"Give your service away for free, possibly ad supported but maybe not, acquire a lot of customers very efficiently through word of mouth, referral networks, organic search marketing, etc, then offer premium priced value added services or an enhanced version of your service to your customer base."
~ Fred Wilson, Venture Capitalist
The above quote is a description of the “freemium” business model. Think of a service like the music streaming site Spotify. Anyone can start listening to music for free on Spotify. But if you want to get rid of the ads or listen to songs from Spotify when you are not connected to the Internet, you need to pay for the premium version. The enterprise software Asana follows a related model. Small companies can use it for free, but once they have more than 15 employees using it, they need to pay.
The freemium model is not new, but it’s especially popular among new software companies. Since the cost of having an additional user is almost nothing, a price tag of zero can very effectively spread awareness of a product and attract a large user base. This has a huge appeal in the grow or die environment of Silicon Valley, and some of those customers will pay for premium features. Free trials follow a similar logic.
But freemium has another factor going in its favor: Once people start using a freemium service, the mere fact that they’re using it will lead them to value it more than an identical service. And once it comes time to pay, that can be a big deal.
This is the result of something academics refer to as the endowment effect - one of many fun examples of how we all fail to live up to the perfectly rational expectations economists set for us. Economics classicly takes as given that the price that someone would pay for a good is the same as the price they would accept as compensation for that good. If you’re willing to pay up to $450 for a television, you should be willing to accept $450 for that same television when you’re the one selling it.
But as economists and psychologists have repeatedly noted, people fail to live up to their economic models by overvaluing their own possessions. One study on Duke students found that their willingness to pay for basketball tickets was 14 times less than what students would demand in compensation to sell their own ticket. A famous study that set up simple marketplaces for items like mugs and pens also claimed that sellers valued their items much higher than buyers - despite having just received them. This is the endowment effect.
Why does the mere fact of ownership seem to make an object more valuable to its possessor? Because people exhibit loss aversion: They generally react more strongly to losses than gains. So, for example, a taxpayer will lose more satisfaction from a $100 tax hike than he or she would gain from a $100 tax benefit. For this reason, people generally prefer the status quo (we dwell more on the potential negatives of a change even if it is balanced out by equal or slightly better positives). And while buyers may think about relative price points, sellers focus more on what is lost by selling a possession.
As a result, someone asked to give something up thinks very differently from someone considering a purchase. So when asking for payment for premium features, the freemium model operates in a game with more friendly rules.
Someone considering a monthly rate for premium Spotify, or deciding whether to pay for Asana as their team increases in size, is less likely to think about price points and the potential advantages of the service versus alternatives. Instead, he or she thinks about all the ways they use Asana that they would now miss out on. Or, when they’ve decided to eschew ads on Spotify, think about how annoying it would be to go back to finding and (potentially) paying for songs individually on other sites rather than having instant access on Spotify.
Not every freemium service will benefit from the endowment effect. It's most relevant for services like Asana, Dropbox, and Flickr. Since they are free up to a certain amount of users or storage space, users habituate to the service until they reach the limit and are asked for payment. On a service like LinkedIn, however, the free users (individuals) and premium users (businesses) will choose their relevant pricing option from the start and rarely switch. So endowment effects do not come into play.
But in the other cases, a freemium model can not only attract customers but put them in a situation where - when they are asked for payment - they will be willing to pay much more. Or at the very least, unwilling to say no.