Pricing Guide for the Knowledge Economy with Behavioral Economics

How Free Things Are Disrupting Businesses + Radical Innovation + Guide to Free Business Models

Book Review: Free/Chris Anderson

Free is an indispensable introduction to the disruption of “a product for a price,” one of the Industrial Economy’s key constructs. It is rich with examples of many of the pricing innovations and business models with which you’re probably familiar but haven’t thought about in depth. Many of its examples have to do with digital products, which are inherently disruptive because their distribution cost is close to zero, and they can displace legacy analog products.

Free is important and useful for two reasons beyond pricing and business model innovation: it contains a good dollop of behavioral economics with regard to pricing, and it gives numerous examples for thinking beyond the two-party market model that dominated the Industrial Economy, buyer and seller. As Anderson repeatedly shows, in digitally networked markets spawned by the Internet, firms put themselves at significant risk when they don’t adopt a networked ecosystem mindset. For example:

When something becomes free, it creates a new kind of scarcity and, in the Knowledge Economy, attention is scarce.

Book Overview

As exemplified also in my review of The Long Tail, Anderson is talented at synthesizing and simplifying complex economic changes while retaining enough detail to solidify his arguments and keep it interesting. He reaches back into the 19th and 20th centuries to show some of the roots of free (the concept). For example, humans had to invent the concept of zero, back in the abacus days. Therefore, Free is interesting from this perspective, too.

Below the book overview’s highlights of each chapter, Analysis and Conclusions shows how Free applies to innovation (and survival) in the Knowledge Economy. Ironically, the book is not free ;^) but you can buy it for almost free here.

Chapter 1: The Birth of Free

• Gelatin, Jello case study in 1895
  • New product, people didn’t get it, communication problem
  • Free cookbooks didn’t require salesman’s license
• Gillette’s disposable blades work because they give away the razor
• Cell phones in the U.S.A. (not free but heavily subsidized)
• Radiohead music (“Pay us what you want”)

Part One: What Is Free?

Chapter 2: Free 101

Visible example of disruptive potential: Ryanair (almost) free flights, schedule of charges

Free1: Direct cross-subsidies

• Buy this, get that for less [examples]

Free2: The Three-party market [cross-subsidy examples]

• Comcast gives away the DVR
• Pay later subsidizes free now
• Paying people subsidize free people (shareware, freemium)
• Three-party market: advertising in the context of free

Free3: Freemium: all over the web [examples]

• Free version + value-added (paid) version

Free4: Nonmonetary markets

• Gift economy, i.e. Wikipedia incentives: expression, fun, good karma, self-interest
• Labor exchange: get free porn by solving captchas; you are helping hackers to crack captchas, even if they don’t tell you
• Piracy: online music, videos; cost of distribution zero
• Free in daily life (examples): Apple store free classes, free health club trials, skype, pets, swaps
• The three prices: something, nothing and less than nothing (negative); the third takes the form of cash rebates, coupons, loyalty cards; they really aren’t negative, but consumers treat them as negative prices
• Cash rebates treated differently from money saved; it’s spent
• Tom Sawyer and the fence
• Chinese doctors paid when their patients are well
• Free conference call makes money on subsidies from carriers, tariff rules

Chapter 3: The History of Free

• Free is difficult to grasp because it is not a thing—but the absence of a thing, a concept
• The history of zero, as a (mathematical) concept [we didn’t always have the concept]. Stones, abacus
• Everything is free among family, prices only relevant outside. Strangers
• Progressive tax: “rich” subsidize the “poor”; charity
• Interest, “usury”
• Capitalism & enemies; marxism, Darwin, Kropotkin’s satisfaction breaks down above Dunbar’s number (but works within it)
• The first free lunch, U.S. saloons, 1872, the free lunch counter
• Samples, gifts, tasters; free ice water by Mt. Rushmore
• Free and music; U.S.A. broadcasting in the 30s and 40s
• The age of abundance: from hunger to obesity
• Food’s five inputs: sun, air, water, land (nutrients) and labor; first three are free, last two costly, the Industrial Revolution mechanized agriculture; chemistry and fertilizer; before, animals determined farm size (mature)
• Corn economy: the three grains: rice, wheat, corn
  • Rice protein-rich, hard to grow
  • Wheat easy to grow, protein-poor
  • Corn easy to grow, protein-rich
  • The all-important protein/labor ratio: corn people can feed themselves with less work; Aztecs warlike because they had time
  • Corn upon corn, the chicken McNugget; cardboard “corn,” too
• The mass starvation that never was; people wired to believe the worst of an issue, not the best, so starvation was the focus, not abundance; abundance solves itself, scarcity requires fighting
• Salt used to be money, now it’s free; T-shirts used to be so costly the average man had 8; today they cost 1/25 the amount in 1900 due to global labor; clothing becoming disposable
• Plastic: reduced manufacturing & material costs, led to disposable culture; throwaway in the 50s thought to be a sign of “advanced” society
• Economies are flowing to abundance; the change in industries in the Fortune-100
• Inventing hard, fabricating easy

