By: Chris Anderson

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Free. It's a magical price, and it's reshaping business as we know it.

This story starts back in 1872, when saloons started to offer "free" food to anybody who purchased at least one drink. The food ranged from sandwiches to full course meals, the cost of which were far more than the cost of the drink. The saloon owners, of course, were betting that the customers would end up buying more than drink, and develop the habit of stopping by for their "free" lunch.

This is where the term "there's no such thing as a free lunch" originated.

Around the same time, a guy by the name of King Gillette invented the world's first disposable-blade razor. He famously sold the razors (the handle part) cheaply to places like banks, who would give them away to new customers as part of promotions. Then, the problem of building a customer base solved, he sold them the replacement blades for a healthy profit, and the rest is history.

Gillette became a multi-billion dollar company, and entire industries today are based on the model that the saloons and Gillette pioneered.

It's so pervasive that you probably don't even notice it. Back in the day, free radio and television programming (supported by advertising) united everybody and created the mass market. Supermarkets offered some products at cost (like milk) to attract you to come and buy more profitable items.

But today, with the shift to a digital economy where the costs of production are falling every single day, we are ushering in a new era of "free", and you better be ready.

It's time for you to figure out how to compete with free.

Why free is so attractive - the Penny Gap

To truly understand why free is such a powerful marketing method, we need to understand the psychology behind it.

According to economist Nick Szabo, every time we are confronted with a price, our brain raises a flag. He calls this the toll of thinking. Do we really want this? What if we don't like it? Will I use it? Is this price worth it?

Behavioural economist Dan Ariely (of Predictably Irrational fame) tells us that most transactions have an upside and a downside. But when things are free, we forget the downside. Why? Because as humans, we are intrinsically afraid of loss. With free, there's no visible possibility of loss. So we speed right by all those questions we would otherwise have about the value of an item and land directly on "yes please."

First Round Capital VC Josh Kopelman calls this the "penny gap." As it turns out, there's an enormous difference between one penny, and free.

The conclusion is that there are really two markets - free and anything else.

A new kind of free driven by technology

In economics, it's accepted that competition will eventually drive the price of any good to its marginal cost. In the good old days, there was always significant marginal cost because we were dealing with products that required inputs that cost money.

Each Big Mac has a bun, two burger patties, and special sauce. That costs something.

But the drivers of today's digital economy are computer processing power, digital storage and bandwidth. Moore's Law tells us that the amount of computer processing power for a given cost doubles every two years. Hard drive storage and bandwidth costs are improving at an even faster rate.

Which means that the price of the inputs in the digital age are eventually bring driven to zero, or close enough to it that companies are now starting to act as though we are already there.

It has turned "free" from a marketing gimmick or a cross-subsidy into something else entirely.

The implication is that if you are building a digital product, you can be certain that your costs of production are going to be cheaper in the future than they are today. Which means you can sell a product today for what it will cost tomorrow, confident that your costs will eventually go lower than your price.

The modern poster child for free - Google

If the physical economy poster child for free was Gillette, then the digital economy poster child for free is Google.

It makes so much money from its search product that is has the ability to make almost everything else the company produces free.

They famously created (and subsequently abolished) something called 20% time, where their employees could work on a side project for a day a week, in the hopes that they would come up with another service that Google users would get value from.

They didn't ask themselves questions that most businesses would ask, like "will we be able to make money on this?" They asked questions like "wouldn't it be cool if?" or "do people want this?"

So they give away tools like Gmail, Google Maps and Youtube (which is now generating its own revenue) in the hopes that you'll continue to use their search product.

This strategy has led to a stranglehold on the search market. As of March 2017, Google held a 78% market share on the $36 billion search engine market in the US.

As we covered in our summary of the great book Zero To One, Google tries to convince us they are a technology company with their hands in many pies to take our focus away from the fact that they have created a monopoly in a rapidly expanding multi-billion dollar market.

Well done Google, well done.

The different kinds of free

Now that we've got the gist of what free looks like in the digital economy, and why it's changing the game, let's move on to the different business models you can create from it.

In any version of free, we are basically shifting the cost of a product or service from one person to another, or between now and the future.

There are 3 main models that emerge from this. Let's take a look at them in turn.

1. Direct cross-subsidies

In a direct cross-subsidy, the producer gives the consumer product #1 for free, in the hope that this will then entice the consumer to subsequently purchase product #2.

A company will look at a portfolio of products and price some at zero, to make other products that they sell (where they make healthy profits) more attractive.

As Anderson points out, technology is giving companies greater flexibility in how broadly how they define their markets (cough, Google), allowing more freedom to give away some products to promote others.

