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. 

When Should an Entrepreneur Pursue a Freemium Business Model?

Yesterday the Wall Street Journal published an article about how many companies with "freemium" business models have failed to become solidly profitable.  Freemium refers to the idea that some firms give away a basic version of their product or service, in hopes that some significant fraction of consumers will upgrade to the paid version.   According to the Wall Street Journal article written by Sarah Needleman and Angus Loten, "The 'freemium' strategy is turning out to be a costly trap, leaving them with higher operating costs and thousands of freeloaders."  

Of course, some companies have enjoyed spectacular success with a freemium business model.  Take LinkedIn, for example.  Most people use the free version.  However, LinkedIn generates significant revenue and profits by offering a premium service, which has become very attractive to company human resource departments that use LinkedIn as part of their recruitment and hiring strategy. 

What types of firms should consider a freemium strategy?   I think there are two key attributes that entrepreneurs should consider when determining whether a freemium approach suits their business.  First, is there economic value (and early mover advantage) to be derived from a "get big fast" strategy?  Specifically, are there strong network effects in the business?  If so, then attracting high numbers of users can enhance the perceived value to each user.   Second, are the marginal costs of providing the good or service  close to zero?  If so, then adding a new non-paying user doesn't drain the company's finances. If, however, there are some incremental costs that will be incurred, then the firm may have a serious problem with a freemium approach.  The problem, of course, is that many start-ups assume that marginal costs are zero, when in fact there are some hidden costs for each additional user for which they have not accounted properly.

For more on freemium business models, see the video below featuring Chris Anderson, author of Free: The Future of a Radical Price.