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Free…The new revenue model

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It’s the new disruptive business model. And it’s coming to a business near you… faster than a speeding bullet!

Caveat Emptor. Buyer beware. Customers are taught to be sceptical at an early age. Every purchase requires a decision, a conscientious choice, even when the purchase price is less than pocket change. But what happens if the purchase price falls to nothing? Naught. Zip. Not even a cent. Then, almost every barrier to the decision-making process vanishes. And things begin to get freaky. In fact, there’s now a word for it. “Freeconomics.”

It’s a cold winter morning. As i wait to catch my train, a stranger approaches me.

“Would you like a free pen?” the young man, in backpacker’s business attire, asks me.

I know that I’ll have to earn my pen and, let’s face it, it’s hardly a desirable prize. Common sense tells me that ‘there’s no such thing as a free lunch’. But I have the time and, as a journalist and business owner, I’m always in need of a good pen.

The young man would like me to complete a survey. His request triggers a memory from the day before; a discussion about Survey Monkey, an online survey builder that’s free for low-level users.

My fellow train commuters trade sympathetic gazes for the naïve dope trapped at the mercy of a persistent, poorly dressed tourist and his branded biro.

I had been recommended Survey Monkey, an addictive digital product, during a conversation conducted via GTalk, a free telephony service that’s available to users of Google’s free email product, Gmail.

In fact, it occurs to me that many of my daily tasks are performed with seemingly ‘free’ products, from the mobile phone in my pocket (it came free with my phone plan) to the online news service, Scopical [now Streem), that lives on my desktop.

My moment with the backpacker and his survey draws to its logical conclusion (I accept my gift). I begin to wonder how much of my personal time is worth a ‘free’ pen (and not a bad pen, it turns out). At what point does the cost of something (time, money, maybe even my dignity among travelling companions) become meaningless in relation to the benefit provided.

And how on earth do so many companies manage to sway my actions so easily with the power of ‘free’ and still make a hefty profit while doing so?

Free as a Prince album

The modern business world is built on trade.

I give you something of value and I expect something of equal (or greater) value in return. It’s a simple equation and the basis upon which all commerce has been conducted since the beginning of time, from street vendors trading food for pottery under the gaze of the Pharaohs to multinational corporations transacting billions of dollars across multiple borders every second.

In fact, it’s probably fair to say that all human relationships are based on some form of give and take. Think about this next time you’re stuck haggling for the remote control.

So, what will happen if I offer to give you something for free?

Firstly, you might think, “There is no such thing as a free lunch,” as I did when offered my ‘free’ pen. And, for the most part, you would be right. Most ‘free’ business models want something in return. This most common example is called the cross-subsidy model.

Secondly, assuming that a trade-off is about to take place, you might then go on to ask, “So, what’s the catch?” This is where things start to get ‘freeky’.

When the proverbial pound of flesh is reduced to a whisker, a follicle or something even more insignificant to its owner, the ‘catch’ can then become meaningless. The barrier to decision-making is removed.

Together, these two principles form what has been dubbed ‘freeconomics’, a term coined by Wired Magazine Editor Chris (“Long Tail”) Anderson in a seminal article on the subject published in February this year.

Freeconomics makes it possible for an international music artist like Prince to debut his latest album, Planet Earth, by giving away 2.8 million copies, each worth US$19, to readers of London’s Daily Mail. It’s what allows science fiction author and celebrity blogger Cory Doctorow to release his books for free online. It’s what allows Google to offer first one gigabyte, then two, of free storage to every Gmail user (and compel Yahoo! to respond with the ultimate offer: infinite free storage).

And lastly, most profoundly, it’s changing the way companies do business and we, as consumers, now think.

The economics

Don’t let your eyes glaze over. Economics can be fun. It was an economist who first told me what she described as the world’s shortest joke. (“Pretentious? Moi?)

The beauty of economics is its ability to make complex human behaviours simple, and render them in language that we can study. For example, basic economics tells us that, in a competitive market, price falls to the marginal cost; the cost of producing one additional unit. This is nothing radical.

Imagine that you want to produce 10 copies of your annual Christmas Carol CD for family and friends. You’ve done your budget and the cost is $100, taking into account studio time, backup singers, CD sleeve artwork and the cost of buying and burning 10 discs. Now that you’ve finished the job and given away your 10 CDs, you receive a call from the one person you forgot, your rich Aunty Flo, who would also like a copy (and she’s insistent). Of course, you burn an additional CD for your aunt. It costs you only $2 to burn and print the label on the additional disc.

