Part 2: Free - the Disruptive Price

In Part 1, we discussed the motivational power of scarcity. Based on that discussion, you might conclude that abundance will demotivate. In some ways it does: air is everywhere, so few people take action to guard and protect it. Our relationship to air exposes another characteristic of commerce: air is free, and free drives impulsive, unconscious action. A business with a clear understanding of what free means to humans can use it as a disruptive strategy for rapid market penetration and indirect revenue generation. Free is a proven way to build a broad community, gain widespread adoption, and encourage active participation. It is a potent tool used to manipulate the behaviours of customers and potential customers. It has value, but no price.

Our relationship to free has led four business models, each separating the delivery of value from compensation for that value. The newest of these, called freemium, is most used on the Internet, where distribution is free and the number of potential consumers is vast. This chapter digs into what free really means to people and to our behaviours, describes the four types of free, and analyses several popular products in this context.

The relationship between free and value

Free is more than a price¹; like money, it is a method for sharing value. There is ample evidence that humans treat the $0.00 in a significantly different way than any other price . When something is free, or payment is well hidden, people tend to treat it like either a gift or a no-risk acquisition. You can see this at a conference offering free food: people consume with little thought. In the context of scarcity = value, the zero price tag implies ubiquity. Few are parsimonious with a resource they consider plentiful, and waste has little apparent consequence.

To understand the power of this strange price, recall the place of money in the types of value discussed in part 1. Value is created in terms of utility and generatives—something you can do in the first case, and something you are in the second. Features are the most commonly discussed type of benefit since they are easy to measure: the customer using the product gains a capability they didn’t have before. Flight and playing recorded music are examples. Generatives, delivered by experiences and characteristics, are hard to quantify and hard to copy. This means they are often more valuable than features. Money has a lonely place in this model of value delivery: it can be stored, measured, and exchanged for some types of value. In other words, it has a few features, but typically doesn’t confer any characteristics or experiences: it has little value in itself.

This leads us to ask what it is about money that changes the way we understand the exchange of value. To get a sense of the impact of money, consider two scenarios where value is exchanged but money is not:

• You ask a few friends to help you move—in essence, asking for a gift of time and effort. In thanks, you provide a gift of food and drink (in Canada, this is usually pizza and beer). Features have been exchanged for features—lifting for libations in this case—but more importantly, experiences have been shared and characteristics (such as reliability and trust) have been conferred.
• A grocer sponsors the local youth football team, providing uniforms and other equipment. The team makes sure the grocer is known as the team sponsor. For the grocer a few generative characteristics deliver value: being a patron gives the grocer a sense of self-worth, while demonstrating to the community that the grocer is an authentic member of the community.

Now imagine these scenarios with an injection of money. How would your friends react if you said, “here’s $100 to split” instead of providing food and drink? Would the grocer still be part of the community if he gave the team money to put up a billboard?

These anecdotes tell us what we already know: free isn't just another price. Most rational, macroeconomic projections of human behaviour break down at $0.00, partly because money transforms social debt into a transactional exchange. They do not account for our visceral experience of the motive power of free or the psy-chology of zero. They don't match experiment and observation.

Free is a quantifiably distinct driver of human behaviour—a mental hacking trick. It is what makes sponsorship different from advertising, friendship different from employment, and family different from colleagues. We will talk about this difference in detail when we explore the conflicts between familial and contractual value exchanges. For now, let’s examine the business models that use free.

Business Models That Incorporate Free

There are four key models for value exchange involving free: non-monetary markets, direct cross subsidies, the three party market, and freemium. The first model is based on generosity or theft; the other three put a price on value. Together, they represent proven ways to mingle contractual and familial exchanges of value—a difficult feat. In this article we will concentrate on the least intuitive models: non-monetary markets and freemium.

Non-monetary Markets

When value is given or taken without money changing hands, you’re in the Non-monetary Market, also known as the gift economy. Consider people who volunteer to work for a local school—perhaps monitoring a playground, or ensuring children get home safely. Volunteers give the school functional value², and in return they receive characteristic value and experiential value³. Friendly favours and sponsorship usually fall in this category.

There are dark sides to this model. Piracy is a version where products are stolen because they are popular. This is fuelled by the belief that abundant products are worthless; attention and reputation are still delivered, but money is not. Another dark aspect to non-monetary markets is the lampooning or vilification of a person or organization that does not want attention or reputation. Many memes, including the Star Wars Kid and Brother Sharp⁴are hilarious or compelling—but the value proposition for the subjects of the meme may be destructive and negative.

 

Three Party Market

Advertising is the most common form of the Three Party Market. It is so named because three stakeholders are involved in the exchange of value:

• producers of content, products and services,
• advertisers for organizations,
• consumers.

Producers need to get paid. Advertisers pay producers for the right to deliver ads to consumers. Consumers to get free content from creators, and purchase some of the products the advertisers are selling.

