The Power of Free

Josh Kopelman has today’s Great VC Post up titled The Penny Gap.

“The truth is, scaling from $5 to $50 million is not the toughest part of a new venture – it’s getting your users to pay you anything at all. The biggest gap in any venture is that between a service that is free and one that costs a penny.   I can’t think of a single premium service that has achieved truly viral distribution.  Can you?”

He’s also drawn a few pretty (and relevant) graphs.

  • Steve Murchie

    He makes some interesting points, but I don’t think the economics hold up. In very few cases (theoretical or empirical) does one find truly discontinuous demand curves, such as in his example where demand for the good at price=0 is very high, but demand drops precipitously at price=$0.01. His analysis assumes that free goods/services have some innate value to the consumer that is erased when any price is applied, which ignores the notion of utility to the consumer. In classic terms, demand is a function of the utility of product/service, and price drives the response of the consumer to acquiring that utility.
    Practically speaking, as a consumer there are plenty of free services out there that have little or no utility to me, and I don’t use them just because they are free. On the other hand, “freemium” services have been very effective at capturing my attention (and share of wallet). If I scan through the installed programs on my PC, I can find 15 or more that were free to use in a basic form, and I have upgraded maybe 25% of them to the premium service to gain some kind of extra value, or to continue use after a trial. For the supplier of the goods/services, the key to encouraging that leap is good product marketing and factoring the feature set into manageable, logical upgrade chunks – not economics.
    Let’s take Plaxo as an example. I’ve been using the free version for several years to try to stay ahead of my contacts’ e-mail/address/job changes. The free version has done everything I needed, and I have resisted upgrading to the premium service as it felt unnecessary. Finally, though, through the spawning of numerous e-mail accounts with different contacts, I found that I was getting duplicates and needed help with cleanup. Plaxo’s premium service offers duplicate detection and resolution, and I upgraded for that feature alone, not even caring about the other features. Could Plaxo have monetized that feature at a lower cost that would have captured more demand with less resistance? Yup, but they would have to spend more time understand customer demand and factoring their feature set if they want it.

  • fewquid

    Could not agree more with Kopelman, although I believe there are additional trade offs he doesn’t mention. e.g. customers who pay tend to have far more loyalty than those who get something for free…
    With respect, I have to disagree with Steve Murchie’s comment:
    “In very few cases (theoretical or empirical) does one find truly discontinuous demand curves, such as in his example where demand for the good at price=0 is very high, but demand drops precipitously at price=$0.01”
    The second the cost is more than zero, there’s a discontinuity in the willingness of people to sign up. If I have to pay $0.01, it still takes a credit card or paypal (or whatever) and therefore takes the same kind of commitment as spending any other amount I consider relatively trivial.
    Broadly speaking I think pricing breaks down in to categories with elastic boundaries e.g. $0.01 to $5.00, $5.01 – $20, $20.01 – $39.95 etc. Within those ranges, the willingness to pay is fairly even regardless of whether you are at the high or low end of the range.

  • Kirill

    I can’t think of a single premium service that has achieved truly viral distribution. Can you?
    Skype. They have (IMHO) an ideal model – they give for free what costs them (almost) nothing (because p2p works without wasting their bandwidth) and they charge for what costs them alot (terminating calls).
    And the same phenomoenom is occuring now with movies via Bit Torrent — as opposed to CinemaNow or MovieLink. That’s the power of free.
    Not. That’s the power of choice. Where can I buy an HDTV version of ‘For the Fistful of Dollars’?
    Yes, many people download for free just because it’s free and they’ll never buy this stuff even for $1, but they’re market only for advertisers (if even for them at all). But many people download just because they can’t buy for whatever money.

  • Steve Murchie

    fewquid: I think we’re in violent agreement, but I just wanted to clarify a concept. In a situation of true discontinuity, the market demand for a good between two price points P1 and P2 is… zero. In the example, it is hard to imagine a price between 0.00 and 0.01, so the market resistance to payment seems like a discontinuity. However, if I create a counterexample where I offer a bundle of 50 of the products at 0.002 apiece for a total of 0.01, the discontinuity model says my demand would be zero since effective price is between 0.00 and 0.01. So sticky resistance to price increase > discontinuous demand.
    I think your notion of categories of elasticity is more logical and empirically evident, and a jagged demand curve is a lot more ‘respectable’ than a discontuous one. The one issue none of us have raised is the lack of a mechanism to actually purchase a good/service for a penny. Given the costs of payment processing and so on, suppliers tend to offer their first premium service at a significantly higher price, hence the absence of real-world evidence of this thesis.