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.

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.

Free Radical

[tweetmeme source=”pricingright”] As a follow-up to Mr. Chris Anderson’s talk at Haas Alumni Luncheon and his description of continuously decreasing marginal cost I talked about opportunity costs and when it replaced the cost to produce/store/serve one additional unit.

Let us set aside the cost discussion and focus on price. Mr. Anderson’s new book’s sub-title is “The Future of a Radical Price”. Free service with Ad supported business model is not new and Mr. Anderson says that as well. What he says about free model is the emergence of a “freemium” model. What is “freemium”? Mr. Anderson explains this in a letter he wrote to The Economist,

The big shift since the crisis has been the rise of “freemium” (free+premium) models, where products and services are offered in free basic and paid premium versions. Think Flickr and Flicker Pro (more storage), virtually all online games and even your own site (some free and some paid content).

So many users pay nothing and get limited service and some pay to get a different class of service. I am not certain why this is radical or new. Let us consider following scenarios

  1. Taxation on Paying Customers: The free users are irrelevant to provide service to the paid customers. In this case the business is simply throwing away money by serving the free customers. There is nothing new here. Paying customers subsidize the free customers – so paying a higher price to support the marketer’s higher cost structure. What is in it for these customers to support the freeloaders? If the business one day decides to jettison all free users, it is simply eliminating a cost function that has no associated revenue and giving value back to paying customers.
  2. Up-sell: The business depends on converting a part of the free users to paid users over a period but otherwise it does not need the presence of free users to serve paid users. In this case it is no different from a business spending on marketing to bring in paid customers. Any one free user  by herself is not important but as a collection she is. This is similar to a mail campaign that has 1% conversion rate. Each mail you send out by itself is not important, but it is as part of the whole bunch you send out. So suddenly eliminating free customers is the equivalent of completely cutting off marketing spend. As long as the business can hold on to current paid customers and  has other ways to acquire new customers it can cut-off free users. In this case too the model is no different from what exists  in non digital businesses. Incidentally, whether or not there is a  cost to serve one single free user is irrelevant because the relevant cost to consider is the total cost to serve all free customers.
  3. Value Distribution: The business needs the presence of free users to serve its paid users, in other words presence of the free customers adds value that is shared between the marketer, paying customers and the free customers. This is the classic two sided market, like eBay, in which one side creates value and hence is not charged and the other side consumed value and is charged for that. One again this is not radical. The presence of free customers is essential for the service and the paying customers who are not subsidizing free customers but compensating them for the value add.

Price is about capturing value created for customers, if the business chooses not to charge for that value-add then they do not have a working business model. Free is not a price, definitely not radical,  it is either failure to capture value, customer acquisition activity or  simply matching price with value added.

It is not what you can give away, it is what you can charge for

In one of my previous posts I talked about why free is not a viable business model.  With every Web2.0 business based on free model, can anyone hope to charge for services? The answer comes from an essay by Gordon Crovitz, on online news media pricing:

For years, publishers and editors have asked the wrong question: Will people pay to access my newspaper content on the Web? The right question is: What kind of journalism can my staff produce that is different and valuable enough that people will pay for it online?

Applying this to Web based businesses, which for some reason are looking at their marginal cost of production ($0.00) to price their offering,  “It is not what it costs a marketer to produce or whether people will pay for your service but does their service add unique value that is not available for a lower price anywhere else?”

Of course this depends on whether people who recognize the value are still willing to pay for it even though no such service is available elsewhere. That depends on whether or not the marketer gave it away for free in the beginning and is now trying to move from a free to fee model. If you had trained your customer by giving them your service for free it is not going to be easy to switch them to a fee model.

So why not charge them from the beginning? Why worry about freemium/ freeconomics and building users base? Why invent complicated schemes based on growing mind share?

Crovitz says,

The truth is simpler: People are happy to pay for news and information however it’s delivered, but only if it has real, differentiated value.

True for any online service.

For related discussion on this see a post by Peg Corwin in her Score Chicago blog. She discusses Chris Anderson’s model  and the proposal by Walter Isaacson on newpaper.

See also a case for Unbundled Wall Street Journal in my Unbundling blog.

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