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Capitalism 2.0: The Free Rider Problem

Posted on Monday, Sep 26th 2011

If you have studied economics, you are familiar with the free rider problem. To refresh everyone’s memory, here is Wikipedia’s definition of the concept:

In economicscollective bargainingpsychology, and political science, a free rider (or freeloader) is someone who consumes a resource without paying for it, or pays less than the full cost. The free rider problem is the question of how to limit free riding (or its negative effects). Free riding is usually considered to be an economic problem only when it leads to the non-production or under-production of a public good (and thus to Pareto inefficiency), or when it leads to the excessive use of a common property resource.

The term free rider comes from the example of someone using public transportation without paying the fare. If too many people do this, the system will not have enough money to operate. Another example of a free rider is someone who does not pay his or her share of taxes, which help pay for public goods that all citizens benefit from, such as roads, water treatment plants, and fire services.

As we think through the restructuring of capitalism as a system, we need to look carefully at the free rider problem.

Unfortunately, the system we operate under today is a colossal free rider problem in action. From the West’s massive budget, debt and deficit crisis to support welfare economics, to the Internet’s rampant appetite for free resources – products, services, and content – the situation is unsustainable.

To give you an example, only 2% of the customers who play their games pay any money to Zynga. The rest play for free. But it takes resources to offer those games free, creating a question of fairness and sustainability.

Those of you who enjoy this blog free of charge and express your displeasure that 1M/1M premium is a paid program and that we do not offer our self-assessment content free disregard that the cost of running this operation – this effort at global entrepreneurship development – is not zero.

The New York Times is gradually tightening the belt on free content. The Wall Street Journal was never free. There is a cost to developing, researching, writing, and publishing articles and columns, and free is not a business model.

All over the startupsphere, we see freemium  being offered as a business model. But only 2-4% of free traffic typically converts into paid customers. Free users consume infrastructure and talent, both of which are becoming cheaper.

If you follow the value chain, creating the infrastructure costs money. The people who work on the projects need to pay their bills and have a decent standard of living.

There are a few ways of supporting free services without destroying the downstream value chain. One of them is venture capital. A second is charity funding.

But remember, the capitalism 2.0 I envision assumes that the primary transaction is between the producer of value and the consumer of value, with the financier being optional. If you apply that model, neither option, venture capital or charity funding, is acceptable. The consumer needs to pay a fair price for the value he or she consumes. That is the most desirable result.

As has happened with so many previous fads, VC enchantment with the freemium model will end badly. A great deal of money will be lost, and there will come a point when freemium business plans no longer find the capital they need to get off the ground. They will simply go out of fashion.

The charity option will remain. And, to be fair, projects like Salman Khan’s Khan Academy are welcome nonprofits supported by the generosity of philanthropists. Nonetheless, the sustainability of these efforts is dependent entirely on charity funding, which I find concerning.

Finally, there is also a tremendous skill mismatch in the workforce today in that the skills in demand are not the skills that are available, creating a pressing need for retraining. That companies are not willing to foot the bill for retraining is again an economic issue. The margin pressure is tremendous, causing training budgets to erode and wages to drop. This creates further dimensions of unsustainability.

Although globalization and technology create competition that drives down wages, we must not miss the fact that the downward pressure on pricing and margins is causing similar devastation.

We could describe what is happening today as creative destruction. It is hard for those suffering to digest, but it is not an inaccurate assessment of the situation.

The system that will emerge from this rubble needs to deal with the free rider problem with greater care. Otherwise, humanity’s progress over the past century, progress that has been largely on the wings of capitalism, could end ignominiously in a new period of regression.

This segment is a part in the series : Capitalism 2.0

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That is the problem with the "freemium" model. Free riders eat up a ton of resources and their benefit is often dubious.

We are a firm believer of the "freemium" model early in a company's development. It does a great job of getting people using the system and giving feedback. And in the super early stage of a company,. feedback and learning is much more important than revenue.

But the secret is to eventually ween the user base off of that. Make would you offer for free less appealing than your paid offerings. This takes skill to do and a real feel for the marketplace, but is absolutely essential for revenue maximization and growth.

We have seen this a lot in our portfolio of companies and is one of the biggest areas that we advise upon.

TK Kuegler Monday, September 26, 2011 at 3:15 AM PT

micropayments is the answer. a few cents paid through pay pal or something similar with zero transaction cost( perhaps paid for out a 10% of the few cents ). If i spend 1 hour on the net playing a game / reading news / or using some service/ or use a net loadable copy of office programs / i should not mind paying 20c. Same for songs played safely without pirating. 100million people paying 20c/hr is 20million/hr or approx 0.5billion/day and thats just a start…..

Sramana here is my two bits

Saugato Mukerji UOW Monday, September 26, 2011 at 3:24 AM PT

Unfortunately, micro transactions are pretty hard for most start-ups to make happen. The transaction costs kill most start-ups and make it nearly impossible to make work on the balance sheet.

TK Kuegler Monday, September 26, 2011 at 3:33 AM PT

Thats the whole point imagine an entrepreneur say Sramana sets up a micro payments clearing house. The new startup would only create an account with the clearing house and only pay a fraction of the micro payments. There need be only one actual monthly payment to the small entrepreneur from the clearing house to pay him the accumulated micropayments. individual customers make a $5 deposit with the clearing house to kickstart their a/c.

