So what types of businesses can profit by giving away stuff? It turns out that this question has recently been explored by a couple of obscure but dedicated economists (is there any other kind?): Marshall van Alstyne of the University of Michigan School of Information and Geoffrey Park of Tulane University. In a paper published last year entitled "Information Complements, Substitutes and Strategic Product Design," the pair presented a theoretical model that explained the razor-and-blades strategy and provided a road map for companies that might pursue it. Their work is full of complex equations and terms like "free strategic complements" and "cross-market externalities," but I think I've managed to glean a few core principles.
No. 1 is that the company must have a compound product, one that can be split into pieces, some of which are given away and some of which are sold at a large profit. Cell phones are a good example: As the cost of the handset has dropped, companies have found it more profitable to essentially give away the device and charge for the calling plan. But, as van Alstyne points out, the paired products must have "strong complementarity" - that is, the one must be unusable without the other. A cell phone without service is no more useful than a razor without blades. Red Hat gives away its Linux-based operating system so it can sell consulting and maintenance contracts, but many customers - particularly the techno-geeks who tend to favor Linux - don't need the services that Red Hat provides. There may not be enough complementarity in that model, which helps explain why Red Hat's share price lost about 86 percent of its value in the past year.
The second condition is that the free goods must have negligible marginal costs: Once you've made one, it should cost next to nothing to make the second and each one after that. That explains why the giveaway model works so well for information technology: Creating the first copy of Acrobat Reader took years and cost millions; knocking off copy after copy entails only the cost of running the server from which customers download them, for free.
The third requirement is to have a product, like razor blades, with inelastic demand: In other words, people will keep buying it, over and over, in perpetuity. That's why Bill Gates is so enthusiastically touting Microsoft's .Net initiative; it's a way to shift the company's business model from selling razors (that is, the Windows operating system) to selling blades (Internet-based software applications). As PC sales have flattened, Microsoft has had trouble convincing people to keep shelling out for "upgrades" that they regard as little more than bug fixes. In the future, if Gates has his way, the software platform will be a one-time purchase, while the applications that run on top of it will be sold by subscription and delivered over the Web. That's a self-perpetuating razor-and-blades model, except for one thing: Gates still wants to make money off both the razor and the blades. Here's a wild-eyed suggestion, Mr. Gates: Give Windows away.
Another sector that could profit from Gillette's insight is telephony. For years, the cost of providing long-distance calls has dropped toward zero. But companies like AT&T and WorldCom continue to milk the dying market for every cent they can, plaguing consumers with confusing bills and phantom charges. Meanwhile, the demand for more valuable services, particularly high-speed Internet access, piles up. The phone companies would be better off giving away long-distance calls and charging for the cool stuff.
But then, telco executives have never been known for their vision. Before he died in 1932, King Gillette lost his fortune in the stock market crash and in patent lawsuits. His company has also struggled of late: Its share price is on a two-year slide, and in the quarter that ended July 20, the company's profits from razors and blades dropped 14 percent. Nevertheless, Gillette has $9.1 billion in annual revenue, and you can buy its blades from Dubuque to Djibouti. And King Gillette's essential insight has not lost any of its force or clarity. The phone company executives could learn something from Gillette's eccentric life: One way to make money in this world is to let something go.
