Free – The Effect of Reference Price

Mr. Malcolm Gladwell reviewed  Mr. Chris Anderson’s new book, “Free: The Future of a Radical Price”. It is a very well written review and very methodically breaks down Mr.Anderson’s claims.  From Mr.Gladwell’s review I found that Mr.Anderson quoted Professor Dan Ariely’s work and using it to support his case for free.

Anderson describes an experiment conducted by the M.I.T. behavioral economist Dan Ariely, the author of “Predictably Irrational.” Ariely offered a group of subjects a choice between two kinds of chocolate—Hershey’s Kisses, for one cent, and Lindt truffles, for fifteen cents. Three-quarters of the subjects chose the truffles. Then he redid the experiment, reducing the price of both chocolates by one cent. The Kisses were now free. What happened? The order of preference was reversed. Sixty-nine per cent of the subjects chose the Kisses. The price difference between the two chocolates was exactly the same, but that magic word “free” has the power to create a consumer stampede.

This experiment is very well explained in Professor Ariely’s book. But the problem is Mr.Anderson seem to have only read part of Professor Ariely’s work on free and ignore that parts that argue why free as a starting price is not a good idea even when you reach a large number of customers.  The problem with Mr.Anderson’s book and his argument is he talks in absolutes without considering all arguments about a topic and quotes research (even from the same source) selectively. Here is what Professor Ariely said in an interview with WSJ regarding giving services away for free to attract users (WSJ (September 2008):

BUSINESS INSIGHT: On the other hand, what about companies that set the initial price of something too low, even offering a product or service free of charge in order to encourage people to use it? Isn’t that why so many online publishers are facing such great difficulties, because they initially offered their content for free and then consumers couldn’t move past that anchoring point?
DR. ARIELY: The truth of the matter is that it’s very hard to realize the value of something even after you’ve used it. Say you use e-mail. How valuable is it to you? Sure, if something is free then people will start using it. But what companies don’t realize is that the mapping of utility to money is very difficult. People won’t say, “This is so great. I’ll pay $20 for it.” Instead they’ll say, “I used it for free all along and now you’re charging me? I’m not interested.”

You can clearly see the effect of the initial price of $0. Once people get it for free, $0 becomes the reference price and it is very difficult to change that. The New York Times tried it with Times Select and failed. Airlines had a tough time charging for what used to be free and only could do it or baggage fees. USAir tried to charge for inflight drinks but backtracked on customer backlash.

You might succeed in stealing market share from the competitors but by giving away for free you set a bad reference price that destroys value in the long run.

9 thoughts on “Free – The Effect of Reference Price

  1. Concerning the experiment on anchoring the price, i agree that you should not only look at only those experiments that benefit your point. I have not read the other one, so I will refrin from using it in the argument. I still think it will probably not be relevant, but i will read it before talking about it

    “For a decision to make business sense, the incremental profit (profit gained less profit forgone) should be positive.”
    I completely agree with the statement, but don’t think that anyone talking about this area is ignoring the lost possible profits from selling that service. Making something free does not necessarily mean that you have not thought of the possible lost profits. From my perspective the main point is that this foregone value is offend a lot less then we would intuitively think.
    If we take the case of skype, then they have a huge amount of free calls through theirs service, while only 7-8 % of the calls are paid for. Intuitively the lost profit is huge, because of all the free call, yet those calls would not have been made, had it not been free.

    Or the recent album from Nine inch Nail, which was freely available and still managed to make it to the top of the amazon download chart.

    The general opinion in the thoughts on free, from some of the internet most vocal people in the area, like Kevin Kelly, Chris Anderson and Mike Masnich, is not that you should discard profits foregone in a calculation. Rather that the profit foregone is less then you would think and that there is offend a great potential for profits from other sources.

