There's an old joke about a businessman who gives away his products. A customer asks: How do you make money doing that? He answers: I make it up on volume.

It's nonsensical, yes. But a funny thing has happened: Giving away
the product has become a legitimate business model on the Internet and
even beyond. And it's been getting increased attention. Author Chris
Anderson will publish a new book in July titled, Free: The Past and Future of a Radical Price. It's a follow-up to his Wired magazine cover story last year, Free! Why $0.00 is the Future of Business. Anderson, the editor of Wired and a former Economist reporter, also wrote the 2006 book, The Long Tail, in
which he observed how companies such as and Netflix were
thriving by offering gigantic catalogs of products that each sell in
small quantities. Today, those companies are among the few thriving
through a recession.

Anderson isn't alone in exploring what has been dubbed
freeconomics. Venture capitalist Fred Wilson of Union Square Ventures
popularized the term freemium to describe an emergent business model
-- popular among online service and software companies -- of acquiring
users en masse with a free offering but charging for an enhanced version in hopes of subsidizing the free usage.

Even businesses that aren't about to give away the store can benefit
from an understanding of the forces behind freeconomics by
re-imagining old models of charging for their products and services.
Technologist Jeff Jarvis, in his new book, What Would Google Do?
wonders if there's a revenue-generating free model for automobile
makers. Could automakers adopt the Google model and give away
advertising-supported cars? Once you accept that price need not be tied
to the cost of production and begin thinking creatively, new
possibilities can emerge -- even for offline products, says Kevin Werbach,
Wharton professor of legal studies and business ethics. There's no
fundamental reason why gasoline couldn't be free and you would pay an
annual fee for usage of your car, Werbach says. Similarly, there's no
reason that cars couldn't be free and you would pay a service fee for
gas. Neither of those models makes much sense in the market place
today, but why not? 

According to Werbach, a startup manufacturer of electric cars,
called Better Place, is looking at making its cars available at a low
price and charging for new batteries, just as printer manufacturers
offer low-cost printers and put a hefty price on ink cartridges.
People look at it like it's crazy, but if a car is part of an
integrated ongoing service, then there's no fundamental reason to
allocate the price one way or another.

But what is really new here? After all, free has been around probably since the beginning of business, says Z. John Zhang,
a Wharton marketing professor who has authored books on pricing
strategy. You go to a supermarket and they give you free samples and
then you buy a whole box. Some bars let women go in for free and they
charge the men. 'Free' is one of the most powerful words in marketing.
It truly motivates people. If you see 'free,' even if you don't want
it, you're going to get it. Marketers will take every opportunity to
use that word.

Bending the Demand Curve

Indeed, the appeal of free has been shown to be so extraordinary
that it bends the demand curve. The demand you get at a price of zero is many times higher than the demand you get at a very low price, says Kartik Hosanagar,
a Wharton professor of operations and information management who
studies pricing and technology. Suddenly demand shoots up in a
nonlinear fashion. Josh Kopelman, a venture investor and entrepreneur
who founded, has written about what he dubbed the penny gap.
Even charging one cent for something dramatically lessens the demand
[generated at] zero cents.

It's no surprise that many companies have worked free into their
offers in a number of different ways. Cosmetics are never on sale.
They say, 'Buy this at regular price and get a free gift.' That
protects the normal price, says Wharton marketing professor Stephen J. Hoch.
Adobe gives away its Adobe Reader software for displaying documents
that use the company's PDF electronic document format, but charges
corporations for the Adobe Acrobat software needed to create the
documents. If you charge for both, the software will never take off,
states Hosanagar. 

Of course, products and services offered for free aren't really
free; they're just paid for in another way. Cross-subsidies have been a
selling strategy for ages, the classic example being Gillette's move a
century ago to sell razors cheaply to create demand for expensive
blades, long before printer makers adopted a similar strategy with
printers and their supplies. 

Then there are two-sided markets, which derive revenue from two sets
of customers. In those, whichever side is more price inelastic [less
sensitive to price changes], that's the side you want to charge more
[for], says Zhang. In the case of Ladies' Nights, he says,
establishments may increase overall revenue by letting women in for
free to attract more males -- who are price inelastic in that their
desire to be there will not be greatly affected by entrance price. 

Newspapers traditionally have charged readers as well as the
advertisers who want to reach those readers. For years, however, some
types of publications have been given away to readers for free, with
publishing costs supported by advertisers. But the profusion of free
content online has made reader demand extremely elastic -- suddenly
sensitive to any price above zero -- and many publishers are fumbling
with revised models, including cross-selling. The Wall Street Journal, for example, now sells wine to readers at, Zhang notes.

What's new, of course, is the Internet, which makes the marginal cost
of delivering one more product close to zero. As Anderson explains in a
February Wall Street Journal
article, Digital goods -- from music to Wikipedia -- can be produced
and distributed at virtually no marginal cost ... making price a race
to the bottom. Add in easier sourcing online of cheap products and
materials, and the Internet means cost is evaporating from the system
and opportunities for free offers have exploded.

