The Freemium Model of Business:

Freemium is a business model where the basic or core version of the offering of the business is made available to the end-customer for free and a premium is charged for the advanced or special version of the offering for the end-customer. The word ‘Freemium’ is a combination of words ‘Free’ and ‘Premium’, reflecting the relationship between the the se two different version s of the offerings of business essential for formation of a sustainable and viable revenue stream and hence a business.

Internet has been one of the most disruptive innovations for mankind, and this Freemium model of business is emerging as one of the most disruptive and popularly applied business model for internet companies. As such, the interest levels in exploring and understanding the economics of this business model and establishing the norms and theorems for the model has been an upcoming area of research for new-age economists. While the classical economics moves around the interplay between the demand-supply and marginal utility and marginal cost of business offerings, these dynamics are getting redefined in the context of creating a huge demand by providing one version of business offering free, and supplying a revenue-generating marginal utility to the customer who are willing to pay a premium for it.

This series of articles aims at exploring this dynamics of economic principles in the wake of the emerging Freemium Model of Business.

What is not a Freemium Model of Business?

The core of the concept of Freemium model of business is linked to the existence of minimum 2 versions of business offerings – of which one is offered for free and other is offered for a premium. Customers paying a premium for the offerings are essentially a sub-set of the total customer base. These core features of the Freemium business model differentiate it from the other business models which are based on providing business offerings for free.

A model of offering a bundled set of products or services wherein at least one product/service is provided for free with other product/service which is being charged does not conform to be called as Freemium (eg.: Promotional schemes offered by FMCG companies of giving a bucket free with a packet of washing powder). Over here, the free item is not available to the customer unless he purchases the other item which is paid, thus making it different from the Freemium model of business.

A business model where the base product/service is offered for free but its basic utility to the customer is severely limited unless he purchases the premium product/service does not allow it to be categorized under Freemium model of business (eg.: The famous Gillette razor and blade model of business wherein the razor blade is sold for a concessional rate but the subsequent blades are sold at a heavy premium). The basic difference of this from Freemium is that the offerings are not independent and stand-alone versions on its own, and always need to be used together for deriving meaningful utility to the customer.

A business model wherein a business offering is provided for free to generate large customer demand, and hence the customer base is monetized through a different channel by a different set of customer is again not Freemium. (eg.: Google model of sponsored ads over internet search users, where Google creates a huge customer-base by offering the search facility for free, and generates revenues from a different set of customers – i.e. advertisers, who are sponsoring advertisements to this customer base using the free services). The difference here from the Freemium model of business is that the premium customers are not essentially a clear sub-set of the total customer-base of basic business offering.

This list can be longer, but the above three models are the closest to the Freemium and as such needs special mention.

What exactly is the Freemium Model of Business?

Having specified these differences, it becomes pertinent now to explain what exactly is this Freemium model of business?

Freemium is based on the concept of versioning an offering of the business where the basic free version is used as lowest possible barrier of adoption of the offering by the end-customer and hence create a large customer base for the business; and convert a part of this customer-base into paying customers who are willing to pay the premium for advanced special version of the offering.

Freemium business model needs existence of two types of customers who are primarily differentiated by their revenue generation potential. One set of customers (named ‘free customers’) consumes the offerings of the business for free and other set of customers (named ‘premium customers’) consumes the offerings of the business for a premium. In process, the paying premium customers cross-subsidize the free customers and form the core revenue stream of the business required to cover the cost of acquiring and servicing both free and premium customers.

Examples of Freemium Model of Business:

The premium offerings consumed by the premium customers can be differentiated from that consumed by the free customers in several ways. A few examples of this differentiation are:

LinkedIn.com:

LinkedIn is a very popular professional networking website across the world. LinkedIn offers the basic networking features for free, but services like posting a job opening in this network of professionals is made a paid service. Here the premium offering is differentiated by providing a special utility to the paid customers over the basic offering being offered to the free customers.

