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“Free:The Future of a Radical Price” or Irrational Exuberance?

In his new book, Chris Anderson proposes a radical pricing strategy for today’s digital age — “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.” As the New York Time’s Virginia Posterel noted in her review of the book in this week’s Sunday Book Review:”

“Driving the trend are the steeply declining prices of three essential technologies: computing power, digital storage and transmission capacity. Reproducing and delivering digital content – words, music, software, pictures, video – has now fulfilled the prophecy once made about electricity. It has become too cheap to meter. “Whatever it costs YouTube to stream a video today will cost half as much in a year,” Anderson writes. “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.”

The New Yorker’s Malcolm Gradwell wrote an excellent review of Anderson’s book.  In it he noted that:

“Anderson’s argument begins with a technological trend. The cost of the building blocks of all electronic activity-storage, processing, and bandwidth-has fallen so far that it is now approaching zero. In 1961, Anderson says, a single transistor was ten dollars. In 1963, it was five dollars. By 1968, it was one dollar. Today, Intel will sell you two billion transistors for eleven hundred dollars-meaning that the cost of a single transistor is now about .000055 cents.

Anderson’s second point is that when prices hit zero extraordinary things happen. Anderson describes an experiment conducted by the M.I.T. behavioral economist Dan Ariely, the author of “Predictably Irrational.” Ariely offered a group of subjects a choice between two kinds of chocolate-Hershey’s Kisses, for one cent, and Lindt truffles, for fifteen cents. Three-quarters of the subjects chose the truffles. Then he redid the experiment, reducing the price of both chocolates by one cent. The Kisses were now free. What happened? The order of preference was reversed. Sixty-nine per cent of the subjects chose the Kisses. The price difference between the two chocolates was exactly the same, but that magic word “free” has the power to create a consumer stampede. Amazon has had the same experience with its offer of free shipping for orders over twenty-five dollars. The idea is to induce you to buy a second book, if your first book comes in at less than the twenty-five-dollar threshold. And that’s exactly what it does. In France, however, the offer was mistakenly set at the equivalent of twenty cents-and consumers didn’t buy the second book. “From the consumer’s perspective, there is a huge difference between cheap and free,” Anderson writes. “Give a product away, and it can go viral. Charge a single cent for it and you’re in an entirely different business. . . . The truth is that zero is one market and any other price is another.”

Since the falling costs of digital technology let you make as much stuff as you want, Anderson argues, and the magic of the word “free” creates instant demand among consumers, then Free (Anderson honors it with a capital) represents an enormous business opportunity. Companies ought to be able to make huge amounts of money “around” the thing being given away-as Google gives away its search and e-mail and makes its money on advertising.”

Has Anderson struck on a key business trend that will never be reversed or is this just another case of Irrational Exuberance like that experienced during the Dot Com Bubble?  From a certain perspective I agree with Anderson’s position and even execute strategies that support it.  As a blogger I create or synthesize content in an effort to make my firm more visible to potential customers.  My content is free and my business benefits from the new customers who find my firm by reading my blog.  While this strategy may work on a small scale, can the next generation of valuable technology companies really be built off of this principle?  I don’t think so.  As Marc Andreessen noted in an interview with CNET’s Rafe Needleman “The problem is that there aren’t valuable companies being formed. And there never have been,” Andreessen continues. There are, he says, on average 15 tech companies launched a year that will ultimately do $100 million a year in revenues, and these companies are responsible for 97 percent of the returns in the venture industry overall.”  Can you build a $100 million company off of free?  Malcolm Gradwell made a rather prescient point in his review of Anderson’s book:

“When you let people upload and download as many videos as they want, lots of them will take you up on the offer. That’s the magic of Free psychology: an estimated seventy-five billion videos will be served up by YouTube this year. Although the magic of Free technology means that the cost of serving up each video is “close enough to free to round down,” “close enough to free” multiplied by seventy-five billion is still a very large number. A recent report by Credit Suisse estimates that YouTube’s bandwidth costs in 2009 will be three hundred and sixty million dollars. In the case of YouTube, the effects of technological Free and psychological Free work against each other.

