Enough With The Marginal Cost Argument

Economists love to talk about, “marginal this, marginal that”.  Two relevant terms to producing and pricing widgets are, Marginal Cost (cost to produce and sell one additional widget) and Marginal Revenue (additional revenue by selling one more widget). The commonsense rule is no one should sell widgets at a price lower than its marginal cost, otherwise you are losing money on each marginal unit you sell.

Now there is wider uptake of the marginality concept among the some of the well known names of the digital media world. The first is Mr.Chris Anderson who makes a case for his “FREE” based on the argument that marginal cost of digital goods is $0. Recently, Mr. Seth Godin, author of several marketing books made  this same marginal cost argument about education. He  is making a valid point, except from cost and producer perspective and not from the consumer value perspective. He writes,

MIT and Stanford are starting to make classes available for free online. The marginal cost of this is pretty close to zero, so it’s easy for them to share. Abundant education is easy to access and offers motivated individuals a chance to learn.

Scarcity comes from things like accreditation, admissions policies or small classrooms.

The marginal cost is $0 only for units 2 through N, the first unit has a very high marginal cost (the cost to set up the operations and run it).    But that is still not relevant to the value argument.

Being admitted to the school, accreditation, the many learning opportunities from the classmates, the network and the complete immersion all are considerable value to the the customers (the students). The value-add  increases when schools restrict their class sizes and implement stringent admission criteria – in other words by creating scarcity.

Even for the digital course one could argue that with proper segmentation there exists a segment that is willing to pay for it or some aspects of convenience. Again it is the value-add to customers argument not the cost argument that is relevant to pricing.

For any marketer the key is to know what their customer segments are, what they value , what they don’t and make a credible value proposition. It is not about the marginal cost!

Survivorship Bias and Other Flaws in Anderson’s FREE

In his new book, FREE: The Future of a radical Price, Mr. Chris Anderson supports his arguments with many examples of businesses that used razor-razor blade model, advertising model, and free + premium model. The last few pages of his books are just a list of examples of businesses that are successfully implementing, according to him, what he calls the “freemium” model. Are examples enough to state absolutes like “the future of a radical price”?

Even if that is enough, Mr. Anderson lists only those businesses that seem to have made it, at least for now, and does not include those businesses that tried many of the free models and failed. That is the classic survivorship bias. If we restrict just to the new media businesses that Mr. Anderson focuses on, there are many instances of ventured that went under. Even the small subset one can find in TechCrunch’s  “DeadPool” is a daunting number.

Even among those businesses selected,  the time horizon is too short to say they are successful or will deliver long term profit growth. Mr. Anderson uses  a different metric, “uptake among customers” rather than profit to measure their success. His careful choice of metric is not by accident, it is about cleverly framing the argument and directing his readers and listeners to focus on a metric that is irrelevant but supports his argument.

The next problem is confusing correlation with causation. Among the blockbuster success stories he quotes like YouTube, he attributes the customer uptake to the free model. He uses  Prof. Dan Ariely’s  Hershey’s experiment to substantiate this claim on causation. You can see Prof. Ariely’s comments on people using his experiment in his blog. In his Hershey’s  experiments, the claims were based on experiments that used control groups and treatment groups. But Mr. Anderson makes his claim based on YouTube being free.

Businesses, before jumping on Mr. Anderson’s far-reaching conclusions, should ask about his decision making process and analyze their own business based on hard data. As professors Pfeffer and Sutton point out in their book Hard Facts, the difference between an academic (who is much maligned by the new media Gurus) and a self proclaimed Guru is  that an academic gives you an open system of decision making where as a Guru gives you a closed system that talks in absolutes, ignores evidence, focuses just on benefits and minimizing the drawbacks of their recommendation.

The Most Discussed Free Experiment

Update: An article in The Economist (11/27/2009) adds some evidence to the hypothesis stated in this article.

There is one behavioral economics experiment that has been in blogs and mainstream media more than any other, it is the Hersheys and Lindt experiment done by Dan Ariely, Professor at Duke and author of Predictably Irrational. The news presence comes thanks to Mr. Chris Anderson who used it in his latest book, Free, to make his case about the attractiveness of the $0.00 price.

We already know that from Prof. Ariely’s book and we also know that Mr Anderson leaves out the part of the book (and research) in which Prof Ariely warns about the anchoring effects of initial low price. Now let us take the discussion one step further. The Hershey’s experiment found that when offered free, more people preferred Hershey’s than they did when offered at 1 cent. (You can read Predictably Irrational for the details).

Suppose if there had been a third stage to this experiment, this time in addition to offering Lindt  at a small price and Hershey’s at $0.00, there were also other candies (comparable to Hershey’s kisses) offered at $0.00 as well. Then what do you think will be the share of the different free offerings?  For sure, the market will be fragmented. In addition, I hypothesize that(which needs experimentation to verify)

1. more people will switch back to Lindt
2. of the free versions, the name brand versions will end up garnering a larger share
3. most of the free versions will find very few to no takers

The problem is when you give it away for free and there are many free offerings from your competitors, customers will start worrying about their opportunity cost and go back to priced versions.  The fact that some offerings are not free  signal value to customers and reduces their risk of trying.

Now where does that leave the “long tail” free offerings?

When good enough is good enough

The New York Times reviewed a few productivity applications for iPhone. One of their recommendation is reQall. This review says,

My favorite stand-alone organizational app is reQall, which David Pogue has already praised in The Times. ReQall really does turn your iPhone into a personal assistant — you dictate all your to-dos, reminders, appointments and other ephemera, and it translates your commands into actionable tasks.

A great review that clearly conveys value to customers. But the very next line goes on to destroy that value,

(I find the free version good enough, but heavy users might want to invest in the $25-a-year Pro version.)

Clearly the application was a superior option but as the review says their free version is good enough for a vast majority of users. I am not faulting the review but rather the way ReQall versions are designed. By offering a good enough free version most customers end up choosing that version even though they might have chosen the paid version.

I have written several posts on multi-version pricing- which is about offering multiple product/service versions at different price points to serve different customer segments. There are many examples of effective usage of multi-version pricing, from CPG leader (Nestle) to a salon. The important design decision in multi-version pricing is the price-feature mix so that customers self-select themselves to the pricing option that ends up maximizing profit to the business.

Mr. Chris Anderson calls this type of multi-version pricing as “freemium” in his new book, “Free: the future of a radical price”. Please do note that multi-version pricing is not new and has been covered extensively in the economics and practiced effectively by many businesses. The freemium model is just an extreme case of multi-version pricing, when one of the version is made free. While offering a free version helps to drive customers to your business,  if not done correctly and without analysis of your customer segments it ends up serving the needs of most of your customers thereby destroying the value created.

Do you know your customer segments and what they value?

But it is Free!

There is one of the Seinfeld episodes in which Kramer finds himself working for a business, even though he was not officially part of their workforce. His boss ends up firing him for producing sloppy work – as if done by someone who never had any business training. Here is how the final conversation goes (as far as I can recall):

Kramer: But I don’t even work here.

Boss: That’s what makes it more difficult.

Just because Kramer worked for free did it make sense for a business to have him do work for them?

Now look at this in the context of what Mr.Chris Anderson is saying about information wants to be free, free news sources will displace paid news and making your service free will make it go viral.

Would  any business use data whose quality and veracity is unknown, just because it is free?

If the service  adds no unique value, why should a customer use it?

If the service does add unique value, why shouldn’t you charge for it?

Does Marginal Cost Affect Your Pricing?