Scarcity and the world of digital media

DesertThe favorite discussion topic of the media and Internet elite is currently how the economics of content will develop in our digital age. Several big media conglomerates recently announced that they would start charging for online content. This was mostly greeted with ridicule from the digerati, who are still high on the radical ideology outlined in Chris Anderson’s book “Free”.

Brad Burnham pointed out in a recent blog post that both sides probably lack a deep understanding of the fundamental economic shift that is going on here. He mentioned the work of pioneers like Herbert Simon and Michael Goldhaber on the economics of attention as a framework for better insights.

I think it’s correct to say that we are currently experiencing the rise of something like a parallel economy, driven not (like our currently suffering traditional economy) by money and scarce physical goods, but by information and scarce attention. However, probably nobody really understands yet what this economy will look like as it matures and how its interaction with the “real world” will work. Obviously, the two will have to coexist, because last time I checked, my local supermarket didn’t accept hyperlinks as payment for groceries.

We are all so deeply rooted in the principles of the traditional physical economy that it is easy to forget the basics. The good old economy as we know it revolves around scarce physical goods and (more recently) around scarce services. The goods are scarce because considerable work has to be invested into their production, starting from the (often scarce) raw materials that we find in nature. Services are scarce because most of them require some kind of skill, and acquiring these qualifications needs time, which is limited and therefore valuable. Humans trade these scarce goods and services amongst each other because of course not everybody can produce every type of good or service. And then there’s of course money, which provides a more efficient way to trade stuff by separating value from a lumpy physical item or perishable service. Money is basically condensed value, which stems from physical scarcity.

So far so good. But how is the digital economy different?

Most importantly, value in the Internet economy is detached from the physical world and its limitations. For instance, a digital text can be valuable without having a physical manifestation. Sure, all these bits have to be stored somewhere, but the storage medium is a reusable commodity, not bound to this particular piece of information. Digital information can of course be copied without loss of quality (this doesn’t exist in the physical world) and distributed over a network, instantly reaching every corner of the world. And all of this is remarkably cheap nowadays.

The result is a huge abundance of information. And this changes what is scarce: Not the actual product (information), but the capacity for consumption — attention. Every day more free information is made available to the world than a human being could consume in a lifetime. Obviously, human attention is finite, and therefore it’s the scarce factor in the digital world.

That’s why many Internet users can’t understand that media companies want to charge for their online content. Aren’t they already getting the most valuable thing that an Internet user has to offer, his or her attention? And obviously, attention can be converted into real money through advertising, so what’s the problem?

At this point the discussion typically breaks down, because media companies, and newspapers in particular, have a very hard time financing their costly content production just from online advertising. There are probably two main reasons for this problem:

First, on the cost side, newspapers still apply the old principles from the physical world to their content production process. In the old media world, news has to be distributed physically (or through scarce airwaves), and therefore it is most efficient to produce local newspapers that cover all the important news in one single information product. This results in probably dozens or even hundreds of editors slightly rewriting the very same news agency report, adding almost no value. In a digital world of ubiquitous information, that’s completely unnecessary.

Furthermore, a key value proposition of newspapers is the context that they create by selecting the most newsworthy content. Again, this process is duplicated for every single newspaper. In the online world, there are far more efficient and sophisticated ways to provide this value, even though most can’t exist without at least some human intervention. But frankly, semi-automated aggregators like Memeorandum often provide a better view of what is going on in the world than most newspaper homepages.

About 50% of the total cost of a newspaper goes into physical production and distribution, the rest into actual content production. But if you subtract the obsolete and redundant editorial work that most newspapers are still doing, what would be left? Maybe 5%, maybe 10% of the cost base? Most probably, it’s even less. The percentage of truly original reporting in most traditional media is surprisingly low. But in the digital world, there’s no mechanism to finance the unneeded redundant production of information, because there’s already so much information out there.

Secondly, on the revenue side, advertising is a very unsophisticated and inefficient way to convert attention into money. Today’s advertising models are still built on the scarcity models of the past — the type where ad space is scarce, not attention. If you wanted to reach people in a certain local market with your commercial message, your only option was to advertise in the local newspaper or on local TV and radio stations. Even in big markets, there were only a handful of channels available, with very limited and therefore expensive ad space. Targeting was only very basic, because reaching many people with a lot of wastage through mass media was still more efficient than other methods.

That’s of course fundamentally different in the online world, but ad agencies and publishers are still stuck in old thinking. Most online publishers complain about the low rates that they’re getting for display ads. But that’s not surprising, since online ad inventory is almost unlimited. The trick is to reach the right audience at the right time. But ad agencies still think in big demographic clusters, not in the situation-specific micro-segmentation that the Internet could provide. It’s therefore not surprising that paid search is by far the most lucrative form of online advertising, since Google and its competitors can convert very specific attention (somebody searching for a certain topic right now) into commercially relevant results.

So what needs to happen to make the attention-driven online media economy viable?