So how does YouTube bring in revenue? Well, it tries to sell advertisements alongside its videos. The problem is that the videos attracted by psychological Free-pirated material, cat videos, and other forms of user-generated content-are not the sort of thing that advertisers want to be associated with. In order to sell advertising, YouTube has had to buy the rights to professionally produced content, such as television shows and movies. Credit Suisse put the cost of those licenses in 2009 at roughly two hundred and sixty million dollars. For Anderson, YouTube illustrates the principle that Free removes the necessity of aesthetic judgment. (As he puts it, YouTube proves that “crap is in the eye of the beholder.”) But, in order to make money, YouTube has been obliged to pay for programs that aren’t crap. To recap: YouTube is a great example of Free, except that Free technology ends up not being Free because of the way consumers respond to Free, fatally compromising YouTube’s ability to make money around Free, and forcing it to retreat from the “abundance thinking” that lies at the heart of Free. Credit Suisse estimates that YouTube will lose close to half a billion dollars this year. If it were a bank, it would be eligible for TARP funds.”

The Dot Com Bubble collapsed when the cold hard business reality of the limitations in the Dot Com business model became painfully apparent.  As Wikipedia so elegantly notes:

“A canonical “dot-com” company’s business model relied on harnessing network effects by operating at a sustained net loss to build market share (or mind share). These companies expected that they could build enough brand awareness to charge profitable rates for their services later. The motto “get big fast” reflected this strategy.[3] During the loss period the companies relied on venture capital and especially initial public offerings of stock to pay their expenses. The novelty of these stocks, combined with the difficulty of valuing the companies, sent many stocks to dizzying heights and made the initial controllers of the company wildly rich on paper.

. . . The bursting of the bubble may also have been related to the poor results of Internet retailers following the 1999 Christmas season. This was the first unequivocal and public evidence that the “Get Rich Quick” Internet strategy was flawed for most companies. These retailers’ results were made public in March when annual and quarterly reports of public firms were released.

By 2001 the bubble was deflating at full speed. A majority of the dot-coms ceased trading after burning through their venture capital, many having never made a net profit. Investors often jokingly referred to these failed dot-coms as either “dot-bombs” or “dot-compost” or dot-shells.”

While Anderson’s overall theory is interesting, “Free” will never be the road to building viable, sustainable, and valuable technology companies.  I hate to be old fashioned, but great technology companies like Cisco, IBM, Oracle, HP, SAP, Microsoft, Salesforce.com, and even Google are built by creating outstanding products and services that deliver sustainable economic benefits for their customers.  Twitter is perhaps one of the best poster children for Anderson’s theory.  Twitter give its service away for free and incurs significant costs – in terms of SMS delivery fees and their own data center operating expenses.  While I love Twitter and appreciate what a game changing platform it is, I’m not sure it will ever become as valuable as the boring old tech stocks that dominate the market today.  Boring old database and ERP provider Oracle, for example, has generated over $23 billion in revenues and $9.8 billion in EBITDA in the past 12 months.  Wall Street has rewarded Oracle with over a $100 billion enterprise value.  I am willing to bet any takers that in five years Twitter, as an independent business, will not be generating even 1% of Oracle’s revenues, profits, or enterprise value. 

An Interesting Postscript

In researching this post, I came across a fascinating article written by Waldo Jaquith in The Virginia Quarterly Review entitled “Chris Anderson’s Free Contains Apparent Plagiarism.”  To quote Waldo:

“we have discovered almost a dozen passages that are reproduced nearly verbatim from uncredited sources. These instances were identified after a cursory investigation, after I checked by hand several dozen suspect passages in the whole of the 274-page book. This was not an exhaustive search, since I don’t have access to an electronic version of the book. Most of the passages, but not all, come from Wikipedia.”

Chris Anderson did respond to the author’s inquiry about the plagiarism:

“Anderson responded personally to a request for comments about how this unattributed text came to appear in his book, providing the following remarks by e-mail:

All those are my screwups after we decided not to run notes as planned, due to my inability to find a good citation format for web sources…

This all came about once we collapsed the notes into the copy. I had the original sources footnoted, but once we lost the footnotes at the 11th hour, I went through the document and redid all the attributions, in three groups:

  • Long passages of direct quotes (indent, with source)
  • Intellectual debts, phrases and other credit due (author credited inline, as with Michael Pollan)
  • In the case of source material without an individual author to credit (as in the case of Wikipedia), do a write-through.

Obviously in my rush at the end I missed a few of that last category, which is bad. As you’ll note, these are mostly on the margins of the book’s focus, mostly on historical asides, but that’s no excuse. I should have had a better process to make sure the write-through covered all the text that was not directly sourced.

I think what we’ll do is publish those notes after all, online as they should have been to begin with. That way the links are live and we don’t have to wrestle with how to freeze them in time, which is what threw me in the first place.”

Maybe there is a real cost to ‘Free’ after all.

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