2008-02-26

Is free special?

There are two things I accept as special about free: much less transactional costs/efforts (as I can skip the payment process entirely) and the psychological appeal (of not having to pay any!). Other than that, there is nothing special about free. But it seems that free is gaining the status as a very special price. Here are quotes from Chris Anderson's Wired article "Free! Why $0.00 Is the Future of Business" and my thoughts.

“The new model is based not on cross-subsidies — the shifting of costs from one product to another — but on the fact that the cost of products themselves is falling fast.”

This is misleading. I wonder any of Google exec believes that they give away Gmail mainly because it does not cost anything to them. They do it because it helps their business. You have to make money somewhere. You cannot offer something for free forever no matter how low your cost is, unless you can make profits somewhere. You should somehow shift to or bundle with another profitable business, Whether it is very visible (buy A and get B free) or not (Google’s Gmail and Adwords).

“This difference between cheap and free is what venture capitalist Josh Kopelman calls the "penny gap." People think demand is elastic and that volume falls in a straight line as price rises, but the truth is that zero is one market and any other price is another. In many cases, that's the difference between a great market and none at all.”

I agree that free does have certain psychological appeal to people, making the demand jump at the price zero. There is a research-based book by behavioral economist Dan Ariely (http://www.predictablyirrational.com/). You may want to have a look.

“The huge psychological gap between "almost zero" and "zero" is why micropayments failed.”

No, I would not extend the psychological magic of zero price to this far. I think we just do not have a micropayment model yet that is very convenient, like cash. The price may be just one dollar, but I have to go through the hassle of entering this and that information. I actually listed this as a factor for paid music to be popular again. See http://hyokon.com/2008/02/in-addition-to-free-part-2-how-to.html. I bet we'll have more convenient micropayment toold in the future, and we'll have much more small transactions.

“Free music is just publicity for a far more lucrative tour business. Nobody thinks of this as piracy.”

No, I don't think so. I think the reason why a lot of musicians are turning to free model is that they lost the alternative. The musicians think “Why not give away our songs? They won’t pay anyway. Let’s just think of it as a promotion, and do a tour to make money.” Touring is more profitable? I am surprised. When people actually did pay for music, tour was a promotion. Not the other way around.

“Some artists give away their music online as a way of marketing concerts, merchandise, licensing, and other paid fare. But others have simply accepted that, for them, music is not a moneymaking business. It's something they do for other reasons, from fun to creative expression. Which, of course, has always been true for most musicians anyway.”

I was worried some would bring this up someday. Maybe my concerns are becoming real. Before, the pro-free argument was ‘make it free, and you will make more money.’ Now, it is ‘Don’t be sad that you don’t make money. It is not about the money, right?’ I am very sad. I want a world, where you can succeed just by being a good musician. I want to see more Beatles, more Queen, more Stevie Wonder. Someone out of nowhere becoming a star and becoming rich. I think some of the pro-free arguments are heading towards discounting the division of labor, by saying you do multiple things to make a living (or if you are lucky one thing as a job and the others as a hobby). Do we want it to happen? It is one thing that we can do multiple things, which I like, but it is an entirely different thing that we ‘should’ do multiple things. I mentioned it also at In addition to free (Part 1- Free is not a cure-all).

“In each case, the act of using the service creates something of value, either improving the service itself or creating information that can be useful somewhere else.”

I agree that this will reduce the price for the users, just like self-service hamburger can be cheaper. This is every web entrepreneur’s dream - Users doing the work for free. But is this implying that this will ultimately create a perpetual money-making machine where you as a company does not have to incur any cost? Otherwise, I wonder why this is mentioned related with the free issue.

