‘Freemium’ as a Business Model and the Fallacy of Consumer Costs

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Remember back to that fall semester course you took: the introduction to economics and the basic principals of that dismal science—which were presented to you as proofs of the mechanics of microeconomic theory. Over time, many of those proofs have stood the test of time, while others have been experimented upon and understood for their applied limitations.

One of the key principals of economic theory, and specifically in terms of business economics, is the principal that past market engagements and the transactional costs already incurred, which are definitively deemed nonrecoverable, are assumed to not play a role in any future economic decision-making—hence the principal of sunk costs.

Insights gained from research within behavioral economics finds that, in actuality, the opposite of this assumed reasoning is true. Classical economic theory here is outdated given observed and tested reality.

There exists a “sunk cost fallacy.” The consumer mindset is framed by past occurrences, specific both in terms to the individual’s personal experiences in question, and by the external factors that influence the arena of the consumer experience which is framed by the supplying agent at market.

Why consumers choose and pursue products or services is not as cut-and-dry as traditional economic theory hopes to illustrate. In reality, consumer choice is a complex function, one often framed by the prevalent status-quo motivations of a society, and which at times can lure consumers into getting stuck in a sunk cost trap: where a consumer finds themselves spending money when not gaining any utility from product or service, creating a negative loop.

Understanding Freemium

Why does this insight matter for enterprises within the technology market? Ventures must account how the whole user experience in relations to the burden of costs, both in terms of time spent and in actual money expensed. Together they frame the totality of the consumer experience. When put together they limit or promote the possibility for future successful engagements.

Let’s move forward and explore the freemium consumer model used by many technology companies and the application of the sunk cost fallacy insight.

At a base level, the freemium business model provides a venture’s enterprise free of charge to consumers. The model allows real money charges for optional premium and proprietary features, thus expanding on application functionality for the user, hence leveraging added utility gains for venture profit. This process is aided by providing additional virtual goods often by using an application specified form of currency, importantly masking the real money charges.

In transitioning from a full freemium model to building a minority of core users subscribed to premium features there exists pertinent steps that require an acknowledgment, especially when framing the totality of the user experience with respect to the sunk costs. For example, the change in the value attained and overall user functionality in this transition matters, as does the impediment of any new learning curve in the transition and in how much the user experience changes in moving towards premium.

Furthermore, the conversion rate set for the transition is importantly dependent on the limitations of the project, highlighting the solvency of the venture, the understood growth rate and revenue forecasts, especially with respect to the marginal cost of each additional user. Incubating this minority group of subscribed users is a careful balance. Not wanting to monetize add-ons on the base platform at the threat of spamming, by opening the platform to third parties, by cross selling other items from the company, and by playing the big data game where the users become the product, at the expense of successfully transitioning are all important considerations for a venture.

Importantly, to be able to give a core product away for free and sell premium products on a reoccurring subscription or onetime costed basis, there needs to be a quality product that adds and builds inherent value for the consumer. Effectively monetizing the consumer experience and harnessing user interest, will ideally turn a valued user into an evangelist, therefore allowing a venture to effectively scale.

Though true, the expenses tallied in the premium model, when utilized properly, can effectively ease the ‘pain of paying’ for the consumer. This fact is specifically relevant to applications where the user experience tied to cash transactions by using an application specified currency.

The masking of the actual money amounts being handled has allowed ventures to successfully manage the pain points during the user experience, thus effectively minimizing their cognitive impact. But, if instead of managing expectations, if you are just kicking the burden of cost down the road, it will build into something greater, that will still eventually have to be dealt with by the user.

When the consumer receives the current cycle invoice, it anchors a monetary cost to their past expensed consumer experience. This memory, positive or negative, will frame their future engagement with a venture. Here a user’s evaluation of the past carries risk for a venture’s future.

All past financial transactions matter, all spent time matters; thus, sunk costs matter.

Applying the Model

In harking back to traditional economic theory, in perfectly competitive markets the price of a given product or services will be tied directly to the noted marginal cost of production. Hence the requested price for base products or services given the market fundamentals can be theoretically low, or even nonexistent.

This is evident as we have seen with the freemium model in the technology market place. This downward pressure on venture pricing strategy is coupled with a reality of tense market competition. Intrinsic to all ventures is the real goal of creating company value by increasing the network of users. All ventures seek to foster a conception of added value which compounds over time becoming reality, both in the utility gained by its consumer and the eventual growing sum of total active users.

The inherent challenge for the freemium model is that it is entirely user dependent. The inherent value for the freemium model makes a venture’s product accessible by allowing for people to become familiar with the new and novel by instituting open entry, then allowing the venture to effectively focus on on-boarding and on retention, to then incubate their users and leverage revenue in the long-run from a premium model and grow. This process requires ventures to take into account the sunk costs at play.

The idea of “no-cost” user experience is wrong. Consumers always expense, may it be in real money values, or with their time. Both factors frame a profound consumer experience of desired expectations.

User on-boarding, engagement, and retention, all matter, but understanding the sunk costs already incurred by their valued users matters more. At the end of the day, the freemium model is about fostering added value, and if they fail to provide this utility gain by failing to understand the time already spent by their users engaging—by failing to understand their expectations per assumed value added—they risk any transition forward.

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