The key to running a successful large-scale utility is to match capacity (ie, capital) to demand, and the key to matching capacity to demand is to manipulate demand through pricing. The worst thing for a utility, particularly in the early stages of its growth, is to have unused capacity. At the end of the nineteenth century, Samuel Insull, president of the then-tiny Chicago Edison, started the electric utility revolution when he had the counterintuitive realization that to make more money his company had to cut its prices drastically, at least for those customers whose patterns of electricity use would help the utility maximize its capacity utilization.

Amazon Web Services is emerging as the Chicago Edison of utility computing. Perhaps because its background in retailing gives it a different perspective than that of traditional IT vendors, it has left those vendors in the dust when it comes to pioneering the new network-based model of supplying computing and storage capacity. Late yesterday, the company continued its innovations on the pricing front, announcing a new pricing model aimed at selling spare computing capacity, through its EC2 service, on a moment by moment basis. Buyers can bid for unused compute cycles in what is essentially a spot market for virtual computers. When their bid is higher than the spot price in the market, their virtual machines start running (at the spot price). When their bid falls below the spot price, their machines stop running, and the capacity is reallocated to those customers with higher bids.

Amazon’s spot market promises to significantly reduce the cost of computing tasks that don’t have immediate deadlines, such as large data-mining or other analytical efforts. And it promises to further increase Amazon’s capacity utilization, which will in turn allow Amazon to continue to reduce its prices, attract more customers, further smooth demand, and avoid wasted capital. As Insull discovered, cutting prices to optimize capacity utilization sets a virtuous cycle in motion.

In describing the new “spot instances” plan, AWS chief Werner Vogels used words that could have come out of Insull’s mouth a century ago:

Spot Instances are an innovation that is made possible by the unparalleled economies of scale created by the tremendous growth of the AWS Infrastructure Services. The broad Amazon EC2 customer base brings such diversity in workload and utilization patterns that it allows us to operate Amazon EC2 with extreme efficiency. True to the Amazon philosophy, we let our customers benefit from the economies of scale they help us create by lowering our prices when we achieve lower cost structures. Consistently we have lowered compute, storage and bandwidth prices based on such cost savings.

At Chicago Edison, Insull had nothing to lose. He had recently quit his executive position at Thomas Edison’s General Electric, the dominant player in on-premises electricity generation. No longer subject to the constraints of the old business model, which he had played a crucial role in establishing, he had the freedom to destroy that model. Amazon Web Services is also an outsider in the IT business, unbeholden to the constraints of the established and very lucrative business model, and that is the company’s great advantage.

UPDATE: Jonathan Boutelle, a founder of Slideshare, already has a strategy for gaming AWS’s spot market: bid high, buy low. That should be music to Amazon’s ears. If enough buyers pursue it, the spot price will quickly approach the set price.