Enabled by the miracle of abundance, digital economics has turned traditional economics upside down. Read your college textbook and it's likely to define economics as "the social science of choice under scarcity." The entire field is built on studying trade-offs and how they're made. Milton Friedman himself reminded us time and time again that "there's no such thing as a free lunch." But Friedman was wrong in two ways. First, a free lunch doesn't necessarily mean the food is being given away or that you'll pay for it later — it could just mean someone else is picking up the tab. Second, in the digital realm, as we've seen, the main feedstocks of the information economy — storage, processing power, and bandwidth — are getting cheaper by the day. Two of the main scarcity functions of traditional economics — the marginal costs of manufacturing and distribution — are rushing headlong to zip. It's as if the restaurant suddenly didn't have to pay any food or labor costs for that lunch.

I was shocked. I could not believe that the most fundamental of economics is being declined here. I don't know how to respond. Let me just say that I do believe that there is no free lunch. Even the most low-cost Internet business of the world cannot go on very long providing 'only' free products. They do have trade-offs. (By the way, Friedman did say that there is free lunch, which is free markets and private property. http://www.cato.org/speeches/sp-mf050693.html And on this free lunch, I agree with him.)

Two last points. First, free is not the lowest price. There can even be negative price. Heard about ‘get paid to use’? Try search it on the web, and you’ll find quite a few. When a customer is more valuable to you than your product is to your customer, you’ll even pay the customers. As traditional mass marketing becomes less and less effective, businesses will try to spend money directly to customers. And we'll see more of these.

Second, digital products are not always different from physical products in terms of marginal costs. Let’s say you are a car manufacturer. You just produced 1000 cars and have them as inventory. What is the marginal cost of giving away the car? (I am ignoring the opportunity cost here, which by the way is present even in the case of free-to-produce digital products.) Zero. Internet is not really different at all. When do you occur your costs? When you bought servers and hired people to develop your service. After that? Yes, it is near zero. But you still have the ultimate marginal cost, that is keeping vs. shutting down your business. There is no such thing as no-cost business. If you give away all your products thinking "The marginal cost is zero. Therefore I am OK", you will go bankrupt sooner or later. Even if all you have is just some magically free servers and no staff, you still have costs. That is, 'you' have to eat. There is nothing magical here.

To be fair, I do accept that free has some special qualities. One, it has psychological appeal that seems to boost demand. Two, when you buy a free product, usually you don't have to go through the payment process. Which makes it cheaper than free otherwise.

Still, we are not having another new economy. We don't have to write the economics again. We do live with trade-offs, no matter how cheap microprocessors become. Or, maybe we do have a new economy, only until when we enter a negative-price economy.

11 comments:

  1. I think you missed the point of the article you quote. He's talking about a qualitative shift, and you seem insistent on seeing it as only quantitative.

    Yes, micro-payments are more probable, if you can eliminate the hassle effect, but the real shift is Philanthropy. Donations to an otherwise free business can and will make survival possible.

    Will you make a fortune? Probably not. But if we have a hassle free way of trading and giving online, dropping a quarter in the box when you see something you like would be even more commonplace than paypal donations are today.

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  2. I had to stop reading at the touring comment.

    Touring has ALWAYS been more profitable for the band. I am lucky enough to be friends with quite a few artists who are or have been signed with major record labels, have toured the world, and had hit songs played on the radio. All of them have stated plainly that they, as the artist, make NO money from record sales. Even platinum albums. Not a dime. Why? Long story - but basically the record labels structured contracts in a way that artists don't get paid.

    On the road, the money goes directly to the artist, not the label. Artists make money by their fee they charge for coming to play & merch sales (t-shirt, stickers, posters, etc). This has always been the cash cow for artists. Sure, labels made billions a year off the record sales, but artists rarely, if ever, saw or currently see any of it. So, yeah, touring is the more profitable business - for the artist. That's the crux here.

    Artists now have direct distribution to their fans through the internet, so they no longer need to be jilted by labels in order to have a career playing music. They see giving recordings away is the same as radio play, but more specialized because those people who get it free are more likely to be real fans - who then spend more money (than they would have on a CD) on concert tickets, t-shirts, posters, backstage passes, fan club memberships, etc.