  • Clearly, media companies have to become leaner and more focused. They need to concentrate on original content that really adds value and therefore is worthy of people’s attention. That’s frankly only a fraction of the current media production. All the other fluff, as well as the fat corporate structures on top of the actual content production, will simply not be viable online.
  • Also, media companies need to recognize that unique context, filtering and editorial selection are more essential than ever in dealing with people’s limited attention. This will be a great way for media brands to get competitive differentiation. But today’s typical news homepage is still built on an old, generic one-size-fits-all model that is neither cost-effective nor customer-friendly.
  • Publishers and advertisers have to experiment with new ways of converting attention into commercial value, i.e. building the bridge from the attention economy to the monetary economy. I think we currently stand at the very beginning of this process. Traditional advertising is becoming increasingly ineffective. But new ways to channel people’s attention in order to sell them something are still embryonic. Almost certainly, there will be many ways to do this, but no silver bullets.
  • Media companies have to recognize and deeply understand that attention is the scarce commodity in the digital economy and therefore is a currency in itself. The current conflicts between Google and newspaper publishers show that old media executives are starting to get this, although most of their actions go into the completely wrong direction.

But at the end of the day, attention has to be convertible into money somehow, since people still live in the physical world, where scarcity is a reality and money is needed. Companies and their executives will continue to be measured by their financial success, not by the attention they accumulate. Determining the monetary value of intangibles like attention, intellectual property, brand assets and customer loyalty is a thorny problem, and it’s unlikely that there will be a commonly accepted solution anytime soon.

However, people working outside of the traditional corporate framework might be willing to forgo at least some of this conversion. Under some circumstances, people tend to value attention more than money. Let’s be honest: Most people in the Western world already have more material things than they need. Particularly the richest European countries are increasingly turning into post-material societies that don’t necessarily try to optimize their GDP, but instead the general well-being of their population. And getting attention is something of fundamental importance for humans.

So it wouldn’t be surprising if more and more people would add value to the digital economy without getting paid for it in monetary terms. The open source ecosystem is of course a great example of how this can work. And most bloggers blog (and Twitterers tweet) because they like the attention and the good things that can result from it, not because they get paid.

Another example: Craigslist provides fundamentally the same value as the many classified sections in newspapers that it basically killed, but it captures only a fraction of the monetary value. Does that make any sense at all? Yes, because Craigslist created a top 20 website that commands a lot of attention with minimal resources. It provides a valuable service and gets paid with huge amounts of attention and loyalty, as well as with quite a bit of money. It is wildly profitable in monetary terms, but obscenely profitable in attention terms. That’s bad news for the people who used to make a living selling classified ads, but good news for Craig Newmark.

Welcome to creative destruction, attention economy edition.

(Picture: Josh Sommers, CC license)

Software pricing: When does freemium really work?

Free beerFreemium — the combination of a free basic version with paid “premium” versions of a software product — is an increasingly popular business model for software. Many Internet startups and even giants like Microsoft and Oracle are using this model for at least some of their products. A lot of iPhone apps for instance are available in a basic “light” version that needs to be upgraded to the paid version for more functionality or content — a typical freemium strategy.
The advantages of freemium seem obvious: It’s a good way to get free marketing. It can reduce sales costs dramatically, because users can self-educate. It lets the product speak for itself, thereby leveling the playing field, which is a particular advantage for smaller companies with small marketing budgets.

But does freemium really work that well in practice? There are early signs of a backlash against this model. Google recently strongly de-emphasized (i.e. practically killed) the previously offered free version of its Google Apps suite, which used to be free for companies up to 25 users. Potential customers are now encouraged to try the product for free for 30 days and then start to pay $50 per user per year. A similar change can be seen at 37signals, once the poster child for freemium, who now hides the permanently free versions of its products pretty well. Startups like photo sharing site Phanfare and the recently demised LucidEra (a vendor of SaaS business intelligence) tried freemium models, but weren’t successful. And many other startups that use freemium are still far away from profitability.

So the question is: Under what conditions does freemium really work for software vendors? Obviously, customers like freemium, but how can software companies use this model to build a really sustainable business?

It think there are probably six conditions:

1. Your marginal costs have to be extremely close to zero.
Freemium only works if the distribution and support of an additional copy of your product (i.e. the marginal costs) costs you almost nothing. Thanks to the Internet, the digital distribution of software is now nearly free, both for downloadable applications and online apps.

That sounds obvious enough, but I think many companies underestimate how close to zero the costs really need to be. Web-based applications for instance need to provide enough server capacity and storage for all these freebie users. This can quickly add up to substantial amounts, even if the capacity for one single user is cheap.

2. The target market has to be big enough.
There doesn’t seem to be any reliable data about how many users of a free product end up buying a paid edition. Obviously, this will strongly differ from product to product. But from anecdotal evidence, it’s probably safe to assume that typically less than 10% of users convert to the paid version.

If freemium is your main sales channel, this obviously means that your target market needs to be large enough so that you still can build a sizable business just from getting paid by a few percent of the total potential user base. Furthermore, the free marketing benefits (and maybe even positive network effects) of freemium can only kick in if there are enough people to spread the word about your product, and for that they first have to be interested in what you have to sell. In other words, niche products that only appeal to relatively few users are probably not ideal for freemium. Some more targeted form of sales might be the way to go there.

