Limits to Freeconomics Part IV - Freemium, or if you ain't paying you ain't the customer

Went to see Wired Editor Chris Anderson talking about his new book, Free, at the RSA earlier this week (slides above, ht Made by Many who also covered event). What a difference a year makes. This time last year I was railing against the original Freeconomic vision that Chris Anderson originally had (see here for The Economists' debunking). A year later, and the vision has been pegged back somewhat. The title has been shortened to "Free", the Ad and VC funded binge that Freeconomics was based on has been replaced. At the RSA we were treated to the full history and detailed exploration of various permutations of giving away something to catch a bigger prize - permutations of the "Razr and Blade" (give away device, sell consumables) and "Freemium" (Free for the bulk and Premium for a few).

All in all a very nice time was had by all galloping through the Economics 101 of Indirect Payment, until the questions. There were some other bits in the book, assertions which had been glossed over inm the presentation - such as the assertion about Free, that:

"It's the animal force of economics. The internet is the most competitive market we have ever seen and costs are nearly zero. The law of physics means that if you do not make your product free, gravity will do it for you."

First off was the little matter of "Near free" not quite being the same as "free", and even a small number (say price per digital video copy) multiplied by a very large number (like number of YouTube downloads) still equals a stonking loss if you aren't making any money. Now ordinarily this doesn't matter in the selling of a New Thing, because it only gets pointed out by economists, mathematicans and irritating small-cap bloggers.

Unfortunately, this time it had been pointed out, in public, by an equal but opposite Guru, Malcom Gladwell, who had noted that "Free" drives a huge demand, and:

When you let people upload and download as many videos as they want, lots of them will take you up on the offer. That’s the magic of Free psychology: an estimated seventy-five billion videos will be served up by YouTube this year. Although the magic of Free technology means that the cost of serving up each video is “close enough to free to round down,” “close enough to free” multiplied by seventy-five billion is still a very large number.

And he went on to note that, via example, the bit that is going free is not the only cost in the supply chain that needs paying for - using the example of the falling cost of biotech, he notes that its not just the drug design thats in the supply chain:

... he’s forgotten about the plants and the power lines. The expensive part of making drugs has never been what happens in the laboratory. It’s what happens after the laboratory, like the clinical testing, which can take years and cost hundreds of millions of dollars.

Ditto the internets - at the moment those costs are being resolved by letting us pirate content (IP law hasn't kept up) and buy our bandwidth and devices (DSL, iPhone = Not Free).

Mr Anderson chose to ignore this question, and dissembled magnificently (and unhelpfully). However, the next question unsportingly came at it again from a different angle. Someone pointed out that the cost of any good is set by 3 inputs - time, resource input and quality. If resource input was minimal, what about time (oh, instant), and quality.

"Quality is a very semantic thing" said Mr Anderson, and off he went again in another flight of fancy, but we got the message. Caveat Emptor.

At this point may I just point out a very old law of economics, which I think should be called "The Freemium Law" as it addresses this issue very well. In essence it says:

"If you ain't paying for it, you ain't the customer"

The Customer is the one who pays the bills. So you are not Google's customer - the Ad Industry is the Customer. And you are the user, so your role is to get used. To adapt the old poker adage, if there is a free lunch and you can't see anyone else at the table who is paying, you're the lunch. This typically takes the form (in digital media) of extracting your future net present value in 3 ways:

- Advertising
- Datamining your clickstream for better advertising or on-sale
- Getting you to contribute content for free that is then sold on - or sold out (Bebo et al)

This is all covered in Freeconomics Parts 1, 2 and 3 - start here for the full essays or here for the slideshow, but we didn't cover Freemium in any great depth.

Freemium simply means that a small % of users pay a price for a premium service so that the rest are subsidised to go free. At its simplest it means in any Freemium service, you have to ensure that those paying get their moneys worth and the Free users get what you can afford from the fees you collect. Other revenue streams such as advertising, datamining etc can then be added to the mix.

The challenge of Freemium is this: typically only a small % of users will pay - say 10% (its typically less than this) - and they have to pay the costs of all the free users. Clearly the lower the marginal cost and the cheaper it is to serve extra users (ie the higher the fixed over the variable cost ratio is, and the lower all costs are) the better. But there is also the dreaded supply/demand curve effect - push the premium price up, and the volume prepared to pay goes down - and finding the optimum price that premium people will pay AND that will pay for the free users costs is a non trivial exercise.

Simple maths says that its best to have many premium users paying a small % fee, but as premium penetration is usually a small % of all users, a low premium fee means that in effect not a lot of free stuff can be given away - but raising the price usually reduces penetration (its trying to balance 2 different siding scales where each impacts the other, ie its a dynamic system).

Here's the kicker. In essence the removal of the "Ad funded" model, and the melting away of VC money, has now left the Freemium model to carry the banner as default Business Model for all these Web 2.0 companies still standing and many a startup. And, just as we showed Advertising wasn't a big enough bucket to fund everything, it is unlikely freemium will work in all cases either.

Those services that work best are those that gain incremental benefit from having extra free users on board, as they get a network effect of increasing returns at a faster rate than the linear increase of costs (dotcom era chatroom and dating sites essentially let paying customers peek at more of the data on other user's profiles and activity). As long as they can monetise this extra benefit at a higher rate than it costs, they are fine (which is why revealing user data is so appealing - its near-free to provide and has voyeuristic value-add. (This may well explain Facebook's recent activity on privacy restructuring, it potentially allows premium peek-usage services as well as data on-sale)

That is Freemium in a nutshell. Anyway, on with the show.

There was then a question about the boundaries of the Free system - if everything depended on free content to copy, and no one was paying for using anything, how ya gonna pay the mortgage?

It was at this point that Mr Anderson revealed the Deus Ex Machina of this Freecosystem, the thing that actually keeps the wheels turning in this economic perpetual motion machine. "Thats for the Day Job"

The Day Job! Of course! Yes, the Day Job is what earns the Real Money. You then use your Free Time to make Free Stuff to sell on the Free World. But if your Day Job is making stuff that people that people are making for free, then what?

There followed another meandering ramble up to the heights of cloud computing and the depths of the Open C community, but the upshot is this - the Silicon Valley Model (of which Wired is the Bible and its Editor the Prophet) wants free content to run on its Big Aggregators, get a Free Ride on the (evil, not Net Neutral Yah Boo) Telcos/ISPs and come painlessly onto your (Another SV Company - Yay!) groovy Gadgets. If you are so churlish as to suggest your creative content should be worth something, well you aren't with The Program.

(Did anyone note Umair Haque's post pointing out that Michael Jackson, over his entire lifetime, earned far less than the CEO of even a moderate Hedge Fund socks away in a year, or a YouTube founder in one sale? And imagine how much money poor old MJ would make if he started today)

Anyway, there endeth the lesson. You are welcome to create your user generated content, and even Freemium services - but keep the Day Job, eh .

Update - the FT doesn't think its much cop either.