The Gist: In order to stay competitive and protect profit, companies must continually innovate and do so strategically. Strategic innovation means identifying what differentiates a company from its competitors (what Moore calls a company's "Core") and focus company efforts and resources accordingly. Too often, however, companies focus too heavily on the basic points of competition (what Moore calls "Context"), committing resources to activities that are expected and necessary but have a low return on investment. Continued focus on Context at the expense of Core leads to commoditization of services and the erosion of profit.

Ebook Implications: As new competition enters the publishing market attempting to change the industry's business model, incumbents must identify what truly differentiates its services and make smart, strong investments.

In his book Free, Chris Anderson lays out the arguments for a Free pricing strategy and gives some good examples of how it can succeed. (A list of 50 of these examples can be found at the back of the book, organized by business model). Relying primarily on these examples, Anderson strives to prove that products, and especially digital products, can be (and many should be) free because the marginal cost of providing them is low and getting lower all the time. While this sounds nice (especially to consumers), Anderson eventually points out that Free works in only limited situations. Free has a place in the economy -- alongside paid products and services.

Despite the stories of success and the evidence that Free can be profitable, Anderson fails to give the reader any real framework with which to understand these models and evaluate any further applicability. The most egregious example of this is his discussion of two-sided networks. In his introduction, Anderson boldly declares that economics has nothing to say of Free. In the following sentence, he backtracks (but only slightly) and says:

In fairness some [theories] do exist, as later research would reveal. But they were mostly obscure academic discussions of “two-sided markets” and, as we’ll see in the economics chapter, nearly forgotten theories from the nineteenth century.

Anderson’s later discussion of two-sided networks barely runs over a page. Instead, Anderson focuses on Bertrand marginal cost pricing, concluding that in competitive markets characterized by abundance, price tends to fall to marginal cost. Based on this, companies selling information products should seriously consider Free. Best yet, these companies should be the first to do so.

Anderson takes examples that run counter to this theory (e.g. Microsoft) and explains them away by stating that they fall outside the restrictions set by the definition (Microsoft does not operate in a competitive industry). While that may be true, it does not explain why Windows beat out the Mac OS in the early history of computers without charging consumers the marginal cost. (The theory actually states that there need only be 2 companies). More fundamentally, if Anderson is willing to discount this example because it falls outside the theory’s assumptions, he would need to discount any application of the theory as no market meets the strict restrictions set forth by Bertrand.

Microsoft’s success was due to a number of different factors, many of which can be understood in the context of two-sided networks. Bertrand economics, while undoubtedly useful, is too simple an explanation to be used in isolation and to the extent that Anderson recommends. Anderson’s heavy reliance upon Bertrand economics focuses too much on price and too little on network value.

Free worked in many of Anderson’s examples because it increased the size of a platform and that size has real value.

In his book Free, Chris Anderson talks about micropayments -- paying pennies (or fractions of pennies) for content.

As I read this, I was reminded of the current discussions concerning the online news business model. Proponents of micropayments suggest that newspapers can return to their previous glory (or at least solvency) by charging small amounts for articles. In theory, this model sounds promising -- we throw pennies away; why not throw those pennies at the newspapers? From a purely financial standpoint, I agree that this makes some sense.

But do consumers really make decisions using only rational, financial information? According to Anderson, decisions are heavily influenced by transaction costs that include “the cognitive load of having to process information.” With micropayments, clicks to new content are now burdened with the constant, nagging thought of “do I really want to pay for this?” The relatively cheap price has now become expensive.

What’s more, micropayment proponents miss an even more basic point. Consider what will happen when the first previously free newspaper decides to start charging. Consumers, faced with these new cognitive costs and the plethora of free alternatives, will flock to other sites. With the reduced traffic, the advertising revenue will in turn decrease. A bad situation has now become much worse.

When a company’s revenue model is based on a two sided network, pricing decisions should not be made without first understanding the consequences for the overall platform.