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  3. @anonymous
    I don't have any personal experience like you do. But it is hard to believe. Doesn't it apply to only the new artists, who has no track record? Put it differently, does it apply to Led Zeppelin or Pink Floyd? Do they 'not' make any money from record sales?

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  4. I agree with the other anonymous commenter. Few, if any, musicians have ever made significant money on record sales, certainly not as much as on concerts. Even all the greats that you mention. However, the costs of setting up a concert tour are minimal compared to the profits of well-attended concerts. Maybe it's a slight exaggeration to say that they don't make any money at all on record sales, but nothing significant compared to live concertizing. Even Led Zeppelin would not have been able to make an honest living off of record sales. Yes, record labels really do suck that much. Not only do they give very low percentages of their profits to the artist, but all money spent on promoting the record is charged to the artist. In some cases, artists even lose money on record deals because of this, and it's more likely to happen to more successful albums, because the label will spend more of the artist's money promoting more successful music. I'm sorry; I didn't mean for this to become a rant about record labels.

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  5. Actually, the rant is not only deserved, but applicable to the overall discussion.

    "Pirating" music is one of the single biggest arguments of our day regarding the free/pay issue. Ideally, the musicians would agree to "sell" their content for their own profit, even if that means giving it away for free. The record labels are the ones really set to lose out in a direct-sell economy.

    Middle men everywhere get rich getting between the producers and the consumers and taking a chunk. In some cases, this is a valued service (Grocery stores offer what you need locally so you don't have to track down fresh food all over the globe, as an example). The record labels started out this way, as a sort of collective bargaining of the artists, or older artists setting out with their money to discover and nurture new talent.

    Unfortunately, the money is so good, the labels are fighting to stay in between you and the music, even though technology has rendered them obsolete. Too bad the RIAA didn't just BUY napster instead of suing them. Would have been cheaper in the long run.

    (i do want to apologize to those rare labels that actually pass the majority of the profits to the artists. I don't know of any, but there has to be at least one, and i'm sorry i lumped you in with all the "not-so-nice" guys)

    It will be very interesting to see how many more artists start giving away music legally (i gave audioslave $5!) in order to drive their concerts and promotion deals. I bet Coke will give them more than $5 to be in their commercial....

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  6. I have to disagree with you. Chris Anderson's article is not saying that traditional economics is out the window. He writes, "Surely economics has something to say about that? It does." He goes on to explain other costs of attention and time, which basically comprise the opportunity cost.
    Neither is he saying that any company is just giving away everything for free and not making money anywhere. He mentions people like google creating markets in which they make money from other sources than the primary customer.
    Micropayments being a hassle really is part of the psychology of "free". Less hassle means less of your time in addition to less money. Even in the instance of real live cash, I go to a convenience store where there are Andes mints for $0.10 each. I absolutely love Andes mints and if they were free I would take one in a heartbeat, but I have never once given up my ten cents for an Andes mint at this store, because I don't want to spend it.
    As for the whole musician thing, I have to agree with previous comments, that musicians have never made their real money on record sales. Concerts have always always always been more profitable for the artist. Someone is making loads of money on records, but it certainly is never ever the musician. As far as musicians not being in it for the money, being a musician myself, I have to say that very few people who really have their heart in it expect to get rich. Yes, musicians really do want to make a living, and most even dream of becoming stars, but it's not necessarily a realistic goal. And sure, it would be great to have a world where one could succeed just by being a good musician, but that world has never existed and never will. There are a LOT of great musicians out there, and the ones who make it big have other things that got them there, whether its good connections, a knack for meeting people, good business sense, or even pure luck.
    When he talks about the "act of using a service creating something of value," he's not talking about the users doing the work for you. He's talking about the use of a service creating information that can be value. Every user that uses Google's search contributes to demographical information that Google can sell to advertisers. Don't worry, Google is not selling your individual searches to anyone, but they are selling the information that x% of searches included such-and-such a word. This article shows the value of Googles free 411 service. http://www.wired.com/techbiz/it/magazine/16-03/ff_free_411
    I'd like to see you try to tell a car company that they can give you a car at no marginal cost. Firstly, on the business's side of things, there's the opportunity cost of the possibility of selling the car, which is thousands of dollars. Maybe not so much to a big corporation, but it's big enough to record in the company's books. Consider the opportunity cost of giving away 1GB of storage on the internet. Sure there are plenty of other things you can do with that space, but you have more gigabytes that you can do those other things with. The number of gigabytes that you can use is fast approaching infinity (i.e. Yahoo's unlimited email storage). The number of cars a manufacturer has in stock will always be finite. That's what's different about digital economics, that the abundance of many of its resources is, for all practical purposes, approaching infinity.
    Now I have two last points. Firstly, that Chris Anderson's main point is that "Free" is playing a major role in the evolution of economics, not instantly creating a new economy. Secondly, it's that the other whole point of the article is how companies are making more money by using the concept of "free." He never brings up any companies that are just giving things away because they have no marginal cost and calling it a good day.
    I don't mean to bash your ideas. I think it's great that there are open forums for discussion of these types of things. Happy blogging!

