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.