How to Compete with “Free” Products and Services

HANNAH BATES: Welcome to HBR On Strategy, case studies and conversations with the world’s top business and management experts, hand-selected to help you unlock new ways of doing business. Free products and services are everywhere – from buy one get one free offers  to free office software like Canva and Google docs, and, yes, this podcast you’re listening to right now. If your revenue strategy doesn’t include give aways, these free goods and services can put extra pressure on your business. How can you compete? Brigham Young University professor of strategy David Bryce studied give-away strategies across 26 different product markets. He says that companies make own key mistakes when they try to compete with a free entrant: responding too quicky with their own free offering, or not responding at all. In this episode, you’ll learn which key factors to consider as you decide how to compete with a free entrant. You’ll also learn how to refine your own product mix and consider which of your customers to target with free products. This episode originally aired on HBR IdeaCast in May 2011. Just a note — we recorded this by phone. While the audio quality isn’t great, the conversation is. I think you’ll enjoy it. Here it is.

SARAH GREEN: Welcome to the HBR IdeaCast from Harvard Business Review. I’m Sarah Green. What do you do when your competitors start giving away their products for free? That’s the question we’ll be tackling this week with David Bryce, a professor of strategy at Brigham Young University’s Marriott School of Management. He is the co-author of the article Competing Against Free in our June 2011 issue. Dave, thanks so much for talking with us today.

DAVID BRYCE: You bet

SARAH GREEN: Competing against free products is something that’s been happening– you write in the piece– in the digital realm for a while. But now you say it’s spreading to the physical world. Can you give us an example?

DAVID BRYCE: Yes, well, we give several examples in the article. And one of the examples we give is GlaxoSmithKline and their battle against Galderma in the dermatology space. Galderma was essentially offering a product in Europe that got accepted in the United States and so they brought that over. And because GlaxoSmithKline had the dominant share in the US market, they decided to essentially rebate that product completely in the first year. So they were offering the product with a full rebate. So what that meant was that customers that had that prescribed by their dermatologists were basically able to get that product for free. So there are other examples. For example, Ryanair in Europe is an airline and an example of an airline that is able to give away deeply discounted and even free tickets, depending on how much extras a customer wants, such as, do they want to fly bags with them or do they want to buy food on the airline? And if they don’t want any of those things, they can essentially get a free ticket.

SARAH GREEN: So can you tell me what is the business reason for why a company might want to give away stuff like that for free? Especially if it’s something like an airline ticket that we’re used to paying a lot of money for?

DAVID BRYCE: Well, the idea is that there are different ways to get revenue. And historically, companies have really thought that they had to get the revenue directly from the product itself, through the price mechanism. But what they’re learning is they no longer need to do that. And a good example in the digital world is, of course, Google. And everybody uses Google’s products for free and they don’t really see that they’re putting out any money and yet Google is this multi-billion dollar business. Well, how is that the case? Well, in the case of Google, what they’re doing is they’re using a third-party pay strategy. That essentially means that they are selling their access to their users to advertisers who want to get access. And the advertisers are paying for access to those users and that’s how Google is generating revenue. And so third-party pay is just one strategy that companies use. But the notion is that if I get a free product out there that attracts users, then essentially, I can find other ways to generate revenue from those users. I can upsell them to a paid product, for example. I could cross-sell some different products or services that are related to the product that I’m giving away for free. As I said, the third-party pay strategy could be used. Or you can also even use a bundling strategy. So sometimes, you see a company like Hewlett Packard who gives away free printer with the purchase of a computer. And obviously, the consumer is paying a price for the computer, but they’re getting the printer bundled for free. And so these are all strategies to draw users or customers into the company, get them using their products, and then generate revenue in various different ways, all of which are legitimate. But it gives the user this great opportunity to get something for free and helps the company too.

SARAH GREEN: I want to talk a little bit more about this third-party pay strategy. Because it seems like more and more, we’re putting pressure on advertising, especially to support multiple different kinds of businesses. But how much can advertising really support? At some point, there’s advertising on everything and don’t people just start to tune out? And is that really enough revenue to drive the whole business?

