Competing in Undifferentiated Markets

In his support for Mr. Chris Anderson’s book , Mr. Seth Godin writes

As I see ‘free’, there are two forces at work:

In an attention economy (like this one), marketers struggle for attention and if you don’t have it, you lose. Free is a relatively cheap way to get attention (both at the start and then through viral techniques).

Second, in a digital economy with lots of players and lower barriers to entry, it’s quite natural that the price will be lowered until it meets the incremental cost of making one more unit. If a brand can gain share by charging less, a rational player will.

Whether digital or not,

  • any market that has lots of players,
  • has low or no barriers to entry
  • has excess capacity where any one player can easily supply the entire market
  •  and the products are undifferentiated from one another

prices will race towards the marginal cost.

But is that the market anyone want to play?

If a player can gain share in one round by reducing prices (even to $0)  there is no guarantee he gets to keep it in the next round. There is also no guarantee that he gets to monetize it.

The question is not whether or not you make your service free (because your MC is $0) and gain share by charging less but whether your service adds unique value to the target customers, you can make a credible value proposition and get to share  that value created.

Suppose You Made Pricing Decisions Based On Your Marginal Cost

Let us suppose you made pricing decisions based on your marginal cost. One of the examples quoted in Mr. Chris Anderson’s series on “free” is digital music. Mr. Anderson says, since the cost to produce, store, distribute digital music is $0 (or approaches $0) it makes sense to give it away and find other ways to make money, like concert tours and other paraphernalia. Let us take the marginal cost argument to the extreme and apply to the concert itself.

The marginal cost to admit one additional person into the concert arena is, you guessed it, $0. Once you decide to put on a concert, pay for marketing, stage, security etc it does not cost anything additional to allow one more person for  free into the concert arena. So why not do that?  Because the marginal cost is relevant only up to the point whether or not you can breakeven on your initial investment and is always irrelevant to your pricing decision as long as you do not charge below your marginal cost.

Before you put on a concert , you add up all your costs of what it would take to do it. Then you look at what is your “average price” below which you cannot breakeven and hence makes no sense to do your concert. This is the floor for the average price. Then you determine the multiple customer segments and their willingness to pay for the tickets and design a multi-version pricing scheme that appeals to those segments. You design your pricing and product mix such that those with higher willingess to pay will self-select themselves to the higher priced version (because of closer seat etc). Then you determine the total profit  and see if this is net positive over the total cost of your concert. At no point you are deciding based on the marginal cost.

Why is this any different when you cho0se to distribute your music digitally?  I am not saying do not make your digital music free, by all means do it if that is the best among all available options in terms of total profits delivered. Make your business decisions because you have done the analysis and evaluated all options and not based on “everyone else is doing it” or “free is the law”.

But the problem with writing a book that says, make it free when it drives maximum profit through other means, charge for it when that delivers maximum profit,  is you are seen as hedging your bets. As Professor Dan Ariely points out, people trust confidence more than expertise. Prof. Ariely says, “We’re Swayed by Confidence More than Expertise“. You can sell more books with confident assertions.

Because though confidence and accuracy sometimes go hand-in-hand, they don’t necessarily do so. And when we want confident advisors, some will exaggerate to give us what we want.  Maybe this is why so many pundits on TV for example exaggerate their certainty?

Who Needs Analysis When The Future Of Pricing Is “Free”

Consider the following case

You have just designed a web service. It lets you publish your body temperature from your phone that all your friends can follow.  You are thinking of charging for such service, so people pay a monthly fee to use the service. But you do not know what price to charge and you do not know how many will subscribe at each price. In other words you do not know the demand curve. Because finding the demand curve is not a simple exercise and it is all the more complicated when you are creating a new product and the value to your customers is not clear.  It will cost you to do a market research but nothing compared to what it will cost you to develop the market and reach our target customers. If you do not know the market size and what what you can capture you cannot undertake a huge investment in marketing this product.

It just happens that you read and hear a lot  about the future of a radical new price and how the marginal cost of digital goods is $0 and how making your service free or following a free + premium model works and is now the law.  You are told that what you are competing for is attention because this is an era of attention economics and abundance economics at the same time. Do note that attention is a scarce quantity but the products are available in abundance. The  free + premium  = freemium  seems like the perfect fit for you.

All you need to do it is first give away the version of your service for free to grab people’s attention. You are told that since your marginal cost is $0 it does not cost to add any one free subscriber.  Because you gave your service for free, it is going to go viral and will have a great uptake. Now that you have all the attention you wanted start monetizing it, either by up-selling some of your customers to a premium service that lets them publish temperature in two different units or by selling them thermometers. Simple right?

Why are you not running with it? What did you ask? You want to know  the demand curve for the new upgraded service and thermometers?   You want to know how the profit gained from this business model compares to profit you would have gained if you had bothered to find the demand curve in the first place and charged for your service? No, no, you got it all wrong. Your business is to grab attention, you got it now just monetize it without asking questions that will require market research and marketing budget. Demand curve is valid only in economics which is a study of scarcity and does not work when things you sell are in abundance.

What did you say? You are making decision not on whether or not to support one additional free customer but whether not to offer the service at all because all your costs are fixed? Your marginal costs are $0, be happy.

And you are worried about setting a bad reference price of $0 now and how this will affect customers’ willingness to pay for the premium service? Are you forgetting you will not achieve such a high uptake if not for the $0 price?

What now?  You say, there are at least 100 others offering the same temperature publishing service – 60 of them offer your premium multiple units publishing for free and 100 others are offering  a service that lets people publish their heartbeat? That is abundance, right? This is the era of abundance, did you not read or understand all the materials on that already?

Now don’t stand around claiming free is not a law. You did not understand the freemium model correctly. It is happening now whether you like it or not.

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.

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.

Cloudy With a Chance of Free Business Model

There is a children book called Cloudy With A  Chance of Meatballs which is  a great story about a town where food was in abundance, because it rained food three times a day. It rained breakfast, lunch and dinner. In this scenario, there is such thing called free lunch. In fact the town hired sanitation crew just to cleanup the excess food from the streets and keep them clear. I bet no one in the town went hungry and there was no need to save food for the rainy day (pun intended). There is a page in the book that shows a restaurant with people eating inside. One notable aspect about that restaurant is there was no roof. Waiters simply caught “the rain” and served their customers. The marginal cost of food is zero for the restaurant.

That brings us to free as a business model that Mr. Chris Anderson talks about. Mr. Anderson says how free is the future for digital goods and services because their marginal cost approaches $0.  The meatballs book  applies Mr. Anderson’s argument about marginal cost to physical goods. Abundance of one component simply makes it irrelevant in pricing because a marketer cannot make a value proposition based on that component. The business model shifts to other components that deliver value.

  1. Since the marginal cost of food is zero, should the restaurant serve its customers for free?: No. The marginal cost is irrelevant. The restaurant should charge the customers for the convenience  (someone else catching the raining and serving) and experience. The fact that marginal cost is $0 for food only changes the product/service that is being sold.
  2. If the restaurant simply serves the rain that people can do it for themselves, why would anyone go to any restaurant?: Same answer as above.
  3. How would one restaurant differentiate itself from others?: Better service, live entertainment,  complements like wine that is not part of the rain.
  4. What role do chefs have to play in such a town? If the food from the rain is bland or flavorless then chefs role could be to improve its flavor. They could also specialize in plating the dishes in an attractive manner.

Pricing is about capturing a share of that delivered value. Since  “free” does not capture value it cannot be a business model.