Making Money When Its All Free

-- By AlexeySokolin - 17 Oct 2011

Transitional Stages Matter

On the horizon is a world where cultural goods are distributed freely and quickly to everyone who wants them. Such a world fundamentally challenges the conception of private property in ideas and the businesses built on that foundation.

Now is a time of transition. Transitional stages are important because define how power is distributed and the principles that will drive cultural norms. It matters how we move from intellectual property regimes of today and how we restructure our industry. This paper explores various economic models which have emerged to address the needs of tomorrow.

Economic Axioms for Digital Goods

Digital goods such as software, music, video and text have a Marginal Cost of zero. It costs nothing to duplicate and transfer an mp3 or ebook file.

They are also called pubic goods and are nonrival, non-excludable, and subject to free ridership. While some may indeed be emergent (e.g., music, literature), many require significant capital investment. In other words, they have a non-zero Fixed Cost. Western economic theory suggests that because public goods are free to consume, they do not get produced at adequate quantity or quality without substantial subsidy. Free software may suggest otherwise.

Examples of digital with high fixed costs goods are blockbuster movies (Harry Potter), high-end video games (Starcraft), and professional software (Adobe Photoshop). These goods cost nothing to share, but large sums of money to create, requiring employees, office buildings and financing. This also includes the cost of financing which is a function of the risk of the venture. Higher-risk ventures require a higher rate of return as part of the fixed cost—start-ups and movies are expensive to finance.

A Survey of Business Models

Pay for Product. In the most conventional business model, people pay directly for the product or service they consume. The product has value, and the buyer is willing to pay up to their personal assessment of that value. The parties split that value assessment such that the buyer is better off and the seller is better off, subject to bargaining power (e.g., monopoly). Ethical concerns arise when the seller uses coercive political force to appropriate most of the value to itself, as in the case of Telecoms overcharging consumers to use free-to-produce text messages. Prior to the digital economy, large firm organizational structures were needed to build distribution infrastructure and spread out costs through economies of scale. Pricing power followed. In the digital economy, goods are free to distribute and the asymmetric capture of rents by oligopolies becomes difficult to justify. Even more controversial is the distributive result: those unable to pay rents are deprived of access to public resources.

Sharing. The free economy shifts the balance of power to consumers, providing on demand access to any digital good. For some, however, sharing raises ethical questions about misappropriation from other consumers. A classic free riding problem can occur, such that one group of people benefit from the contribution of another group of people (producers, sellers, or the buyers which pay and subsidize fixed costs) without their consent. For institutions structured to produce costly digital goods, this interferes with generating market compensation and leads to antagonism with a powerful and otherwise beneficial distribution channel. More people see the content but less profit is made.

Freemium. Services can be tiered: one group of people uses a free product, while another pays for additional functionality. Examples include Flickr, and Dropbox. Usually the free product is targeted for personal use and the premium product is for professional use. This model is ethically attractive: all groups understand how revenue is being generated and opt-in to the system. The difficulty is reaching appropriate scale and getting enough free users to convert to premium such that the entire venture is funded.

Advertising and Data. Instead of making money from a product directly, businesses can generate large user-bases and sell their audience. For example, 96% of Google’s revenues are from advertising. Attention is scarce and valuable to companies that sell products for which people pay directly. An alternate spin on this is to sell the underlying behavioral data of the user-base. The data provides insight on what happens next and how to best market to this population. While ingenious, these two approaches can erode the user experience, as well as their secrecy, anonymity and autonomy.

Differentiated Marketing. Another way to escape zero pricing is to market a product so that it is not a commodity, and commands a premium. Technology commentators advocate connecting with fans and generating a reason to buy with value separate from that of the free product, such as a superior experience or emotional connection. While functionalists tend to dismiss branding as brainwashing, some believe that well-marketed products create legitimate emotional benefits. The pricing can be done either by tiering, or using auctions. In the auction set-up, people self-discriminate and bid up to their willingness to pay. For some this is zero, for others it is a positive value. Successful examples are Radiohead’s “In Rainbows” (1.2 million downloads), Nine Inch Nails ($1.6 million in one week), and Kickstarter ($75 million raised). Inherent in the auction model is a utility so positive that people pay as expression of gratitude. The creator must be particularly good at signaling the differentiation of the good from a commodity such that price does not equal marginal cost.

Adjacent Product Bundling. A version of freemium and marketing, some businesses give away their core product using the distribution mechanism of sharing and make money but selling related services. A popular musician can bundle t-shirts with their music, an artist can sign limited edition prints of their digital drawings, an expert blogger can do speaking engagements on top of her regular content.

How Do We Decide

Structuring the digital economy raises a host of ethical considerations. Are we achieving the right distributive result? Are we coercing one set of people to benefit another without consent? Are our core privacy principles being undermined? Business models adapt to the philosophies we choose. We must do so carefully in this transition.

# * Set ALLOWTOPICVIEW = TWikiAdminGroup, AlexeySokolin

Note: TWiki has strict formatting rules. Make sure you preserve the three spaces, asterisk, and extra space at the beginning of that line. If you wish to give access to any other users simply add them to the comma separated list