In the digital world, there’s disconnect between the price of production and the final price of the product. What does this mean for business? Wired editor-in-chief, Chris Anderson, explains.

Question: How will we decide what is free and what isn’t?

Chris Anderson: I think the most profound thing about turning products into digital products from my prospective is that price becomes arbitrary. In the traditional world, there’s a pretty strong correlation between the cost of a product to make and the price you can charge for it. You charge something that's slightly above the cost and the more competition there is, the less you can charge. It tends to drive prices down to the marginal cost. In digital products where the marginal cost is zero, the price can be anywhere from zero to infinity. There is a complete disconnect between the price of production and the price you charge. What this means is not that everything goes to zero, you get a range. You get a much wider dynamic range of pricing from zero to higher. Now how is that possible?

The way it’s possible is that you’re using free to reach the broadest possible audience, then you segment that audience into different ability and willingness to pay, which means you’re doing different products. You’ve got Flicker and then you’ve got Flicker Pro. What you’ve done is you’ve sort of said, here’s a service and utility to all people who’ve got photographs. However, if you’re really keen, if you’re a super enthusiastic photographer, at some point you’re going to want more space. You’re going to want better features, etcetera. At that point, we convert you to paid and because you’re so invested in the service, because you care so much about it, you are kind of the alpha user; price is almost immaterial to you. You value the service so much that you are willing to pay almost anything. You’re willing to pay more than you might have if they had a one size fits all product for almost anybody. That one would have to be relatively cheap. Zero is the one that fits everyone. And 9.95, 19.95, 29.95, whatever, becomes the one for the segment of enthusiasts. You can build a good business where you charge more to some customers and less for others.

Question: Is market segmentation the answer?

Chris Anderson: Absolutely. What digital allows you to do is to have a range of prices. What digital requires you to do is a have a range of products. One of the examples I give a lot is the video game industry, which may seem trivial but is a fascinating experiment. Watching an industry shift from silver discs, online, on their own terms. The music industry had it sort of happen to them. Software is kind of doing it as it shifts from discs to software as a service. But the video game industry is doing it driven by consumer demand. Starting in China and Korea, [it's] is doing it to sort of reinvent what they do. And as games become single player to massively multiplayer, they start to follow the World of Warcraft model. It’s a bit fascinating to watch them to figure out as they go on they tend to be free to play and then to convert five percent, ten percent, to paid customers. One of the best examples that may be familiar to many people watching is Club Penguin. Club Penguin is a game for kids, an online game for kids. My kids play it. Probably many people in the audience, their kids play it. It’s free to play, owned by Disney. Bought by, if I’m not mistaken, four or seven hundred million, lots, hundreds of millions. Free to play but at a certain point, you know, your kid is going to want a pet for their penguin, called puffle. Now to get a pink puffle for your penguin, you’re going to have to subscribe. At that point, they come to the parents and they say, Mom, Dad, can I have your credit card? Will you get your credit card out and subscribe for me? What’s interesting about this is that our kids come to us all the time saying, I saw this ad on TV, can I have it? And the answer is no. Right? You know, you trust me, it’s not as good as it looks in the ad.

You won’t play with it for long. You don’t really want it. And it’s easy to say no. But when your kid comes to you and says, I’ve been playing Club Penguin for two weeks. I built my igloo. I populated the igloo. I made these friends. I’ve done all this stuff. Now I want more, the play utility already ascertained, the value to the kid, the importance in their life, already established. You’re much more inclined to pay and they get something like 20 to 30 percent conversion rates. What’s cool about that, once you’re willing to convert on those terms, is that you’re willing to pay more. You’re more likely to be happy and your turn rates go down. That is an example of segmentation. Within the game, they’ve found all these different ways to charge you for more in a way that felt totally natural. It’s like, I get it. I want more. I hardly mind paying.

Question: What does free allow you to do?

Chris Anderson: What free allows you to do – not everyone has figured this out, the kind of terrifying reality of free for the advertising industry-- is that it’s an alternative to advertising. Rather than telling people about a product, you can let them try the product. The nice thing about – if you can try the product, you don’t’ have to take out ads. You can just let the product sell itself, speak for itself, let it go viral. People will recommend a product that’s free because there’s no risk to the people they recommend it to that they’ll be unhappy using it. At least they wouldn’t have wasted their money. The potential there is that free products can go wide. Free products can become viral.

They can end up marketing themselves. And you can end up converting ten percent of a very big number at very low customer acquisition costs. That’s good. However, there [are] a couple problems. First of all, there’s the what if you convert one percent? Or .1 percent? Or .01 percent? At a certain point, the conversion rate is going to be so low that it almost doesn’t matter how big your number is, you’re still not converting enough people. The second point is that, let’s say that your conversion rate is one percent but it’s out there being used by millions of people. Well, I talk about near zero marginal cost.

There is a difference between near zero marginal cost and zero marginal cost. Even if the product only costs ten cents per user for you to storage, etcetera. It’s ten cents times ten million people. It starts to add up to real money. So Facebook and Twitter are two companies that are free to users. They got so popular and so big that those tiny marginal costs started to add up to some very significant real costs. They had to raise hundreds of millions of dollars to pay. Now neither of them in their first form really worked hard on that conversion, on making money, but as they now have real costs, they’re starting to do it.

You’re seeing a real time experiment in the premium model. Of course, Facebook may use advertising but Twitter is probably going to try to avoid advertising and go for premium models. It’ll be very interesting to see what happens. What does a one percent conversion rate to paid look like at Twitter? What would a five percent conversion rate look like? You know, a ten percent conversion rate to Twitter would be the best business you could ever imagine. In the regular world, if you’re selling muffins and you’ve got a ten percent conversion rate, you’re going out of business. But in a digital space, a ten percent conversion rate can be incredibly lucrative because it’s, again, ten percent of a very big number.

Recorded on September 30, 2009