I’ve been reading devouring Predictably Irrational, in which “beehavioural” economist Dan Ariely explores the ways in which consumers behave irrationally (or emotionally) in response to economic forces. Amongst other things, he shows how and why “free” is something very different to something worth zero dollars, because it elicits powerfully irrational behaviour in even the most rational of us. To understand what this means for web businesses we need to take a step back into history.

The First Internet Age (1996 – 2001) established the practice of providing free internet services to consumers. Whether it was search results, movie reviews or dial-up internet access, the model was essentially the same: provide the consumer with a free service in return for exposing them to online advertising. Get enough consumers to view enough ads and you can make a healthy profit, as long as you keep your costs low. In the first Internet Age, however, it cost too much to build a web platform, establish a large online audience and then persuade marketers to try online advertising, and many startups failed when the venture capital funding these costs was withdrawn.

At the beginning of the Second Internet Age (2003 – present) new web development tools allowed a startup to build a new web platform with not much more than the available credit on a couple of credit cards. There still wasn’t much hope of luring big marketers to spend with them on online advertising, but it would take fewer online marketers to make a startup profitable because of the lower platform costs. That credit card wouldn’t stretch to hiring the expensive VP of Ad Sales you’d need to get advertisers onboard, so many startups decided to work on acquiring a large audience first, continue to keep costs low, and try to solve the revenue problem later.

When the venture capital industry was again ready to invest in internet startups, things got a little out-of-hand: quickly the industry moved past rewarding startups that were focused on acquiring a large audience and towards rewarding startups that neglected revenue. People were proud, cocky, even arrogant about building a product that serviced millions of consumers for free without having made any progress towards finding a way to make money from it.

That all came to a grinding, lurching halt with the GFC. No professional investor will now invest in an early-stage startup without a revenue stream. Early-stage investment money is still out there for startups that meet the new criteria, but the criteria have changed: now it’s all about making a little revenue from every new customer, right from day one. That’s OK if your startup is still on the back of an envelope, but what about all the hundreds of thousands of post-money startups in the industry, caught between funding rounds, servicing customers, paying salaries and battling competitors?

Think turning your business around 180 degrees from audience-first to revenue-first in the midst of a recession is challenging? Here’s the bad news: Dan Ariely’s research shows that for most of us, it will be impossible.

The dangerous power of “free”

In Predictably Irrational, Dan Ariely describes a series of experiments where a premium chocolate and a small, cheap chocolate are offered to test subjects, where the premium chocolate is offered at a higher price to the cheap chocolate. After repeating the offer hundreds of times, a clear ratio of about 70% chose the premium product and 30% chose the cheap product. Increasing the cost of both products by the same amount, or lowering the cost of both products by the same amount has no effect on that 70/30 ratio… until, that is, the two are discounted so that the cheap chocolate is now free. It shouldn’t affect the ratio of purchasing — the two chocolates still have the same relative price — but it does, dramatically so: now the free chocolate gets 70% of the orders and it is the premium chocolate only getting 30% of the buyers.

Ariely identifies what he calls “the fear of loss” as the motivating factor. Every transaction has an upside and a downside: we must balance the reward of making the right transaction (I bought a BluRay DVD player and not a HD DVD player) against the risk of making a bad transaction (I paid too much for a Windows smartphone and I only ever use it to make calls anyway, I should have just kept the phone I already had.) When we’re offered something for free, the risk of a bad transaction suddenly evaporates — no matter how inappropriate the goods or services I now have, they didn’t cost me anything — I’m still ahead.

According to Ariely, being liberated from the fear of loss elicits such an emotional reaction that we will often act irrationally when offered something for free — buying more socks than we need just because for every two pairs we get a free pair, or queueing up for 30mins just to get a free ice-cream cone, or staggering home from a conference with a showbag full of crappy pens, ugly coffee mugs and horrid t-shirts that will never see the light of day again.

Are you trapped in free?

So here’s our problem: in the Second Internet Age, we’ve all been giving services away for free because asking consumers to pay was just an unnecessary barrier to growing an audience, and because nobody expected us to focus on earning revenue until later. Now the times have changed and we need to get consumers to pay for services they’ve been using for free. We know it’s going to be hard, but Ariely tells us it’s going to be next-to-impossible. The irrational consumer response to “free” means that even if one of your competitors is still offering a similar product for free, consumers will strongly resist paying even one cent for your product. You can offer a significantly better product, perhaps as much as twice as good in the minds of the target consumer, and they will still stick with the free product.

You not only have to change your own business model but that of all the players in your market segment to move from free to paid services. For those of us with both a limited free version and a full-featured paid version, your biggest, most intractable competitor (with the most loyal customers least likely to switch) is your own free version.

