The Catalyst Code

I’ve been meaning to blog on Chris Anderson’s article Fee! Why $.00 Is the Future of Business. Chris extols the virtue of free as a business model. He begins the King Gillette’s brilliant marketing ploy of give ‘em the razor, charge ‘em for the blades. He then moves rhapsodic into how more things are going to be given away for free because they don’t cost much of anything to produce. He concludes, “But a generation raised on the free Web is coming of age, and they will find entirely new ways to embrace waste, transforming the world in the process. Because free is what you want – and free, increasingly, is what you’re gong to get.”

This is terrible and dangerous business advice. My late professor, Milton Friedman, had it right when he titled one of his books “There’s No Such Thing as a Free Lunch.”

Let’s begin with the economics. There are really three main reasons why things are free (or really cheap).

The first—and this is the razor-blade example—is complementary products. Men need the razor to go with the blade. If you work through the math, the profit maximizing price for the razor could be zero or even negative (that is the seller pays people to take one of the complementary goods). The same story explains why supermarkets sometimes sell milk for less than their cost. It brings people into the store and when there they buy other goods.

The second is that sellers give things away to get people to try their products. This sort of zero or low pricing tends to be temporary. The seller has confidence that if people try the seller’s good or service they will come back for more. So it makes sense to give the product or service away. They can raise prices later. This is why the Video Professor on TV says he will give away a free eBay tutorial. He hopes, as he says, that people will like it and come back to buy his other lessons.

The third is that the good is sold in a “two-sided market.” That describes the situation where a good is given to one group of customers to attract them to a platform where access to them is sold to another group of customers who want to interact with them. Here again free could also be negative: we pay you to come.

The two-sided market situation is actually what explains many of the examples that Anderson gives. This business model has been around for millennia—girl’s parents pay village matchmaker and the guy’s parents get their kid hooked up for free. But there are many others. Let me mention two big 20th century ones.

The payment card industry pays consumers massive amounts of money to take and use their credit cards. You get free float, rewards, and so forth. People who pay off their balances every month (and more than half do) do better than free—they actually get paid to use the product. The card businesses make the bulk of their profits from charging merchants to accept cards.

Then there’s advertising supported media. Free radio and television gives content away like bait to attract viewers and listeners and then sells access to them to advertisers.

Now, contrary to what Anderson says, the fact that it doesn’t cost anything (or much) to make an extra copy doesn’t have a whole lot to do with which customer group gets stuff for free. It is just as costless for Google to stick an ad on a search results page as it is to stick an organic search result. But they put ads on those pages in order to monetize their search services. Advertiser pays, searcher gets in for free. In the end, the rule of thumb is that the customer group that needs/wants access to the other customer group pays the freight.

I agree with Anderson that kids are used to lots of things being free on the web. But let’s not overstate the extent to which the web is full of free stuff. To begin with, although serious analysts tend to ignore it, a lot of the traffic on the web involves pornography and gambling which sellers charge for. Then there’s etailers where nothing is free. Auction sites tend to collect from the sellers, not the buyers, but then that’s true for lots of off-line exchanges too. Online video games and other services have fees as well. I’m not aware of any statistics on how much of the total revenue earned through web-based businesses is from ones that give lots of things away for free, but my guess is that it isn’t nearly as large as one might think or Anderson’s article implies.

Bottom line: two-sided business models that involve making a service free to one side and costly to another side are important and will be an increasing part of the web economy. Anderson is right that we’re going to see more “free.” But as the dotbusters discovered “free” comes with a lot of risks. Indeed, figuring out which customer group (or side or the market) should get the service for free, and which should pay, is one often one of the hardest problems faced by all but the most rudimentary web-based businesses.

Getting back to King Gillette, “free” isn’t always forever. I just bought a Mach 3 razor and a package of blades today. The razor which came with two blades cost me $8.79. The blades cost me $25.99 for a package of 12 or $2.16 each. That means the razor cost me $4.47.

Lots of people in the payments cards industry talk about cash and checks soon disappearing. I’d like to throw just a little cold water on this.

A few years ago, in the first edition of Paying with Plastic, Dick Schmalensee and I noted the seemingly inexorable trend towards electronic payments. We remarked on a visit I had made, this is in the late 1990s now, to the Massachusetts Registry of Motor Vehicles at the CambridgeSide Galleria near our offices. When I went to renew my license I was greeted by signs that said “We don’t take cash.” I thought that was pretty gutsy and a sign of things to come.

Well, I went today to renew my automobile registration which had lapsed. Like most men I went with my cards and cash but not checks. This time I was greeted by a sign that announced the Registry would only take checks and money orders for registration renewals. Luckily, there was a Bank of America branch around the corner where I got my first money order in the last couple of decades.

