Business Models for Free Software


The announcement that deservedly got the most attention at the Oct 22 Apple event was Apple dropping the price of their consumer software to zero. iOS was already free, but now the free list includes Mac OS X, iWork (spreadsheet, word processing, presentations), and iLife (photo editing, video editing, music editing). The New York Times incorrectly framed this as “Apple Targets Microsoft Office With Free Apps”. The correct frame comes from the always interesting Ben Thompson. In particular his two posts done prior to the event: “Open Source Apps” and “What Clayton Christensen Got Wrong.”

The natural economic price of a competitive good with zero marginal cost is zero, as discussed in an earlier post. So one way to think about free software is to ask: why isn’t it free already? The answer of course is we have friction and barriers to entry. Software used to be shipped on disks in stores, which had a supply chain markup and limited shelf space. But app stores removed many of these barriers, and prices for apps are moving to zero, albeit with a tilt towards the freemium model. Note: Freemium means the app itself is free, but you pay for extra add on features. The game Candy Crush being the poster child for this model, since it makes $850,000 a day.

Marco Arment (Tumblr, Instapaper) had a great recent post on this topic of free software since he’s currently writing a new podcast app. Let me quote Arment’s bullet points below on what typical customers believe:

  • Everyone outside of the immediate Apple tech sphere assumes, since I make apps for iOS, that I work for Apple. People with iPhones and iPads. Professionals, including my lawyer, accountant, and doctor. Relatives. Everyone.
  • It’s therefore non-obvious why I need to charge money, and it’s not widely understood that I get most of that money.
  • Nobody thinks iOS software is worth more than a few dollars, if even that much. It’s “just” a little app on a phone.
  • Almost everyone, when presented with a paid-up-front app, will first seek a free alternative. (Usually, they’ll find one.1) Many people with iPhones and iPads full of apps have never bought a single paid-up-front one.
  • Customers hate the current method of paid “upgrades” (pulling the previous version from the store and putting up a new, separate paid-up-front app).
  • These objections don’t apply nearly as much to in-app purchase.

You can see why most apps in the app store are becoming free, or freemium.

Now on to Ben Thompson’s post. Thompson points out that the consumer market and the business market are radically different. Quote: “The attribute most valued by consumers, assuming a product is at least in the general vicinity of a need, is ease-of-use. It’s not the only one – again, doing a job-that-needs-done is most important – but all things being equal, consumers prefer a superior user experience. What is interesting about this attribute is that it is impossible to overshoot.” On the other hand “business buyers are usually extremely rational. A CIO, for example, must justify a software purchase, and said justification usually comes down to balancing lists of features versus prices.” How this ties together is Apple has a business model of selling premium experience directly to consumers. They do this by selling their hardware at a premium, and (with their recent announcement) giving the software away for free. This model wouldn’t work for businesses. Businesses would never pay a premium for anything, especially ease of use. And in fact Apple’s business productivity apps remain expensive, not free.

As the tidal wave of free consumer software washes over tech businesses, we’re seeing widely disparate business model responses. Let’s look case by case:

  • Apple: sell premium systems. Sell systems with marked up hardware while giving away the associated consumer software. Business productivity apps still cost money.
  • Google: give away free operating system (Android) and services (search, maps, etc). Sell hardware at cost. No money there. Instead make money selling ads on those free services.
  • Microsoft: charge for operating system and business productivity software. But this is old school. Now they are attempting to transform into a “devices and services company”. That is, become Apple for hardware and Google for services.
  • Amazon: sell hardware at cost tied to free customized software. Make money by locking in sales of real world physical goods (books, household products, you name it).
  • Micromax and Xiaomi. An Asian variation on the Amazon model where they sell digital goods instead of physical goods. They sell expensive phones at cost to lock in follow on digital sales. Not well known in the US, but could be huge. We’ll see over time whether this approach is geographically limited or not.
  • Facebook: sell ads, don’t care about hardware or software.

Microsoft is structurally in the toughest spot in the consumer space since they are getting squeezed between Apple and Google. In fact Microsoft is now the only company charging consumers for an operating system. Though of course they are doing just fine selling to businesses, which have always been their bread and butter. As noted by Techpinions: “Apple did not slash software prices to zero to discomfort Microsoft; Apple doesn’t much care about Microsoft these days. Rather it is a solidification of a business model that Apple has been developing for years.”

A great analogy is to think of business strategies as “cups of water”:

He says that he thinks about a company’s strategy as a cup of water they’re holding, trying to keep as much water in the cup as possible at all times (and sometimes increasing it), while navigating the landscape around them. Trying not to lose a drop.

Competitors, partners, and other companies are doing the same thing, tending to their own cups of water, navigating their own landscape. Sometimes near where you are, sometimes not in the same zip code.

And added to this, every once in a while as you pass by a competitor, you might want to give a nudge, or a hard push — to make them lose a little of the water in their cup.

So overall you’ve got 3 types of actors here: companies protecting their cups of water; companies trying to knock other companies’ cups of water over; and the landscape that everyone’s navigating.

What interesting is the mobile/internet/tablet space is changing so rapidly right now that the major players all have distinctive business models to defend their glasses of water. By contrast a well established market is more like side by side lemonade stands. Pretty mundane. Think Coke vs Pepsi or GM vs Ford. You win by executing slightly better than your competitor on the same basic strategy. The knocking over glasses of water analogy is powerful because it captures how competing at the business model level can be devastating and permanent. It’s somewhat comical, but captures the underlying brutality.


Categorized as Economics

By Nathan Taylor

I blog at on tech trends and the near future. I'm on twitter as @ntaylor963.

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