Imagine the following scenario. You have a nice little product which meets the needs of a small but profitable market. Let’s say it costs £4 to make, with costs of sales (per unit) at £1, including marketing communications, sales and so on. It sells at £10, so you walk away with £5 profit from every sale. Not bad.
Even better, the costs of production are falling rapidly, which means that you can keep your margins constant yet, as prices fall, the market expands and your total income rises. You’re on a roll – and this becomes “normal”. Lower prices continue to expand the market, which consistently delivers rising net income. You get used to it.
Then the market begins to mature so that lowering prices no longer boosts demand as it once did. Now, reducing your prices means reducing your profits too. Suddenly, your business priorities flip from how to reduce costs and prices (to grow sales and income), to how to peg prices at their current level.
Luckily, however, production costs are still falling, so even though your market is no longer growing rapidly, with stable prices your profits continue to improve.
Then the rug is swept under your feet. Some cheeky little upstart has the affrontery to offer your product for free! It happened like this. While you were busy keeping prices steady and enjoying the margin boosts of falling production costs, the economics of your industry continued to shift under your feet. Over time, production costs have fallen so low that the cost of selling the product is actually higher than the cost of making it. Reducing production costs has been replaced by a new priority: reducing market costs.
But what’s the best way to do this?Your competitor’s logic is simple and compelling. Assuming your sales costs are still around £1.00 while the cost of making your product has now fallen to say, 70p, the best way of reducing costs even further is to eliminate them by making your product free. Then it “sells itself” virally and you no longer incur the costs of cash handling (which can be considerable). Even better, your market returns to rapid expansion (thanks to the new price point of zero). Now your challenge is to attract other sources of revenue, such as advertising: your model has flipped again.
This is not a fantasy. It’s the experience of entire industries (such as music). For executives struggling to migrate their way through these tipping points it can be a nightmare.
Now consider another scenario. You are eyeing a market that you know could be huge, except your opportunity is being stifled by a formidable barrier. To reach critical mass, users have to invest upfront in expensive equipment which is way beyond the price they’re willing to pay. So you gulp hard and subsidise equipment sales, and the market takes off. The bigger the subsidy, the faster the growth, so you end up increasing your subsidy year by year.
Then (as ever) the market matures, so your subsidy no longer delivers the benefits it once did. Now, however, customers are used to this subsidy and expect it. The competitive risks of eliminating it are just too horrifying to imagine. What’s more, you’ve also managed to create a monster in the form of a grey market where people buy your product not to use it but to get the equipment subsidy – and then sell the equipment on at a market price.
Your marketing strategy seemed very clever at the time. But it’s managed to create a situation where a good share of your industry’s margins end up in the pockets of wideboys and even criminals. This is the situation the mobile phone networks find themselves in right now, with up to 50% of pay-as-you-go handset sales going to “box breakers” who are buying the product simply to arbitrage the handset subsidy.
Now consider one last scenario. You have a product which is important but which, frankly, people find boring and aren’t particularly interested in buying. So you offer it free, and find ways of recouping your costs by imposing little extra fees and charges along the way. Then you wake up to find yourself ensnared by some truly bizarre dynamics. First, you’re investing more time and effort trying to find ways to leverage those little extra charges on the side than actually making money from your core offering. Second, your customers don’t trust you. In fact, they often hate you because of the dishonest, underhand ways that you seem to treat them.
Third, even though they hate you, considering the alternatives, this remains the best position to be in. Yes, there are huge untapped opportunities for profitable growth in your industry, but you can’t tap them because they depend on much higher levels of customer trust. Meanwhile, if you root out your trust-undermining business practices your profits are bound to fall. And if you try to recoup them by charging customers for stuff they once got “free” (the product itself) you are met with howls of outrage: “even more proof of your rip-off mentality”. This is how large parts of the consumer financial services industry (current accounts, financial advice, credit cards) have evolved over the last few decades.
The two lessons
There are two lessons to be learned from these scenarios and it’s vital that they are learned together. The first is that the Web is transforming the underlying economics of any and every industry that deals in information, and that refusing Canute-like to adapt to these realities is a recipe for disaster. There really are huge opportunities for business model innovation, even if migrating to these new models is painful.
At the same time, however, “free” usually acts like a powerful drug. Like morphine to dull the pain after an operation, it can work wonders. But it also bends the marketing mind. Unless it is used very carefully, and in moderation, it obscures economic realities, distorting market signals to the point where customers no longer know the value of what they are buying (or not buying) and luring brands into addictive marketing urges they will not be able to break free from.
Right now, there is a crescendo of hype about how, thanks to the Web, the power of “free” is just waiting to be unleashed to transform markets and industries. If you believe some people (such as Wired editor-in-chief Chris Anderson), if you are not making “free” an integral part of your marketing strategy you’re a marketing has-been. Beware. Hype usually comes free. Bad marketing decisions are extremely expensive.