Therefore, if the total cost of producing 10 units is $100 and if the cost of producing 11 units is $102, then the marginal cost (the difference), at that level of output, is $2.

In short, every additional product produced or service provided incurs an additional variable cost to the company. This is the marginal cost. And if you want to prevent your competitors from undercutting you, you’d better keep a close eye on this price point because it’s as low as you can go.

But what happens when the marginal cost falls to zero, as it has with some digital products and services?

The first part of the answer directly relates to technology’s deflationary force (another fun economic term).

As the costs faced by digital companies fall (bandwidth, storage, processing power), so will the price asked of a consumer (the marginal cost). Because these costs are falling extremely fast, exponentially in fact, the logical conclusion is that, at some point, a company’s primary expenses, its marginal costs per sale, will hit zero, or at least a number so small (perhaps a millionth of a cent per customer) to create a scenario whereby the actual cost will become meaningless to the average human.

In other words, free.

Two trends

This is the first trend of ‘freeconomics’ (anything in the digital realm quickly feels the effects of falling costs) and will only gain further traction as more and more industries adopt digital models, from banking to gambling.

Take Google, for example. As Anderson observed, “When Google turned advertising into a software application, a classic services business formerly based on human economics (things get more expensive each year) switched to software economics (things get cheaper). So, too, for everything from banking to gambling. The moment a company’s primary expenses become things based in silicon, free becomes not just an option but the inevitable destination.”

As Skype has popularised Voice over Internet Protocol (VoIP), traditional telephony carriers have glimpsed the writing on the wall, and it ain’t pretty. The same goes for media moguls and music labels.

This, of course, leads to the second trend of ‘freeconomics’ (the extension of the cross-subsidy model) because, suddenly, cross-subsidies take on a greater, more practical relevance.

How else can these software companies hope to monetise their customers when their core product is falling to a price level that is tantamount to free?

Savvy marketers and business owners are now applying the cross-subsidy model to more and more industries, also enabled by the falling costs of technology. And the variety of models that we can expect to see is limited only by the human imagination.

For example, have you heard about the free cinema that makes its profits from popcorn sales? Probably not. It does exist… yet (at least, not to the knowledge of this writer). However, the low cost of digital technologies could make this model work right now, so long as the film studios can find a safe way to take a profit from the candy bar or, more likely, the cinema owners can learn to juggle their revenues and costs.

As sure as the sun rises, new technologies will emerge allowing businesses to pursue new revenue streams that are yet to be dreamed up.

That’s the theory. But how do these trends actually work? And what’s in it for you?

Moore’s Law in the Age of Google

In 1965, Intel co-founder Gerard E. Moore made a clever observation. He noted an important trend in the evolution of computer hardware and hypothesised that the number of transistors that can be inexpensively placed on an integrated circuit is increasing exponentially, likely to double approximately every two years.

Of course, he has been proven right.

Almost every measure of the capabilities of digital electronic devices can now be linked to Moore’s law: processing speed, memory capacity, even the resolution of digital cameras. All of these are improving at exponential rates as well. This has dramatically increased the usefulness of digital electronics and created new trillion dollar economies.

Why is it now possible to get hold of your favourite music tracks without ever needing to visit a music store? When did it become second nature to watch last Wednesday’s The Gruen Transfer on Thursday, after visiting abc.net.au or iTunes or, for some adventurous souls, BitTorrent?

Why is it that I rarely seem to buy newspapers, except maybe on weekends or when I’m in them (and my immodesty demands that I shell out cold hard cash)? And why would I not be surprised if you are reading this story online, right now?

Of course, it’s because Moore’s Law has an equally exponential effect on the marginal cost of products and services to the manufacturer (or the content developer, as is more often the case in digital domains) and, therefore, the cost of things to the consumer.

To what, therefore, can we attribute the astounding success of Google’s Page and Brin and of Apple’s Steve Jobs? What has fuelled the success of our Australian internet champions, such as Melbourne-based Adrian Giles and Andrew Barlow, co-founders of internet traffic monitor Hitwise? Or Sydney-situated Mike Cannon-Brookes and Scott Farquhar, co-founders of enterprise-wiki Atlassian? Or Brisbanite Graeme Wood, father of online accommodation aggregators and the creator of Wotif.com?

Aside from their clear smarts as business people and their sheer pluckiness as entrepreneurs, their success can be equally attributed to one thing (in three packages): The falling price of storage, bandwidth and processing power.