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  7. I think a way for a free service to guarantee its survival (and perhaps long-term profitability as well) is to make sure it becomes something that people can't live without. If you become something that millions of people will clearly "suffer" if you shut down your switch, people will do whatever they can do to keep that from happening - they'll donate, buy T-shirts, etc.

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  8. I like your comments, and let me write some comments shortly. Meanwhile, I would appreiciate if you could use some other names than anonymous. That will help communicate more easily.

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  9. anonymous #2 wrote “I have to agree with previous comments, that musicians have never made their real money on record sales. Concerts have always always always been more profitable for the artist. Someone is making loads of money on records, but it certainly is never ever the musician.”

    You guys seem to know more about the music business. To learn some more myself, I have done some Googling. This article seems especially informative.

    So, the label pays the musician the advance, which is basically like a startup fund used for the musician’s studio recording, promotion, and living expenses. Then you release a record, sell them, and the musician should pay back, with royalty, until the label has recouped the advance. After that, the musician will receive the royalty. On the concerts, the label does not seem to ask for a stake (though financially weaker indie labels might?). So, the musician keeps most of the concert revenue, after the staff salaries and stage rents, etc.

    My question is this. If the recording is not profitable, why not skip it and just do the live? The real profitability should be thought on an incremental basis. That is, if you add/remove recording, does it increase or decrease your total profitability? My hypothesis is that musicians release records because they are better off than not doing the record and just touring.

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  10. Anonymous #2 said, “Someone is making loads of money on records, but it certainly is never ever the musician.”
    I might be wrong here, but having read some posts and discussions on the web, I don't think labels are in general bad guys. They paid you in advance for your recording, and probably better eating and sleeping. I thought they go after you, if they lose money on the CD sales. Apparently, that's not the standard practice. They only recoup from record sales. I don't know, but it seems like a fair business.

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  11. Anonymous #2 wrote,
    "…being a musician myself, I have to say that very few people who really have their heart in it expect to get rich. … And sure, it would be great to have a world where one could succeed just by being a good musician, but that world has never existed and never will."

    I actually hope and believe in a world where creative small individuals and groups can devote to what they are passionate about and make a good living. Have a look at my work-in-process book(?) called “Mass Niche – The Long Tail by the Long Tail”.

    In that world, becoming the next Beatles or Google will still be hard. But you have a much better chance of becoming a trio making 500K a year, or one-person business making 200K a year. Do we see real examples? Yes. Have a look at the chapter “Rise of onlie fashion boutiques”. As I wrote in the book(?), this is not just for clothing. It will be everywhere – blogging, music, book, even manufacturing. We just need to work harder on making such environments.

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