by Joseph Bowen • December 21, 2022
Tags: Economics / Entrepreneurship / Software
Quick post explaining one of the reasons I like the SaaS business model: the economic concept of “club goods”. One thing that I aim to do with much of my writing is illustrate different mental frameworks one can adopt to view the world through for the purpose of solving problems or searching for ideas. Economics provides many useful frameworks for entrepreneurs, and this post will explore just one of them. It’s a relatively simple one too, making it a good starting point for this blog before it explores more advanced frameworks both from economics and other fields. After learning about the classifications of economic goods you should be able to scan your own business ideas and categorize them in a helpful way. And, keeping in mind the Baader–Meinhof phenomenon (you see what you look for), new and exciting business ideas could start to pop out at you from your everyday life in a way they wouldn’t have before.
Let’s get started.
In economics you can classify products and services in a 2x2 matrix organized around two concepts: rivalrousness and excludability.
If something is “rivalrous” it means that the consumption of the good eliminates or reduces the ability for someone else to consume that same good. Like a milkshake: if I buy a milkshake and then drink it, you can’t then drink the same milkshake that I bought– you would need to buy your own if you wanted one. It doesn’t matter if your milkshake is identical to mine (or “fungible” in an economic sense); what matters is that we both can’t drink the entirety of the exact specific milkshake that I bought. It’s still rivalrous even if we put two straws in it and share it because each sip I take reduces the amount of milkshake left for you and vice versa.
If you buy a car I can’t also buy the same exact car, I would need to buy my own. Furthermore, if I want to buy your car it becomes less valuable to me the more you drive it. Your car is worth more money when it has 10,000 miles on it than later when it has 100,000 miles on it. Your use of the car reduces the ability of someone else to use the same car in the same condition.
There are endless examples of rivalrous goods. If I buy a pair of sunglasses no one else can wear them while I’m wearing them. If I take medicine no one else can take it after I’ve taken it. This applies to services too– if you book a haircut at 3pm, no one else can also get a haircut at 3pm from that same barber– the 3pm spot is rivalrous.
At first it might seem silly to have a term for this because most of what we think of as goods and services are rivalrous. And that’s true, but before we talk about exceptions to this (and there are important exceptions), let’s stack another seemingly obvious concept on top of what we have so far: every example I’ve given is not only rivalrous but also “excludable”. That is to say that it’s a good where the producers of the good are able to stop people who haven’t paid for it from consuming it. If I can’t pay for my sunglasses the cashiers won’t let me leave the store with them. If I can’t afford your car when I want to buy it you won’t give me the keys. Just like with rivalrousness, most things that we think about when we think about economic goods are also excludable. These types of goods (those that are both rivalrous and excludable) are classified as “private goods”. This fills out our first spot on the matrix.
Some goods are rivalrous but non-excludable. That is, some goods are consumable only by one person at a time while at the same time it is difficult to stop people from consuming the good without paying for it. These are called “common-pool goods” and many environmental problems we deal with involve goods of this type. For example, let’s take a look at ocean fishing. Ocean fish are clearly rivalrous because if I scoop up hundreds of them in a fishing net then no one else can scoop up those fish. But they’re non-excludable because the fish are a natural resource– there’s no producer a fisherman pays to “buy” the fish. The fisherman can just take as many as he wants. Even if there were a “producer” like someone who owned the oceans or a government body that made fishing regulations then the producer would have a very difficult time enforcing their rules due to the oceans sheer massive size. There can be a tax on taking fish out of the water but if most of the fishing goes unnoticed then the tax does little to exclude those that don’t pay from consuming the fish.
Still other goods are non-excludable like ocean fish but also non-rivalrous. This is where it gets exciting: non-rivalrousness. A good is non-rivalrous if one person consuming it does not impede someone else’s ability to consume it. In other words, multiple people can enjoy the same thing: it is not destroyed when it is consumed. Non-rivalrousness is important because it is the economic counterpart to "scalability" in the business world. Goods that are both non-rivalrous and non-excludable are called “public goods”. National defense is a good example of a public good. Consider an example where a country uses tax dollars to fund a military that prevents other countries from invading. This is non-rivalrous because the benefits of this arrangement are enjoyed by all citizens within the country at the same time. It doesn’t matter if there are 2 million or 100 million citizens because one citizen’s enjoyment of national defense does not interfere with another citizen’s ability to enjoy that same national defense. National defense is also non-excludable because it’s impossible to prevent people that haven’t paid taxes from enjoying the benefits of it. It’s not like the military can say to foreign threats “Okay, you can invade and attack this house because they didn’t pay taxes, but don’t attack any other houses please”. Many public goods are funded by taxes, but not all. Consider radio. A radio broadcaster does not get to control who listens to their broadcast– once the signal is sent then anyone with a radio can tune in. This makes it non-excludable. It’s also non-rivalrous because many people can use their radios to listen to the same broadcast. Radio stations attempt to “charge” their listeners via their time by playing ads, but there’s nothing stopping you from changing the channel or even turning the volume down when they cut to commercial.
