FREE. The Future of a Radical Price

PROLOGUE

In November 2008, the surviving members of the original Monty Python team, stunned by the extent of digital piracy of their videos, issued a very stern announcement on YouTube:

For 3 years you YouTubers have been ripping us off, taking tens of thousands of our videos and putting them on YouTube. Now the tables are turned. It’s time for us to take matters into our own hands. We know who you are, we know where you live and we could come after you in ways too horrible to tell. But being the extraordinarily nice chaps we are, we’ve figured a better way to get our own back: We’ve launched our own Monty Python channel on YouTube. No more of those crap quality videos you’ve been posting. We’re giving you the real thing—high quality videos delivered straight from our vault. What’s more, we’re taking our most viewed clips and uploading brand new high quality versions. And what’s even more, we’re letting you see absolutely everything for free. So there! But we want something in return. None of your driveling, mindless comments. Instead, we want you to click on the links, buy our movies & TV shows and soften our pain and disgust at being ripped off all these years.

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Three months later, the results of this rash experiment with Free were in. Monty Python’s DVDs had climbed to No. 2 on Amazon’s Movies and TV best-sellers list, with increased sales of 23,000 percent. So there! Free worked, and worked brilliantly. More than 2 million people watched the clips on YouTube as word of mouth spread and parents introduced their children to the Black Knight and the Dead Parrot Sketch. Thousands of viewers were reminded how much they loved Monty Python and wanted more, so they ordered the DVDs. Response videos, mashups, and remixes spread, and a new generation learned the proper meaning of “Killer Rabbit.” And all this cost Monty Python essentially nothing, since YouTube paid all the bandwidth and storage costs, such as they were. What’s surprising about this example is how unsurprising it is. There are countless other cases just like this online, where pretty much everything is given away for free in some version with the hopes of selling something else—or, even more frequently, with no expectation of pay at all. I’m typing these words on a $250 “netbook” computer, which is the fastest growing new category of laptop. The operating system happens to be a version of free Linux, although it doesn’t matter since I don’t run any programs but the free Firefox Web browser. I’m not using Microsoft Word, but rather free Google Docs, which has the advantage of making my drafts available to me wherever I am, and I don’t have to worry about backing them up since Google takes care of that for me. Everything else I do on this computer is free, from my email to my Twitter feeds. Even the wireless access is free, thanks to the coffee shop I’m sitting in. And yet Google is one of the most profitable companies in America, the “Linux ecosystem” is a $30 billion industry, and the coffee shop seems to be selling $3 lattes as fast as they can make them. Therein lies the paradox of Free: People are making lots of money charging nothing. Not nothing for everything, but nothing for enough that we have essentially created an economy as big as a good-sized country around the price of $0.00. How did this happen and where is it going? That’s the central question of this book. For me, it started with a loose end in The Long Tail. My first book

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was about the new shape of consumer demand, when everything is available and we can choose from the infinite aisle rather than just the best-seller bin. The abundant marketplace of the Long Tail was enabled by the unlimited “shelf space” of the Internet, which is the first distribution system in history that is as well suited for the niche as for the mass, for the obscure as well as the mainstream. The result was the birth of a wildly diverse new culture and a threat to the institutions of the existing one, from mainstream media to music labels. There’s only one way you can have unlimited shelf space: if that shelf space costs nothing. The near-zero “marginal costs” of digital distribution (that is, the additional cost of sending out another copy beyond the “fixed costs” of the required hardware with which to do it) allow us to be indiscriminate in what we use it for—no gatekeepers are required to decide if something deserves global reach or not. And out of that free-for-all came the miracle of today’s Web, the greatest accumulation of human knowledge, experience, and expression the world has ever seen. So that’s what free shelf space can do. As I marveled over the consequences, I started thinking more about Free, and realized just how far it had spread. It didn’t just explain the explosion of variety online, it defined the pricing there, too. What’s more, this “free” wasn’t just a marketing gimmick like the free samples and prizes inside that we’re used to in traditional retail. This free seemed to have no strings attached: It wasn’t just a lure for a future sale, but genuinely gratis. Most of us depend on one or more Google services every day, but they never show up on our credit card. No meter ticks as you use Facebook. Wikipedia costs you nothing. Twenty-first-century Free is different from twentieth-century Free. Somewhere in the transition from atoms to bits, a phenomenon that we thought we understood was transformed. “Free” became Free. Surely economics must have something to say about this, I thought. But I couldn’t find anything. No theories of gratis, or pricing models that went to zero. (In fairness, some do exist, as later research would reveal. But they were mostly obscure academic discussions of “two-sided markets” and, as we’ll see in the economics chapter, nearly forgotten theories from the nineteenth century.) Somehow an economy had emerged around Free before the economic model that could describe it. Thus this book, an exploration of a concept that is in the midst of

