THE Internet has changed the way people do business. But are users of these services customers in the traditional sense since they do not pay for the services?
Most online content and services have been free since the beginning of the Internet. Over the years there have been some attempts to introduce paying models but most of them have failed.
Internet companies like eBay that offer their services for free have generated a massive number of users.
Every business has customers but are users of these free services “customers” in the traditional sense of the word? Is someone a customer if he doesn’t pay for the service?
I guess you could call them customers because they do generate money for the website, although in an indirect way.
Monetisation can be in the form of advertising, which is the typical Google model. Or it can be achieved by charging a commission on transactions made through the site, which is the eBay model.
When you buy something on eBay, although you don’t get charged beyond the cost of the item, the seller is required to pay a small fee to eBay as commission for the sale.
Conventional wisdom tells us that the seller is obviously a more valuable “customer” than the buyer. But conventional wisdom would be wrong, in this case.
Just because it’s the seller who provides income for eBay doesn’t mean that the seller is necessarily more valuable than the buyer who uses the service for free. Without the buyer, there would be no sale.
Therefore, each buyer in such a business definitely has some value to the company. The question is how much?
For a long time, it was anybody’s guess. It’s hard to set a value on “free” customers because traditional customer valuation techniques do not apply in an Internet business model where the services are offered for free to the buyer.
But three business school professors – Sunil Gupta, Carl Mela, and Jose Vidal-Sanz (from Harvard, Duke and Madrid’s Universidad Carlos III respectively) – have co-authored a paper called The Value of a “Free” Customer which uses a complex mathematical model to figure out the value of each new customer (buyer) joining a website offering a service for free.
Examples of such websites are property sites (whose clients include home buyers and sellers), auction sites (whose customers include buyers and sellers) and job sites (whose customers include both prospective employees and employers).
“A buyer on eBay does not provide direct revenues or profits to the firm but brings in more sellers and increasing numbers of transactions,” said Gupta in a Harvard Business School interview.
“As more jobseekers sign on to Monster.com, more employers are willing to be paying customers for the firm. It is this indirect effect that generates value for a firm.”
The professors’ conclusion might be a bit surprising, although if you’re an entrepreneur running a free-service dotcom, it’s probably something you already instinctively know.
The value of each free customer (buyer) was actually slightly higher than the value of each paying customer (seller).
“We find that in the most recent period buyers have a value of about US$550 (RM1,980) and the sellers have a value of around US$500,” they say. “We also find that our approach leads to estimates of firm value that are more accurate than models that fail to consider network effects.”
The free customer’s value also changes over time.
The professors found that in general, a free customer’s value initially increases as the firm grows but later declines when the firm achieves a critical mass of free customers.
Why being able to estimate the value of free customers is important is that it allows website owners as it allows them to then optimise their marketing expenditure.
Renowned IT author Nicholas Carr explains in a blog review of the professors’ papers that while heavy marketing spending is required in the early days to attract a critical mass of buyers, the network effect itself becomes a larger attractant than marketing as the business grows, allowing a company to cut back its marketing budget over time.
“Knowing the optimum spending amount with some precision at different points in time would help businesses maximise their profits,” Carr says.
“The information would also, the authors argue, allow a company’s founders, managers, and investors to gain a more accurate understanding of the firm’s overall value.”
The research provides guidelines to firms such as eBay or Monster.com on how much they should spend to attract a new buyer or a jobseeker, says Gupta.
“It also shows how a firm may want to allocate its marketing expenditure between buyers and sellers.”
It should be noted that the study is focused on “two-sided markets” where a firm has two types of customers (buyers and sellers) who interact with each other.
They did not look at Web 2.0 sites like social networking sites where the dynamics of customer interaction is far more complex than the “two-sided market” situation. Thus, their model is not applicable to such sites.
Gupta has said that he is currently working on understanding and modelling complex network structures such as those of MySpace.
This is important, Carr explains, because on the Internet today, “free” customers are also critical to businesses with more complex network structures, from YouTube to MySpace to Skype to an open-source software company like Red Hat or MySQL.
Oon Yeoh loves being a valuable free customer. Visit his free website at www.oonyeoh.com