Economics of Cloud Computing – A Different Angle

This article was originally posted on the VMware vCloud corporate blog. I am re-posting here for the convenience of the readers of my personal blog.

A homonym (and anonymous) friend of mind I used to work with in a previous IT life sent me a document exploring cloud economics from slightly different angle than usual. We often talk about this topic in the scope of elasticity, CAPEX vs. OPEX, PAYG (pay as you go) cost models and things like that. In this case he talks about the economics of clouds as a function of the costs of “knowing stuff”. I found it pretty interesting and I thought it was worth sharing.

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“From an economic point of view, the model of cloud computing is the latest incarnation of the benefits achieved by providers of IT services as a consequence of specialization achieved by them.

We consider this business model is growing in the market through technology developments in the following stages: innovation, standardization, commoditization, falling prices and spreading.


The keyword to understand this concept is specialization. It is through this ability, refined over time, that is possible to lower the average cost to maintain the data center, at least for medium and large size customers.

Many of you know very well that there are many items that concur to data center costs. Hereafter we focus our attention on transaction costs, that is research costs to find better prices among suppliers, costs associated with the negotiation and execution of each transaction and the cost of technology scouting.

An important contribution to transaction costs is due to uncertainty about the future. In 1937, economist Ronald Coase, Nobel Prize for Economics in 1991 for his discovery and clarification of the significance of transaction costs for the institutional structure and functioning of the economy, wrote that it is good to internalize the costs of transactions as much as possible within the borders of the company.

Coase explained that, under the threshold of its sustainability, every company should try to do every transaction inside it, but when the complexity increases the company is likely to turn inefficient. Indeed, reached the threshold of sustainability, this indicates the limit of the process of internalization of transactions; in other words, the optimal size of the company. If a company goes beyond such limit the resulting increase in his size may imply diminishing returns of investments and therefore make more and more expensive the change of doing additional transactions within the company. So it is better to find opportunity in the market.

Today, the complexity regarding the integration between the hardware (servers, storage and networking) and software applications are pushing up transaction costs. In this context the cloud model, from an economic standpoint, is a way to reduce these costs. With this perspective, we observe the evolution if IT with an analogy: the internationalization of trading. Let’s assume that a country is comparable to an IT company which must decide whether to develop and run the service internally, or buy it externally. To make things simple, let’s see what happened to international trading and compare the results to the IT industry, in order to clarify this vision.

We start from the father of modern economics, Adam Smith, who in 1776 already wrote about the efficiency achieved through specialization of labor (some of you may know the Adam Smith’s Pin Factory story).

In detail, Smith argued that if a foreign country can supply something (a commodity) at a cost that is cheaper than another country could spend to produce it, than it would be better to buy it from the foreign country and focus the attention on other tasks where competitive advantage can be created.

With the growth of the demand of IT services from others department of the company, it is necessary to reach a higher level of standardization, only in this way we can lower the cost of production of that service.
As long as the marginal cost of internal (domestic) production is less than the average costs provided by the outsourced service, it is likely that companies prefer to avoid the exploration of opportunity offered by the market.

But a specialized supplier is always looking for maximizing economies of scale and when the company evaluates the difference in labor costs (make vs. buy), it may turn out to be more convenient to buy the external service.

In this case we are now faced with a “mature” service, that is highly standardized, and thus very competive.

In conclusion, it can be argued that each organization has a different level of specialization hence a different cost to develop a given service. So each company will specialize in the development of services in the field where they have the greater relative advantages (or minor relative disadvantages).

It is clear that only part of the IT business is undertaking this journey, for now it is a phenomenon to be studied in perspective. It should not be seen as a catastrophe: the enormous gain in productivity will have beneficial effects throughout the IT industry due to the gain in efficiency and profitability for the various companies.

Today the benefits of the cloud model begins to emerge, supported by the economic theory. Victor Hugo said: “You can resist an invading army; you cannot resist an idea whose time has come.”

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I found this writing to be pretty interesting. There are a few concepts, such as the “simplification” and “standardization”, that are usually discussed in the industry but here there is a “business” spin that I found pretty intriguing. It’s like knowing that you need something but not knowing why. This script gets into some aspects of this “why”. Of course it only scratches the surface.

The other thing that caught my attention is this “specialization” concept. Talking further with the source he commented that it’s also a function of time. That is to say that the effort of developing and running something internally is not a one-shot. It’s rather a continuous tuning and innovation that needs to occur due to the pace the IT industry is moving so the “sustainability over time” of the innovating effort is key to evaluate the make vs. buy decision.

Massimo.

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