The More You Give Away The More You Profit – Not

Chris Anderson of Wired and the author of The Long Tail has been talking and writing about his new theory, the economics of free. Recently he wrote a piece in The Wall Street Journal on his idea of giving things away. The theory has catchy names like “freeconomics” and “freemium”. Some of the entrepreneurs I talked to and the bloggers I read use the two words extensively and treat the concept as if it is universal knowledge. They not only expect you to  just know the freeconomics idea but fully agree with it.

Chris Anderson who based his Long Tail theory on the online distribution channel is basing his new free theory on digital goods as well. He starts out by saying,

Digital goods — from music and video to Wikipedia — can be produced and distributed at virtually no marginal cost, and so, by the laws of economics, price has gone the same way, to $0.00. For the Google Generation, the Internet is the land of the free.

To put this in context, the economics laws state that price of undifferentiated, substitutable commodities with no capacity constraints with  highly competitive market and multiple suppliers tend to drop to their marginal cost.  Economics does not say prices will fall to marginal cost as a universal rule. When customers can easily switch between suppliers and when any one supplier can meet the entire market demand price wars will ensue. When the suppliers keep reducing their prices and no one has real cost advantage the prices will spiral down to the marginal cost. Anything lower makes no sense.

For a marketer whose goal is profit maximization the fact that marginal cost is zero is immaterial. If your product is undifferentiated in a highly competitive market, why bother to play at all?  You can have 100% of the market share at  Price = $0.0, but for what purpose? A marketer wants to be in a market where her products are differentiated and can be sold at a price that maximizes the firm profit.  The way a marketer should price is based on the Total Economic Value to the customers by using their products given the alternatives. Pricing is based on correctly identifying this value-add and communicating this to the customers so the marketer not only creates value but captures a portion of it.

Does the cost not matter? It matters after the marketer identified the value-add and the price they can sell to determine whether or not the goods they sell can be produced at a cost profitable to the firm. Pricing based on marginal cost is what Drucker called as the first sin of pricing, cost-based pricing.

That said what Chris Anderson says is absolutely true, for digital goods like blogs, content, wikis, online surveys, emails, and any other web2.0 widget you can think of. Not only is their marginal cost zero but this is a market with excess capacity, infinite suppliers and no product differentiation. Many of these digital goods are developed with and distributed withour regard to the value-add to customers and in cases where there is value-add, without communicating this value.

Many of the digital goods (including this blog), from facebook virtual gifts to web2.0 widgets have no economic value to customers. For services that are usable, the customers sees no clear difference between the many offerings. For a few for which there is value-add, the marketers destroyed value by giving them away for free and by failing to communicate the value message.

To see the importance of communicating the value-add, let us start with email as an example. This is not a new service but serves very well as a case study. It is safe to say that most people cannot live without email. It adds considerable value to our personal and business life. Yet we all pay $0.00 for our email. When everyone who introduced this service for free we all assumed a reference price of $0.00 for email. Now this makes it almost impossible for any one to charge for email.

Another argument Chris makes is  how this free concept and two-sided market model is working well for companies like facebook and Google. To his credit he goes on to explain how the advertising supported business model for most websites failed to work. Let us take YouTube which Google acquired for $1.6 billion. In November, the CEO of Google Eric Schmidt was quoted in The Economist as saying,

“a huge end-user success and we’re awaiting the monetisation.”

Given the number of video uploads and views, huge is still an understatement. YouTube has virtually 100% of the market share for user generated video content. Yet the company that brought in $5.7 billion in revenue just the last quarter says it is still waiting for monetizing YouTube.

The freemium model Chris Anderson describes is to give away a basic version for free and make money from a few premium subscribers who you charge for the services.

This model uses free as a form of marketing to put the product in the hands of the maximum number of people, converting just a small fraction to paying customers. It’s an inversion of the old free sample promotion: Rather than giving away one brownie to sell 99 others, you give away 99 virtual penguins to sell one virtual igloo. (Confused? Ask a child: This is the business model for the phenomenally successful Club Penguin.)

The problems with this model are, one there are too many people giving away free samples and two the sample is good enough to serve the purpose of those who try. The second factor shrinks the market of customers willing to pay nearly unsustainable levels and the first factor fragments this already small segment that are not going to be enough to support the free sample majority.

A recurring theme in all of this is the marginal cost of digital goods. Chris Anderson says how the marginal cost of anything digital falls by 50% every year. Once again the decision on how to price a good, digital or otherwise, is not determined by its marginal cost. Cost leadership matters only when that is part of the strategy. In the digital world there is no cost advantage to any one player. The fact that marginal cost races down to zero does not mean the prices have to. For example, the archived articles of The Wall Street Journal are charged at a much higher price than the price of a complete newspaper.

Free is not a busines model nor are freemium or freeconomics. Business models are about creating value to customer and capturing your share of it. Pricing is a way to capture the value created. If the value created is unclear, when the value commuication is ineffective or when the marketer chooses to give away the value created for free, there is no business model.  Cost matters only when you have clear advantage or to make sure you are not selling below your marginal cost and definitely for determining price through a markup.

Other pricing you might find interesting: Unbundled Pricing

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