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March 26, 2008

How Free Stuff Makes Money

Rita Gunther McGrath
Associate Professor of Management
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The Internet has radically changed the economics of information. It has also made many business models that used to be highly profitable irrelevant (think advertising-supported newspapers), while enabling others to grow and thrive (think Wikis).

In a recent Wired article, editor Chris Anderson creates a useful taxonomy of new business models, leveraging the idea that some aspects of the offering are free to the end user (although someone in the economic ecosystem is making money).

The different models he lists are:

The freemium. In this model, basic versions of products (such as software) are given away for free, while premiums and upgrades are offered for a price. This works because the cost of providing the basic version is generally pretty low while the profits on the upgraded version are substantial.

A clever version of this is currently offered by Classmates.com, a social networking site that provides information about people you attended school with. I’ve been bombarded recently with come-ons from this site, suggesting that I find out who signed my “guest book.” But to find out this interesting information — you guessed it — you have to subscribe and take out a “premium” membership. I find that irritating. And no, I haven’t bought.

Advertising. This is probably the best known of the “free” models and has formed the basis for many traditional industries, from newspapers to television. The places where advertising dollars are spent have radically changed, and this has shifted the economic underpinnings of many industries while creating a boom for others. The core idea is that advertisers will pay to get your attention, regardless of the ”free” offerings you actually came to consume.

Cross-subsidies. These are the traditional loss leaders well known to retailers. The idea here is that you give away one product (or portion of a product) in the pursuit of charging higher prices on others — examples are money-losing sale offers in the supermarket, low-priced CDs at Wal-Mart or toasters at the bank. They are all provided to get you to buy the more expensive offers.

The key assumption here is that customers are open to cross purchasing — not always true. When Wal-Mart went into Germany, for instance, they discovered (much to their dismay) that German shoppers are happy to engage in “basket splitting” — meaning they will go to multiple stores and scoop up the low priced items only, rather than buying everything from one place. Wal-Mart eventually had to make a rather humiliating exit from that market.

Ironically, business books fall into this category too. Very few people make a lot of money on business-book sales — instead, the real money comes from speaking and consulting work.

Zero-marginal cost. Software distributed over the web and digital music fall into this category. While there is a cost to create the initial offer, the cost of distributing it broadly is very low.

And sometimes the free good is actually a come-on for another item. For instance, while it may be impossible for a singer to limit the distribution of songs in digital form, they may make their money on concert sales (a variant on the cross-subsidy idea).

Labor Exchange. In this model, marketers offer you something for free in exchange for you providing them information or assistance. Anderson uses the example of Google providing “free” directory assistance because they can use the calls to improve their voice-recognition technology, potentially opening the way to a huge market down the road.

Gift economy. In this model, things are given away for free out of altruism or because people simply enjoy doing the work required to create the goods. The classic examples here would be open-source software and Wikipedia entries. People voluntarily create and consume the free good.

While there is still room in the economy for premium-priced real goods, the “free” based business models are becoming a force to be reckoned with.

Among the implications of the free economy? There are a few that business people should keep in mind:

First, when many aspects of an offering are free, premiums are going to be placed on those aspects that are scarce or expensive. While you may be able to get free lectures on YouTube, for instance, people will still pay for the in-person experience of a real, live, class because that in-the-moment experience is irreplaceable.

Second, don’t be greedy — you may find that you have to give away a lot to keep your core offerings relevant and of interest to your target customers.

Finally, be open-minded. While you may find that you can no longer make money on certain aspects of your business, there may be surprising opportunities to capitalize on relationships in other ways.

Comments

by Aditya Ghuwalewala | March 27, 2008 at 1:40 AM

I wrote a post on how internet affected the cost of things: http://adscovery.wordpress.com/2008/02/22/free-vs-close-to-free/

by Goutham | March 28, 2008 at 10:22 AM

I read an article by Dan Ariely, PhD in American Airline's inflight magazine on just how effective offering sthg for free is- He offered people the choice of a Lindt chocolate truffle for 15c or a plain-Jane Hersheys kiss for 1c. 73% chose the truffle. When the price was dropped to 14c and free respectively, 69% went for the Hersheys Kiss even though the price gap of 14c was the same. Ariely notes that the temptation of getting something for free can overwhelm logic!

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