Here are some examples:

• The Apple Store Genius Bar service is free, you buy the hardware.
• The Xbox console is sold far under cost so that you'll buy the games.
• Cell phone carriers subsidize your phone to sell you access to their network. 

2. Three-party markets

In a three-party market, the producer of product #1 gives you their product free of charge. Advertisers pay to be included in that product in the hope that they'll be able to sell product #3 (their product) to the end consumer.

As Anderson points out, newspaper and magazine publishers don't charge their readers anything close to the actual cost of creating, printing and distributing their products. Their business is not selling magazines to readers, their real product is selling readers to advertisers.

Of course, this model is being dramatically disrupted as we speak in the shift from print to digital advertising, but the model remains the same.

Here are some examples:

• Any type of ad supported media, like almost every single website you visit on the Internet.
• Free admission for kids at museums to attract the adults who have to pay.
• Zenefits giving away it's HR software so it can sell users health insurance.

3. Freemium

The freemium model is so ubiquitous these days that it probably needs no introduction.

Most businesses that employ it understands the 5 percent rule - where 5 percent of users pay for the product and support the rest. Which means that every user who pays for the premium version of the service, nineteen get the basic free version.

Of course, this is made possible by the fact that the cost of servicing those nineteen free users is close enough to zero to consider it nothing.

There are four different ways you can approach the freemium model:

• Time limited, where you give users a free trial.
• Feature limited, where the free version of your service gives you limited options.
• Seat limited, where a small number of people use service for free, but a larger group needs to pay.
• Customer type limited, which is the cousin of seat limited, as small companies use the service for free and older/larger companies pay.

Here are some examples:

• Companies like McKinsey who give away generic management advice, sell customized management advice.
• TurboTax giving away federal tax software so they can sell state tax software.
• Skype giving away computer to computer calls so they can charge for computer to phone calls.
  
  

Thriving in a Free Economy

While as consumers we are conditioned to love free, as business owners we are conditioned to loathe it.

Ultimately, what's required to thrive in a free economy isn't a deep understanding of new business models, but a mindset shift - from scarcity thinking to abundance thinking.

Think about it - if an entire market of insurance brokers and HR software companies can be disrupted by a single startup, it's only a matter of time before it happens to you. Just because you can't see it yet is of no concern to the market - if it can happen, it eventually will.

It would be better for you and your company if you got there first.

Anderson gives us ten key principles of abundance thinking.

1. If you make a digital product, realize sooner or later it’s going to be free.

In every competitive market, price falls to the marginal cost. The Internet is the most competitive market the world has ever seen, and the costs there are trending towards zero. Ergo, all digital products will eventually be free.

2. Atoms would like to be free, too, but they're not so pushy about it.

Free is so attractive to consumers that eventually somebody will figure out how to offer what your company currently produces, for free.

3. You can’t stop free

If the only thing stopping your product from being free is a secret code or a scary warning, somebody out there will find a way to defeat it. Instead of fighting it, figure out a way to sell upgrades.

4. You can make money from free. 

There's a corollary to this whole discussion that we haven't touched on - that when the cost is driven out of a market, the value flows elsewhere. People will always pay to save time, lower risk, increase status, and the list goes on. Figure out where the value flows after your core product is free, and go there.

Redefine your market

Ryanair is a great example of this. By making their airline seats cheap (or in some cases free) to make more money in everything surrounding the flight - everything from car rentals to travel destinations.

6. Round down. 

If free is just a matter of when, not if, the best move is to get there first. Why? The first to free gets attention, and there are always ways to turn attention into money.

7. Sooner or later you will compete with free.

Somebody in your business - through cross-subsidies or software - is going to figure out a way to give away what you charge for. It might not be exactly the same thing, but a price discount of 100 percent has a way of making some things irrelevant. Your options are to match the free price, or ensure that the differences in quality overcome the differences in price.

8. Embrace waste. 

If something is becoming too cheap to meter, stop metering it.

9. Free makes other things more valuable.

Every abundance creates a new scarcity. One hundred years ago entertainment was scarce and time was plentiful; now it's the reverse.

10. Manage for abundance, not scarcity

Traditional management is focussed on the ability to control expensive mistakes. When resources are cheap (especially when they are digital), you don't have to manage with that mindset anymore. Experimentation and learning become your goal rather than controlling risk.

Conclusion

I'm not sure I've ever read a book where the conclusion was so clear - everything you see around you with a price tag today wants to be free, and eventually will be.

What you do about that will determine your future.

Good luck.