Why Do So Many People Freak Out When They See 'Free' As Part Of A Business Model?

from the divide-by-zero dept

A bunch of folks have been sending in a blog post by entrepreneur Hank Williams apparently attacking the concept of "free" and blaming venture capitalists, saying that they're overfunding a bunch of startups allowing them to give away stuff for free and distort the natural market. There's a lot of things that are incorrect in his analysis. Let's go through a few of them. He kicks it off by suggesting that it's "inherently impossible to start a small self-sustaining business," though there are numerous small online business owners who would disagree with him. It's not inherently impossible at all. In fact, I'd say it's rather common.

He then claims "in the digital world, advertising, the only real revenue stream, cannot support a small digital business." This appears to be wrong on two counts. First, there are numerous small online businesses that are supported by advertising revenue. But, more importantly, the idea that advertising is "the only real revenue stream" is inherently wrong. Advertising certainly is one revenue stream -- and an important one at that -- but there are many business models where you can make money by leveraging "free" to make scarce goods more valuable. Advertising is one such business model (using "free" content to make someone's scarce attention more valuable), but it's hardly the only one.

Williams then yanks out the old line that "it is very hard to charge when your competition is free." That, of course, is ridiculous. It's the same thing as saying you can't compete. In a competitive market, prices will get pushed down to marginal cost, no matter what (driving out all profit), so businesses that survive innovate, in order to get an advantage above the marginal cost in order to profit. That doesn't change if the marginal cost is $0 or $10,000. The trick is merely in knowing what scarcity you can sell that can't easily be copied. If you're trying to sell something that is easily copied, then you're selling the wrong thing. You have no competitive advantage. That's not anyone's fault but the business owner. In fact, the only fault I'd pin on VC's is if they pushed their portfolio companies to go against these basic economics.

Finally, he says that a bunch of these companies embracing "free" need to die and then "with less "free" floating around, a more regular supply and demand dynamic can take hold." But that, too, is incorrect. The supply and demand curve includes a price of $0, and when the supply is infinite, the supply curve is flat at the $0 line. So, the proper supply and demand dynamic has taken hold: and it says the price should be free.

This isn't to pick on Williams, as others have made similar arguments in the past, and I'm always interested in understanding why people are so confused by this. In the end, I can only assume that it's a "divide by zero" problem. For most of history, it's been shown that people naturally have trouble understanding the concept of zero. We may think we do, but as soon as a zero enters an equation, people tend to freak out and assume a model is broken. Yet, if we trust the model and realize it's not broken -- good things start to happen. Many businesses have learned that they can embrace "free" not because of a bunch of VC funding, but because that's the natural economic state of the market, and it allows them to make many, many other things more valuable. The real business trick is in making sure those things that are made valuable are what you're selling.

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  1. icon
    PaulT (profile), 5 Apr 2008 @ 4:25pm

    Re: You have redefined Marginal Cost Again

    Erm, I have to ask... you answered Mike's definition of marginal cost with a definition of "normal profit" and an unreferenced Wikipedia fragment. What was that meant to prove?

    Now, I'm no economist so I have to resort to Wiki as well, but this is what it says:

    "In economics and finance, marginal cost is the change in total cost that arises when the quantity produced changes by one unit." (http://en.wikipedia.org/wiki/Marginal_cost)

    That's what Mike's normally referring to, I believe. The cost for duplicating 1 unit of a digital file is not significantly different from producing 1 million. Therefore, it's an infinite good and the usual economies of scale related to physical, scarce goods don't apply. So, as per Mike's quote in your post, a business needs to innovate to leverage the non-infinite goods (and therefore earn the "normal profit" you linked to via other means).

    Feel free to dispute this understanding or any of Mike's posts above but please at least refute the actual definition of marginal cost if nothing else...

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