How can a business compete with a free product? It's not easy, and it's more than just a theoretical question. U.S. newspapers are finding it difficult to compete with free news and the commentary of bloggers and other internet sources. And in the software world, the rise of open source products, which are available for free on the internet, is reshaping the technology industry.
One solution: "Divide and conquer," says Haim Mendelson, the Kleiner Perkins Caufield and Byers Professor in the Graduate School of Business. Commercial firms, he says, have three levers to gain competitive advantage when they compete with a free product: Timing, product features, and the skillful use of network effects across market segments.
A recent paper on this topic by Mendelson, coauthored with Deishin Lee, PhD '04, now a faculty member at Harvard Business School, is not a how-to manual for hard-pressed executives. Rather the researchers have built a theoretical model explaining the choices open to commercial firms. "Although open source is the lead example of our work, the principles certainly apply to other businesses, including, for example, the media business," says Mendelson.
Underpinning the research is the concept of network effects, which holds that the value of a good or service to a potential customer increases as greater numbers of other customers own the good or are users of the service. In software, for example, Microsoft's Office Suite enjoys great popularity partly because so many people use it. Having such a large user base encourages businesses to buy it since employees are probably already familiar with it and won't need much training. And the more people who use the software, the less likely it will be that incompatibility will be a problem.
With that in mind, Mendelson says the ideal scenario for the commercial vendor is to bring its product to market first, to judiciously improve its product features, to keep its product "closed" so the open source product cannot tap into the network already built by the commercial product, and to segment the market so it can take advantage of a divide-and-conquer strategy.
Many products are sold into more than one market segment (consumers or small businesses, for example) with different characteristics. The divide and conquer strategy leverages the advantages the commercial vendor achieves across those segments: One segment is used to "seed" the network so the product can achieve critical mass, which makes it more attractive to buyers in other segments who then end up choosing the more popular product over the free product.
Some products, Microsoft Office is a good example, initially were targeted at a commercial market. As its popularity grew, it made sense to sell Office to consumers, many of whom had become familiar with it at work. Other products, such as Apple's computers and iPhones, were first popular in the home market but that success led to their use in an office setting. In either case, it makes sense for a vendor to seed the market by selling a product relatively cheaply to the first market segment and then charge the second segment more, says Mendelson.
There are times, however, when the open source product gets to market first. In that case, the commercial vendor does well to enter the market with a compatible product and then invest in new product features to make its product compelling even though it costs more—a strategy sometimes known as "embrace and extend." In this case, being "open" (or compatible) helps the commercial firm tap into the network created by the free product. Then, the commercial firm must compete by out-innovating the free product.
In fact, frequently adding features to a commercial product is important no matter who gets to market first. New and improved features can outweigh the price advantage of an open source product.
In the media world, the network effects are indirect: Content providers prefer to publish where there is a large audience, and audiences prefer to go where there is a good selection of high-quality content. As a result, a larger audience attracts content providers, which in turn is attractive to audiences, which creates the "virtuous cycle" of network effects.
In this space, competing with the avalanche of free material is very challenging, and different providers compete in different ways. In the area of news, standards are largely open and free content has been abundant for years. As a result, content providers find it difficult to exploit the network effects, and the main lever available to them is product innovation.
In the area of music, Apple managed to create a closed network based on the "virtuous cycle" of the iPod device making the iTunes online music network more attractive, and vice versa. In spite of the prevalence of "free" music, the combination of innovative products, a superior user experience, and a closed network, which is incompatible with competing devices and music stores, created growing and highly profitable music offerings.
Ultimately, from the point of view of the buyer, free products provide an important benefit. "Even if consumers do not end up adopting the free product, it can act as a credible threat to the commercial firm, forcing it to both lower prices and invest more in product innovation," says Mendelson.