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.

Filed Under: economics, free, venture capital, zero

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  1. identicon
    Debunked, 7 Apr 2008 @ 10:20am

    Wow- Predatory Pricing

    Mike quote:
    Marginal cost does not include profit for the producer. It is merely the cost of producing one more good.

    Sorry wrong.
    A normal profit (not an excess or economic profit) is included in the marginal cost. You can yell and scream all you want but that is in the definition and day to day practice of working marginal cost analysis. The short term, medium term and long term analysis of costs include all the costs all of the time (but the percentages of costs to each other can sometimes vary in short vs long term scenarios). For an example, if you have a long term history of a 3% bad receivables cost, then you would have to include that 3% also as a cost in your short run analysis. The mistake that you and others here keep making is to just wish away the long term costs (..."in the longest run all costs are marginal") when doing short run analysis (the cost of making the next unit). You can't just make longterm risks (systemic and catastrophic and market, etc) and costs (including normal profits) go away in short run analysis because it is convenient for your theory. Many entrepreneurs underestimate on both costs and risk factors (as I can attest from my own business mistakes and battlescars).

    Mike quote:
    A smart competitor will merely drop his price all the way to marginal cost, undercutting the company that includes a profit margin, and use that to try to push the competitor out of business.

    Wow - this is a doozy!
    1. Using your wrong redefinition of "marginal cost=no profits" what you have done here is praise and endorse "predatory pricing" (look it up in Wikipedia).
    2. You are encouraging companies to engage in an illegal activity. Granted you are safe because the hurdles are so high on the prosecution of this "illegal activity" but it certainly leaves a bad taste in my mouth when I read this.
    3. In addition if you read up on predatory pricing you will find that it often backfires on the firm trying it because they misjudged their own or competitors strength or miscalculated barriers to entry. So you are not only recommending an illegal activity but one that has a relatively low success rate.

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