Now, mind you, the Commonwealth isn’t exactly on the cutting edge. The office had big CRT monitors and a sign that claimed that their computer system would go down if I used my mobile phone (it rang, I talked, there was no meltdown).

So perhaps this is the kind of weird fluke that happens in Massachusetts. I have no doubt that paper currency will gradually disappear. But I think folks should never underestimate the power of inertia in payment systems. Or even think that the people who matter—buyers and sellers—agree with us that plastic trumps the tried and true. People have been predicting the death of cash for fifty years now (if not more). And, cash must be remarking, plagiarizing Mark Twain, that the announcement of its death is premature. For some interesting quotes see my presentation, Paying with Plastic: Back to the Future.

Quick, someone grab a Websters.

Because I want to talk about the crux of my current conundrum with loyalty programs (as they are now architected). What are these programs trying to achieve anyway? My economist friends say that they are all about the “lock in” – so reeling in customers with the promise that sometime in the future they will get something of value that can be had in exchange for the points that are accrued. (check out Loyalty Cards and Polymorphic Equilibria). And yes, I looked it up to be sure what it meant too.

But for most people today, that payoff is “too little too late” – with many soured by the experience of trying to redeem air miles. But these sorts of programs are relatively easy to architect and are being positioned as “table stakes” for most retailers today. So at what point do participants start to feel like hostages instead of happily rewarded consumers?

More difficult but more necessary – at least in my view – is creating a customer experience that people value enough to make them want to tell their friends and the kind of loyalty that will make them want to stick with that retailer for life. Wal-Mart does not have a formal loyalty program, yet the consistent experience they deliver to customers who seek EDLP keeps people coming back on a regular basis (so much so that they are and have been the world’s largest company since 2001). Apple has no formal loyalty program, but their reputation for innovative products with cool designs keeps people buying their product (including a $700 iPhone) and packing the Apple stores. Neiman Marcus (whose innovative loyalty program is really the gold standard) does not rely on it to keep customers loyal, but rather to create the feeling of being a member of a really exclusive club—a club that’s hard to get into and that once you’re in, you never want to leave.

And, speaking of Wal-Mart, Colloquy’s recently published Retail Loyalty Index ranked Wal-Mart as the most dominant retailer for shopping frequency in all categories (including department store) but at or near the bottom when it came to customer loyalty. So, I have to say that I am admittedly a little perplexed over what is meant by “customer loyalty.” Colloquy’s report was compiled after surveying 3,000 consumers across 6 demographic segments to determine the brands to which consumers are most loyal. Results are presented in the aggregate (e.g. overall loyalty across all consumer segments) and by merchant type (e.g. personal care, department store, mass merchant, grocery).

To quote the survey takeaway: “The survey results demonstrate that, while everyday low price tactics successfully build sales through frequency, this success comes at a cost. With the traditional marketing mix taking a back seat to a relentless focus on price, a marketing strategy focused solely on sale prices and promotions not only faces a diminishing return but can also actually breed disloyal customers. … Simply having twice the number of locations of your competition, it seems, does not guarantee loyalty.”

This is where I get lost. People shop at Wal-Mart more often than the stores that they feel most loyal to? Sort of makes you wonder what loyalty means to those folks. The survey asked respondents to define it as a willingness to recommend a retailer to your friends. A look at Wal-Mart’s annual revenues suggests that an awful lot of those people are suggesting it to their friends. The notion that “marketing strategies based on sale prices and promotions” breed disloyal customers rings sort of hollow when (a) most loyalty programs are really price discrimination schemes anyway and (b) Wal-Mart overshadows the second largest US retailer by a factor of 4. It’s hard for me to understand what price Wal-Mart is paying as a result of having created these so-called “disloyal” customers.

I know, I’ve talked about this before. But it’s worth the revisit: There is a loyalty frenzy going on today that has perhaps lost sight of the real reason that customer loyalty is such an important business objective. Keeping customers loyal is critical to the overall vitality and tenure of a business. Loyalty programs that simply operate as a business veneer don’t do much to further achieve those objectives.

Just ask Wal-Mart.

The sight of merchants up on Capitol Hill demanding that the Feds regulate—read “make a lot smaller”—interchange fees reminds me of the saying: what goes around comes around. Wal-Mart should have learned this lesson. It was behind the massive class action that forced MasterCard and Visa to pay the merchants $3 billion. That class was “certified” only because the 2nd Circuit Court of Appeals adopted an extremely lax legal standard for deciding whether a class made sense (in an unusual move, that court actually reversed its position on this in late 2006).