Beyond minimizing distribution costs, the Internet has fostered
other distinct trends that have pushed prices and consumer expectations
toward zero. Two-way markets become more sophisticated online -- Google
is able to offer web searches for free by matching advertisers to what
people appear to be seeking: Search for cars, get some car ads. Some
of these transactions could not be done before, because transaction
costs for matching an advertiser with a consumer were too high, says
Hosanagar. This has inspired online firms, such as Google, Yahoo and
Facebook, to take advantage of the nonlinear allure of free to build
giant audiences in hopes of future revenues, even in cases where
revenues from ads or other sources are not covering the cost of the
free service, says Hosanagar.

Other factors also have been at play. On the web there's little
financial barrier to set up a store, an information site or blog, and
compete with established players who may have high fixed costs and
brick-and-mortar investments. This easy entry into markets has played a
role in creating what BusinessWeek called the free-labor economy. People are putting together elaborate and sometimes useful sites at no cost other than time. Simultaneously,
digital technology has enabled easy copying of copyrighted materials --
music, movies, photos and news articles -- that are or were products of
traditional industries. The result of all this has been a change in
consumer expectations. A culture of free has emerged -- there are a
lot of things for which people simply don't expect to pay. Forced to
compete against free offerings -- in some cases from competitors
churning through investors' money to aggregate eyeballs and hoping to
sell out without necessarily making a profit -- old-line businesses
have suffered.

Consumers' sense of entitlement to free content online has had
catastrophic effects -- meaning both large and quick -- that I don't
think anyone would have predicted, says Hoch. It's had a yet unknown
catastrophic effect on the news. It's had a catastrophic effect on
music. Clearly the concept that you can make it up in volume is bogus,
because you can't. Music CD sales have gone from $13 billion in the
U.S. to about $7 billion since 2001 while legal digital downloads
generated about $1.5 billion in sales. 

Newspapers and magazines, saddled with high fixed costs and high
distribution costs, have been hit by both the free culture online and
the ease with which their product -- which is costly to produce but
easy to copy and paste -- is hijacked by free sites put together by
unpaid bloggers. Most papers have resorted to offering their content
for free, but online ad revenues alone have not covered their high
fixed costs. A February Time magazine cover story by longtime
print journalist Walter Isaacson titled, How to Save Your Newspaper,
takes on the threat of freeconomics squarely. This is not a business
model that makes sense, Isaacson writes. He suggests newspapers figure
out how to protect their intellectual property and charge readers real
money to consume it.

Zhang agrees: Right now, newspapers are doing things that level the
playing field, bringing themselves down to the level of lower-quality
competition. They should move to the high-end and exploit their
advantages and distinctions. Isaacson advocates for a system that
makes it easy for readers to pay small micropayments online for the
articles they view. But that's easier said than done. The sort of
online micropayments Isaacson and others advocate have a poor track
record, in large part because the psychology of the penny gap is hard
to overcome. It's especially difficult because people have come to
expect a vast selection of no-cost news online. The last thing you
want to do is get people addicted to free. If you're going to go free,
you ought to expect that it is going to be the price forever, says
Hoch. If you're going to be a low price seller, he adds, you sure as
hell better have low costs.

More Software Apps, Fewer People

The effects of the free culture online have had a hard impact on
offline businesses. Many jobs once done by people are turning into
software applications, Anderson says. Your cranky tax accountant has
morphed into free TurboTax online, your stockbroker is now a trading
web site and your travel agent is more likely a glorified search

Google has used profits from web-search ads to finance moves into
other free online applications, confounding competitors who had grown
accustomed to charging money for similar products. Google Docs, a free
suite of office applications (word processor, spreadsheet, etc.)
competes with software for which Microsoft normally charges hundreds of
dollars. Microsoft has been forced to respond by promising that free
web versions of its software suite will be available in the future.
There can be a situation where, fundamentally, the amount of money in
the system changes, says Werbach. That's not great news for companies
with fixed costs to meet, such as payroll.

Companies have experimented and struggled with a wide spectrum of
pricing strategies. Some see hope in the freemium model, giving away
a basic version of a product, but charging for premium features. Yahoo
lets tens of thousands of fantasy football players participate in its
online leagues for free every season, then lures them into paying for
real-time game statistics or player scouting reports. Every tax season,
companies -- including H&R Block and Intuit -- offer free basic
online tax filing, but charge for more complicated returns. Newspaper
web sites have grappled with the question of what content to give away
and what to lock up in areas that readers must pay to see.

Some businesses have been especially creative. In 2007, the rock band Radiohead offered its album In Rainbows
as a download for a pay what you want price. Research firm ComScore
estimated 38% of people downloading the album paid an average of $6. A
later release of the album as a physical CD sold more copies than the
band's prior two CDs. 

A business needs to adapt its revenue models to new technology,
says Zhang. Not everyone can compete against free, but there are still
creative ways -- more ways now than ever -- to employ the strategy.  

The problem is in thinking the business model of your industry is
ordained forever, says Werbach. Business isn't static, and it's less
static today than it's ever been. The great challenge the Internet
poses is that it makes it possible to very quickly shift the allocation
of money in certain industries. It's not easy to go through that kind
of transformation, but that's life. Successful companies are the ones
that appreciate that.