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radical evolution. As I came to learn, Free is both a familiar concept and a deeply mysterious one. It is as powerful as it is misunderstood. The Free that emerged over the past decade is different from the Free that came before, but how and why are rarely explored. What’s more, today’s Free is full of apparent contradictions: You can make money giving things away. There really is a free lunch. Sometimes you get more than you pay for. This was a fun book to write. It took me from the patent medicine makers of late-nineteenth-century America to the pirate markets of China. I dived into the psychology of gifts and the morality of waste. I started a project on the side to try out new business models around electronics where the intellectual property is free (a model known as open source hardware). I got to brainstorm with my publishers on the many ways to make this book itself free in most of its forms, while still creating ways for everyone who helped produce it to get paid. In some ways, this was a public research project, as The Long Tail had been. I previewed the thesis in an article in Wired and blogged about it as I had with The Long Tail. But it took a different path, more in my own head than in a collective conversation with contributors online. This book is more driven by history and narrative, and it is as much about Free’s past as it is about its future. My research took me as often to archives and eighteenth-century psychology texts as it did to the latest Web phenomena. And so I found myself in more of a traditional writer’s mode, of solitary studying and typing with earphones on in Starbucks, as God intended. When I wasn’t writing, I was traveling, talking to people about Free. I found that the idea that you could create a huge global economy around a base price of zero was invariably polarizing, but the one common factor was that nearly everyone had their doubts. At risk of ageist generalization, there were broadly two camps of skeptics: those over thirty and those below. The older critics, who had grown up with twentieth-century Free, were rightly suspicious: Surely “free” is nothing of the sort—we all pay sooner or later. Not only is it not new, but it’s the oldest marketing gimmick in the book. When you hear “free,” reach for your wallet. The younger critics had a different response: “Duh!” This is the Google Generation, and they’ve grown up online simply assuming that everything digital is free. They have internalized the subtle market dynamics of near-zero marginal cost economics in the same way that we internalize

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Newtonian mechanics when we learn to catch a ball. The fact that we are now creating a global economy around the price of zero seemed too self-evident to even note. With that, I realized that this was a perfect subject for a book. Any topic that can divide critics equally into two opposite camps—“totally wrong” and “so obvious”—has got to be a good one. I hope that those who read this book, even if they start in one of those camps, will end in neither. Free is not new, but it is changing. And it is doing so in ways that are forcing us to rethink some of our basic understandings of human behavior and economic incentives. Those who understand the new Free will command tomorrow’s markets and disrupt today’s—indeed, they’re already doing it. This book is about them and what they’re teaching us. It is about the past and future of a radical price.

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THE BIRTH OF FREE

There’s no getting around it: Gelatin comes from flesh and bones. It’s

the translucent, glutinous substance that skims to the top when you boil meat. But if you collect enough of it and purify it, adding color and flavor, it becomes something else: Jell-O. A clean powder in a packet, far removed from its abattoir origins of marrow and connective tissue. We don’t think much about the origins of Jell-O today, but in the late 1800s, if you wanted to put a jiggly treat on your dinner table, you had to make it the hard way: putting off-cuts in a stewpot and waiting a half day for the hydrolyzed collagen to emerge from the gristle. In 1895, Pearle Wait, a carpenter in LeRoy, New York, with a side business of patent medicine packaging, sat at his kitchen table poking at a bowl of gelatin. He’d been wanting to get into the then-new packaged foods business and thought this might be the stuff, if only he could figure out how to make it more appealing. Although glue-makers had been producing it for decades as a by-product of their animal rendering, it had yet to prove popular with American consumers. For good reason: It was a lot of work for a pretty small reward. Wait wondered if there might be a way to take gelatin more mainstream. Earlier efforts to sell prepackaged powdered gelatin, including by