Saugato Mukerji UOW Monday, September 26, 2011 at 4:00 AM PT

If someone has a business plan or idea around that concept, we would be happy to take a look. Right up where we would like to invest.

TK Kuegler Monday, September 26, 2011 at 4:18 AM PT

Insightful post – thanks.

Vaaudev Ram Monday, September 26, 2011 at 4:21 AM PT

Micro payments introduce friction and will potentially kill off any growth possibilities. I agree with TK that for most startups very early in the game, freemium is the only viable choice today.

Why does freemium even exist? You have to ask yourself "are my consumers able to live without my offerings for a day? a week? a month?" If the answer is a yes to anyone of these time frames, freemium becomes a strong contender. Would facebook be where it is today without freemium? (Of course you might question FBs valuation and i might agree!) The trick, again as TK says is to know when to wean people off the free fixes.

Bala Deshpande Monday, September 26, 2011 at 5:10 AM PT

Financial regulations and the large companies in the field currently and regulations means such a concept can only come out as a spin off from one of the big guys, like the secondary trading platforms that exists but the owners of those platforms happen to be the established players.
Whenever you have a clearing house concept ( middleperson) business generally speaking you are dealing with entrenched players

baba12 Monday, September 26, 2011 at 5:12 AM PT

Exactly… banking regulations will kill any secondary micro transaction business.

TK Kuegler Monday, September 26, 2011 at 5:18 AM PT

We in consumer electronics call this phenomena "The race to zero". It is a similar problem, only with material goods. Customers expect to pay less and get more value with each new generation of electronics. Manufacturer's are running into the limits of Moore's Law in terms of being able to produce better performing goods at ever cheaper prices. This was hidden for awhile by the electronics retailers shaving their profit margins and becoming leaner operations. But eventually they started going out of business because in their quest for quick market share, they lost site of why they existed; to generate a profit. What has been occurring in the consumer electronics industry is what is occuring with tech startups.

The most successful consumer electronics manufacturer is Apple IMO. They have spent years developing their brand, and value proposition. You don't see their products discounted, and consumers line up to buy the newest gadget from them. They are ready to pay full price in order to be the first kid on the block with the latest toy from Apple. We could all take a lesson from Apple in terms of marketing and maintaining an image that makes you profitable.

Think of ways to creatively market your product with a value proposition that will make it worth paying more for, instead of going with "nobody beats our price".

Offering a limited version of a product for free is a proven way of converting free trial users to paying customers. But what separates you from everyone else making similar products and offering similar trials? There is a need for more creativity in branding and marketing. So often this is short circuited by just copying your competitor and doing what everyone else does. Spend some time and a little money crafting your message, image, and marketing campaign. Think different…

Mike Garner Monday, September 26, 2011 at 8:05 AM PT

Yes, the electronics business – outside of Apple – all the way down to chips, equipment and EDA – is fast becoming a non-profit industry, and that simply isn’t sustainable.

Sramana Mitra Monday, September 26, 2011 at 8:13 AM PT

we struggle with with this issue every day in our B2B integration services company and our newest endeavor called the Virtual Inventory Cloud (VIC) Everyone in our ecosystem wants VIC for free, but we remind them the cost and development of this cool thing is born on the backs of GCom and Microsoft. We are fortunate not be a B2C model and can use the economic leverage of large customers to drive adoption among the suppliers, but it is still a struggle for us every day. I think the previous blog post about Apple is spot on. Innovation is what drives value and this value is what peopel will pay for. Innovation is what drives the US economy and must underpin the world recovery from our economic tailspin. I realize this sounds overly simplistic, but the basics of capitalism and innovation still work, albeit painfully and slowly sometimes.

Sramana, this is a wonderful topic and one that deserves further thought and dialogue among your devoted.

Steven Smith Monday, September 26, 2011 at 12:31 PM PT

The freerider problem is indeed one of the most significant weaknesses in the fabric of our contemporary economy. It's not just economic, but cultural. It reflects the expectations of an "entitlement generation".

The seeds were sown with Netscape and Microsoft giving away browsers. Venture Capital firms subsidized this behavior to acquire rapid market share for their portfolio companies. It evolved into a guise to acquire a direct marketing database that could be sold to a larger entity, often with the underlying technology of secondary import. Culturally, this has indeed created a freerider attitude.

In ActSeed, we describe this as "The Attention Economy" and we champion a return to "The Wallet Economy".

Excellent article, Sramana. This is a fundamental issue that I fear may take years to unwind. Hey, the problem wasn't created overnight either. Looking to the history of welfare reform may give us some insight into solutions, although welfare was a government-subsidized issue that government could largely fix by policy change, whereas the freerider issue we face isn't directly government-fed.

Bill Attinger Thursday, September 29, 2011 at 9:10 AM PT

Dear Sramana,
The free rider problem comes out of 'the chicken or the egg' dilemma. Are you confused about free beer and free speech ? May you read this book ?

The freemium model is based on free speech and costly beer. Do you believe everything is patentable ? Please change your mindset and don't advocate capitalism 2.0 without understanding the massive role of open source technology in democratizing the world.

Thanks and Regards,

Sandip Ray Wednesday, April 11, 2012 at 12:11 AM PT

Free products and services do not equate with free speech. They equate with free beer, which is not a viable concept. Check your premises. Your thinking is too convoluted.

Sramana Mitra Tuesday, April 17, 2012 at 7:37 PM PT