Melbourne - April 1st, 2010 - "Free" is being hailed as the Internet's natural and ultimate future - as evidenced by a growing cohort of bloggers who insist "free" is the only solution to content providers' Internet woes. However, Ovum believes their economic logic is flawed, and that financing "free" through advertising alone requires a scale which is unlikely to be achieved in online entertainment unless the sector undergoes a radical revolution.
The misconceptions of "freeconomics"
The idea that the ultimate future for digital media on the Internet is free is a misconception based on the narrow argument that the marginal cost of distribution on the Internet is approaching zero. It is true that the costs of bandwidth and storage are falling, but they are certainly not yet zero. Moreover, looking at the marginal cost of distribution alone ignores rights and royalties, the significant capital required for developing a digital platform in the first place, marketing costs, and the cost of capital itself - not to mention management's interest in making a profit. Any business model designed to offset the cost of digital media to the consumer must capture significantly more value than just the marginal cost of distribution. Achieving such a thing might require massive scale that accrues many small sums from ad impressions (e.g. Google's search model) or perhaps a significant upsell - for example, retaining high-ARPU subscribers by offering them a free service. But to date, free ad-supported digital content services (e.g. YouTube, Hulu) haven't reached a profitable scale using advertising alone. Even Facebook's enormous scale has not quite enabled it to move into profit.
Financing "free" using market externalities
Developing ecosystems where enough value is captured to profit from digital media through market externalities (a third party), instead of charging at the point of purchase, sounds like a neat way of financing "free" for the Internet. Suggested third-party sources of revenue include advertising, conversational marketing, sponsorship, lead generation, selling personal data, API/developer fees, and subscriber churn reduction. But financing "free" requires a highly scalable business model, and ideally one that can benefit from network effects and automation - in other words, Google and Facebook's model, which is predominantly advertising. Google got big by positioning itself at the gateway to the Internet and monetizing a wide range of consumers who were searching for something. Facebook has just pipped the mighty Google on visits in the US, and although still struggling to make a profit from advertising revenues, it's at least now cash-positive.
Google and Facebook are successfully financing "free" using massive scale - scale built from considerable network effects (the more people that are on a social network, the more people want to be on that social network) achieved by skillfully riding the waves of other peoples' content, at zero marginal cost to themselves. However, financing "free" when you don't have to pay for content is one thing; financing it with a narrower range of digital content, like entertainment, that you also have to pay for, is a different matter.
"Free" is challenged by powerful forces of competition and ownership
A successfully scaled free service would eat up market share and become too powerful, enabling it to dictate terms with rights owners, who would be unlikely to enable such a service unless they owned it. Powerful pay-TV operators, and the likes of Apple iTunes, would leverage their strong content relationships in the same way.
Digital entertainment platforms will find it difficult to build the scale required to support free services because of the friction created by rights ownership. Globally fragmented release windows, and slow rights clearance of back catalog due to multi-party negotiations and exclusivity agreements, will make it difficult to produce a massive range of content, essential for triggering network effects and building scale.
Finally, at least a couple of generations' desire to own entertainment content precludes the use of a "free" digital transaction under any circumstances other than the most draconian and unappealing DRM, because free, highly portable content risks driving illegal file-sharing.