It is important to note here that the special feature becomes worthy of paying the premium because of the basic offering which is being offered for free. Because the basic professional networking is being offered for free, LinkedIn can source a large pool of professionals who are seriously looking to network professionally and hence form a lucrative target segment for the recruiters who have job openings to fill with such professionals

Flickr.com:

Flickr is a popular photo-sharing and storing website across the world. Flickr offers the basic service of photo storing and sharing for free, but this offering is limited by the number of the photos user can upload using a free account. Premium customers of Flickr buy a Flickr Pro account, which offers customer unlimited storage space and also many advanced methods of sharing and enhancing the photographs. Here besides the advanced nature of the offering, the differentiation is created by the capacity being offered to the customer.

Getting a Flickr Pro account also attaches a perception of being serious photographer about the user. This creates a distinct customer-class and as such provides the satisfaction of being in an exclusive club of experts or serious professionals in the area. This exclusivity being offered by creating a separate class of paying customers forms another differentiation and reason for making the premium offering worth the premium being charged.

Pandora:

Pandora is an online radio streaming service. It offers the basic radio streaming for free and has a paid service called Pandora One which is has added benefits.

One of the key benefits of the paid service of Pandora is that streaming is uninterrupted for longer period of time. Online streaming of radio is cut after 1 hour of inactivity on the computer system in case of free users. However premium customers of Pandora One can continuously listen to the radio service without bothering about staying on system to escape cutting of stream due to inactivity on computer system. Here the differentiation between the paid and free offerings is being created by the amount of time the service is available.

The above three examples of Freemium business model application to internet companies demonstrates the popular methods used for creating a differentiation between the paid and premium customers. These can be listed here as:

• Advanced and enhanced features
• Enhanced capacity
• Creation of exclusive customer class
• Longer duration of time for which offering is available

Besides these popular methods of differentiation between the free and premium customers, there are other methods by which this differentiation can be created. These will be explored in the subsequent articles of these series on Freemium model of business.

Implication of differentiating customers into free and premium groups:

While the differentiation created in the Freemium model of business is the key to the model, this differentiation means that it is only the group of premium paying customers who form the significant revenue stream for the business.

Once the basic web offering is developed, the cost of running the business of internet companies primarily can be put under the cost of acquiring new customers, and cost of servicing them. These customers can be both free and premium. However the revenues being generated from the business is coming only from the set of premium customers. This implies that the set of paying customers are subsidizing the cost of acquisition and servicing of both free and paying customers. These points towards the necessity of having the right mix between the paying and free; so that this cross-subsidizing results into a profitable and viable business. To achieve this, the free offering of the business should be compelling enough to attract a large customer base. It is expected that a small number of this customer base will convert into the paying customer segment. Determining the right funneling channel to reach the desired conversion ratio at which the business becomes a sustainable and profitable venture hence becomes an important element of study of applicability of Freemium business model.

Revenue generated by the business is essentially a product of the unit price and number of paying customers. While the number of paying customers is determined by the user-base created due to attraction of the free offerings, the unit price is determined the real and perceived value of the premium offering to the potential customers who would pay for the premium offering. As such, determining the right trigger point, at which the utility of the offering enhances to the a level sufficient enough for getting a customer to pay a premium for it becomes another important aspect of studying the applicability of Freemium model of the business.

Thus, determination of right distribution of free and paying customers and identification of right trigger point at which a premium can be charged for an offering becomes two most significant aspects of studying the applicability of the Freemium business model in a business.

Conclusion:

Freemium model of business forms a very interesting application of classical economics principles of demand-supply and marginal utility dynamics. As it finds maximum applicability to the new-age digital businesses based on internet, this has the potential of redefining the contours of economics as per the innovative revenue-generation attempts of the emerging companies with disruptive technologies and business game-plans. This series of articles will be exploring the different dimensions of Freemium model of business and look to explore how the basic principles of economics get reinforced through the development of this model.

<This post is being reproduced from e-zine on Economics named Arthsaar>