Chapter 4: The Psychology of Free

• The Village Voice vs. The Onion; free is accused of killing one pub (Village Voice), while enabling another, but this isn’t true; free didn’t kill the Voice, its business fundamentals did
• How free is different from a penny: the latter requires payment, which is more important than the amount
• People who pay even a penny are more valuable to advertisers, they pay 5x more for those eyes
• Free publications “controlled circulation” reach highly desirable demographics
• The penny gap; it forces the cognitive consideration of payment, which eliminates a lot of people (yes, even a penny!); “is it worth it” is part of the brain’s infrastructure that’s not invoked by free, so it carries a mental transaction cost (cognitive cost)
• Why micropayments fail in most cases; the cognitive cost too high
• Case: Tokyo “Sample Lab” is a store with free products; charge for entry, charge vendors for shelf space, charge vendors for feedback on samples (continuous focus group)
• Huge difference between cheap and free
• Behavioral economics and the cost of free
• Lindt v. Hershey kisses: effect of going from a penny to free
• Most transactions have an upside + downside (cost); free has no downside so is often preferred
• Amazon free shipping worked great: the mistake in France, where management had given the price as “1 franc shipping”
• Negative of free: people don’t care about things they don’t pay for
• How free maximizes reach
• Open source built on community; free version and polished versions
• The value of time: Steve Jobs sold the music industry on 99 cent songs because he could assure people they would always work; kids have time, won’t pay; everyone else would—and did
• Prices come with guarantees; free doesn’t (maybe because free doesn’t obligate the supplier to have a working product)
• Free can impart confidence; you can try it
• Free and paid work great together
• Piracy; theft that doesn’t hurt the producer because nothing is stolen except opportunity cost; pirates reproduce the music, they don’t take something from the artist/label
• Piracy is imposed free; video games, DRM, complications (“will it work”)
• Free almost always a choice, but it may be imposed by the market

Part Two: Digital Free

Chapter 5: Too Cheap to Matter

• Electric is [now figuratively] “too cheap to meter” [relative to the 19th century)
• The automobile, gasoline, manufacturing
• Digital doesn’t have the waste of material
• Better Place offered free cars
• Semiconductors and Moore’s Law: high brains to brawn ratio; inputs are intellectual (George Gilder, Microcosm)
• Ideas are abundant and take nothing from their originators by being shared: Thomas Jefferson: “He who received an idea from me, receives instruction himself without lessening mine; as he who lights his taper at mine, receives light without darkening me.”
• Zerox PARC lab, Alan Kay: engineers should not try to figure out what tech was good for, let people do that; we need to make tech so easy to do that everyone can use it how they will (IOW, if you want to learn about products, people and innovation, don’t ask what products people want, ask them what they want to do)
• Digital waste can lead to abundance; leads to experimentation (and innovation); transistors and silicon and computing
• YouTube impact on media
• Digital tech triple play: processing, storage, bandwidth, The Web is the land of free (and source of innovation)

Chapter 6: “Information Wants to be Free”

• “Free” refers to “liberated” and “no cost”; the quote referred to the liberated definition
• Hacker ethic
• Stewart Brand: “One the one hand, information wants to be expensive because it’s so valuable. The right information in the right place just changes your life; On the other hand, information wants to be free because the cost of getting it out is getting lower and lower all the time. So you have these two fighting against each other.”
• Anderson1: “Commodity information (everybody gets the same version) wants to be free. Customized information (you get something unique and meaningful to you) wants to be expensive.”
• Anderson2: “Abundant information wants to be free. Scarce information wants to be expensive.”
• Brand: the telephone company doesn’t sell conversations, just the wire and handset
• “Information wants to be free” is a meme; memes always morph

Chapter 7: Competing with Free

• Gates’ early memo to hobbyists: in 1975, software was free, hardware cost money; he made the argument that people should pay for software
• It was easy for hobbyists/geeks to copy and share software (that process was complicated then in terms of form factors, but there was no DRM, and they had the skills), but once computers went mainstream, most mainstream users didn’t have the skills, so they became willing to pay for software (see Jobs’ argument for songs above).
• Case study: Linux, Torvalds, and the Microsoft response: denial, anger, bargaining, depression, acceptance
• Yahoo v. Google; free email storage offered by Google
• Stock trades for free: Zecco
• TED free online, $6,000 onsite

Chapter 8: De-Monetization

• Google: massive cross-subsidies from search, other free products; Google is free to maximize reach
• The Sopranos distribution strategy: paid (HBO), blog, facebook, twitter, youtube cut segments, contests = the maximizing strategy
• Most Google products are “complements”; they encourage web usage, where Google wins; Gmail and Adsense
• TV is afraid of trading expensive network dollars for digital pennies
• Craiglist: it doesn’t make much money but the value realized by users; someone makes money somewhere
• Free can create huge markets of liquidity (of users, attention..)
• The Internet is a liquidity machine
• To make money, think ecosystem, not only buyer and seller (as in Industrial Economy)
• Wikipedia; huge market, ladder of participation
• Free converts billion dollar industries (TV networks) into million dollar industries; it redistributes wealth and value

