The Freemium Business Model

A business education provider recently launched business education content to the world
using the freemium business model. This article outlines how freemium
works.

Back to the basics of economics

The first thing you learn when starting economics is a concept called
TANSTAFL There aint no so thing as (a) free lunch, first published as
Economics in Eight Words in the El Paso Herald of 1938. We are all
taught to evaluate business models using this principle and always to
look for the catch. What is happening in real terms however is that the
internet has made a lot of stuff available at no charge. How could this
function in terms of the economic principle?

What we have to realise is that economics works slightly different on
the internet – but that the rules remain the same. The basic economic
principle is one of scarcity of resources and a competition by the
captains of industry to best employ these resources more effectively.
This leads to supply and demand and the balance of supply and demand
determines production and price.

If we look a little further into theoretical economics then we must
ask what if supply was infinite – what would happen to price? Price
would generally be equal to cost if supply was infinite. If you could
supply and infinite number of cars then no one would be able to sell a
car for less than it was made. If production is not constrained then
cost would also be zero – and the product would technically be free.

This is derived by looking at the marginal benefit i.e. how much more
would a person pay to consume one more thing that is exactly the same as
all the other things that they have consumed and the marginal cost
i.e. how much would it cost to make one more of these products. Bringing
these two ideas together it would be a set price depending on the
parameters. How much would you pay for seawater? Technically you can
have as much of it as it costs you to get it. There is no cost and no
logic to selling it from a supply and demand perspective.

The marginal cost of one new item on the internet is very low – the
price of a click on a document is low, compared to the production of the
intellectual property. So what is the marginal value (as a function of
income vs expenses) of these resources?

So if we look at a knowledge product on the internet then we must
invariably conclude through economic thinking that it should be free or
that all knowledge of a specific type should be the same price. If
everything were however free, then there would be no supply – as no one
would be able to economically justify providing such a service.

So purely making something available for free is not a viable
option.

Freemium

Freemium aims to separate the portions of a business model that is
value adding and non-value adding. So in a real sense – it is valuable
for me to be able to read my email but because anyone can provide it –
the likes of Google has seen an opportunity to use the email content
that it presents to you to target advertising. This small “price” that
the user pays is enough to sustain the many servers that they run across
the world and provides a viable advertising business model. Note that
the freemium aspect depends on usage of their services at some level to
ensure that there is sufficient traffic to justify the real business
model – which is advertising.

The freemium model can also and should generally exist as a
combination of free and premium. The free product gives you access to a
base level of service – but the premium portion unlocks significant
value. It is in designing the premium offering that organisations that
offer this often get the model wrong. More about that later.

The freemium concept is also similar to a strategy of loss-leader
that was pioneered by retailers in the late 60’s and early seventies.
The idea is to sell one product at cost (or below) to get someone in to
buy other things. If I sold e.g. breadbuns at cost then I am likely to
also sell butter and other related goods and services while the person
is in the shop. I can then promote it as a bread-bun sale and get an
advantage over competitors.

So we learn another lesson – freemium only works for a product that
gets used often, and has a marginal cost that is low for every
additional unit of consumption. This applies to digital products as one
more copy is much cheaper than the initial cost of production.

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:

True Freemium

Give a version of the product for free and charge a fee for the other
versions. There are two ways to go about this:

• Value based – The most successful type of Freemium strategy. The
  more a customer uses the product, the more value she derives, the higher
  the switching costs are, and at some point she’ll hit a limit and
  convert to a paying customer.

• Characteristic based – For example offering the product for free
  for one user (so it is based on company size for instance). Let’s think
  about a B2B application. If I’m a freelancer, I will use the application
  forever and I will never have to upgrade. If I’m a 3-person company, I
  can’t add more users and try the application for real and hence might
  not get to the point where I see the value in using it.

• Quantity based – get 10 free but pay for the 11^th.
  This has been shown to be a model with limited success.

Free Product for a Cross Subsidy

Give one product for free and charge for complementary products.

Time Based Free Trial

Give a free trial for X days and start charging once the trial ends.
The issue here is figuring out what X is. On one hand you want to create
a sense of urgency, on the other hand you need the customer to see the
value in the system. Shareware is a such a model.

Open source

Open source or creative commons is not really a freemium type model
but as there is a limited control over the main product the associated
services can be run by anyone. By creating an open source environment it
does limit the product owner to revert.

Critical success factors

There are three critically successful factors to make a freemium
business model work.

• Quality free product that people want

• The most important condition for creating a successful freemium
  model is that you have a great product that people want. It will be the
  engine that drives your freemium based business. If this free product
  does not have inherent value your freemium will not get off the
  ground.

• So instead of giving away a sample track of the music, let people
  download the whole album. Instead of letting people take a look at your
  worksheets, let them have all your tools for free. You need to be clear
  on how you will make money by differentiation of the premium
  element.

The
free product can be duplicated digitally (or is otherwise easy to
supply)

• Only a small percentage of the free users will usually buy
  something. In order for this to make financial sense, the expense of
  distributing the free product should be very minimal. Digital
  duplication ensures virtually no cost for copying and distribution.
  Other overheads and costs should be limited and should be focused on
  enabling conversion.

If you want to distribute 1 million pieces of something, R1 as unit
price is quite a substantial amount. Distribution costs needs to be low
however.

Large reach

• Freemium depends on generating attention with the free product; then
  to sell premium products or services to some of the free users. In most
  cases only a small percentage of the free users will buy something. This
  is no problem, as long as it is a small percentage of a large number.
  Conversion must be driven by real value and must be accessible to all
  users to be meaningful.

Conclusion

For freemium to work you need a phenomenal product. If your product
is not creating great value for its users, no tactic in the world will
make Freemium work for you.