The Economics of cloud computing

May 11, 2011 CollabNet VersionOne

In my spare time I like to study subjects other that information technology or the latest computing trends for example economics – yes I lead an exciting life 🙂

In this blog I going to apply some of the principles of Economic theory to the current trend of cloud computing and why organizations should be planning a cloud strategy.

A key concept of economic is the scarcity of resources (people + capital) used in the production goods and services and the economic decision on how those resources should be used. The term that is frequently used is “opportunity cost”. In economics every decision that is made results in a “best alternative forgone”, for example if a city decides to spend $10 million on a new school versus a new hospital (the next best alternative), then the opportunity cost is the hospital. However the city does so because it values the school above and beyond the hospital and city officials feel a school will add more total utility to the residents of the city than a hospital.

This exact same principle applies to any business enterprise. The opportunity cost must be weighted for  each endeavor. If it is found that the opportunity cost is greater elsewhere (will equate to a greater return) then the economic sound decision is to choose that of the highest return.

A production possibility curve is a graph that defines the potential output at a micro or macro level in economics. It graphs the potential output of two products (or an economy). The line of the graph represents maximum output (production frontier), i.e. production in an engineering efficient manner (no waste)

Source –

Points (A) and (B) represent production that is achieved in an engineering efficient manner. Point (C) are resources not being used in a productive manner (waste) and point (D) is unobtainable unless we invest.

A key aspect of a possible curve is that it demonstrates the concept of opportunity cost. With a finite amount of resources we can only produce more of “Y” at the cost of “X”.

Now let’s have  the production possibility curve  represent organizational productivity.  At points (A) and (B) our organization would be working in a completely efficiently manner, however you may be instructed by your management that by next year you need to be at point (D). To get to point (D) requires capital investment, i.e. people, processes and tools or even worse you could be at point (C) which  indicates  a dysfunctional organization.

Engineering efficiency is a subset of economic efficiency. The latter implies that if we spend valuable resources in the production of good and services it must be for those products that people want the most (maximum utility). For example if resources are used for the production of a good that could have been used on the production of another good that is deem more valuable, i.e. people are willing to pay more, then we are not producing in a economic efficient manner.

This is one of the core concepts of the equilibrium of the free market system.

This reasoning can be applied to many different scenarios or economics situations including cloud computing.

Cloud computing is a paradigm shift,  that provides consumers with choice and its evolution has principles based upon the free market system. The free market system is arguably one of the recent marvels of our modern world in that it is self-governing (for the most part), self-balancing (equilibrium – where demand meets supply) voted on by consumers with  their dollars and based on the belief that consumers know best how to apply their budget for maximum utility.

In essence if Cloud Computing is applied in its purest form end-users decide how best they can use their resources and maximize productivity. In my previous article I mentioned that cloud computing should have the following attributes

  • On-demanding provisioning
  • Cross Platform Provisioning
  • Rich API
  • A library of pre-built reusable images and stacks
  • Multi-tenant
  • Accounting, charge back
  • Above all else empowers developer

By definition these qualities lead to:

Engineering Efficiency:

  • Doing more with limited resources through reuse, collaboration, automation (elimination of repetitive tasks) and real-time response

Economic Efficiency:

  • Believing in the principle that consumers know the best choice for maximum utility and in the same vein how to maximize productivity. Giving end-users (our consumers) the ability to apply resources where they are needed the most.

Opportunity Cost:

  • Typically the opportunity cost of not investing in a cloud computing strategy is to continue with the (next best alternative) legacy model already in place. If you are at point (C) on the production possibility curve implies that you are willing to settle with dysfunction or if at point (A) and (B) that you are not willing to expand your production possibility beyond what is capable of today, an investment in future growth.

Closer Output on the Production Frontier:

  • To conclude, by adopting a cloud strategy that strikes the right balance of compliance and empowerment an organization will move closer to optimum productivity along the curve.  This provides the best method for resource (system) allocation made by decision makers that are closer to the business requirements (our consumers) rather than by a process that is detached, isolated and disconnected from the realities of business typically seen in corporate datacenters.

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