October 8, 2013

Freemium fallacy

There's something strange about freemium model. Why are all the premium accounts so ridiculously expensive? Sure people like their free account and they might like some extras they get with premium upgrade, but why don't they switch to cheaper providers once they need higher quality paid service?

Obviously, switching costs are often prohibitive, but the freemium model is more tricky than that.

It's a typical squeeze sales tactic. You are lured into heaven of cool free stuff and your journey is directed to a point - the squeeze - where all the friendly talk stops and you are quite rudely offered no choice other than to buy products/services.

Someone has got to pay for the resources consumed by free users and it's premium users who foot the bill. That's alright except that freemium pricing has nothing to do with real costs. The ridiculously small resource/feature limits on free accounts cannot be explained by costs alone either.

These parameters are instead carefully tuned to maximize profits. Free account limits are generous enough to lure people deep enough into the system. They are also set strict enough to not lose any paying customers. Since there is no competition to worry about at the squeeze point, freemium providers have the luxury to charge as much as customers are willing to pay for the premium service. Premium accounts have value pricing on them.

The tactic essentially leverages human stupidity. People fail to properly plan ahead. Judging costs of freemium service involves probabilistic calculations, which most people aren't capable of doing properly. They choose the free service, because it seems to be the right choice at the time. When they realize their mistake, it's usually too late to change direction.

Companies using the freemium model actually don't want to lose any single paying customer. Free accounts are often so limited that no serious user will ever use them as a permanent solution. The ratio of paying to free users can be surprisingly high. Up to a point where the free acounts comprise negligible fraction of service costs. That's why freemium companies can be ridiculously profitable even though superficially prividing free service.

So a cheaper provider can theoretically compete with expensive freemium service, but it will most likely capture only a small fraction of the market. Human stupidity is incurable. Relying on smart customers means small market. Competition is barely possible in resource-limited services where smaller players can enter the market easily. Software-limited services require sizeable market share to function profitably. Freemium companies are likely to dominate those areas.

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