. All that is needed is a little creativity.

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