DAVID BRYCE: I’ve wondered that question myself. I kind of wonder that, are we going to get, eventually, to a saturation point where they just simply isn’t any more advertising revenue to go around? And already, we’ve seen some companies hitting that point. So for example, there’s this company called Xmarks who was offering a web browser add-on and tools for browsing. And they had attracted more than two million product users and plenty of venture capital money, but they recently shut down because they couldn’t deliver a clear demographic group to advertisers. So essentially, there weren’t enough advertisers out there who were willing to pay for access to those particular customers. So here’s a company, got a free strategy, got venture capital, has got two million users, but just really can’t make this work. So I think your point is well taken. I think there is a limit to how many companies can do this and how much advertising money is out there. And I think more and more, a lot of the advertising money is flowing to companies like Google and Yahoo and other online giants. And so it’s getting harder and harder for some of these other companies to break into that.

SARAH GREEN: So what if you’re on the other end of this and you’re not offering stuff for free? What are your options if a competitor introduces a product that is free?

DAVID BRYCE: Well, and this is what the article really is about, is how do you respond to this and how do you know when and what to do? And what we found as we looked out across about 26 different product markets that we analyzed, what we found is that many of the companies really got this wrong. They offered a product too quickly to respond to a free entrant– so they would say, here comes this free entrant, they would panic, they would offer free product themselves. And what we would find is that, ultimately, that free entrant would die and the free model with sort of go away. And an example of that is what happened in the internet wars in the UK back in their late ’90s. You had, essentially, a company called Freeserve that came into the UK market with the first free internet offer to UK consumers. And the way that free internet worked is that they would get the internet free, but they had to pay for the phone line. They had to pay, essentially, the phone fee. And so it wasn’t really a free product. And even today, you have a situation in the UK where it’s mostly flat-rate pricing, and yet Virgin Internet came in and really tried to copy the Freeserve model and offer free product. And we just think it was too early for them to do that because about two years later, people essentially backed off of that offering. They had to basically go to flat-rate pricing in the UK. So on the one hand, you get these companies that will offer free too early when they should wait it out and either wait for the competitor or the entrant to self-destruct or wait for the structure of the market to play out a little more. On the other side, you get many, many companies who simply don’t know what to do and so they don’t respond at all. And what we find in that case is that the free entrant will often begin getting more and more market share and sort of moving in on these companies. And if they don’t respond, they’re going to be in trouble. And I think, again, going back to the Ryanair case, Ryanair now has more market share in Europe than Air France and I think that’s a problem. And Air France needs to figure out what are they going to do about this in order to maintain their market share?

SARAH GREEN: Well, it sounds like it’s something that’s really easy to get wrong, unfortunately– overreact or underreact. How do you know that you’re getting it right?

DAVID BRYCE: And so what we’ve developed is a simple way to think about this problem. And we’ve probably oversimplified at a little bit, but it covers what we believe is probably 70-80% of the factors that you need to consider. And that is that we look at the defection rate of paying customers to the free offering. At what rate are your own customers leaving to go embrace the free product? And if you’re getting more than 5% deterioration per year– 5% loss, if you will, in your customer base that’s leaving for this free product per year– then we’re saying that’s a high defection rate. Lower than 5% percent is what we say is a low defection rate. On the other side, another factor is the growth rate in the number of users of the free offering. In general– not just among your customers– but in general, how quickly are other customers flocking to this free offering. If they’re coming at a rate of more than 40% a year, then we’re saying that’s a high growth rate in the product. If it’s less than 40%, that’s a low rate. Well, you can see that this is forming a two-by-two matrix. And so, if you have a very high defection rate, your customers are leaving, and you have a very high growth rate among all users coming to this offering, what we’re saying is that is a business model threat. That is something that you have to respond to not only with the free product but you’re actually going to probably restructure your business model as well in response to that. Because essentially, that’s going to destroy your company in probably a few years. And we’ve seen this with Craigslist in many markets as they’ve come in on the newspapers with this free internet advertising. It’s essentially destroyed the classified ad revenues of many newspapers in many markets. And there’s been very few incumbents who have been able to really retain those revenues and go up effectively against Craigslist. And we do have an example in the article of a company that was able to do that– that’s Deseret Media in Salt Lake City. They basically launched a website– ksl.com– that was an online advertising, classified ad listing type of web site. And it’s now integrated with all of their properties– television, radio, and others. And so they have a very significant branding, an online presence, in the Salt Lake market. And that essentially meant that Craigslist was never able to get a foothold in Salt Lake City. But they’ve had to do substantial restructuring to their business model itself in order to fend off that competitor and save those revenues.