Lastly, we have goods that are non-rivalrous but excludable. These are called “club goods”, and they’re a very powerful concept for entrepreneurs. Club goods are goods where multiple people can consume the same thing, and the producers are able to effectively prevent those who haven’t paid from consuming it. Let’s consider their namesake for an example: a fitness club. Only people who pay for a gym membership are allowed inside, so it’s excludable. However, many people can use the gym at the same time, and an even larger number of people can have memberships at the same time, so the gym is also non-rivalrous. The marginal cost of supplying a new customer with a gym membership is very, very low.
Even though multiple people can use the gym at the same time there is a ceiling to that phenomenon, as anyone who has worked out in a crowded gym can tell you. This crowding effect is referred to as “congestion”, and it’s something that all club goods technically experience. However, some club goods experience it in such small amounts that it becomes very easy to handle a customer base in the millions.
Enter: computers.
Let’s examine what happens when you buy an eBook from an online store. If you don’t pay the store then they won’t send you the eBook. That makes it excludable. However, if you do pay the store it’s not like they send you the only copy of the eBook they have, leaving themselves with one less eBook. No, they duplicate the computer file and send you the duplication. They keep their original copy. It’s non-rivalrous. It’s trivially easy for them to duplicate the eBook– they can do so hundreds, thousands, or even millions of times with almost the same amount of effort. The marginal cost of duplicating the eBook is near zero. It’s not just non-rivalrous, it’s highly non-rivalrous. “Congestion” here refers to the bandwidth of the website and the processing power of the servers performing work like accepting payments, serving downloads, and sending emails. And even if those get congested they can be easily scaled up.
In fact, the eBook is so non-rivalrous that once someone buys it they themselves can duplicate it and send it to others. This piracy makes the eBook slightly less excludable than other club goods. The gym example before didn’t have this problem. I can give you my keycard to scan into the gym, but then I myself wouldn’t have the keycard and couldn’t go in myself. If I upload an eBook to Pirate Bay, I keep my copy of the eBook.
Downloadable software is another great example of a club good, but it also has this piracy problem. Software providers deploy constantly evolving methods to prevent people from using illegally downloaded software, but those that download software illegally deploy equally evolving countermeasures that often succeed.
There is a business model that captures all of the magic of club goods, experiences very little congestion, and solves the piracy problem: Software as a Service (SaaS).
A SaaS company builds software that performs a valuable task and then hosts the software themselves on a server that they control. Then, users of the software would pay ongoing fees (often in the form of monthly subscriptions) to access the software. A computer program can perform a valuable task for hundreds, thousands, or even millions of people at the same time (highly non-rivalrous) and access to the service can be revoked the moment a payment doesn’t go through (highly excludable). Some rapid fire examples: Netflix, Spotify, Duolingo, Xbox Game Pass, Dropbox, Headspace, Canva, Grammarly, Evernote, Salesforce, Zoom. All of these companies are club goods.
Some club goods are so non-rivalrous they’re actually considered “anti-rivalrous”. In business terms we would think of these club goods as having “network effects”. These are goods where not only does one person’s use of the good not impede someone else’s, but each additional person that uses the good makes the good more valuable to the existing user base and more alluring for new prospective users. Social media companies are the classic example of this. Social media companies “sell” (in the form of showing ads) connection to their user base and access to the content that their user base has generated. So, the larger the user base the more connections there are to be had and more content is generated. This makes the service more valuable for all the users. Other examples of club goods with network effects include dating apps, review websites, and sharing-economy apps. Some goods have network effects without being club goods, like currencies, the internet itself, phones themselves, and iMessage.
Understanding the different classifications of economic goods is valuable for entrepreneurs because it provides a useful framework for identifying, evaluating, and optimizing business ideas and offerings. Private goods and club goods each have their own unique characteristics and challenges, and understanding these can help entrepreneurs preemptively solve problems. For example, you may be drooling over the prospect of recurring revenue with an idea of yours that is a club good, but ask yourself: does it have network effects? If so, you’ll have to solve the age-old problem of convincing the first users to join the empty network. Categorizing your business as one that has network effects will allow you to see that earlier. Again, this post is a relatively simple example, but building up a large collection of these lenses to view the world through is like having X-ray vision when it comes to evaluating ideas.
© Joseph Bowen