Gates posted in his Tweet some linear supply and demand curves (quantity vs. price) and then said
This chart assumes that the total cost of production increases as supply increases. When a car company makes a new vehicle, the 10th car costs the same to manufacture as the 1000th. But software doesn’t work like this. Microsoft might spend a lot of money to develop the first unit of a new program, but every unit after that is virtually free to produce.
Gates seems rather ignorant that (internal) economies of scale exist in many other industries. E.g., textbook-reminder material from The Economist:
Economies of scale are factors that cause the average cost of producing something to fall as the volume of its output increases. Hence it might cost \$3,000 to produce 100 copies of a magazine but only \$4,000 to produce 1,000 copies. The average cost in this case has fallen from \$30 to \$4 a copy because the main elements of cost in producing a magazine (editorial and design) are unrelated to the number of magazines produced.
Economies of scale were the main drivers of corporate gigantism in the 20th century. They were fundamental to Henry Ford's revolutionary assembly line, and they continue to be the spur to many mergers and acquisitions today. [...]
Internal economies of scale arise in a number of areas. For example, it is easier for large firms to carry the overheads of sophisticated research and development (R&D). In the pharmaceuticals industry R&D is crucial. Yet the cost of discovering the next blockbuster drug is enormous and increasing. Several of the mergers between pharmaceuticals companies in recent years have been driven by the companies' desire to spread their R&D expenditure across a greater volume of sales.
The software industry may be just an extreme example, where R&D costs are much higher than other costs, but the other costs are certainly not zero.
If a firm offers any customer support whatsoever for their software, it can't be the case that the support cost is completely independent from the number of units sold. Even if it's just scaling support websites so they take millions of page hits from self-help customer, it's still a cost. However, leaving aside his apparent poor knowledge of other industries, Gate's argument is that per-units costs are negligible ("virtually free") in comparison with R&D, not zero.
It's also not clear that sales and marketing costs don't factor substantially in unit costs for software. After a firm obtains a monopolistic position so it can afford to not bother with any marketing (although that's probably not the case even for Microsoft), maybe those costs do become negligible. Hower, as far as the average softare firm goes, a yahoo survey found that:
On average, [software] companies spend 15%–25% of their revenues in sales and marketing activities. However, there are exceptions like Symantec (SYMC) which has consistently spent ~40% of its revenues in sales and marketing.
So at least in some niches it seems that marketing costs are substantial. I don't expect these marketing costs to be independent of the number of units sold (and thus "produced").
And also from the same source on R&D costs:
R&D costs typically form 10%–20% of the revenues for software companies. However, not all of this goes into innovation. A large portion of it’s spent in testing various configurations of operating systems (or OS) instead of developing new functionality. Industry experts think that even less than 5% of R&D budget is spent on innovation.
Gates is also ignoring a more subtle issue: the R&D cost itself has some relationship to the market share of the software thus developed. Why? You cannot attain a monopolistic position with trivial software that's quick to write and thus offers a low barrier of entry to competition. So the size of the software is related to its ultimate market share (which translates into units sold), and so R&D costs are in this way a determinant of the number of units sold (so "produced"). The exact shape of this relationship is probably more difficult to quantify; empirical evidence has pointed to both economies and diseconomies of scale relating software size to its production cost. (Diseconomies are supposedly of the communication-complexity kind between [more] developers.)
Diseconomies of scale are not unique to software development either. The aforementioned article in The Economist talks about it a general context of organizations:
The larger an organisation becomes in order to reap economies of scale, the more complex it has to be to manage and run such scale. This complexity incurs a cost, and eventually this cost may come to outweigh the savings gained from greater scale. In other words, economies of scale cannot be gleaned for ever.
A related issue that's worth mentioning: Gates probably thinks his software support infrastructure is "virtually free" of cost because he already has it in place for new products. And that brings us to economies of scope. As nicely said (again) in The Economist:
First cousins to economies of scale are economies of scope, factors that make it cheaper to produce a range of products together than to produce each one of them on its own. Such economies can come from businesses sharing centralised functions, such as finance or marketing. Or they can come from interrelationships elsewhere in the business process, such as cross-selling one product alongside another, or using the outputs of one business as the inputs of another.
Gates' tweet doesn't talk about demand, but he does mention it in his extended notes he links to. These notes focus on the so-called "intangible investment" in R&D but also in marketing etc.
And when talking about those, he doesn't sound so radical after all. The pricing of products developed through heavy R&D costs (in particular medication) is a huge issue, with lots of research done on how to recoup the sunk R&D cost, or how to finance future R&D, e.g. by hoarding cash from current sales (as done by firms like Apple, Google, etc.) or other means (e.g. venture capitalism).
Gates is also fairly correct when he criticizes the "magical" belief in equilibrium as the best thing for society, laid up a as an easy target in the following terms:
Equilibrium is magical, because it maximizes value to society. Goods are affordable, plentiful, and profitable. Everyone wins. [Critique based on the software industry follows.]
And in this respect Gates is correct again; equilibrium is affected by economies of scale, although Gates omits (even from his extended notes) the typical/textbook effects that [internal] economies of scale have on equilibrium:
Internal ES [economies of scale]:
– Problem: it forces us to move to a imperfect competition model:
• In imperfect competition, firms can affect the price.
– Industries with few producers
– Industries with product differentiation for consumers
– In order to sell more, the price must be decreased (strategic behaviors)
• Possible cases:
– Monopoly; oligopoly; Monopolistic competition
So as a sort of conclusion: Gates gives some rather bad examples from other industries (e.g. saying that the auto industry lacks economies of scale is laughable), and he fails to talk about the elephant in the room (monopolies)... but his conclusion that equilibrium isn't necessarily a good thing from some points of view (particularly in the case of imperfect competition, engendered by economies of scale)... is actually correct, even though Gates' own argumentation for this is rather unconvincing. Keep in mind that his main point with tweets/blog is to promote a book and to argue that the "intangible investment" lacks sufficient recognition. (His last point reminds me of the controversy --which also involved Gates at one point -- whether there are enough developers; it depends who you ask.)
And let's dispel this myth that economies of scale or monopoly's effect on the [lack of] equilibrium are not covered in econ 101. E.g. a freely available textbook has a
"Figure 10.1 Economies of Scale Lead to Natural Monopoly".
It also talks of sunk costs as a barrier to entry after that.
And Mankiw's textbook has had an "FYI: Why a Monopoly Does Not Have a Supply Curve" for many editions:
You may have noticed that we have analyzed the price in a monopoly
market using the market demand curve and the firm’s cost curves.
We have not made any mention of the market supply curve. By contrast,
when we analyzed prices in competitive markets beginning in Chapter 4,
the two most important words were always supply and demand.
What happened to the supply curve? Although monopoly firms make
decisions about what quantity to supply, a monopoly does not have a supply
curve. A supply curve tells us the quantity that firms choose to supply
at any given price. This concept makes sense when we are analyzing
competitive firms, which are price takers. But a monopoly firm is a price
maker, not a price taker. It is not meaningful to ask what amount such a
firm would produce at any given price because it cannot take the price
as given. Instead, when the firm chooses the quantity to supply, that
decision (along with the
demand curve) determines
Indeed, the monopolist’s
decision about how much
to supply is impossible to
separate from the demand curve
it faces. The shape of the demand curve determines the shape of the
marginal-revenue curve, which in turn determines the monopolist’s
profit-maximizing quantity. In a competitive market, each firm’s supply
decisions can be analyzed without knowing the demand curve, but
that is not true in a monopoly market. Therefore, we never talk about a
monopoly’s supply curve.
Both are introductory "econ 101" textbooks.