Electricity and bad science-fiction

Of course, Chris Anderson is the author, journalists and big, big thinker who brought ‘Long Tail‘ economics into the modern business lexicon.

Long Tail economics simply refers to the phenomenon created by widespread access to digital products, and dictates that infinite variety creates infinite demand. It’s the reverse of the 80/20 rule, which retailers of physical products abide by, whereby 20 percent of products will generally account for 80 percent of sales.

Anderson obviously knows a thing or two about digital mediums and their commercial impact. In a recent video blog accompanying his Freeconomics article in Wired, Anderson compared the falling cost of digital products with early, yet ultimately false, predictions about the impact of nuclear energy on electricity costs.

According to many nuclear advocates of yesteryear, nuclear power was going to make electricity so inexpensive it would seem ‘free’ to the user (too cheap to meter).

Of course, the high cost of creating nuclear power made this an impossibility. Yet Anderson observed that if electricity had, indeed, become ‘free,’ so cheap as to appear inconsequential to the consumer, the world would have adjusted profoundly, in ways we can barely comprehend.

To begin with, every industry would have sought electric alternatives to their every power requirement.

In this world, we never would have needed to ask, ‘Who killed the electric car?’ Invading oil-rich foreign countries would be a far less seductive initiative (whatever the ostensible justification). And it would be nice to think that global warming would not be keeping us hot under the collar.

This hypothetical scenario, where ‘free’ has become a force powerful enough to re-shape the modern world, might seem far-fetched; the work of a second-rate science-fiction writer (an episode of Sliders perhaps). But the reality is that it’s happening right now, quickly, in the world of kilobytes, gigabytes, terabytes and, prepare yourself, petabytes. In fact, while we were once impressed by a kilobyte of storage (what you once held on a floppy disk), Google servers are already processing one petabyte of user data every 72 minutes.

How can Google do this? Because the cost of production is nearing free.

And it’s not hard to imagine the impact that will have on any industry that relies on digital tools. In other words, unless you’re herding sheep in Afganistan, it’s likely that wherever you work, whatever you do for a crust, you too will be affected.

Free as a virus

If electricity had become ‘free’, the entire world would have been altered to reflect the massive shift in supply and demand that would inevitably have occurred. The concept of ‘free’, like a rampant viral email, is similarly infecting other industries and business models, beyond pure digital media, right now.

Like electricity released from a circuit, good ideas disperse into their immediate surrounding structures. If the idea is strong enough, it can cause a ‘spot fire’ of discussion and inspiration that creates more energy of its own.

In short, good ideas grow exponentially.

One obvious conclusion might be that those industries and businesses most closely linked to digital media will be affected first. “Television is dead.” “Newspapers are in decline.” “The music industry is obsolete.” You’ve heard the claims. Some have more truth than others. But, of course, we are already watching some of the players evolve and re-define themselves using the tools of the new structure.

In 2007, The New York Times abolished its premium experiment, TimesSelect, and went free online. And following its acquisition by News Corporation, The Wall Street Journal is now in the process of being unshackled from its subscriber-only chains and having its digital content disseminated widely through Rupert Murdoch’s global media empire.

Television has adopted the internet as a new digital medium to distribute programs (and advertising) and now offers digital channels (if you have a set-top box). The music industry is becoming adept at employing new online social networking tools, such as Facebook, MySpace and LinkedIn, and finding new ways to generate revenue (for example, sacrifice record sales for live performance sales, as was the motivation for Prince’s overwhelming generosity toward London readers, or Radiohead’s strategy inviting fans to ‘pay what you like‘ for its 2007 album, In Rainbows). Of course, most pundits assume that all these mediums will converge in one way or another.

But this trend also stands to influence the first consumers of many digital products: other businesses. This, of course, has a trickle-down effect.

As one example, a typical ‘consultant’ or ‘business adviser’ may no longer be able to charge the same high fees for knowledge-based services if a great deal of the expert’s ‘knowledge bank,’ accrued from a lifetime of experience, is now available for free to one and all on the web. And this is just one established industry already affected.

While the deflationary force of technology will inevitably reduce the cost of a product, it will equally influence a consumer’s expectation of cost.

This constantly evolving and diluting value chain is likely to re-define the concept of ‘value for money’ across all industries, making items once considered cheap seem expensive and, ultimately, erasing buyer distrust of the ‘free’ model once and for all.

This is the first rule of ‘freeconomics’, anything in the digital realm quickly feels the effects of falling costs. And it’s happening not in theory, but in effect.