Direct Cross Subsidy

A Direct Cross Subsidy occurs when a company gives away a product for free, knowing that the product will encourage the purchase of another product for profit. Anyone with a mobile phone contract knows this model: they give you the phone for free or at a heavy discount, with a three year contract worth many thousands of dollars. Gillette was a pioneer in this field, giving away razor han-dles, and selling the blades.

Freemium

Freemium products have a basic, free version and a paid premium version. It is a way to make money by exchanging value with large numbers of people, not a way to make money by restricting the delivery of features (e.g. trialware or crippleware⁵). The basic service is full featured and useful, like a free photo-sharing account on flikr.com. The premium version is paid, and provides additional value to a small consumer segment, such as additional storage space or multiple photo albums. This model requires a large number of participants, with a small number who pay for the premium service. This large participant base can lead to new products based on scale and network effects. For example, part of the reason Facebook delivers value to participants is because it has so many participants who can interact in many ways.

Why free works

Depending on the product and the situation, a free price point can lead to riches or disaster. Free makes it possible to engage huge numbers of people in a product or experience, but free products may be devalued. To get a sense of why free works, consider that humans have run two distinct, parallel economies for many thousands of years: contractual value exchanges and familial value exchanges. Each free business model must balance these conflicting ways to exchange value.

In the contractual economy, utility, generatives and money are explicitly traded for each other: I’ll give you this in exchange for that. In many cases these transactions are with strangers, and all transactions have a level of formality and an expectation of compensation. For example, when you go to a restaurant for dinner you expect and are expected to pay for your meal and the services associated with it. As noted in section Part 1 of this series, most of the generatives are used in obviously contractual ways.

In the familial economy, utility, generatives and money are freely given as gifts, with no explicit expectation of compensation. As noted above, this gift giving leads to close social bonds, such as feeling indebted to your grandmother for the wonderful dinner she made for the family—but you won't pull out your wallet after dessert! This economy is most strongly related to the generatives community and patronage, but other generatives can also deliver familial value.

Familial and contractual transactions are not mutually exclusive, but they are very difficult to combine. A bit of the familial injected into the contractual can make your customer feel like “you treated me like a person” with glowing re-views, customer loyalty and so on. This is terribly difficult to achieve, as evidenced by the large sums of time, money and effort dedicated to training people to interact with customers. On the other hand, injecting contractual obligations into a familial relationship is corrosive and destructive, even when money isn’t involved.

Organizations that want to succeed in the Internet economy have to straddle scarcity and abundance while appealing to both familial and contractual transactions. By their nature, free revenue streams are more complex than simple pur-chases. We will explore them through a few scenarios, to get a better sense of how value is generated and delivered, and how some of this value can be converted to money in a relatively efficient way. We begin with a non-monetary market important to organizations in the social sector⁶: volunteers.

Non-monetary markets and Wikipedia

Wikipedia is the direct result of gifts of time, effort, expertise and money. It was created by gifts, and is sustained by them. They hired employees since their start in 2001, but volunteer effort is still critical to their product.

Value Analysis

The people who give of themselves to make Wikipedia a vibrant community are in it for a few reasons. First, editors and contributors demonstrate their authenticity by making useful changes to the factual content of the site. Even tiny contributions also make the volunteer a patron; substantial and continued contributions bring membership to the Wikipedia community. Wikipedia, as an organization and a technology platform, has made it possible for the community to recognize volunteers by bolstering their reputation as authorities on particular topics.

People and organizations also contribute money to Wikipedia. From the Wiki-media Foundation FAQ,

Compared with 2008-09, in 2009-10 donations increased 87%, from $7.7 million to $15.1 million. Community gifts (gifts of less than 10K) increased significantly to $9.0 million from $5.1 million. Overall, revenue increased to $16.6 million from $8.7 million. This is good news: we are happy that so many peo-ple want to support the work of the Wikimedia Foundation and that people continue to support us during continued troubled economic times.

Volunteers made Wikipedia into a resource so valuable it is changing the world. They also made a product and service so compelling that people and companies have donated in excess of $35 million dollars to support it. The foundation is monetized, not through sales, ads or premium membership: they take gifts of money to support the gifts of volunteers, to give a gift to the world.

Freemium and Google

In many ways, Google is the poster child for free. In the 12 years since it was founded it has gone from an idea to $23 billion in annual revenue. The vast ma-jority of their money is made through the Three Party Market: Google serves up ads that are contextually relevant to people browsing the Internet. They have a few interesting products that use other models, such as Google Apps. For anyone else, a $100 million per year business⁷ might be considered more than an afterthought; it’s a good example of the power of freemium.

Value Analysis

Google Apps is a management framework for a group of business-focused Google products. The core set includes Google Mail⁸, Google Calendar⁹, Google Docs¹⁰ and Google Contacts¹¹; other products, such as Google Voice¹² are regu-larly integrated into the suite, making it more valuable all the time. These services are free for companies with less than 50 accounts, schools, and non-profits with less than 3000 accounts. More than three million businesses run Google Apps¹³, and most of them are not paying Google a penny. So where does the $100 million in revenue come from?