3. Your product has to be very simple.
It’s great that users can self-educate about your product while using it for free. Hopefully, they will soon reach the limits of the free version and feel the desire to upgrade to the paid edition.

But for this to work, your product has to be very, very simple. People don’t read manuals and rarely follow online tutorials. The product just has to be easy to use and has to provide obvious value almost instantly, so that users will have enough motivation to dig deeper. Some of the better iPhone games are a good example.

4. If your product is not simple, you need competent customers.
Not all software products can be and should be simple. This has nothing to do with a lack of usability, but with the scope of features that a product offers. Photoshop is not simple. Database systems and application servers are not simple. Content management systems (the decent ones) are not simple. They’re powerful tools for skilled professionals. Products that satisfy the needs of professional users are almost certainly not as easy to use as consumer software, because you need a certain skill set to make sense of what the product does. That’s a problem for freemium.

LucidEra’s founder tells the story of his company’s failed attempts at selling through the freemium model. Many trial customers were simply not able to figure out what the product was good for. They never really used the more advanced features and therefore never really saw a lot of value in the product.

So if you want to sell a complex, powerful product using freemium pricing, make sure that you address a well-defined, skilled audience. Your users need to already understand what they want to do with your product, and they have to be motivated and skilled enough to invest considerable time into working with it. Only then will they discover enough value to upgrade. If you offer a complex product to a user base that has not previously used this type of software (like in LucidEra’s case, selling BI to mid-market customers), freemium will be tough.

5. There has to be a minimum useful feature set, but plenty of additional functionality.
We’ve probably all used freemium software for which we didn’t see a need to upgrade. There are probably two cases where that happens: When the free version of a product doesn’t offer enough functionality, you don’t recognize that this is a useful product that is worth paying for. On the other hand, some free versions offer so much functionality that it will only make sense for relatively few users to upgrade to the paid version.

Google Apps prior to the recent strategy change was an example of the latter case: Small companies got almost all the functionality for free. If you had less than 25 users (and most small companies are way smaller than that), there was simply no good reason to upgrade.

Most successful freemium vendors now use a carefully designed combination of feature restrictions and a limit on the amount of data you can store or the number of users you can sign up. It’s clearly not easy to strike the right balance. Setting the right restrictions is probably the single most difficult thing in the freemium model.

6. You need to really understand the demand curve.

A demand curve in economics describes how many people are willing to buy a product at a certain price. If you can have only one price for your product, you lose a lot of potential customers (who don’t want to pay that price) and you lose a lot of potential profit (by undercharging the customers that would have been willing to pay more).

The solution for this dilemma is price differentiation. Why does Microsoft offer eight different versions of Windows Vista at different price points? Because it wants to ride the demand curve and extract as much money as possible from different customer groups. If Microsoft would offer only one version at a low price, it would leave a lot of money on the table (but maybe have happier customers).

Freemium is of course a form of price differentiation. The assumption is that there are many people who have a very low willingness to pay, but still find a certain product useful enough to spend some time with it and maybe tell their friends about it, some of whom will be willing to pay something. Most freemium products offer several different paid product levels with different feature sets — price differentiation at work.

The problem is that it’s really difficult to find out the shape of the demand curve and match it with your cost curve. One question is what the price point for your cheapest paid edition should be. Will many people pay $9.99 a month? Or is it better to start at $99/month and hope that you get so much free marketing out of your free version that many people will sign up who are willing to pay that price?

A key consideration is your cost curve and the usage pattern that users at different levels have. In some businesses, the most active users who use the most resources are also the most profitable ones, because they have a high willingness to pay. In that case, it makes sense to have a relatively high minimum price. But there are also cases where the low-intensity users are the most profitable. Then it makes sense to extract money from as many people as possible, even if it’s a far lower amount per user.

Conclusion: More an art than a science. And watch out for pitfalls.
There are obviously many variables that go into effective software pricing. Freemium can be a great model, particularly for smaller companies. But it is hard to get it right, and it can also be dangerous on several levels. If you get the demand structure wrong, you might leave a lot of money on the table. If you underestimate the costs caused by your free users, it will reduce your profits dramatically (and it’s not easy to get rid of these users without risking a hit to your reputation). Oh, and how about liability? If you lose a freebie user’s data, can he sue you? Better make sure that your terms of service are watertight.

Freemium is not a panacea for the software industry, it’s just another tool for the hard task of getting software pricing right. It’s great for certain market segments, but software companies should avoid to go freemium just because it’s convenient and reduces sales costs. Sure, a freemium model can get you more users relatively quickly, but in the long term, it might hurt your bottom line and growth prospects dramatically.

Finally, what would Google do? There’s probably a good reason why Google basically got rid of the free edition of Apps and now does pretty conventional software marketing with billboards and the like. They now even do competitive upgrades, as well as channel sales through resellers. Sounds more like traditional software industry tactics than the wonderful world of free Internet-based software.

(Picture: Timothy Lloyd, CC license)