Come fly with me

So, it’s now easy to imagine digital services falling to the marginal cost and, where the marginal cost is next to zero, appearing free. The blogosphere is constantly alive with chatter about how to get something for nothing.

But what about goods and services outside the digital domain? What about something concrete; something as far removed from the digital domain as airline travel?

This service, once the exclusive domain of the ultra-rich elite, could soon be free.

What the?!

About now, you’re probably wondering, “What about rising security costs? We all know about the price of terrorism post 9/11. What about fuel costs? I can barely afford to put petrol in my car. How can an airline possibly hope to provide free air travel?”

It’s here that the second rule of “freeconomics” takes over: cross-subsidisation.

A cross-subsidy occurs when you shift costs from one product to another. In traditional cases the ‘free’ product or service is offered as ‘bait’. That’s why consumers have grown to become sceptical. In the past, ‘lunch’ has never truly been free.

If you sell a monthly phone plan, you can probably afford to give away the handset to get a prospective customer hooked. Sell a cheap video console and then sell expensive games. Install a fancy coffee-maker for next to nothing and then sell expensive coffee sachets.

You’ve probably heard that HP is not in the business of selling printers. It’s in the business of selling ink. Or at least that’s what many claim.

The model is simple and kind of intuitive. You get one thing free if you buy another. Or you get a product free if you pay for a service. But once again, things are changing, as these strategies get more nuanced.

Back to air travel. What would happen if I offered you a plane ticket from Sydney to Perth for $25? You’d think it was a special or promotion. Here today, gone today.

What if I told you that, every year, about 1.3 million passengers are doing just that? They are flying from London to Barcelona, using Dublin-based low-cost airline Ryanair, for just £10 one way.

How can Ryanair possibly achieve this? In order to sell a ticket for less than a cab fare to the airport, Ryanair stringently keeps costs low, offsets losses with higher fares on popular travel days and, perhaps most interestingly, has found alternative ways to generate revenue beyond pure ticket sales.

It charges for in-flight food and beverages, collects a share of car rentals and hotel reservations booked through its web site and charges marketers for in-flight advertising. The company also hopes to one day offer in-air gambling.

Fancy a three-way?

As businesses evolve, the variations of ‘freeconomics’ become more subtle and complex.

The business model we’re all most familiar with has two parties – buyers and sellers. We’re back to our trade analogy (food for pottery). But in this modern context business owners need to imagine this as just one slice of a much larger pie.

According to Anderson, while writing for Wired Magazine, the most common of the economies built around ‘free’ is the three-party system.

Here a third party pays to participate in a market created by a free exchange between the first two parties. Sound complicated? You’re probably experiencing it right now. It’s the basis of virtually all media.

In the traditional media model, a publisher provides a product free (or nearly free) to consumers, and advertisers pay to ride along. Radio is “free to air,” and so is much of television. Likewise, newspaper and magazine publishers don’t charge readers anything close to the actual cost of creating, printing, and distributing their products.

They’re not selling papers and magazines to readers, they’re selling readers to advertisers. It’s a three-way market.

Here’s something to ponder. Take away classified advertising from a newspaper, as the internet is currently achieving so effectively, and how much do you think that newspaper will cost you?

You might one day find yourself visiting a free car-wash that tests new advertising jingles while you get your car soaped. You could soon enjoy free telephone usage, if you are prepared to hear a message about Nine’s hit new TV program or NRMA talk about Hospital Cover.

Google is already testing a product in the US called GOOG-411, which connects mobile phone users who call 1800-GOOG-411 to local services (say, pizza delivery).

Moore’s Law and the falling costs of technology and information are giving businesses more freedom to give away products or services to one set of customers while selling to another set. It might seem more complex than a game of Corporate Whispers, but it works.

Freedom of choice

It’s no good applying the free models unless you can understand how your consumer will interpret them (whether they will work for or against you).

The psychology of ‘free’ is a powerful force. There is a chasm between cheap and free when a decision hangs in the balance. So, when presented with a free option, are we able to make our decisions freely?

The answer is a definite ‘Yes’, for two reasons.

Firstly, ‘free’ still lacks ‘believability’. Secondly, there are some things we prize more than money (or the monetary value of a free product or service).

For example, why does it still seem that everything is getting more and expensive? The price of fresh fruit and vegetables is soaring. Water feels like it is fast becoming a luxury. And a visit to the petrol bowser now seems to require a second mortgage on the family home.

Yet, when we stop to think about it, we all know the reality.

