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The iPhone 5 Is a Free Lunch

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TANSTAAFL: There ain’t no such thing as a free lunch. It’s true and its false. The falsity should be embraced by those who appreciate entrepreneurs.

The phrase was used heavily in Robert A. Heinlein’s Moon is a Harsh Mistress, the 1966 science fiction novel that celebrated free market economics (and also collective action for the common good). Milton Friedman further popularized the phrase, though its earliest usage dates back to the 1930s (according to Wikipedia).

Nineteenth century bars would sometimes offer a free lunch to patrons who bought beer, much like some bars today offer free snacks during happy hour. The central idea of the phrase is that the lunch is not really free; it’s cost is included in the price of the beer. When the government offers “free medical care” or “free housing,” the cost is being paid somewhere, by someone. These programs do not create something of value, they simply move things of value (tax dollars) into other valuable uses (medical care).

But TANSTAAFL misses an important point: sometimes we can create value, not just move it around. Take the new iPhone 5. Recent reports put the cost of the components at $199 (for the 16 GB model), plus another $8 for assembly. The price to consumers: $649. This is a free lunch. Apple has taken $199 of parts and $8 of assembly effort and created something that consumers value in excess of $649. They have created more than $442 of value with every iPhone sold.

The consumers who buy the phone believe that they are better off with the new iPhone than with $649. Most of them would probably be willing to pay even more, say $659 or $699 to get the phone. This difference we economists call “consumer surplus.” It is the difference between the maximum that a consumer would be willing to pay, and the actual price the consumer has to pay. It’s immeasurable, but certainly a positive number. (If the consumer did not value the phone more than the money, he or she would not buy it.)

We should be cautious about schemes that purport to create free lunches by simply moving peas around the plate. We should embrace, however, the process whereby new value is created out of thin air by entrepreneurs.

This free lunch creation happens in many ways. It happens in manufacturing new products such as the iPhone. It can also happen when an entrepreneur moves a product from one place to another. When I was driving across the state, some smart fellow placed a gas station right where I wanted to refuel my car. I was happy to pay him more than the gasoline had cost him. (I would have been even happier to pay less, of course, but I was certainly better off after re-filling than before.)

Businesses sometimes destroy value rather than create it. When a company assembles a set of parts that consumers value less than the cost of production, then business has destroyed value. Think Apple's Newton or Ford's Edsel. Fortunately, the economy is a giant feedback system. Companies that destroy value either cease that activity or go out of business. Companies that succeed in creating value keep some of the free lunch, enabling them to try more value creation possibilities.

There are free lunches out there. Let’s encourage more people to create them.