The release of Chris Anderson’s book, Free: The Future of a Radical Price, has sparked a lot of interesting discussion over the past week or so, drawing responses/reactions from the likes of Malcolm Gladwell, Mark Cuban, and Fred Wilson, among others.  For those who don’t know, Anderson coined the phrase “long tail” in a 2004 Wired article and subsequent book by the same name.

The main thrust of Anderson’s latest book, from the (yes, free) preview article in Wired:

Practically everything Web technology touches starts down the path to gratis, at least as far as we consumers are concerned. Storage now joins bandwidth (YouTube: free) and processing power (Google: free) in the race to the bottom. … Every day the marginal cost of digital information comes closer to nothing.

Gladwell’s book review in The New Yorker critiqued Anderson’s assertion that most goods and services on the Internet will be offered for free, by turning one of Anderson’s key case studies against him:

Anderson is forced to admit that one of his main case studies, YouTube, “has so far failed to make any money for Google.”  … YouTube will lose close to half a billion dollars this year. If it were a bank, it would be eligible for TARP funds.

Cuban followed up with his thoughts as an entrepreneur and operator:

The problem with companies who have built their business around free is that it is far from free to remain successful. … When you succeed with Free, you are going to die by Free.

And then Wilson, a prominent New York VC, defended free/freemium as a strategy:

The Internet allows an entrrepreneur to enter a market with a free offering because the costs of doing so are not astronomical. And most entrpreneurs who take this approach will maintain an attractive free offering of their basic service forever.

A couple of observations:

1. YMMV: Anderson’s ideas don’t apply equally to all business models.

In general, both the long tail and freeconomics work better when applied to digital goods.  The more physical your inventory, the less you can use either idea.  It’s not that they don’t apply at all, it’s just that you won’t be able to use them as much due to costs and other constraints.  For example, in The Long Tail article, Anderson’s Rule #1 for Internet businesses is “Make Everything Available.”  This is a great idea if you’re selling digital goods, like e-books.  However, if you’re selling physical books, then the cost of storing and handling each book is much greater than a few bytes of disk space.  You have to deal with suppliers, distribution, and a warehouse — there are some economics of scale, but these costs can grow fast enough to make carrying “everything” very unprofitable.  Not even Amazon carries every book.  Why do you think they developed the Kindle?  To shift consumers and their business from to e-books, where the economics work even more in their favor — i.e., profit growth.

On top of that, there are lot of digital goods businesses where free doesn’t work so well (yet) — Facebook, Twitter, and Youtube are great examples.  Gladwell points out in his book review that YouTube is far from profitable, and Cuban thinks that it will never be.  Part of Cuban’s famed “only a moron would buy YouTube” argument is that the removal of copyrighted content from YouTube ruined their product, opening the door for Hulu.  The same product challenges await Facebook and Twitter, who don’t yet have answers for how to add revenue-generating features without screwing up the experience, a la MySpace.  More on this later.

2. It’s interesting to see the VC’s (Wilson) point of view vs. the entrepreneur’s (Cuban) point of view on this.

Everyone knows that offering your product for free is a great way to enter a market and acquire users/customers.  However, there are questions as to how defensible and sustainable this strategy is.  It’s tough to have a defensible position when you’re on a free model, since someone can always come along with a better product that’s also free, and steal your user base.  Cuban puts it well:

Lets look at the rule that eventually KILLS all freemium based content plays: There will always be a company that replaces you. At some point your BlackSwan competitor will appear and they will kick  your ass. Their product will be better or more interesting or just better marketed than yours, and it also will be free.  They will be Facebook to your Myspace, or Myspace to your Friendster or Google to your Yahoo.

It’s also tough to build a sustainable business model on free or freemium, especially with recent declines in online advertising revenues.  And, as mentioned above, you can easily alienate your users by adding revenue-generating features.  The Facebook group, We Will Not Pay To Use Facebook. We Are Gone If This Happens, has almost 5 million members.

On the other hand, Wilson the investor seems to have little doubt that these are challenges that can be overcome:

We have seen it again and again. I’m not going to even give examples. … Once you have built that audience, you can deliver upsells via freemium models, you can monetize it via advertising and you can branch out into other services which are easier to monetize.

Who’s right?  Well, they’re both right… only the investor has the luxury of making the assumption, while the entrepreneur has to figure out how to make it happen.  As John Gapper of the Financial Times puts it:

For a venture capitalist investing in internet businesses that are trying to grow as rapidly as possible, free is also a good bet. If nine out of 10 of those businesses fail because they burn through their capital but one grows enough to make money from advertising or freemium services, that is a good result.

On the other hand, the entrepreneur is often 100% invested in that single business, in terms of money, time, and emotion.  Failure to make the switch from free to non-free can be crushing.  That difference in perspective explains a lot about why Cuban and Wilson see different sides of the same coin.  Cuban is much more worried about how to build a defensible, sustainable business from the beginning, while Wilson feels like this transition is less of an issue, because he expects to fail 90% of the time.

In this context, it seems that the current poster children for free — YouTube, Facebook, and Twitter — must answer these two questions:

1. Is it even possible to make the switch from free to freemium/paid?
2. When do you do it?

YouTube has failed so far, Facebook seems to have some early answers, and Twitter is just getting started.  Reply with your thoughts on these companies, or the free debate in general, in the comments.