There’s a quite a bit of debate going on about free. See Fred Wilson’s summary and argument for reference.

In brief, Anderson says everything will be free in the future, Gladwell thinks that’s wrong and Wilson takes the position that free, ad supported websites is the best model on the web.

Taking a step back from the free debate

A business that doesn’t charge for it’s product doesn’t generate revenues. To acquire customers, a business must market its goods and services to potential customers, a function called marketing which costs money. A business is profitable when it sells a product at a price that is higher than the sum of the cost of goods/services and marketing. Or

profit = revenue – cost of goods sold – marketing

Marketing is expensive

Advertising and marketing is a huge business. The TV advertising market is 65B, online advertising is 25B and radio is about 25B. That’s nothing to say of print, out-of-home, and other channels.

Consider the chart above. The red line represents revenue as a function of the average revenue per user/customer (ARPU) and the number of customers. In this example, a small number of customers generate the majority of revenue, hence the parabolic shape. Called the 80/20 rule or Pareto’s principle, this is true for a lot of businesses because larger customers have more money to spend.

The green line represents profitability of a customer with existing marketing costs. Any customers above this line are profitable to serve. By giving away a product for free, a company eliminates significant marketing costs. Our equation above says that profitability must increase and therefore our profitability line falls to the blue line – more customers are profitable, if the company is able to generate the same revenue from the customer.

Opportunity cost as the new customer acquisition cost

When giving away a product for free, the role of marketing changes from acquiring customers to upselling customers to paid services. Customer acquisition costs shift from advertising to opportunity cost, the lost potential sale by having given away a product for free..

This is a subtle but important point and changes the way marketing success should be measured. As Geoffrey Moore wrote, there are two different kinds of businesses – high touch and high volume. Clearly then, businesses using free as a marketing tool are looking to be high volume. Our chart above shows this – make fewer dollars per customer but acquire more customers.

Understanding when free is a valid marketing tool is essential for a business. Anderson is wrong; not everything will be free, because free is not a price or a business model. It’s a marketing tactic – a very effective one at that.