This sounds like a crazy question, after all, is there anything simpler than giving things away for free? In fact, there is another question hidden behind: Why do I want to give things away for free? Why giving things away for free will determine how one should give away things for free.

Then why would a business want to give away things for free?

The answer is that the future demand for a particular good depends on whether the consumer is using this good in the current period. There are several reasons why current usage will determine future usage. The most common reason is “experience goods” that is, before trying this good, the consumer has no idea how good and how useful this good is. The rational motivates giving away samples for new products.

The second reason is network effect. For example, LinkedIn is only useful if there are many professional on this platform. However, if one charges a price to every professional, many professional will simply refuse to get on the Platform. By offering free basic services to all professionals, LinkedIn is able to increase its base dramatically. 1

The third reason is addiction. I will delay the discussion in the specific example later.

With so many reasons to give things away for free, why would anyone not give things away for free? Duh, because blindly giving things away for free actually decreases consumers’ willingness to pay, which is the opposite of our goal. Even a temporary free giving-away might anchor consumers’ expectation. This has two consequence. It lead to stronger resistance when the firm transitions to paid services; It incentivize consumers to delay purchase and wait for free offers (eg. sales and discounts). In other words, it could self-canabalizing. I for example, whenever purchasing on Amazon, would look at its price trajectory, and figure out that I can expect that Amazon will discount it to price x with 90% confidence. I will set up an automatic alert when the price on Amazon does fall to or below x.

My favorite example of giving things for free is Dropbox. Let us start with the basic. It is a freemium business, except it is different. Users are given some free space account when they sign up. The amount of free space is fixed, only nominally.  The capacity of the first disk drive, the IBM 350 disk storage unit, is only 3.75MB. The typical hard disk we use today, is probably around 1TB.2 This is a a quarter million to one change, and mirrors the inflation of file size we experienced. I still remember those days in middle school when I would use a 3.5-inch floppy disk, which has accomodates about 1.5MB. Today, even if it is still compatible with my computer, I would find a floppy disk completely useless, because the real 1.5MB has been “inflated away”. It is fair to say, in real terms, Dropbox is chipping away the size of free space every year. By inflating the free space away, it avoids the thorny problems of generating resistance or at least annoying consumers.

There is also wisdom in continuously and slowly inflating size away. When the size of free space is reduced in one stroke, one will have more incentive to find alternative storage services; however, when the consumer find himself just slightly above the limit every month or so, that incentive is greatly reduced, similar to the “boiling frog” story.  In addition, the asynchrony of hitting the limits among users poses a challenge to coordinate migrating to alternative platform.

What really brings my attention to Dropbox is actually an email from them, informing me due to a technical problem that have affected me (I was not even aware of it), they are giving me one year of Dropbox Pro for FREE, that is 1TB for free for one year:

We apologize for any inconvenience this may have caused. To thank you for bearing with us, we’re giving you Dropbox Pro for free for one year starting today, October 10, 2014. If you have any questions, please reply to this message or email us at selectivesync@dropbox.com. We’re here to help.

This is excellent, maybe for me, but definitely for them. For one thing, they made it clear this is just a compensation, so it avoids anchoring consumers’ expectation in any way—it is just my lucky day. More importantly, it could potentially convert me from a free riders to a paid customer. Here is why. First, the technical problem was Selective Sync. It is reasonable to expect that whoever uses that function derives more value from an average user and probably deal with larger data files. Good targeting. Second, addiction to a service is present here. There is a Chinese saying “It is easy to transition from a poor life to a rich one, but the reverse is much harder”. There is some psychological cost to transition from knowing no limits to living under stringent limits. This cost, is often unanticipated by consumers.

Beyond the psychological aspect, there is a more rational or orthodox source of addiction.  It might seem weird to talk about addiction to an IT service/product, but it is very relevant in this area. Let me take the least consumer-facing product–VMware’s ESX, a hypervisor technology. Swapping out ESX for alternatives are exactly hard, but many companies use the management tool designed for ESX, and they build their operations around that. These are the real switching costs.3 Dropbox is no different. When one is granted free access, the natural response is to use the heck out of it, after all, he reasons:”I probably will never get as lucky”. He figures out all the bells and whistles of using Dropbox, what a fun! Dropbox is after all an extremely useful service, and everyone can find so many uses of it. From my perspective, I might want to use it to collaborate with other people on research. Imagine one year later, my pro service is over.  I still have a couple of collaboration in progress. No, I cannot leave Dropbox. How could I propose to my collaborator that we find an alternative despite its great performance and just because I am a cheapo? The bottom line is it is very hard to switch collaboration platforms. There is a psychological aspect to it: people tends to overly discount the future cost (of moving their files away and switching to another sync service when their account expire) vis-a-vis the utility they gain from using Dropbox in the current period (a phenomenon known as time inconsistency). In other words, I would think to myself that I will simply move all my files back to hard disk when my pro service expires, but when the time comes, I will instead choose to pay for continued pro service. This problem is exacerbated by the fact that people on average tend to underestimate the cost of making the transition back (planning fallacy).

I had to say, it is a most brilliant move. I am very impressed. The only sad ending to the story is that: knowing my time-inconsistency problem, I am not taking advantage of the free offering. I am only using 0.6% of the 1TB.4


1 In this example, free basic services is a permanent feature for LinkedIn, but one can imagine a platform only provides free service during mobilization stage. For example, google search offered ad-free search in the beginning and then incorporated ads when it became dominant. In some sense, google started to charge us in terms of “attention fee”.


