Freemium Business Models: Taking Advantage of Cognitive Bias

Psychologists have described a number of cognitive biases that affect our decision-making processes. These biases are systematic errors or traps that we encounter as we make choices.  Put another way, these biases are ways in which actual human behavior deviates from the assumptions economists make in their models of "rational" choice. 

In this terrific blog post titled, "The Psychology Behind Freemium," Alex Mayyasi describes how one such bias may explain the success of many freemium business models.   For those not familiar with the term, a freemium business is one in which customers can use a service for free at first, but must pay for upgraded versions or additional features.  

Mayyasi attributes the success of freemium business models in part to something called the "endowment effect."  If humans were perfectly "rational" in their choices, they would be willing to pay the same amount for a product or service they did not have as they would demand to be paid for giving up a good that they already possessed.  However, many individuals actually demand more in compensation for giving up a good they already have than they are willing to pay for that same good if they do not already possess it.   Mayyasi cites a study by Ziv Carmon and Dan Ariely in which they examined how people behave with regard to NCAA Final Four men's basketball game tickets.  They asked people what the highest price was that they were willing to pay for such tickets.   They also asked them the price at which they would be willing to sell their tickets if they already owned them.  The selling price was more than 10 times the buying price! 

Psychologists attribute the endowment effect, in part, to a cognitive bias called loss aversion.  As Mayyasi says, people "generally react more strongly to losses than gains."  Selling something you already have is a "loss" in many people's minds.  Loss aversion may kick in when you experience a freemium product or service and face the decision about whether to pay a fee to continue enjoying the service. 

I would argue that you can think about this effect in terms of sunk costs too.    Sunk costs are not just investments of dollars.  Sunk costs can be investments of time and energy as well.  If you have put a great deal of time and effort into a video game, you don't want to "waste" those resources that you have invested.  Therefore, when faced with the question of whether to now pay for additional features of the game to continue playing, you are prone to invest some money.  You put more resources into the endeavor because you don't want to "waste" the investment you have already made.