The good news: if you’re truly new, any price will do

Was there any good news in this book? Thankfully, yes: Ariely proves as well as anyone can with scientific method that market pricing is always arbitrary, relying much more on a consumer’s prior exposure to prices for similar services than for anything to do with supply and demand economics. In other words, if you’re building something entirely new, you can charge whatever you want for it, and consumers will “anchor” on that initial price and compare all subsequent offers to that anchored price. Set the anchor price really high, and that price quickly becomes normal, even if it’s apparent to the consumer that the cost of supply is much lower than the anchor price.

The sting in the tail? You better set it high and not low, and particularly not free, since consumers will also anchor on a low price, and almost irretrievably so on “free”. Once something is offered for free, you are much more likely to lose the customer than to persuade them to pay for it.

Go read Predictably Irrational

I’ve only scratched the surface of Ariely’s book in this blog post, you really should subscribe to his Predictably Irrational blog and buy his book for yourself. He has recommendations there for how to get yourself out of your free conundrum and how to exit gracefully from a social transaction-based relationship with customers. Though if you’d like to skip the research and get straight to work on solving the problem, you need only to talk to us at Pollenizer!

(by Material Boy on Flickr)

A video taken at Barcamp Sydney 5 of me talking about my thoughts on Freemium

Freemium?

Free + Premium = Freemium. It basically means that you offer your product for free to begin with, get users hooked and then charge a small % of your audience a premium fee for premium features down the track. This lowers friction in acquiring customers; you’re not limiting growth by adding a payment system or even hinting that people might have to pay at some point. Free means people can check you out, kick your tyres, grow to love you and never leave. Or that’s the idea.

Free as in: not free at all

But is it really free anyway? It certainly costs in terms of time, and we know that Internet consumers move fast, scan around, try and find gold, move on. They don’t have time, so you’d better be worth checking out. There is also the mental cost of working out what you are, how you are going to help me, how I use you and why you are better than the million other options I have. Plus there is switching costs. These are always underestimated. “But I have an import tool!” It doesn’t matter. It’s the mental and risk parts of switching which are the biggest costs. Even if they are not doing anything right now, to a customer it always feels big and bothersome. So there already is a cost, and it’s bigger than you think.

Slightly better than nothing at all

The next big problem with creating a free product is that you tend to think that because it is free, it only has to be pretty good. I know we’re all proud of our products, and they work great and look good, but we almost subconsciously create free products to be worth cents each year to customers. We make them better than existing products (like email, IM, wikis, self publishing, documents) but only marginally so.

Here is a good test to see if you’ve created a ‘just better’ product. Send an email out to all users with a bill/invoice for $50 for lifetime usage. How many would pay it? What about $20? $10? Would 90% of your users not even pay $5 to keep using your product? Then they musn’t value it very highly. Josh Kopelman said it well in his tweet “Too many freemium models have too much free and not enough mium”.

(by luz from Flickr

Premiree!

What if you decided to charge money first, and then offer it for free later? If your end goal was a million customers, with 10,000 paying and the rest free, you could start by finding 100 people who were willing to pay you. Then get to 1,000. Then let in the freebies, with some cobbling of features, and grow to your 10,000 paying. I highly recommend setting out to start charging people from day one. It can really change your business.

Why go premium first?

1. It changes the way you think about your product. If you are going to charge someone even $10 for it, then they have to think it’s worth about $100 to them in value to make it worth the $10. So you set out to create something worth $100 instead of $2 CPM, probably about the amount needed to get them to shift.
2. It validates your business. You know straight away that someone will pay for it and if you’re created enough value.
   
3. It brings in revenue, very handy if you want to pay bills (even if it’s not much).
4. It makes you ‘post-revenue’ which in investor speak means you’ve earned a dollar and are now much, much more attractive. You may even make so much money that you don’t even need investment.
   
5. You only have to worry about a small customer base. It’s easier to spoil 100 paying customers with great service and awesome customer support than it is to juggle 10,000 users who don’t even love you that much. Paul Graham just supported this in point 5 here.
   

Focus Contradiction

Does building a premium product mean that you can’t be focused? Must you add lots and lots of features? Sacré bleu! Definitely not. Quite the contrary. It means that you have to be even more focused. You have to pick a starting segment that is so absolutely crying out for your product that they are willing to fork over money for a beta. They need to really need it. This is good. Go to your best customers first. They need it. And they are more likely to help you build it into something they want than someone who only wants to use it for free. These people are the lieutenants of your community. Nurture them, foster them, love them. Focus on them. Then go to the next segment.

Beta Up

The reality check on this is that in the very early stages, your product is so full of bugs and holes that not even your mother would pay for it. That’s ok. Find a few beta testers, preferably close to your first premium target market. Talk to them in person. You don’t need thousands. But tell them all from day one that you want to charge $10 for it. If they are laughing, then you’re in trouble. If they are pulling out their wallets, FTW! Also, subscription doesn’t mean that you can’t give people a low-risk way to try your product. You can offer limited-time trials, demo accounts, money-back guarantees or get more creative.

Premiree isn’t for everyone, but you should at least be asking yourself the question ‘Why not charge? I’m worth it, dammit!’