In “Premiree- More Premium, Less Free” Mick wrote that many startups hit trouble by aiming to deliver a free product and delivering something in which the value matches the price. But why do so many startups choose free as a price? What happens in a competitive market if you choose not to price your product at zero dollars? And is “free” equal to “zero dollars”? What changes in your relationship with your customers when you move from free to paid service?
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persuade marketers to try online advertising, and many startups failed when the venture capital funding these costs was withdrawn.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!