The Emergence of the ‘Freemium’ Market
A new type of market structure is needed to explain a zero or marginal cost, technology-delivered services market. The answer is a freemium market structure. As the name suggests, services offered via a freemium model are segmented into “free” and “premium” offerings. With essentially zero costs for serving additional customers, there can be a significant amount of entry into a freemium market once technology and programming costs have been met. The successful freemium product seller survives by offering free products and services that create a sufficiently large market base. A fraction of that customer base is then upsold to premium products that contain differentiated value offerings.
The ability to sell internet-based products and services has made freemium markets more pervasive. For example, by using a PC, Skype users can make unlimited calls at no charge without buying a separate phone. Skype derives revenues largely from users making calls to non-PC-connected telephones. As of mid-2010, Skype had 560 million registered users, including about 8 million revenue-producing customers.
Skype was sold to Microsoft for $8.5 billion earlier this year, even though less than 2 percent of its users generate revenue for the company. It should be noted that Skype depends on network effects for its growth. Skype used the free offering to achieve critical mass, then relied on its premium offering to provide profitable services to its user base.
It's easy to see that service providers in a freemium market face a twofold challenge:
- to segment customers and services between the free offerings and those commanding a premium; and
- to establish alternative business models where a broad, free customer base is used to generate revenue from other customers.
For the enterprise, the vast majority of users will be satisfied with the value offered by products in the free part of the product continuum. The “art” will involve developing customer acquisition processes that encourage users to migrate into the premium portion of the project range. It's reasonable to expect that only a small portion of a company’s free product customer base will also buy its premium products.
From a business perspective, competition in providing freemium products will eventually drive the price of such products to zero (marginal revenues will equal marginal costs). Targeting niche value sources for this free product customer base will allow firms to extract profits from sales of premium products. The existence of the free version effectively provides consumers with an opportunity to sample offerings in a product category with no purchase risk — i.e., no transaction costs, no substitution costs in switching from incumbent services, no training costs and no significant time investment in this sampling process.
The ideal situation for freemium marketers is to introduce consumers to their products, then use those relationships to educate them about the additional value available from premium offerings, encouraging a fraction of the consumer base to pay for this added value.
The evolution of the freemium market assumes that technology will drive competition and erode excessive profit areas. This process is already happening pervasively across many information-based products and services. As more and more consumer product areas comingle with the internet, the freemium market structure will increasingly become the norm for technology-delivered services.
Companies will need to adjust quickly to selling in a freemium market in ways that don’t apply in any other single economic market structure. Here are two factors to consider:
- product switching costs become zero, creating the potential for high customer churn rates; and
- consumers will shun transactions that aren't effortless.
Amazon Kindle owners buy more books than they would otherwise despite little or no price advantage over hard copy equivalents ostensibly because the transaction costs of buying a book — time, effort and confidentiality — have been dramatically reduced.
A constant process of product innovation will be required. Today’s differentiating feature will either be fleeting in value or absorbed into the next product generation’s standard (free) offerings.
Douglas P. Handler is a manager with the Global Economics & Research Practice, Innovations Group of the Cisco Internet Business Solutions Group. Douglas can be reached at email@example.com. Joseph Bradley is senior director of economics and planning at Cisco Internet Business Solutions Group. Joseph can be reached at firstname.lastname@example.org.