By J Katherine Bahr
In many digital markets that arose over the last 20 years, companies face a conundrum: before their products can create value, they first need to establish a large user base. These strong network effects in much of the technology sector have prompted new business models that, while sound in theory, can fail in practice to capture market share and revenue.
The freemium strategy —where companies offer a basic version of a product for free with an option to pay for upgraded features —ranks high on the list. Freemium models thrive at enticing new users, but do they lead to higher revenues? A new study published in the Strategic Management Journal (SMJ) examines how Apple’s introduction of the Game Center in 2010 changed network effects in mobile app markets to answer that question. The data suggests, no, freemium models don’t always lead to higher revenues in a market with network effects, at least not for everyone.
Examining How Network Effects Change Markets
Network effects often precipitate a concentrated market (where a small number of companies hold market share), making competition highly difficult. Typically, this leads to winner-take-all outcomes, and the company that creates the largest user base when the market first emerges wins out. Apple iOS’s gaming app market is a prime example of this trend, with roughly 40% of each category’s revenues going to market leaders.
Apple’s introduction of Game Center strengthened the gaming app market’s network effects with multiplayer and interactive features. To better compete amidst the changing market, many apps shifted to a freemium model with their next major product update. But the shift took up to 70 days. Researchers exploited this delay to isolate how companies with already established freemium strategies performed with the new, stronger network effects at play.
Using public data on more than 1.4 million mobile apps and Apple’s daily list of top 500 sales and download rankings (to approximate revenue), researchers identified market leaders and followers in more than 485 narrow market categories, including car racing games, bubble shooter games, and match-three games. They found that in categories using freemium strategies before Game Center’s introduction, the strengthened network effects widened already large revenue gaps between leaders and followers by 55%. Leaders gained ground and second-ranked followers lost it.
The results suggest freemium models and network effects are not always mutually beneficial, as many companies believe. Companies that do not lead their market ultimately suffer when both are at play, and the market itself also suffers since competition and innovation ultimately decrease.
How Freemium Models Work
Freemium models are among the most common strategies for companies competing in digital markets, in part because of strong network effects are so common in these categories. Digital freemium or free models usually take one of three forms:
Tiered: Free introductory version, with option to upgrade to a paid premium version.
Examples: Dropbox, LinkedIn, Hubspot
Feature Purchases: Fully functional free model, with in-app purchases to remove ads or unlock features
Examples: Spotify, Hulu, most gaming apps
Data-based: Free, but ads and customer data sales generate revenue
Examples: Facebook, Instagram, YouTube
However, in theory and in practice, the freemium model has drawbacks.
Freemium Model Drawbacks
- A free version creates more awareness and demand for your product, but also essentially creates a competitor in the market.
- Freemium strategies make it difficult for market followers—and even leaders in competitive markets—to generate revenue.
- The more free users you have, the more it costs to support the application, creating potential revenue loss.
- Conversion to paid customers, and converting enough customers to cover the cost of free users, usually takes a long time.
- Churn rates can be high in the freemium model, meaning companies spend a significant amount of time trying to retain their network size.
The study does not offer an alternative to freemium strategies in a market with network effects. Freemium strategies might simply be the table stakes for entering a digital market with network effects, or a savvy and creative business owner might find ways of building a network and revenue through a new business model.
Find a full explanation of the study and how network effects and freemium models intertwine in the full text, available in the Strategic Management Journal.
Boudreau, K. J, Jeppesen, L.B., Miric, M. (2021). Competing on freemium: Digital competition with network effects. Strategic Management Journal. https://doi.org/10.1002/smj.3366.
J Katherine Bahr is a Knoxville-based freelance writer and content marketer with an advanced degree in creative writing and a decade working in publishing and marketing.