Freemium as an Optimal Strategy for Market Dominant Firms

Abstract

Despite its immense popularity, the freemium business model remains a complex strategy to master and often a topic of heated debate. Adopting a generalized version of the screening framework à la Mussa and Rosen (1978), we ask when and why a firm should endogenously offer a zero price on its low-end product when users' product usages generate network externalities on each other. In the standard M&R model without network effects, freemium never emerges as optimal and the firm always chooses the efficient price point for its low-end product. We show that even with network effects, freemium is typically not optimal. When network effects are identical across products ('symmetric'), the firm has greater incentive to expand its network size and may find it profitable to sell to the low-end customers. However, this does not lead to freemium as an equilibrium strategy. Instead, the firm should offer a low-end product to attract customers, while keeping its price positive. Freemium can only emerge if the high- and low-end products provide different levels of ('asymmetric') marginal network effects. In other words, the firm would set a zero price for its low-end product only if the high-end product provided larger utility gain from an expansion of the firm's user base. In contrast to conventional beliefs, a firm pursuing the freemium strategy might increase the baseline quality on its low-end product above the "efficient" level, which seemingly reduces differentiation.