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The Freemium Economy: How Companies Can Get You To Pay Up

Apr 12, 2017
World Class Faculty & Research

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SMITH BRAIN TRUST – What could be better than free? For companies with a freemium business model – Spotify, Dropbox, Hulu and The New York Times are examples – it’s a key question. Can a company increase its number of paying customers when a free version is available? And if so, how?

Researchers at the University of Maryland’s Robert H. Smith School of Business say they have mapped a strategy. Working with the National Academies Press, an online bookseller, the researchers conducted a field experiment to determine how companies might improve their sales of premium products, even while offering free ones.

"If the free version is OK, how do you get the customer to justify paying for more?" says P.K. Kannan, the Ralph J. Tyser Professor of Marketing Science at the Smith School. That’s where the strategy of offering more premium products comes into play.

Under the freemium price strategy, companies offer a basic version of a product at no charge, and a premium version with added features for a price. Popular examples include Spotify, which offers its music-streaming service for free with ads and some limited functionality, and charges $9.99 a month for a premium service that’s ad-free and lets listeners play any track they want and listen offline when they want to. Other freemium-based companies, including cloud-storage company Dropbox and entertainment-streaming services Netflix and Hulu, offer 30-day memberships for free, followed by a range of billing and service options.

Similarly, NAP, the bookseller at the center of Kannan’s research project, has traditionally offered free downloadable PDF versions of books, and sold paperback versions.

In their working paper, Kannan, Smith School PhD candidate Xian Gu and assistant professor of marketing Liye Ma, seek to find out whether more customers would decide to pay for products, rather than choosing the free PDF, if there were more products to choose from. They randomly chose certain titles and added either e-books at a lower price point or hardcover books at a higher price point. And they found that the paperback versions of those titles sold far better.

But how the new product formats are priced made a difference, the researchers say. When the e-book's price was closer to the price of the paperback, customers were more likely to select the paperback version, foregoing the free PDF option.

In other words, if the options are "free" or "not free," people will choose "free." When the options are "free," "less expensive" and "more expensive," the "less expensive" option wins out, as in the case when the hardcover option was added. The seller wins too.

A menu of options is good, but it’s important not to exceed the optimum number of choices. "Too few is bad, but too many is bad as well," Kannan says. That’s because when people are given a wealth of options, "they get analysis paralysis," Kannan explains. "They just don’t know what to do."

And in those cases, many people will make no decision at all – a missed sales opportunity for the company. Among scholars and other experts, analysis paralysis is a deeply researched phenomenon.

Behavioral economists have found, for example, that when employees are offered a chance to sign up for a 401(k) at their place of employment, the signup rates are lower when there are multiple investment options. People actually sign up more if there are limited options.

Companies have found that a sprawling product line isn’t always worth it. Procter & Gamble’s Olay skin-care line, for example, saw sales sag in 2015 after expanding its brand options. "People got confused and they stopped buying because they didn’t know what was what," Kannan says. The Cincinnati-based company discontinued one-sixth of its brands to focus on its core products.

"There is a cost involved in the cognitive processing of all this information," Kannan says. "It really has an impact on how you make your choice."

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About the University of Maryland's Robert H. Smith School of Business 

The Robert H. Smith School of Business is an internationally recognized leader in management education and research. One of 12 colleges and schools at the University of Maryland, College Park, the Smith School offers undergraduate, full-time and part-time MBA, executive MBA, online MBA, specialty masters, PhD and executive education programs, as well as outreach services to the corporate community. The school offers its degree, custom and certification programs in learning locations in North America and Asia.