Not Free! Why $0.00 Is Not the Future of Business

Wired editor-in-chief Chris Anderson recently wrote a provocatively-titled article called Free! Why $0.00 Is the Future of Business. Anderson argues that the economics of computing on the net, where storage and bandwidth costs fall even faster than the cost of processing power, will drive the price of many services to the marginal cost– in other words, $0.00.

Anderson starts by recounting the story of King Gillette, whose disposal razors laid the foundation for a multi-billion dollar industry. Now some companies have “razor blade” strategies. Think Hewlett Packard printers and cartridges, commoditized industrial products and high-margin services, Xbox video game consoles and games. The loss leader products in these examples have substantial marginal cost, which, along with antidumping laws, prevents companies from giving them away for free.

On the web, however, marginal costs are often close enough to zero to be zero for practical purposes. Anderson notes:

Not too cheap to meter, as Atomic Energy Commission chief Lewis Strauss said in a different context, but too cheap to matter…

From the consumer’s perspective, though, there is a huge difference between cheap and free. Give a product away and it can go viral. Charge a single cent for it and you’re in an entirely different business, one of clawing and scratching for every customer. The psychology of “free” is powerful indeed, as any marketer will tell you.

This difference between cheap and free is what venture capitalist Josh Kopelman calls the “penny gap.” People think demand is elastic and that volume falls in a straight line as price rises, but the truth is that zero is one market and any other price is another. In many cases, that’s the difference between a great market and none at all.

This concept is powerful and disruptive for problems that are amenable to web-based solutions. It’s not so powerful if you need a giant locomotive to move goods across the country. However, if information can replace the physical goods, prepare for disruption.

Microsoft, whose Windows and Office software programs generate billions of dollars in profit every quarter, thought it was immune to the web-based threat. Microsoft thought that the web could never provide rich enough functionality for users, and users would never accept a solution that required a live internet connection. Funny thing. Google just introduced technology that allows people to use its Office-like applications without an internet connection. Meanwhile, when connected to the internet, users can share documents and work collaboratively more easily than with the more fully-featured Microsoft version. Cost for Microsoft Office? About $300 for an upgrade. Cost for Google’s version? $0.00.

So where does the money come from? After all, a business is a business, and if it is to remain so, a fundamental inequality must hold true:

Value Provided to Customers > Price Paid by Customers > Cost to Provide Value

Leaving aside questions of value, the only way for a price to really be zero is if the cost is less than zero. While this may seem absurd, it’s the magic behind Google. It’s just that instead of serving customers for free, Google serves an audience to advertises for high margins. Anderson would like us to think that this is a fundamental change in the nature of business, but it’s really as old as newspapers.

Free is not a pricing strategy. It’s an advertising strategy (gather as large and valuable an audience as possible). It’s a promotional strategy (offer free services to cross-sell or up-sell other offerings). It’s a testing strategy (allow users to test your software for free, so that the premium version is more reliable).

Companies that take part in the “free” economy need to have a good strategy for monetizing what they giveaway at some point. And as Anderson points out, while we have more and more abundance in many aspects of our lives, our time and attention are scarcer than ever. The ability to offer something for nothing, even if the offering is valuable, is worthless if no one notices. Along with the abundance of the web, comes a strong network effect that Robert Frank and Philip Cook explored in The Winner Take All Society. In this global age, benefits accrue disproportionately to the “winners.” Google makes billions from “free” search. A small group of other search companies combined makes less money than Google. But offering a free search service is unlikely to generate significant profits, unless you can find a valuable and underserved niche. Similarly, a handful of popular bloggers make good money by giving away their ideas for free, and charging for ads. I am not holding my breath for this strategy to work for pricing blogs.

So we still have to provide value to customers, whether they are users or advertisers. We better be able to charge more for this value than it costs us to provide it. Otherwise we will go out of business. Anderson is right that the cost side of inequality is changing rapidly and that this can have a disruptive effect on markets. But while $0.00 may make for a catchy headline, it is not the future of business.

(Anderson, who previously wrote The Long Tail, is developing a book based on this concept, titled FREE, which will arrive in 2009.)