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  • “Free” as a Business Model

    “Free” as a Business Model

    Toshiya Jitsuzumi
    Professor, Faculty of Policy Studies, Chuo University
    Areas of Specialization: communications policy, communications economics, internet economics and industrial policy

 

“Free” as a Business Model

2018.06.11
Toshiya Jitsuzumi



Toshiya Jitsuzumi
Professor, Faculty of Policy Studies, Chuo University
Areas of Specialization: communications policy, communications economics, internet economics and industrial policy

The Merits of Being “Free”

The value of free content is high for consumers. There is a significant gap in demand between a service that is offered for one penny and a service that is offered for free. This is known as the "penny gap." Because of this, there are numerous services today that are offered for free. Internet giants that dominate the global market, such as GAFA (acronym for Google, Apple, Facebook, and Amazon), have used the “free” business model as a means of expanding their market share. This is sometimes explained by an observation that Moore's law, which suggests that as information and communications technology advances at an exponential rate, has made the marginal costs approach to zero. However, in order to be able to offer such services, infrastructure such as giant server farms is required, and massive initial investments are needed. Therefore, in order to sustainably operate “free” services, careful business strategizing is required. In this article, I'd like to cover three points surrounding the “free” business model.

The “Free” Business Model and Personal Information

According to Chris Anderson, who wrote the book in 2009 with the sensational title, Free, the following three mechanisms support the “free” business model: cross-subsidization, "freemium," and two-sided markets. Free content offered by mobile network operators, in-game purchases in smartphone games and ad monetization for search engines and video streaming sites are models corresponding to each of the three mechanisms. The entire business is supported by mobile phone owners who pay the basic fees, paying users who only make up 2% of all users[1] advertisers, respectively. The competition in the “free” business model is a race to attract these paying users, and the free provision of services is merely a tool for achieving this. In recent years, as big data analysis facilitated by AI has improved the accuracy of ad distribution services, the provision of free services is turning into an exchange in return for personal information, which realizes personalized ads that match advertisers with possible customers. The accumulated personal information is an economic resource[2], and as was the case with Cambridge Analytica, it is an object for lucrative trading.

For internet companies to acquire massive amounts of usable personal information in an easy manner, the use of smartphones and other information communications devices must be ubiquitous, and broadband infrastructure must be well developed. Areas that meet these conditions generally have high average income levels. Areas with high income levels are considered lucrative markets where favorable sales results can be expected, but for internet companies, these are also resource-rich areas where indispensable inputs, i.e. personal information, be acquired. From this viewpoint, the EU's General Data Protection Regulation, which went into effect on May 25, 2018, can be considered as an attempt by the resource-rich areas to control the businesses that use them. This situation reminds us of the resistance against major oil companies by oil-producing countries that occurred in the last century.

Political Intervention in the “Free” Business Model

Even for businesses that offer free services and content, certain laws and regulations apply. In economics, it is taught that in order to achieve the effective allocation of resources, market participants must have sufficient awareness and understanding about the information of the assets and services that are being traded. If these so-called free services are actually being traded for a cost in the form of personal information, the businesses must disclose that fact clearly. This is the economic reasoning behind the privacy policies to which we are required to agree before using these services. Privacy polies are also required to emphasize privacy protection from a civil liberties perspective. On the other hand, as demonstrated quantitatively by Takasaki, Koguchi and Jitsuzumi (2014), the displaying of the privacy policy causes consumers to worry, sometimes discouraging the use of the service. In order to make sure that the information of free services is properly disclosed, it is crucial for the government to employ external incentives, such as legal restrictions, for countering the negative effects that impact business.

In addition, if a few businesses using free services dominate the market and rule the bottleneck in the ecosystem, it is necessary to counteract the possibilities of inefficiency due to the leverage held by their market power. For example, search engines and social media sites serve as portals for internet use, and if the services provided by monopolies are discriminative, it harms the efficiency of resource allocation in its entire ecosystem. In such a case, a system of fair handling of an adjacent layer by a business that dominates a certain layer, called the principle of neutrality, is required. Examples of this are the Telecommunications Business Act Article 6 (Fairness in Use) in Japan, and net neutrality that is currently being debated in the US and the EU. In addition, multiple neutrality principles are being proposed to different business models of internet companies in order to deal with such inter-layer problems. For example, Easley et al. (2018) proposes that search neutrality, OS neutrality, app store neutrality and ad-block neutrality should be included in that list. These are urgent challenges that are facing the government today, as giant internet companies thrive.