SARAH GREEN: I’m glad you mentioned Craigslist and that example. Because it does seem to me like one of the challenges that I see as someone in the media industry is that people constantly misidentify the source of the loss of revenue for a lot of newspapers. And they usually say something like the user’s not willing to pay anymore. But the fact is that the user never really supported journalism. It was always mostly the classified section. So how common was that among businesses that you studied– misidentifying their key source of revenue?

DAVID BRYCE: Well, I think that’s a common problem. I think a lot of this– and the reason it’s a recent phenomenon– is because we have the rise of the internet. So a lot of this has been promoted by the rise of the internet, certainly in the digital markets. And I think what’s happened in the tangible product markets is that they’ve looked over to digital and they’ve seen what’s happening in digital and they’ve been rethinking their own models along digital lines. And so I think it is difficult to sometimes identify that source of trouble.

But I think that, really, the challenge becomes how do established companies think about their own systems in ways that make those systems not become obstacles to launching free but really become facilitators? And we talk in the article quite extensively about some of the obstacles that get in the way. As we look at the incumbents, we see cost accounting systems and profit center P&L structures as being major impediments and obstacles to being able to launch free products, it’s simply because within those structures, you have products associated so closely with their prices that it’s very difficult for a company to conceive of how do we separate that product from the price, offer something for free, and then find revenue elsewhere? It creates a huge structural problem, these systems, and to be able to do that.

SARAH GREEN: It’s interesting. I was just reading a few days ago something about the creator of Instapaper, the app for the iPad, saying that he’s decided to stop offering the free version of his application because he’s like, why should I waste resources chasing customers who won’t pay for anything? So is that kind of the flip side of what you’re saying? Or does it fit into your framework somewhere?

DAVID BRYCE: Well, certainly not everyone should offer free product. The point you made earlier, there’s no doubt that there’s not enough advertising in the world to support everyone going to free. And so it becomes an issue of what is the alternative? I work with companies and one company CEO recently told me, he said, we didn’t respond– this was years ago before I was involved– we didn’t respond to this competitor coming in and offering this product for free because we basically felt that we had a differentiated position in the market and that the value that we were bringing, customers were willing to pay for. Well, it’s a bet that paid off. Essentially, the free competitor went away and customers continued paying for the higher value added.

So we’re not suggesting that everything in the world should be free. What we’re suggesting is that you have to look closely at those customers who you are losing to free offerings and figure out what is the value proposition that someone else is delivering to them that we’re not able to deliver or not able to deliver in a way that they’re willing to pay for. And that’s where you have to start getting creative about refining your product mix, your product portfolio, thinking about which customers are we going to go after with free products? Which customers are we going to try to maintain premium products for? And we ought to be really seeing more of a coexistence, in many markets, of these free products, along with more value-added offerings.

SARAH GREEN: Well, it’s certainly a lot to think through and I know that there’s a lot in the article to help people think through it. Dave, thanks so much for talking with us.

DAVID BRYCE: You bet. Happy to do so.

HANNAH BATES: That was Brigham Young University professor of strategy David Bryce – in conversation with Sarah Green on the HBR IdeaCast. We’ll be back next Wednesday with another hand-picked conversation about business strategy from the Harvard Business Review. If you found this episode helpful, share it with your friends and colleagues, and follow our show on Apple Podcasts, Spotify, or wherever you get your podcasts. While you’re there, be sure to leave us a review. We’re a production of the Harvard Business Review – if you want more articles, case studies, books, and videos like this, find it all at HBR.org. This episode was produced by Anne Saini, and me, Hannah Bates. Ian Fox is our editor. Special thanks to Maureen Hoch, Adi Ignatius, Karen Player, Ramsey Khabbaz, Nicole Smith, Anne Bartholomew, and you – our listener. See you next week.