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the inventor of the process, Peter Cooper (of Cooper Union fame), sold it plain and unflavored on the argument that this was the most flexible form; cooks could add their own flavors. But Wait thought that preflavored gelatins might sell better, so he mixed in fruit juices, along with sugar and food dyes. The jelly took on the color and flavor of the fruits—orange, lemon, raspberry, and strawberry—creating something that looked, smelled, and tasted appealing. Colorful, light, and delightful to play with, it was a treat that could add jiggly, translucent fun to almost any meal. To distance the stuff further from its abattoir origins, his wife, May, renamed it Jell-O. They boxed it up to sell. But it didn’t sell. Jell-O was too foreign a food and too unknown a brand for turn-of-the-century consumers. Kitchen traditions were still based on Victorian recipes, where every food type had its place. Was this new jelly a salad ingredient or a dessert? For two years, Wait kept trying to stir up interest in Jell-O, with little success. Eventually, in 1899, he gave up and sold the trademark—name, hyphen, and all—to Orator Frank Woodward, a fellow townsman. The price was $450. Woodward was a natural salesman, and he had settled in the right place. LeRoy had become something of a nineteenth-century huckster hotbed, best known for its patent medicine makers. Woodward sold plenty of miracle cures and was creative with plaster of paris, too. He marketed plaster target balls for marksmen and invented a plaster laying nest for chickens that was infused with an anti-lice powder. But even Woodward’s firm, the Genesee Pure Food Company, struggled to find a market for powdered gelatin. It was a new product category with an unknown brand name in an era where general stores sold almost all products from behind the counter and customers had to ask for them by name. The Jell-O was manufactured in a nearby factory run by Andrew Samuel Nico. Sales were so slow and disheartening for the new product that on one gloomy day, while contemplating a huge stack of unsold Jell-O boxes, Woodward offered Nico the whole business for $35. Nico refused. The main problem was that consumers didn’t understand the product or what they could do with it. And without consumer demand, merchants wouldn’t stock it. Manufacturers of other products in the new packaged ingredient business, such as Arm & Hammer baking soda and

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Fleischmann’s yeast, often bundled recipe books with their boxes. Woodward figured a usage guidebook might help create demand for Jell-O, too, but how to get them out there? Nobody was buying the boxes in the first place. So in 1902 Woodward and his marketing chief, William E. Humelbaugh, tried something new. First, they crafted a three-inch ad to run in Ladies’ Home Journal, at a cost of $336. Rather optimistically proclaiming Jell-O “America’s Most Famous Dessert,” the ad explained the appeal of the product: This new dessert “could be served with the simple addition of whipped cream or thin custard. If, however, you desire something very fancy, there are hundreds of delightful combinations that can be quickly prepared.” Then, to illustrate all those richly varied combinations, Genesee printed up tens of thousands of pamphlets with Jell-O recipes and gave them to its salesmen to distribute to homemakers for free. This cleverly got around the salesmen’s chief problem. As they traveled around the country in their buggies, they were prohibited from selling door-to-door in most towns without a costly traveling salesman’s license. But the cookbooks were different—giving things away wasn’t selling. They could knock on doors and just hand the woman of the house a free recipe book, no strings attached. Printing paper was cheap compared to making Jell-O. They couldn’t afford to give out free samples of the product itself, so they did the next best thing: free information that could only be used if the consumer bought the product. After blanketing a town with the booklets, the salesmen would then go to the local merchants and advise them that they were about to get a wave of consumers asking for a new product called Jell-O, which they would be wise to stock. The boxes of Jell-O in the back of the buggies finally started to move. By 1904, the campaign had turned into a runaway success. Two years later Jell-O hit a million dollars in annual sales. The company introduced the “Jell-O Girl” in its ads, and the pamphlets grew into Jell-O “best- seller” recipe books. In some years Genesee printed as many as 15 million of the free books, and in the company’s first twenty-five years it printed and distributed an estimated quarter billion free cookbooks door-to-door, across the country. Noted artists such as Norman Rockwell, Linn Ball, and Angus MacDonald

