On my trip to and from Silicon Valley this week, I read Chris Anderson's new book, Free: The Future of a Radical Price. Anderson is also the author of the best-seller, The Long Tail. Both are excellent, thought-provoking books.
In The Long Tail, Anderson wrote about what has happened to markets that used to be defined by blockbuster hits. In many markets, such as music, it used to be the case that a very small number of hits accounted for a huge percentage of sales. With the emergence of digital music, take a look at a histogram with products on the x axis and volume on the y axis. You see a very long tail, i.e. many products exist that sell small volumes, but together all these products in the long tail actually account for a sizeable chunk of the overall market. These products represent tons of niche offerings that now can be economically sold in digital form, whereas it was not economical to sell them when you were restricted by the economics of a physical store shelf. Anderson documents the various businesses now subject to the long tail effect, and he describes how it has revolutionized a number of industries.
In Free, Anderson describes the various business models that feature a "free" component. Anderson explains how companies have developed models whereby they can be profitable despite the fact that some of their products are available to consumers for free. He does a nice job of explaining how and why so many products have become free... basic economics, really. If a product's marginal cost is approximately zero, and the market is highly competitive, then we would expect price to fall toward marginal cost - in short, price will fall toward free in those situations. Of course, again, the digital revolution has caused the marginal cost of many products such as music to fall toward zero, thus leading to the emergence of "free" in those markets. Anderson's book proves thought-provoking because it helps you think about when you might find yourself competing with a "free" model, as well as helping you think about how to incorporate a free element in your model so as to actually increase profits.