Not long after that Wal-Mart got a dose of its own medicine when the 9th Circuit Court of Appeals also adopted class-cert lite in deciding that a massive class of Wal-Mart employees could proceed with an employment discrimination case. Other businesses should learn the same lesson: you can’t advocate price regulation and massive intervention into an industry out of one side of your mouth, and advocate laissez faire government policies towards your business out of the other side. Retail prices are gettin’ a bit high these days for some’s taste; maybe we should ask Congress to cap those prices too.

From an economic policy perspective it is hard to fathom anything much dumber that what Congress is considering. We have a pretty competitive payment card industry—perfect no, better than a lot of industries, yes. Into this industry Congress is proposing to establish—a cartel! The idea is the merchants get to negotiate as a group with MasterCard and Visa; Amex is out of the mix for now but don’t be surprised if someone includes them. Perhaps Congress could make sure the merchants pass the savings on to consumers by allowing a consumer cartel to negotiate with the merchants.

Well, no, since you asked. A recent article in the St. Petersburg Times illustrates the confusion over what interchange fees are and how they work. According to the journalist, the average American household will pay $427 in interchange fees this year. Of course, no American household has ever gotten a bill for interchange fees. Interchange fees are paid by merchants to the bank that handles their cards, which then passes the money on to the bank that issued the card to the consumer. What does the merchant get for those fees? Well, they get paid even if the card issuer doesn’t get paid and they are even covered for the risks of fraud. But most importantly they make some additional sales because their customer was able to pay, and possibly finance, conveniently. You can question whether this is a good deal or not, but face it: millions of merchants have chosen to accept cards precisely because the benefits exceed the costs.

Of course, as every high school economics students knows, consumers ultimately bear all costs in a perfectly competitive frictionless economy. So if merchants were atomistically competitive like they are on the blackboard in intro econ courses merchants would pass on all the interchange fees in the form of higher prices. Of course that’s true for everything else as well. Consumers pay for the rent that merchants pay to shopping mall owners. Just think how much consumers pay for all that advertising on nightly television–consumers who buy the advertised product pay those ads too. It is true–but absolutely trivial–that consumers pay for interchange fees; they pay for everything to some degree.

Merchants, for better or worse, aren’t the perfectly competitive producers you saw on your professor’s blackboard though. In the real world, there are many retail segments where merchants have some market power. In this case, they don’t pass on all of their costs to consumers–some of their costs come out of profits. Anyone who believes that the merchants are spending all of this money lobbying for a reduction in interchange fees because they are going to give it all back to consumers is smokin’ something.

I’m not suggesting the interchange fees are a good thing or that the card networks shouldn’t take the merchant complaints seriously. Any business that has half of its customers engaging in an open rebellion should be very worried. But if merchants have a gripe, they should look to the market and not to government to solve their problems. They can embrace one of the new lower interchange fee systems. They could start their own system. Or they could just say no to cards and offer consumers lower prices.

Starbucks announced its new rewards program designed to perk up (pun intended) its worst sales slump in 7 years. This program is designed to give consumers instant gratification – refills, complimentary flavor shots, free drinks with the purchase of coffee beans, and even two hours of free wi-fi (at their Starbucks cafes) so long as they have registered on line and received a Starbucks card. This strategy is reported to be a key lynchpin in their overall effort to boost affinity to their brand, and therefore, their core product by driving more traffic into their 7,000 U.S. based stores. This newly announced rewards strategy is designed to append to existing rewards cards and extend offers to users who have registered for a new one.

Most reports that I have read describe this as an attempt to build store foot traffic in the hopes that these perks lure long lost Starbucks customers back into their store and attract new ones. It’s not a bad idea and will certainly lift sales, but the key question is whether that short term foot traffic will translate into real long term brand affinity.

Starbucks built its business by recognizing the importance of building a relationship with a customer that wanted not only a great product but a great experience to go along with it. People didn’t go quite as far as to tattoo the Starbucks logo on their arms, but it became de rigour to be seen walking with the recognizable Starbucks logo’d cup and to hang out at the local Starbucks. How many times have you asked people to meet you at a Starbucks? I even know people who base their hotel choices on how close it is to a Starbucks. That’s brand loyalty that most companies would pay dearly to have.

Starbucks also has a history of being an early innovator of rewards and loyalty with their launch six years ago of their Duetto card –a first of its kind dual payment/rewards card. About $1 billion was loaded onto these stored value cards last year alone. So, that’s why I was a little bit surprised and even slightly disappointed to read the details of this new rewards program. This rewards strategy, that basically is sort of glorified price discounting, may help get people back into the store to try the product, but I doubt will deliver the long term traction they seek.