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contributed colored illustrations to the cookbooks. Jell-O had become a fixture in the American kitchen and a household name. Thus was born one of the most powerful marketing tools of the twentieth century: giving away one thing to create demand for another. What Woodward understood was that “free” is a word with an extraordinary ability to reset consumer psychology, create new markets, break old ones, and make almost any product more attractive. He also figured out that “free” didn’t mean profitless. It just meant that the route from product to revenue was indirect, something that would become enshrined in the retail playbook as the concept of a “loss leader.”

KING GILLETTE At the same time, the most famous example of this new marketing method was in the works a few hundred miles north, in Boston. At the age of forty, King Gillette was a frustrated inventor, a bitter anticapitalist, and a salesman of cork-lined bottle caps. Despite ideas, energy, and wealthy parents, he had little to show for his work. He blamed the evils of market competition. Indeed, in 1894 he had published a book, The Human Drift, which argued that all industry should be taken over by a single corporation owned by the public and that millions of Americans should live in a giant city called Metropolis powered by Niagara Falls. His boss at the bottle cap company, meanwhile, had just one piece of advice: Invent something people use and throw away. One day, while he was shaving with a straight razor that was so worn it could no longer be sharpened, the idea came to him. What if the blade could be made of a thin metal strip? Rather than spending time maintaining the blades, men could simply discard them when they became dull. A few years of metallurgy experimentation later, the disposable-blade safety razor was born. But it didn’t take off immediately. In its first year, 1903, Gillette sold a total of 51 razors and 168 blades. Over the next two decades, he tried every marketing gimmick he could think of. He put his own face on the package, making him both legendary and, some people believed, fictional. He sold millions of razors to the army at a steep discount, hoping the habits soldiers

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developed at war would carry over to peacetime. He sold razors in bulk to banks so they could give them away with new deposits (“shave and save” campaigns). Razors were bundled with everything from Wrigley’s gum to packets of coffee, tea, spices, and marshmallows. The freebies helped to sell those products, but the tactic helped Gillette even more. By selling cheaply to partners who would give away the razors, which were useless by themselves, he was creating demand for disposable blades. It was just like Jell-O (whose cookbooks were the “razors” to the gelatin “blades”), but even more tightly linked. Once hooked on disposable razor blades, you were a daily customer for life. Interestingly, the idea that Gillette, the company, gave away the razors is mostly urban myth. The only recorded examples were with the introduction of the Trak II in the 1970s, when the company gave away a cheap version of the razor with a nonreplaceable blade. Its more usual model was to sell razors at a low margin to partners, such as banks, who would typically give them away as part of promotions. Gillette made its real profit from the high margin on the blades. A few billion blades later, this business model is now the foundation of entire industries: Give away the cell phone, sell the monthly plan; make the video game console cheap and sell expensive games; install fancy coffeemakers in offices at no charge so you can sell managers expensive coffee sachets. Starting from these experiments at the beginning of the twentieth century, Free fueled a consumer revolution that defined the next hundred years. The rise of Madison Avenue and the arrival of the supermarket made consumer psychology a science and Free the tool of choice. “Freeto-air” radio and television (the term used for signals sent over the airways that anyone can receive without charge) united a nation and created the mass market. Free was the rallying cry of the modern marketer, and the consumer never failed to respond.

