Editor’s note: This guest post was written by Uzi Shmilovici, CEO and founder of Future Simple, which creates online software for small businesses. The post is based on a study done with Professor Eric Budish, an economics professor at the University of Chicago Booth School of Business. It also includes ideas and comments from Peter Levine, a Venture Partner at Andreessen-Horowitz and a professor at Stanford GSB
The idea of offering your product or a version of it for free has been a source of much debate.
Pricing is always tricky. Unfortunately, many entrepreneurs don’t give it enough thought. They will often copy the pricing strategy of similar products, base their decisions on pompous statements made by “experts” or rely on broken rationale (we worked hard so we should charge $X).
Free is even trickier and with so many opinions about it, we thought it would be refreshing to take a critical approach and dive deep into why some companies are very successful at employing the model while other companies fail. We’ve looked into economics academic papers, behavioral psychology books and strategies that worked for companies to come up with the key concepts below.
The Law of Marginal Cost
Pricing plays a huge part in competing for customers. Here’s an economic law that holds almost as much truth as the law of gravity: in a perfectly competitive market, the long-term product price (aka “market clearing price”) will be the marginal cost of production.
Guess what? Because of declining hosting and bandwidth costs, for most Internet products the marginal cost today is practically … zero.
In other words, if the cost to serve a customer (support aside) is zero, the long-term price of the product in the market will be zero (because of competitive pressure).
An Experience Good
At the core of the “Free” models are the products or services being offered to the customer. Most Internet products or services fall into the definition of an Experience Good: a product that needs a period of use before the customer can determine the value they can derive from it.
A good example is Dropbox. Consider Drew Houston’s words: “The fact was that Dropbox was offering a product that people didn’t know they needed until they tried.”
There are plenty of academics who looked into the pricing of Experience Goods. In 1983, the Economist Carl Shapiro wrote a fascinating paper about this subject. His conclusion was that since customers tend to underestimate the value of a product, the optimal pricing for an experience good is a low introductory price which is then increased when the customer realizes the value of the product.
In some cases, a customer might overestimate the value of the product. In that case, the optimal pricing strategy is to charge as much in the beginning or to lock in customers with long-term contracts.
This is why customers are reluctant to buy when someone asks them to prepay for a service or product or sign a long-term contract.
Hence, the introductory price is a signaling mechanism. The conclusion? A low entrance price signals that you are confident that your product will create value for the customer.
The Psychology of Free
Much has been written about the Psychology of Free. Two books that looked specifically into the subject are “Free” by Chris Anderson and “Predictably Irrational” by Dan Ariely. Putting it simply, Free is an emotional hot button that immediately reduces the mental barriers for the customer. Free makes people think that they have “nothing to lose” since many ignore time as an investment.
From this perspective, free is a huge accelerator of adoption. The flip side of this is that after using the product for free, it is very hard to get the customer to start paying for it. This phenomenon was broad enough to get its own name: “The penny gap”—the hardest part is to get your customer to pay you the first penny. This is why it is so critical to choose your premium features wisely.
If all that is true, it seems like Free (or Freemium) is the answer. Well…. not so fast. The decision is definitely not easy. Here’s a basic framework to help you make a more informed decision. A word of caution though: for every complex problem there’s a simple solution … and it’s wrong. The framework is helpful as a thinking tool but there’s no magic formula.
Here’s a set of questions that you’ll need to ask yourself:
The Types of “Free”
One of the key factors in making Freemium work is the structure of the offering. What is it that you offer for free vs. charge? There are different types of free strategies. Let’s take a look at the popular ones:
Open Source as a Free model
Lately I’ve seen many entrepreneurs confuse Open Source with Free so I thought it would be helpful to make the distinction. An open source model can definitely accelerate the distribution of your product and is a viable free model. It has two main advantages. You might get developers to contribute to your product (see WordPress). By doing that you can accelerate the development of your product. The other advantage is that you give customers peace of mind as they have control over the source code. You can then make money from selling pro features or value added services. There’s a critical distinction here and that is that your code is out there and anyone can start a company to commercialize this code. Bear in mind that it is very hard (often impossible) to reverse a decision to open-source.
The Last Bit And The Secret To Success
There are many factors to consider when you are evaluating whether to use the Freemium model or not. However, there’s one last secret that I didn’t share with you. During the study, while looking at the successful Freemium companies, a pattern emerged. They all had phenomenal products. All of these decision factors are useless if the product or service you are offering is nothing short of amazing. If your product is not creating great value for its users, no tactic in the world will make Freemium work for you.
Image credit: Shutterstock/JelenaA
Uzi Shmilovici is an internet entrepreneur. He co-founded Netcraft - an Israeli web agency in 2003. Over the years, Netcraft set the tone and became an industry leader in Israel, setting standards in user experience, design and development for the web. Those achievements were recognized when he was named one of the Top-40 Israeli Internet Startup Professionals by TheMarker Magazine in 2008 (the most prominent business magazine in Israel). Netcraft was later acquired by Tapuz, a leading Israeli internet...