Modern living is getting cheaper. You can now score a digital watch simply by purchasing a tin of Milo. You can also pick up a new DVD player at the checkout for less than your weekly groceries. At the same time, while starvation was one of our greatest social concerns as little as eighty years ago, we’re now a nation fixated on the perils of obesity.

We belong to a disposable economy, where planned obsolescence is now part of the business training manual. And globalisation is only making it easier to buy and toss.

Yet, we still can’t accept a gift for ‘free’. It’s just not yet ‘believable’ – a simple yet profound barrier. The lack of a ‘catch’ can, in fact, create a Catch-22. In many cases, a prospective customer won’t accept the ‘free’ item unless they are in some way required to ‘pay’ for it.

There are only two ways around this: Educate or create a form of ‘payment’.

Fortunately for marketers, but not so fortunate for conservationists, buyer awareness and understanding of multi-party cross-subsidy models has been increasing slowly for many years.

Education is becoming less of a barrier (possibly a liability in the eyes of some). As such, this has made it likely that that the second barrier to ‘free’, the increasing value consumers now place on things other than money, will have a greater influence on buyer reluctance than ‘believability’ (and in some cases may counteract it).

My brief encounter with the backpacker clearly cost me time. It also cost me attention. (I’m still thinking about it now.) In the eyes of some, it also cost me respect. We already treat time as a commodity. Advertisers spend money on gaining attention. Intuitively, we also know that reputation is valuable.

Therefore, while compelling, ‘free’ may not be enough, particularly if the offer is not made in a way that is believable and does not tax too much of the consumer’s time, attention or reputation.

Like any major shift in business thinking or practices, ‘freeconomics’ requires imagination. But don’t worry. That’s another thing that won’t cost you a cent.

Click on image to enlarge
FREE: the science-fiction reality
aa29-aug-sep-2008-free-the-new-revenue-model3
Canadian science-fiction writer, Cory Doctorow, is an avant garde digital rights activist and co-editor of BoingBoing.net, one of the most read blogs on the internet. Apart from his involvement with Boing Boing, Doctorow is best known for his advocacy of the free exchange of digital information, unshackled from arcane copyright laws. He is a vociferous advocate of the Creative Commons licensing system, which was devised to accommodate the new digital era. And, much to many dismay of publishing industry traditionalists, he releases all of his science fiction works free of charge online simultaneous to their hard copy release. It’s a model that the typically conservative book publishing industry has had great difficulty coming to terms with. But Doctorow argues that giving his books away digitally actually increases his print sales. He also makes an excellent living on the celebrity speaking circuit, as do scores of other new media celebrities who give away their content in exchange for lustrous personal branding.

Free 2.0: pay your customers!
aa29-aug-sep-2008-free-the-new-revenue-model4In 2003, budget Irish airline Ryanair became the first carrier to actually pay passengers to fly. The airline paid one million passengers £1 each for flights taken between 20 November and 20 December 2003, which represented 40 percent of the airline’s capacity over the period. OK, so there was a catch: passengers still had to pay airport and government charges. But it was 2003, after all. And while Ryanair’s share price dipped slightly following the announcement (with analysts speculating that the promotion must have been due to flagging ticket sales), no one was left in any doubt which airline was the global low-fare pioneer.
ALL’S FREE THAT ENDS FREE
‘The best things in life are free.’ While this old adage still holds, it seems now that so might some of the most expensive.
It may not be too long before your competitors embrace ‘freeconomics’ as a quick way to undermine your product or service (if they haven’t done so already), by adopting new technologies to reduce marginal costs, by introducing the cross-subsidy model, or possibly both!
If you don’t wish to miss the ‘free-dom’ train, fortunately, the path to success is simple… in theory. In practice, it’s a little harder.
Therefore, we’ve put together the Anthill unpatented, unproven but hardly impractical three-part test:
Step One:
Analyse your existing revenue streams: Who are your customers? What are they getting from you? What is the true marginal cost of servicing them?
Step Two:
Analyse alternative revenue streams: What hidden treasures can be found in your existing customer base? Are they an attractive audience to advertisers? Do they possess information that others would pay a premium for? Can you on-sell products after ‘capturing’ a customer, creating an ongoing revenue stream?
Step Three:
Ask yourself, can I use technology to dramatically reduce my marginal costs? Do these new revenue streams create sufficient revenue to pay for the marginal cost and fixed costs? If yes, do they also leave cash left over for profits?
If you can answer, ‘yes, yes and yes’, you’re now in the business of ‘free’.
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