TWENTY-FIRST-CENTURY FREE Now, at the beginning of the twenty-first century, we’re inventing a new form of Free, and this one will define the next era just as profoundly. The

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new form of Free is not a gimmick, a trick to shift money from one pocket to another. Instead, it’s driven by an extraordinary new ability to lower the costs of goods and services close to zero. While the last century’s Free was a powerful marketing method, this century’s Free is an entirely new economic model. This new form of Free is based on the economics of bits, not atoms. It is a unique quality of the digital age that once something becomes software, it inevitably becomes free—in cost, certainly, and often in price. (Imagine if the price of steel had dropped so close to zero that King Gillette could give away both razor and blade, and make his money on something else entirely—shaving cream?) And it’s creating a multibillion-dollar economy —the first in history—where the primary price is zero. In the atoms economy, which is to say most of the stuff around us, things tend to get more expensive over time. But in the bits economy, which is the online world, things get cheaper. The atoms economy is inflationary, while the bits economy is deflationary. The twentieth century was primarily an atoms economy. The twentyfirst century will be equally a bits economy. Anything free in the atoms economy must be paid for by something else, which is why so much traditional free feels like bait and switch—it’s you paying, one way or another. But free in the bits economy can be really free, with money often taken out of the equation altogether. People are rightly suspicious of Free in the atoms economy, and rightly trusting of Free in the bits economy. Intuitively, they understand the difference between the two economies, and why Free works so well online. A decade and a half into the great online experiment, free has become the default, and pay walls the route to obscurity. In 2007, the New York Times went free online, as did much of the Wall Street Journal, using a clever hybrid model that made stories free to those who wanted to share them online, in blog posts or other social media. Musicians from Radiohead to Nine Inch Nails now routinely give away their music online, realizing that Free lets them reach more people and create more fans, some of whom attend their concerts and even—gasp—pay for premium versions of the music. The fastest-growing parts of the gaming industry are ad-supported casual games online and free-to-play massively multiplayer online games.

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The rise of “freeconomics” is being driven by the underlying technologies of the digital age. Just as Moore’s Law dictates that a unit of computer processing power halves in price every two years, the price of bandwidth and storage is dropping even faster. What the Internet does is combine all three, compounding the price declines with a triple play of technology: processors, bandwidth, and storage. As a result, the net annual deflation rate of the online world is nearly 50 percent, which is to say that whatever it costs YouTube to stream a video today will cost half as much in a year. The trend lines that determine the cost of doing business online all point the same way: to zero. No wonder the prices online all go the same way. George Gilder, whose 1990 book, Microcosm, was the first to explore the economics of bits, puts this in historical context:

In every industrial revolution, some key factor of production is drastically reduced in cost. Relative to the previous cost to achieve that function, the new factor is virtually free. [Thanks to steam,] physical force in the Industrial Revolution became virtually free compared to getting it from animal muscle power or human muscle power. Suddenly you could do things you could not afford to do before. You could make a factory work 24 hours a day churning out products in a way that was just incomprehensible before.

Today the most interesting business models are in finding ways to make money around Free. Sooner or later every company is going to have to figure out how to use Free or compete with Free, one way or another. This book is about how to do that. First, we’ll look at the history of Free and why it has such power over our choices. Then we’ll see how digital economics has revolutionized Free, turning it from a marketing gimmick into an economic force, including the new business models it enables. Finally, we’ll dive into the underlying principles of freeconomics: how it works, where it works, and why it’s so often misunderstood and feared. But to start, what does “free” really mean?

WHAT IS FREE?

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FREE 101

A SHORT COURSE ON A MOST MISUNDERSTOOD WORD

“Free” can mean many things, and that meaning has changed over the years. It raises suspicions, yet has the power to grab attention like almost nothing else. It is almost never as simple as it seems, yet it is the most natural transaction of all. If we are now building an economy around Free, we should start by understanding what it is and how it works. Let’s begin with the definition. In Latinate languages, such as French, Spanish, and Italian, “free” is less convoluted because it is not a single word. Instead, it is two words, one derived from the Latin liber (“freedom”) and the other from the Latin gratis (contraction of gratiis, “for thanks,” hence, “without recompense,” or zero price). In Spanish, for instance, libre is a good thing (freedom of speech, etc.) while gratis is often suspected of being a marketing gimmick. In English, though, the two words are mushed together into a single word. This has marketing advantages: the positive “freedom” connotation lowers our defenses to sales tricks. But it also introduces ambiguity. (Which is why English speakers sometimes use “gratis” for emphasis, to underscore that something is really free.) In the open source software world, which is both free (encouraging use and reuse) and free (no charge), people distinguish between the two