    “If you exchange goods and services for free then it is not an economic activity”

    “Economics is the social science that studies the production, distribution, and consumption of goods and services” Wikipedia
    While not being an educated economist I would think that the average economist would say that production, distribution and consumption of goods and services, does not stop being economics because there is no direct monetary value. Is the direct exchange of goods not an act within the analytical framework of economics ?

    The Economics of non-scarcity os about the part of economics that have virtually no marginal cost of reproduction. Since this situation is new, it is not established as a area within economics. At the moment there is an initiative by well educated economists to establish a scientific journal within the economics of non scarcity. I put my faith in their expert knowledge as to judge that this is an independent unexplored area within economics.

    • Peter
      I appreciate the time you take for the discussion.

      if what you say is true and all Mr.Anderson is saying is, ” the incremental profit from making your service free is positive”, then I do not have anything to contradict. If that is the case then what is really new or radical here from the basic axiom, “among the available alternatives choose the one that maximizes profit”. If he is indeed saying that then he should be discussing this with models, showing when the incremental profit is positive. Possibility of generating additional revenue from T-shirt sales and concert tickets by giving away music does not mean these sales are not happening when the music is not free. The question is what is the additional profit by making the music free over and above existing profit from the current sales.

      if the people you mentioned say the forgone profit is less than profit gained then I would like to see a model, the assumptions they are making and data (data that is not just 1-2 examples)

      But is he really saying incremental profit is positive? As I hear and from what read what others like Mr. Seth Godin write about what Mr. Chris Anderson is saying, since the marginal cost is $0 it makes sense to give away your service.

      We need hard numbers to back up claims like “free is the future of radical price”.

      To your question of exchange of goods and services, if there is no money involved the activities are not are not part of nation’s economic activity and do not count towards GDP. It is same as you cooking for your friends for fun.

      Thanks for reading and taking the time and I am so glad your comments are focused on the ideas and not on the person.

  2. I don’t agree with everything chris anderson says. Yet when I was reading Malcolm Gladwell’s review, I wondered a why this could be a point of critic.

    Mr. Anderson quotes Dr. Ariely for a concrete experiment within bahavirol economics, which is Dr. Ariely’s field of expertise.
    This does not obligee Mr. Anderson to include Dr. Argyle’s personal opinion for two reasons. Because It is not a concrete experiment that disproves the experiment with the kisses and because economics of non scarcity is not the specialty of Dr. Ariely.

    The quote you have from him illustrates this perfectly. He talks about how it is hard to get people to pay for something that they initially got for free. This is completely true, but has nothing to do with if business models based on free can be viable. Neither Chris anderson nor anyone else have ever suggested that the economics of free is based on letting something be free and then charging for it.

    There are a lot of reasons to critic the thoughts on free, but this on is not valid.

    • Peter
      Actually Prof.Ariely did do experiments on effect of anchoring of initial prices (what i called as reference price). This is described in his first edition page 33. This is not just his opinion, there is research behind it. This later experiment on anchoring effect of initial prices does not disprove or contradict his Hershey Kisses experiment and nor did I imply that. One proves the effect of a $0 price and the other the risks of doing it. No researcher or decision maker can afford to look at only part of the research. I am not saying he said charge for free later but I am saying Mr.Anderson is ignoring the lost profits by giving away for free and looks only the gain. For a decision to make business sense, the incremental profit (profit gained less profit forgone) should be positive.
      Take the case of WSJ example and see what it would take them to make it free.

      What is economics of non scarcity? doesn’t economics already cover undifferentiated commodity markets with excess capacity?

      In his talk at Haas luncheon, Mr.Anderson made similar claim regarding “there is nothing in economics about free”. That is only partially true. If you exchange goods and services for free then it is not an economic activity, the microeconomics does not bother because free is not a price (except in case of 2-part pricing ) and the macroeconomics does not count such activity in GDP. Economics however does talk about competition in markets for undifferentiated products and any one supplier can meet the demands of the entire market. Economics is about profit maximization

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