The idea of offering your product or a version of it for free has been a source of much debate.
Pricing is always tricky. Unfortunately, many entrepreneurs don’t give it enough thought. They will often copy the pricing strategy of similar products, base their decisions on pompous statements made by “experts” or rely on broken rationale (we worked hard so we should charge $X).
Free is even trickier and with so many opinions about it, we thought it would be refreshing to take a critical approach and dive deep into why some companies are very successful at employing the model while other companies fail. We’ve looked into economics academic papers, behavioral psychology books and strategies that worked for companies to come up with the key concepts below.
The Law of Marginal Cost
Pricing plays a huge part in competing for customers. Here’s an economic law that holds almost as much truth as the law of gravity: in a perfectly competitive market, the long-term product price (aka “market clearing price”) will be the marginal cost of production.
Guess what? Because of declining hosting and bandwidth costs, for most Internet products the marginal cost today is practically … zero.
In other words, if the cost to serve a customer (support aside) is zero, the long-term price of the product in the market will be zero (because of competitive pressure).
At the core of the “Free” models are the products or services being offered to the customer. Most Internet products or services fall into the definition of an Experience Good: a product that needs a period of use before the customer can determine the value they can derive from it.
A good example is Dropbox. Consider Drew Houston’s words: “The fact was that Dropbox was offering a product that people didn’t know they needed until they tried.”
There are plenty of academics who looked into the pricing of Experience Goods. In 1983, the Economist Carl Shapiro wrote a fascinating paper about this subject. His conclusion was that since customers tend to underestimate the value of a product, the optimal pricing for an experience good is a low introductory price which is then increased when the customer realizes the value of the product.
In some cases, a customer might overestimate the value of the product. In that case, the optimal pricing strategy is to charge as much in the beginning or to lock in customers with long-term contracts.
This is why customers are reluctant to buy when someone asks them to prepay for a service or product or sign a long-term contract.
Hence, the introductory price is a signaling mechanism. The conclusion? A low entrance price signals that you are confident that your product will create value for the customer.
The Psychology of Free
Much has been written about the Psychology of Free.
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