3 http://en.wikipedia.org/wiki/History_of_hard_disk_drives

 


3 Yoffie, David, Andrei Hagiu and Michael Slind, “VMware, Inc., 2008,” HBS No. 9-709-435 (Boston: Harvard Business School Publishing, 2010), p.15


4 If this surprises you, here is a even more surprising story. In sophomore year, I was lucky to get a dingle—a double dorm room occupied only by me. What I did? I limited myself and belongs to only half of the room (using bookcase and bed to block my use of the other half), so that I 1)will not accumulate too many belongs that I have to get ride of later 2)will not get used to having a huge room and face the difficult transition of being confined to a much smaller room the next year.

 


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I like getting stuff for free. I think most people also like free stuff. To paraphrase Professor Edelman, if you want people to use your product, make it look free. The internet has made it even easier to get stuff for free, as consumers. Some companies make money by giving away free products and services to customers and then charging some customers for add-on features, advanced functionality, virtual goods and/or premium services. This business model has been dubbed “freemium” – a term combining “free” and “premium” – by Fred Wilson, a notable venture capitalist and blogger in 2006. Many of us now associate this business model with companies like LinkedIn, which charges customers for premium accounts or additional features such as messaging un-connected contacts. Another notable example is dropbox, which gives users a limited amount of free storage and then charges for additional storage. While this business model has become very popular in the most recent generation of internet companies, it has been in use in the software industry since the 80’s, when “lite” software (limited feature) was given away on floppy disk (or preinstalled on computers) for free to promote advanced paid versions. This is not to be confused with free-to-try business model where full versions are given away for a limited period of time and then require payment to continue to use.

Freemium has been a successful business model for software for a number of key reasons. First, the marginal cost of serving an additional customer is equal to or near zero. Because infrastructure costs (storage, computing, bandwidth, etc.) have decreased significantly, once a product has been developed or new features released, there is very little marginal cost. Secondly, customers are fundamentally attracted to the idea of free and will try nearly anything because they have “nothing to lose”, which does not account for the value of time. Assuming the product is actually useful and creates value for the customer, adopting a freemium model can greatly accelerate user growth. Specifically in software applications, integrating data and being compatible / integrated with other applications increases switching costs for the customer, making the app even more sticky. For these reasons, many companies have successfully adopted the freemium model as a strategy for quick growth and user adoption. Dropbox grew from 0 to 50 million users in less than 3 years.

To the extent that the economics work out profitably varies dramatically across companies, products and customers. One thing is certain, to be sustainable, the free to paid conversion rate and lifetime value of the customer must be greater than the cost to serve all customers. On its surface, the relatively straightforward economic formula should be very clear for any entrepreneur, executive or investor to understand the sustainability of a freemium business. How one thinks about a few key questions will define whether freemium really works:

  1. Who is the buyer? It’s not uncommon for the person making the decision to pay or not to be a different person than the end user. For example, enterprise software where the buyers are IT professionals, but the users are other workers in the company.  Understanding both the user and the buyer is critical.
  2. What is features will be free and what will be paid for? Seems simple, but there’s a delicate balance between creating value for the user, the costs associated with developing and delivering each product / feature and providing significant value for the buyer.
  3. How much do you charge? Not to be confused with how much you can charge. Maximizing the value you create and capture depends greatly on how much value customers derive from the product and how sensitive they are to paying for it.

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Ever since my friend referred me to Dropbox, I’ve been an avid fan. The simplicity of “dropping” your files in a folder is painless and convenient. Their motto, “it just works” make file transfer transparent through different platforms (mobile, desktop, tablet) and operating systems (Android, Windows, Mac, Linux). I can easily share files with friends at a click of a button. The simplicity of Dropbox to the end users has made it a viral hit. With over 50 million users and greater than $4B evaluation, Dropbox has gained momentum from its users and its investors…

 Now Goliath, aka Google, has entered into this space, offering Google Drive, a service that matches or exceed’s Dropbox’s technical capabilities. Google Drive offers more free storage, cheaper paid storage, better user security, integrated search, forever deletion recovery, and document collaboration.  With Google drive’s impressive list of features, Dropbox can no longer compete on its simplicity of use.  In fact, when examining Dropbox’s network effects, simplicity of use actually lowers its multi-homing costs. I could easily switch over to Google by dragging the files from Dropbox. I can also just as easily invite my friends over to Google Drive. The costs of switching is so low, it takes minutes to make the transition.

 Google drive’s improved features and Dropbox’s low multi-homing costs is cause of concern, but is it a winner-take-all market? Does this industry have the three major characteristics? 1) strong network effects 2) High multi-homing costs and 3) limited demand for differentiated products? Looking at Google’s offering, there is a strong case. They have converted all their Google doc users into Google drive users. Not only can you edit your Google docs, but now you can store and share other files. With a user base of 350M as of January 2012, Google has now surpassed any first mover advantage Dropbox has built. If users wanted to take their Google docs over to Dropbox, they will find that they cannot edit the proprietary document. In this manner, Google has increased the multi-homing costs. On a side note, Google has approached this by providing standalone value for its customers. New users feel comfortable since it is a compliment to an existing service. The third criteria, limited demand for file-sharing services, indicates that Google may be positioned to take the entire market.

 Steve Jobs argued that Dropbox was a feature and not an independent product. For a while, Dropbox proved him wrong and build a full-fledge product. With Google Drive’s integration of file sharing as a feature to Google Doc, it will be interesting to see if Steve was right all along. As much as I had to admit it, David will have a difficult time taking on Goliath.


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