Free – Ignoring Forgone Profits

Mr. Chris Anderson, author of the book “Free” and proponent of “free as the future of radical new price” and “free + premium = freemium” model,  says how  the decline of marginal cost (incremental cost to produce/store/distribute one additional item) makes $0 price as the inevitable price. I have not read his book and have only read his writings on this in other media and seen his speeches (on video). I am sure I will be told that I misunderstood his book and that he is not saying “free as the new price” (despite the subtitle for the book).  So let us stick to his discussion of freemium model.

According to Mr.Anderson, freemium is about having a free version and a premier version for which you can charge a premium. The reason a business should go for this model, according to Mr.Anderson (or at least my interpretation of his argument), is that making it free enables the product/service to go viral and significantly increases is uptake. In other words a product that did not have a market (or market share) will have the opportunity to capture a large market share when made free. Once you grab these free customer’s attention, which according to Mr.Anderson is he scarce quantity, a business can find other ways to monetize. His examples include up-selling customers to subscription, and a band giving away its songs to sell concert tickets and other items like T-shirts. In the digital world, since the cost to produce/store/sell one additional item approaches $0 (or already $0), he argues, free makes sense.

Mr. Anderson’s argument is valid and true, if we only looked at one side of the equation. It is absolutely true that a business can reach new customers, when none existed, and can monetize them through other ways. The question Mr.Anderson chose not to ask, but any decision maker will always ask, is how much profit am I giving up by charging $0. Failure to do the incremental analysis makes this not “freeconomics” or “economics of abundance” rather “halfonomics”.

Let us try to breakdown the profit to individual customer level. The metric is over the lifetime and not just transactional. Breaking this down to individual customer level and adding them all up,  the decision maker must ask

  1. What is the Lifetime Value of the customer when I make $0 as the price  (LV0)
  2. What is the Lifetime value of the customer when I charge for the product (LV1)
  3. Is  sum of all LV0  greater than sum of all LV1

If (3) above is true, it is no brainer. Choose the option that maximizes total profit over the long term.  But Mr.Anderson’s argument simply asks,

is Σ (LV0)i   > $0?  rather the right question is Σ (LV0)i > Σ (LV1)i

Mr. Anderson talks in absolutes and assumes that Σ (LV1)i = 0.  It is not true. Note that, just because a band sells its music for a non-zero price does not mean it cannot or does not sell concert tickets and T-shirts. One should only look at the additional profit from the new sales that were made possible because of the $0 price. If it still makes sense, then by all means make it free. But then this is basic decision making, nothing new or radical about it.

6 thoughts on “Free – Ignoring Forgone Profits

    • But no one would pay for a speech (or book) that asks a business to measure, collect data and do analysis before making decisions. Talking in absolutes with total disregard for data and talking with utmost confidence, makes one look like a Guru.

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