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like this: “Free as in beer vs. free as in speech.” (Inevitably, some overclever types thought it would be funny to reambiguate this by releasing a beer recipe under a share-and-share-alike license and then charging for the finished product at software conferences. Geeks!) So how did we end up with a single word, and why is that word “free”? Surprisingly, it comes from the same Old English root as “friend.” According to etymologist Douglas Harper:

[They both come] from the Old English freon, freogan “to free, love.” The primary sense seems to have been “beloved, friend”; which in some languages (notably Gmc. and Celtic) developed a sense of “free,” perhaps from the terms “beloved” or “friend” being applied to the free members of one’s clan (as opposed to slaves). The sense of “given without cost” is from 1585, from the notion of “free of cost.”

So “free” comes from the social notion of freedom, both from slavery and from cost. This book is about the “cost” meaning: free, as in beer. Or, for that matter, lunch. A MILLION KINDS OF FREE Even within the commercial use of “free” there is a wide range of meanings—and business models. Sometimes “free” isn’t really free. “Buy one, get one free” is just another way of saying 50 percent off when you buy two. “Free gift inside” really means that the cost of the gift has been included in the overall product. “Free shipping” typically means the price of shipping has been built into the product’s markup. Of course, sometimes free really is free, but this is hardly a new economic model: A “free sample” is simple marketing, intended to both introduce a product and trigger a slight feeling of moral debt that may encourage you to buy the full-price item. A “free trial” may be free, but only for a limited time, and it may be difficult to opt out before it becomes paid. And “free air” at a gas station is what economists call a “complementary good”—a free product (DIY tire inflation) intended to reinforce consumer interest in a paid product (everything else at the gas station, from a pack of gum to the fuel).

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Then there is the whole world of ad-supported media, from free-to-air radio and TV to most of the Web. Ad-supported free content is a business model that dates back more than a century: a third party (the advertisers) pays for a second party (the consumer) to get the content for free. Finally, sometimes free really is free and does represent a new model. Most of this is online, where digital economics, with near-zero marginal costs, hold sway. Flickr, the photo-sharing service, is actually free for most of its users (it doesn’t even use advertising). Likewise most of what Google offers either is free and without advertising or applies the media ad model in a new way to software and services (like Gmail), not content. Then there is the amazing “gift economy” of Wikipedia and the blogosphere, driven by the nonmonetary incentives of reputation, attention, expression, and the like. All these can be sorted into four broad kinds of Free, two that are old but evolving and two that are emerging with the digital economy. Before we get to those, let’s pull back and observe that all forms of Free boil down to variations of the same thing: shifting money around from product to product, person to person, between now and later, or into nonmonetary markets and back out again. Economists call these “cross-subsidies.”

ALL THE WORLD’S A CROSS-SUBSIDY Cross-subsidies are the essence of the phrase “there’s no such thing as a free lunch.” That means that one way or another the food must be paid for, if not by you directly then by someone else in whose interest it is to give you free food. Sometimes people are paying indirectly for products. That free newspaper you’re reading is supported by advertising, which is part of a retailer’s marketing budget, which is built into its profit margin, which you (or someone around you) will ultimately pay for in the form of more expensive goods. You’re also paying with a bit of your time and, by being seen reading that newspaper, your reputation. The free parking in the supermarket is paid for by the markup on the produce, and the free samples are subsidized by those who shell out for the paid versions. In the gift economy (see page 20), the cross-subsidies are more subtle. Blogs are free and usually don’t have ads, but that doesn’t mean that value

