Buzzword Beat -Mark Cuban on "Free"

Mark Cuban has published a new post on his weblog entitled,

When you succeed with Free, you are going to die by Free.

In the post, Cuban argues,

"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. You get the point. Someone out there with a better idea will raise a bunch of money, give it away for free, build scale and charge less to reach the audience. Or will be differentiated enough, and important enough to the audience to maybe even charge more. Who knows. But they will kick your ass and you will be in trouble."

Any thesis in the sphere of economics that includes the words "rule", "kill" and "all" is inherently suspect, and Cuban's post reads like a breezy attempt to join the buzz-fest around the publication of Chris Anderson's new book, "Free, The Future of a Radical Price". The giveaway is Cuban's strained "BlackSwan" reference from Nassem Nicholas Talleb's book of the same name.

(Anderson's book is an expanded version of this Wired magazine article.)

As a number of commentators have already noticed, Cuban's thesis says nothing about "free" or "freemium" business models that is not equally applicable to any business. Yes, business is a hyper-competitive sport, someone will eventually -- no time frame given -- come up with a faster, better, cheaper version of what you do and "kick your ass." A vague and generally agreeable prediction -- hedged by the inclusion of "eventually" so not falsifiable in the abstract or the concrete -- is not worth arguing about.

Here's my take.

"Free" business models like Google's search engine, MySpace and Facebook are predicated on low, arguably zero, marginal costs. Facebook can afford to be the digital bulletin board for 225 million worldwide users only because the marginal cost of storage and bandwidth is very small. Equally important, the capital costs of storage and bandwidth decrease predictably in general accordance with Moore's Law. So even as Facebook's user base explodes, its technology costs (per user) are likely dropping by 15-20% annually.

What Cuban should have said about "free" business models is that the low marginal costs and declining capital costs of these technology-intensive businesses go hand in hand. And if the infrastructure cost of MySpace or Facebook declines by 15% per year, a competitor can replicate that infrastructure four years later at 52% of the original capital cost. With half the capital cost, a new competitor is tempted to compete on price (more, better stuff for "free") and win away the business. Even if the new entrant fails, it will likely compete away some of the incumbent's profits.

In his article Cuban seems to be thinking of social media businesses -- Friendster, MySpace and Facebook-- although he includes Google (which deserves an asterisk if only for its multi-year history of handsome profits). What's economically interesting about these social media businesses, allowing them "to raise a bunch of money" is often explained in terms of "network effects", a popular buzz-phrase for what economists call a positive externality.

According to Wikipedia, the concept of "network effects" was introduced in the early 20th century in the context of emerging telephone systems. The positive network effect (you have a phone, making it more valuable for me to have a phone) helps drive adoption of the new technology. But in the early 20th century, adding those additional phones meant stringing expensive wires to each house or place of business. And after the first entrant incurred that sunk cost, there was little incentive for a competitor to incur the same cost to compete for the same customers with the same service. Even if some of the installation costs declined over time (cabling, electronics, e.g.) the costs of rights-of-way, telephone poles and labor likely increased, allowing the first-mover to build a long-term competitive advantage based on network effects and sunk costs. This is why most telephone systems in 20th century became regulated monopolies.

Facebook's current membership, at 225 million registered users, testifies to the potency of network effects in social media. And with the physical infrastructure of the internet already in place, a network that would have taken decades to build in the last century can arise in mere months today.

That's what's frustrating Rupert Murdoch as Facebook has surpassed MySpace in popularity. It probably keeps Facebook CEO, Mark Zuckerburg, up at night as well. Network-effects businesses on the internet generally don't enjoy the additional competitive advantage of high and rising capital costs to keep new entrants on the sidelines. And the glue that holds the network together and preserves its value may be nothing more than "community," an economic intangible that's as fragile as it is powerful. If a new entrant gains sufficient traction through differentiation or well-funded patience (think Microsoft), it too will eventually enjoy network effects. As users defect from one community to another the winner's positive externality is the loser's negative one. If your friends have stopped updating their MySpace profile in favor of Facebook, you'll probably stop looking for them on MySpace. If your friends start posting their updates on Twitter, you'll spend less time on Facebook. After enough defections the market may reach a "tipping point" (buzz-phrase alert!) as yesterday's market leader becomes tomorrow's also-ran.

Clever entrepreneurs understand the fragility and potentially transitory nature of their competitive advantage if it's based primarily on network effects. Successful ones use their early competitive advantage period to build potentially more durable advantages based on technology and intellectual property. This is an important point where Cuban and I disagree, especially with regard to Google. At December 2008, Google's 20,000 worldwide employees included more than 7,000 engineers. Not a lot of venture capital money is flowing into startups to take on that army of programmers. Google's R&D investment strikes me as a rational strategy while Cuban sees it as a costly act of desperation.

Chris Anderson seems like a smart guy, so maybe he's covered all this in his new book. I'll have something to say about that when it's available at my public library where I'll check it out... for free.