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Freemium Services in Terms of Network Effects

In discussing network effects, we considered the balance between consumers’ reservation price as the product of users’ value for using the product and the network effect as a function of users that use the product and the price of the product. The result was a users’ reservation price for the product as a function of number of users of the product with equilibrium points established by the price of the good (see Figure 1). Of the nonzero equilibrium points, we established that the lower equilibrium point is unstable and the higher equilibrium point equilibrium point is stable and is the point where social welfare is maximized and it is toward that point that the company providing the product should strive toward (See Figure 1). In order to do that the company must be able effectively balance its pricing scheme and establish a consumer base that surpasses the unstable equilibrium, the tipping point, beyond which the consumer base will converge to stable equilibrium, max social welfare, and profit. In class we discussed that that a potential strategy is to offer the product at a lowered price so as to establish a consumer base above the tipping point, then raising the price to a point where the company could realize acceptable profit (See Figure 2). In doing so the company decreases the hurdle that has to be overcome in terms of establishing a consumer base above the tipping point (see Figure 2). That strategy is the theory behind the freemium business model and it has been successfully applied by numerous companies. In a freemium service, the basic components of a service are offered to consumers for free to establish a wide consumer base and advanced features are offered for a fee for profit. In this article we consider the freemium business model as applied by Dropbox and Blizzard’s foray into freemium with World of Warcraft in terms of network effects as discussed in class.

FIGURE 1. Reservation prices of users for a good (Source: ECON 2040 Fall 2011 Homework 5 Question 4).

FIGURE 2. The same reservation price curve as FIGURE 1 with varying prices

Dropbox is a cloud storage service based on the freemium model. It offers users ranging from 2GB for free to up to 1TB for a team account for a fee.  Users are encouraged to invite friends to use Dropbox by rewarding users with extra storage space for each friend that joins Dropbox by the users’ invitation. In offering offers its basic services for free, relative to the graph in Figure 2, Dropbox establishes a low cost to users and thus establish a low tipping point based on which Dropbox could establish a user base in the stable equilibrium region. By encouraging users to promote the use of Dropbox through invitations and simply word of mouth regarding a free and valuable service (in the words of Drew Houston, Dropbox’s founder: “The fact was that Dropbox was offering a product that people didn’t know they needed until they tried”.), Dropbox is able to quickly achieve enough users to pass the tipping point, achieve and maintain the stable equilibrium point. From that point, profit can be realized by offers of increased price that would yield premium service such as extra storage. Based on the solid foundation established through its free service, such an addition would correspond to a slight shift from the previous equilibrium (see Figure 2).

Traditionally World of Warcraft (WoW), the massively multiplayer online role playing game (MMORPG) offered by Blizzard requires a monthly fee in addition to the price of purchasing the software and its periodic version updates. Recently Blizzard began to offer free accounts of the basic version of WoW that allows players to build characters with highest attainable level of 20 (currently in paid version characters may go up to level 85) with several limiting restrictions on the account’s ability to interact with other players, such as joining in-game groups known as guilds and participate in the in-game auction systems between players to trade game related goods. While WoW, with the free option, is not truly a freemium model in that it is still mainly a subscription service, it exhibits behavior that can be compared to a freemium model and has been considered by some as Blizzard’s foray into providing WoW as a true freemium service. In additional to the monetary cost of a WoW subscription one also has to consider the considerable time requirement in playing the game and the social stigma that is associated with MMORPGs, particularly WoW. To many curious potential subscribers the addition of a monetary cost to the costs above sufficiently offset their valuation for the game to be not worthwhile. In offering a limited version for free, Blizzard lowers the tipping point for its consumer base to include those people. In increasing its overall consumer base there would be increased word of mouth to further increase consumer base (see Figure 2). In the growing base of free subscribers, there would be subscribers who find that their true valuation of the game is sufficiently high for them to upgrade to a paid subscription. Thus through offering a free service with WoW, Blizzard gains the potential for increased profit by establishing a greater consumer base and increasing profitability.

In addition to Dropbox and Blizzard, many other companies catering to different markets, such as Pandora, LinkedIn, and companies developing phone apps such as Evernote have successfully applied the freemium model in establishing a user base numbering beyond its tipping point and from there offering premium services to realize profit. Thus we can see that the impact of the practical application of network effects in a business.

Sources:
http://techcrunch.com/2011/09/04/complete-guide-freemium/
http://en.wikipedia.org/wiki/Freemium
http://en.wikipedia.org/wiki/Dropbox_(service)
http://en.wikipedia.org/wiki/World_of_Warcraft
http://www.industrygamers.com/news/wow-team-doesnt-have-any-opposition-to-freemium-concept/

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