The Reconstruction of the Ecosystem through the “Free” Business Model

In recent years, websites that violate copyright laws, such as Manga Mura, are becoming hot topics of discussion in Japan. Although these services are being recognized as problems that are causing major economic harm to existing businesses, the blocking measures employed as countermeasures are being criticized as being invasive of the secrecy of communications.

From the perspective of the manga industry, this matter describes the likelihood of a conventional ecosystem with a publisher in the center, and with paid subscriptions and advertisement as core pillars, becoming reconstructed around a new player, the free content sites, which are dependent on the advertising model. In other words, the path of re-intermediation is being demonstrated. Utilizing the personal information of users who visit the website, can not only increase the accuracy of ad distribution, but also contribute to the improvement of the quality of manga, leading to further business growth. The cost of the distribution system is largely fixed, and the digital reproduction of manga themselves barely costs anything (in other words, marginal costs are close to zero). As a result, as the business expands and ad revenues increase, the sustainable operation of the entire system that bears the proper copyright fees can be expected.

If readers who buy books and magazines are thought of as the paying users of freemium services, there is a potential to reach a 50-fold market increase through free distribution. Assuming the semilog inverse demand function and estimating parameters using a data set of the Japan Magazine Publishers Association, consumer surplus increments generated by free distribution of comic magazines (16 male-targeted magazines and 12 female-targeted magazines) can be estimated at around 540 billion yen in 2017. This exceeds the trial calculation of the amount of damages (total of 413 billion yen)[3] conducted by Content Overseas Distribution Association (CODA) by a large margin.

This shows that, by converting the free business model that is currently inconsistent with the copyright laws into a legitimate business model, we can expect the improvement of social welfare. If this opportunity is missed in Japan and overtaken by overseas firms, it will surely be a major blow to our economy. From the perspective of social welfare maximization, it can be said that this situation requires stakeholders to take business risks to bring about change to the conventional business model.

  1. Value estimated in the Swrve report ("Monetization Report 2016: Lifting the lid on player spend patterns in mobile").
  2. For example, according to estimations by Koguchi and Jitsuzumi (2015), the personal information possessed by mobile operators in Japan has an estimate value of 2.7% to 10.8% of total sales in 2015.
  3. The CODA estimation cites the Joint Meeting of the Intellectual Property Strategy Headquarters and the Ministerial Meeting Concerning Measures Against Crime "The Emergency Measures Against Online Piracy Sites" (tentative) (Prime Minister of Japan and His Cabinet website)

References

Takasaki, H., Koguchi, T., and Jitsuzumi, T. (2014) "A Study on Causes for Privacy Concerns about Personalized Services on Mobile Devices" Society of Public Utility Economics, 66(2), 25-34.
Toshiya Jitsuzumi
Professor, Faculty of Policy Studies, Chuo University
Areas of Specialization: communications policy, communications economics, internet economics and industrial policy


Toshiya Jitsuzumi was born in Osaka in 1963. He graduated from the University of Tokyo Faculty of Law in 1986.
He earned his MBA after completing the graduate school course at New York University Stern School of Business in 1991.
He completed his doctoral course at Waseda University Graduate School of Global Information and Telecommunication Studies, and earned his doctorate in 2003.
After working at the Ministry of Posts and Telecommunications, Nagasaki University, Japan Post, and Kyushu University, he assumed his current position in 2017.
His current subjects of research are net neutrality, AI and OTT businesses.
Major publications include Network Churitsusei no Keizaigaku: Tsushin Hinshitsu wo Meguru Bunseki (Economic Perspectives on Network Neutrality: Analyses of Broadband Quality of Service) (Keiso Shobo, 2013), among others.