Chapter 9: The New Media Models

• Radio broadcast in the 20s, advertising, the old model annoys 90% to reach 10%
• Google is different: only reach people who’ve shown they’re interested
• The end of paid content
• Supply high, demand constant
• Loss of physical form (CD, newspaper)
• Ease of access (online)
• Shift to ad supported
• Computer industry wants content to be free; they sell more gadgets (iPod)
• Generation Free (they are people who are used to it)
• Case: free silverware in Portugal to sell newspapers: Global Noticias
• Selling virtual items: Target gift cards, kids’ game Maple Story
• Subscriptions: Disney Club Penguin; gaming models; virtual trinkets and upgrades
• Advertising: in-game ads are huge
• Real estate: Second Life
• Merchandise: Webkinz plushie gateway to community online, sociality
• Free music CDs: Radiohead, Prince [another reflection on free music]
• Music: the shift of monetization to concerts, apparel
• Indie musician gives free record, Deek Webb; gets emails, promotes concerts that sell out, sells merchandise
• Free books: monetize by consulting; free textbooks; charge for print options, flash cards

Chapter 10: How Big is the Free Economy?

• Free bikes in Paris, Brussels/Bruxelles
• Several models
• Bigger than people think

Part Three: Freeconomics and the Free World

Chapter 11: Econ 000

• Monopolies not what they used to be
• Increasing returns (film, CDs)
• Patents, trademarks, copyright, monopolies don’t work well anymore
• Software piracy
• French economist Bertrand: a truly competitive market (The Internet)
• Free just another version
• Netflix like the gym: pay for access, all you can use (but most people don’t); cell phones; no “nickle and dime,” so people think it’s a good deal (no cognitive cost)

Chapter 12: Nonmonetary Economies

• Herbert Simon: “In an information-rich world, the wealth of information means a dearth of something else: a scarcity of whatever it is that information consumes… attention.”
• Every abundance creates a new scarcity
• Maslow’s pyramid, similar for information
• Now, the attention economy, the reputation economy
• The Web: links, now Google author… attention becomes a currency
• Free university education: UC Berkeley lectures free
• The gift economy: blogs, Amazon reviews
• Free now competes with paid; we always gave freiends and family free things that professionals charged for, but now all online and accessible to all
• Case study: Freecycle

Chapter 13: Waste Is (Sometimes) Good

• Scarcity and waste: relative
• Nature wastes life: mammals unique because we have high investment in offspring [and humans are extreme among mammals]; therefore we don’t like waste (our product is children); fish, insects; biologists “fully exploring the potential space;” contrasting examples are seeds spraying everywhere
• Youtube videos; kids like Star Wars created by their friends more than Lucas versions; youtube like dandelion seeds
• Scarcity management: Anderson as editor (at Wired, The Economist): print (scarce space) and online (infinite)
• Scarcity vs. abundance

Chapter 14: Free World

• China’s music industry will take over: free CDs but music festivals, ringbacks, ringtones, sponsors
• MicroMu
• Chanel Knockoff economy; piracy
• Confucious: copying means respect
• Pirates just another version in China
• Chinese women practical; buy real when they can it and flaunt it
• Economy of fake is evidence “real” for pirated goods
• Pirated digital can be the same quality as original; in bits (physical products), usually not
• Piracy primes the market in China
• Brazlian street vendors pirate CDs, which creates sellout concerts

Chapter 15: Imagining Abundance

• We can’t imagine abundance very well, our brains are wired for scarcity

Chapter 16: “You Get What You Pay For”

• Debunking ideas about free
• You can compete with free; have a better version, and understand the user
• Find the scarcity
• Tip jars on blogs are brain dead

(Part Four): Coda

This section contains several how-to resources:

• Free Rules, principles of abundance thinking
• Freemium Tactics
• Fifty Business Models Built on Free
• Notes, Acknowledgements, Index

Analysis and Conclusions

• At the macro level, Free addresses how people perceive the value of products and services, and this is very valuable for understanding human behavior. Free or subsidized products and services are a part of this larger whole.
• As the examples show, free can enable entire new business models, so like other innovations, it has immense potential for innovation and disruption of numerous markets.
• Innovation becomes most potent when you adopt ecosystem thinking, as Chapter 2 explains in the 3-party market section. “Free” often drives demand for something else. Ryanair, for example, works because customers often feel like they got a great deal, so they order add-ons like movies, food, or bag checking, which can be more profitable to provide.
• The global examples of music in China and Brazil are worth watching because they don’t have the same legal or cultural constraints as in “developed” economies, but adoption may indicate latent potential in other markets.
• Behavioral economics is receiving intense interest by commercial and government organizations. Here’s a recent presentation at Action Design Chicago on the psychology of scarcity that shows how people trade money for time.