Wikipedia defines freemium as¹⁴:

...a business model that works by offering basic Web services...for free, while charging a premium for advanced or special features. The word "freemium" is a [combination of] the two aspects of the business model: "free" and "premi-um" [and] has gained popularity with Web 2.0 companies.

In the case of Google Apps, the premium features include advanced administra-tion capabilities, enforced security, guaranteed 99.9% uptime and 24/7 support. For many companies the annual $50 per seat charge is a tiny cost when com-pared to the cost of owning the infrastructure and licencing the Microsoft prod-ucts needed to do the same work.

The ROI on a freemium business is simple. In How to create a profitable Freemium startup, Andrew Chen¹⁵, (using ‘value’ and ‘cost’ in the broadest sense) says:

Lifetime value > Cost per acquisition + Cost of service (paying & free)

He explains as follows,

To become profitable using a freemium business model…the lifetime value of your paying customers needs to be greater than the cost it took to acquire them, plus the cost servicing all users (free or paying).

In this scenario, lifetime value takes the form of annually renewed licences for business users. Eric Sherman of BNET¹⁶ argues that “Google Apps is a business that can scale to profitability even if it only attracts a relatively small part of the office suite market” because the costs to add and service customers is very low.

Conclusions

There are four main business models for balancing the exchange of familial and contractual value through careful use of the free price-point. Familial exchanges are based on mutual social indebtedness through gift giving. Contractual ex-changes are explicitly based on clearly defined trades. Familial exchanges rarely involve money; contractual exchanges frequently involve money. In all cases val-ue is created through generatives or utility: generatives change who you are; utility changes what you can do.

Free throws a wrench into exchanges of value partly because it implies that a product is abundant (and also worthless). This can be a self-fulfilling prophecy, resulting in uncontrollable viral popularity of a product or service.

To compete successfully in the Internet economy, your organization must come to terms with how value is generated and distributed. With this knowledge, it should set out to enhance value to all stakeholders, while learning to harvest some of the value as currency.

In the next month’s instalment, Part 3: The Abundant Business Case, we discuss ways that your organization can integrate all these concepts into its funding and decision making processes.

Table 1: Types of Free: The table below is a brief summary of each type of free. All content—except the ex-amples—are taken from Free: The future of a radical price, by Chris Anderson¹⁷ . Details of the types of free are fleshed out in the product and service examples that follow.

 

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 ¹Predictable Irrationality, Dan Ariely  – 1¢ Story
  ²Being the kind of person who helps children, and being seen to be that person.
  ³Participation in the growth and health of their community.
  ⁴See the Internet show Know Your Meme (http://KnowYourMeme.com) to learn more about he Star Wars Kid (http://knowyourmeme.com/memes/star-wars-kid) or search Google (http://www.google.ca/search?aq=f&sourceid=chrome&ie=UTF-8&q=Star+Wars+Kid&qscrl=1). Brother Sharp (http://knowyourmeme.com/memes/brother-sharp-%E7%8A%80%E5%88%A9%E5%93%A5) also has a large result set from Google (http://www.google.ca/search?sourceid=chrome&ie=UTF-8&q=brother+sharp&qscrl=1). 
  ⁵Trialware is a functional product that shuts itself off after a certain number of uses or a period of time. Payment is required to unlock continued use. Crippleware offers a partially functional version of a service, such as a photo-editing suite that puts a big watermark over each image.
  ⁶The “social sector” is the preferred to ‘non-profit’ since it defines the purpose of these organizations. “Non-profit” only describes what they are not.
  ⁷See http://www.bnet.com/blog/technology-business/google-apps-turns-the-80-20-rule-into-100-million-a-year/3466
  ⁸Better known as ‘Gmail’, this is their free and very popular email solution.
  ⁹This online calendar app has many features comparable to Microsoft Outlook.
  ¹⁰An online document collaboration tool with most of the features most users need, most of the time.
  ¹¹A central place to manage all your contacts, tightly integrated to other Google products.
  ¹²Free voice calls and SMS to and from phones in the USA. Scheduled for global roll-out over time.
  ¹³See http://www.google.com/apps/intl/en/business/index.html#utm_medium=et&utm_source=catch_all
  ¹⁴See http://en.wikipedia.org/wiki/Freemium for the latest version. This quote was taken from the edit on 21:00, 12 January 2010: http://en.wikipedia.org/w/index.php?title=Freemium&oldid=337459170.
  ¹⁵See http://j.mp/4dLglz
  ¹⁶See http://www.bnet.com/blog/technology-business/google-apps-turns-the-80-20-rule-into-100-million-a-year/3466
  ¹⁷I highly recommend reading this book, along with What Would Google Do? By Jeff Jarvis.