Starbucks now has a chance to again be a loyalty innovator and use technology and creative social networking strategies to tap into the relationships that already loyal users have and to strengthen those held by the more occasional user. I read that roughly 14% of all purchases made at Starbucks last year were made using an existing Starbucks rewards cards. That means 86% of their sales were coming from people who bought the product regardless of whether they were getting rewarded another way for their business. What these data don’t tell us is how much of their profits were derived from those 14%. That said, being tuned into the customer turned Starbucks into a powerful global brand from its single store roots in Seattle. Being connected with them will drive continued long term brand loyalty.

Is Google Making Us Stupid? asks Nicholas Carr in the latest issue of the Atlantic Monthly. Carr dances around the question so in the hand we don’t know whether he is just being provocative or whether he really believes it.

The fact that it begins and ends with a doomsday scenario of computers taking over the world suggests perhaps he really believes it. A key premise is surely right: as we obtain new technologies for expressing ourselves and consuming content from others our brains adapt.

I am dubious that there was much of a real break when we went from the quill to the pencil to the typewriter or even to the PC but there surely was when we went from the oral tradition to writing. It is much more plausible that the link-based structure of the web leads to a change in expression and communication though the evidence Carr reports seems a bit thin—it is based on studying library internet logs but doesn’t track what people did later; the bopping around and linkages that people do on the web sounds an awful lot like people used to do in the library stacks.

I have two conjectures: one is that the nonlinear expression and communication made possible by web technologies is making us smarter in being able to learn and express ourselves; and that we are at such an early stage of this new technology (think 10 years after the invention of the quill pen) that we have only a glimmer of its possibilities in expression and learning.

Apple announced its cheaper and chapter iPhone on June 9th with a July 11th deliverable date, not to mention plans to roll the iPhone 2.0 out in about 70 countries.

It is a more traditional play than Apple did the first time around. It’s working with the carriers to subsidize the phone and in return it appears for giving up the vig on the revenue stream. That’s probably smart. It will get the iPhone established as the hardware platform worldwide by encouraging carriers to tease subscribers with it and subscribers to adopt it. And it helps fend off copy-cat attacks from the likes of Nokia and Samsung.

To me this increases the odds—still long—that Apple will be the catalyst that releases the pent up value of the mobile ecosystem. They can do that by getting their hardware and software platform distributed widely and encouraging software developers to write apps that work worldwide. They might still have to butt heads with the mobile carriers who can get in the way of applications but they will have far more power to do so if they become the mobile device of choice for many subscribers.

An interesting question is, whether developers will divert effort from Android or continue to see that as a good way to hedge their bets?

The Internet is killing yet another traditional media outlet—alumni magazines—according to a recent NY Times article. Social networking technology was just about made for doing what these university publications have been doing for decades—keeping alumni connected and engaged so they will hopefully donate money someday. What’s happening with alumni magazines is also a great example of the real power of this new technology.

Those who aren’t that familiar with social networking think it is mainly about putting half naked pictures of your drunken self for all to see. In fact, of course, social networking is a powerful technology for helping people communicate with each other. It will be used for all sorts of very serious purposes in the future not to mention advertising.

I don’t think there’s much doubt that social networking, as a technology, has a lot of legs. One shouldn’t confuse importance with profitable though: the browser was revolutionary but no one has made money from it directly. Social networking will be different but whether it will become an advertising powerhouse remains to be seen.

The Federal Trade Commission finished its first Town Hall meeting on mobile marketing in DC, probably taking a welcome relief from being beat up by Congress over the impending $5 price for a gallon of gas.

This is a discussion worth having in my view and the FTC should be given some credit for having it. Some folks, like Crisp Wireless’s Michael Weaver, argue that consumers really like advertising and the FTC “shouldn’t shoot the messenger.” And increasingly consumers really do like ads, especially on line, because they are being served ads they actually care about.

Someone I met this weekend, told me they send themselves emails on gmail to get the ads. Although I’m not convinced that this translates as easily as Weaver suggests to the mobile phone. Every time I land at an airport in Europe I get a few messages from the local telcom carrier. They annoy me and I’m sure they tick others off as well. It is one thing to get spammed with email on your PC where your eyes can just glide over them if you don’t have a good spam filter, it is another thing on a mobile phone where they may, for now at least, interfere with what you often want to do—make and receive phone calls.

Mobile marketing has great potential but it will work best in the long run if consumers gets advertisements they care about in a manner they like. Having the FTC poke and prod the mobile marketing business a bit probably isn’t such a bad thing for consumers—or for the business.