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isn’t being exchanged every time you visit. In return for the free content, the attention you give a blogger, whether in a visit or a link, enhances her reputation. She can use reputation to get a better job, enhance her network, or find more customers. Sometimes those reputation credits can turn into cash, but we can rarely predict the exact path—it’s different each time. Cross-subsidies can work in several different ways: • Paid products subsidizing free products. Loss leaders are a staple of business, from the popcorn that subsidizes the loss-making movie to the expensive wine subsidizing the cheap meal in a restaurant. Free just takes that further, with one item being not just sold at a fraction of its cost but given away entirely. This can be as gimmicky as a “free gift inside” or as common as free samples. This form of Free is ancient, familiar, and relatively straightforward as an economic model, so we won’t focus on it much here. • Paying later subsidizing free now. The free cell phone with a two-year-subscription contract is a classic example of the subsidy over time. It’s just shifting phone service from a point-of-sale revenue stream to an ongoing annuity. In this case, your future self is subsidizing your present self. The hope of the carrier is that you won’t think about what you’ll be paying each year for the phone service but instead will be dazzled by the free phone you get today. • Paying people subsidizing free people. From the men who pay to get into nightclubs where the women get in free, to “kids get in free,” to progressive taxation where the wealthy pay more so the less wealthy pay less (and sometimes nothing), the tactic of segmenting a market into groups based on their willingness or ability to pay is a conventional part of pricing theory. Free takes that to the extreme, extending the concept to a class of consumers who will get the product or service for nothing. The hope is that the free consumers will attract (in the case of the women) or bring with them (in the case of the kids) paying consumers or that some fraction of the free consumers will convert to paying consumers. When you walk through the striking interiors of Las Vegas attractions, you get the view for free; in exchange the owners are expecting some people to stop and gamble or shop (or, ideally, both).

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Within the broad world of cross-subsidies, Free models tend to fall into four main categories:

FREE 1: DIRECT CROSS-SUBSIDIES

WHAT’S FREE: Any Product That Entices You to Pay for Something Else. FREE TO WHOM: Everyone Willing to Pay Eventually, One Way or Another. When Wal-Mart offers a buy-one-get-one-free deal on DVDs, it’s a loss leader. The company is offering the DVD below cost to lure you into the store, where it hopes to sell you a washing machine or a shopping basket filled with other goods at a profit. In any package of products and services, from banking to mobile calling plans, the price of each individual component is often determined by psychology, not cost. Your cell phone company may not make money on your monthly minutes—it keeps that fee low because it knows that’s the first thing you look at when picking a carrier—but your monthly voice mail fee is pure profit. Companies look at a portfolio of products and price some at zero (or close to it) to make the other products, on which they make healthy profits, more attractive. This is the extension, to more and more industries, of King Gillette’s cross-subsidy. Technology is giving companies greater flexibility in how broadly they can define their markets, allowing them more freedom to give away some of their products or services to promote others. Ryanair, for instance, has disrupted its industry by defining itself more as a fullservice travel agency than a seller of airline seats. Your credit card is free because the bank makes its money from the service charge it imposes on the retailers you buy from. They, in turn, pass that charge back to you. (Of course, if you don’t pay your bill off in full at the end of the month, the bank makes even more money from your interest.)

FREE 2: THE THREE-PARTY MARKET

WHAT’S FREE: Content, Services, Software, and More. FREE TO WHOM: Everyone.

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The most common of the economies built around Free is the three-party system. Here a third party pays to participate in a market created by a free exchange between the first two parties. Sound complicated? You encounter it every day. It’s the basis of virtually all media. In the traditional media model, a publisher provides a product free (or nearly free) to consumers, and advertisers pay to ride along. Again, radio is “free to air,” and so is much of television. Likewise, newspaper and magazine publishers don’t charge readers anything close to the actual cost of creating, printing, and distributing their products. They’re not selling papers and magazines to readers, they’re selling readers to advertisers. It’s a three-way market. In a sense, the Web represents the extension of the media business model to industries of all sorts. This is not simply the notion that advertising will pay for everything. Media companies make money around free content in dozens of ways, from selling information about consumers to brand licensing, “value-added” subscriptions, and direct e commerce (see Chapter 9 and the back of the book for a more complete list). Now an entire ecosystem of Web companies is growing up around the same set of models. Economists call such models “two-sided markets,” because there are two distinct user groups who synergistically support each other: Advertisers pay for media to reach consumers, who in turn support advertisers. Consumers ultimately pay, but only indirectly through the higher prices on products due to their marketing costs. This also applies to nonmedia markets, such as credit cards (free cards to consumers means more spending at merchants and more fees for issuing banks), operating system tools given free to application software developers to attract more consumers to the platform, and so on. In each case, the costs are distributed and/or hidden enough to make the primary goods feel free to consumers.