The economics of free – and how they might change everything

My friend Alexis pointed me this morning to an awesome Wired article by Chris Anderson, author of The Long Tail. I’ve seen him speak a couple of times now and following his obsession with the long tail he is now focused on the impact of ‘free’ – which I think is having some far reaching implications.

There has been a lot of talk about free sites and the importance or otherwise of having revenue models, including a post here on The Equity Kicker in Jan titled Prioritising traffic over monetisation. This is also directly relevant for the recent conversation on music business models.

The focus of much of the debate has been on the right time to start thinking about monetisation. Chris Anderson takes a totally different tack – making arguments that everything is headed towards free anyway.

The article is a 6,000 word preview of his new book Free, and itself carries the title Free! Why $0.00 Is the Future of Business. If you have time read the whole thing – if not these excerpts and this post generally will give you the gist what is for me the main argument.

First some microeconomics:

It’s now clear that practically everything Web technology touches starts down the path to gratis, at least as far as we consumers are concerned. Storage now joins bandwidth (YouTube: free) and processing power (Google: free) in the race to the bottom. Basic economics tells us that in a competitive market, price falls to the marginal cost. There’s never been a more competitive market than the Internet, and every day the marginal cost of digital information comes closer to nothing.

We have known this about content for some time, but it is now increaasingly true for content delivery as well. To repeat in a competitive market, price falls to the marginal cost. For most web services that means zero. Pretty much full stop.

That doesn’t mean zero revenues though, just that the consumer doesn’t pay directly. Advertising is a big part of the story, but not the only part. You need to move to revenue models based on ‘because of’ rather than ‘with’ to borrow a concept from JP Rangaswami. (In fact when I surf to his blog the lead post is about the economics of abundance, artificial scarcity and the Because Effect.)

In a nutshell you make money selling things people buy because of the thing you have given away for free. Bands give music away so people come to their concerts.

How this works on large scale consumer sites still needs to be worked out however.

For Chris the implications go way beyond questions of monetising web sites:

anything that touches digital networks quickly feels the effect of falling costs. There’s nothing new about technology’s deflationary force, but what is new is the speed at which industries of all sorts are becoming digital businesses and thus able to exploit those economics. When Google turned advertising into a software application, a classic services business formerly based on human economics (things get more expensive each year) switched to software economics (things get cheaper). So, too, for everything from banking to gambling. The moment a company’s primary expenses become things based in silicon, free becomes not just an option but the inevitable destination.

In fact free is becoming so pervasive that parts of the internet are eschewing money (almost) altogether. Chris calls this a ‘gift economy’, and this is in some ways a return to a culture that existed in the tribes anthropologists were studying when they coined the phrase. Wikipedia is the largest and most pure example, but Craigslist and many user groups are very similar.

What does all this mean?

I guess at a minimum we can expect the current confusion around revenue models to persist for some time and at the maximum new forms of economics will be required. More practically, this confirms my view that for web startups building audience is more important than building revenues. Moreover innovation around free business models and monetising by bringing third parties to sites in ways other than straightforward advertising could be lucrative. Back to ‘because of’ rather than ‘with’.

I await further installments of the book with eager anticipation.