The Price of Free

• Publication year: 2022
• Author: Written by Lesley Chiou and Avigail Kifer

THE PRICE OF FREE

Written by Lesley Chiou and Avigail Kifer¹

I. INTRODUCTION

Offering products for "free" has long been an important tool in business strategy. The U.S. calendar is peppered with days on which consumers can receive treats for free: National Pizza Day (February), National Donut Day (June), and Free Slurpee Day (July), among others.² The Yellow Pages have been distributed to consumers free of charge for decades, as have free-to-air television and radio services. Brick-and-mortar retail establishments offer free samples or products to draw people into their storefronts, and companies have also offered branded apparel and "giveaways" in hopes that wearers would help spread brand recognition.

Nevertheless, "free" products have recently been the focus of many antitrust investigations and complaints, both in the U.S. and abroad. "Free" products have gained particular prominence and ubiquity as the digital economy has developed and expanded. Today's consumers regularly use zero-price digital products or services in the form of search engines (Google, Yahoo, Bing), creative content (YouTube, Pinterest), social media (Facebook, Twitter, TikTok), communications products (Skype, Zoom), travel booking sites (Priceline, Kayak), and navigation services (Waze, Apple Maps, Google Maps).

While zero prices have received increased attention because of their frequency among digital products, the related economic issues they raise are neither new nor unique to digital markets. Economists have long studied zero prices in non-digital contexts and have developed analytical frameworks that could be applied broadly, including to digital contexts.³ Economists broadly acknowledge that "free" goods are particularly interesting because while they deliver clear consumer benefits, they, like other goods, may have the potential to negatively affect both competition and welfare.⁴ This dichotomy may occur because firms that offer "free" products profit through a variety of different strategies, including by collecting valuable consumer data, collecting advertising revenue, bundling with a positive price product, and/or charging consumers for premium services.⁵ Several government reports and antitrust complaints against firms offering zero price goods have taken issue with some of these strategies, contending that, for example, the collection of valuable consumer data or the bundling of products and services allegedly allowed certain firms to secure and maintain dominance in related markets, such as advertising.⁶

One of the challenges now facing the antitrust community is how to assess whether behavior related to zero-price products is anticompetitive, as many metrics for analyzing competition usually rely on a measure of price. Not surprisingly, regulatory agencies have expressed a keen interest in learning more about how zero-price products have affected competition in the modern economy. In January

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2022, for example, the DOJ and FTC issued a Request for Information (RFI) soliciting public input on modernizing the agencies' merger guidelines. A key area of focus was "digital markets," where the agencies specifically referenced "zero-price markets, negative-price markets, or markets without explicit prices" and asked whether "'quality' and other characteristics play the same role as price in market definition."⁷

While it is possible for anticompetitive conduct to exist in markets containing "free" or zero-price products, there are clear procompetitive economic incentives for such pricing arrangements.⁸ Understanding these incentives and the mechanisms through which zero-price products are offered, particularly in (but not limited to) the digital space, is critical to understanding the evolving legal and regulatory environment around zero-price products and competition. In this article, we lay out these incentives and mechanisms, and then discuss the role that quality plays in markets with zero-price goods.

II. INCENTIVES AND MECHANISMS THROUGH WHICH "FREE" PRODUCTS ARE OFFERED

A seller that offers only a single product or service would not find it profitable to offer this sole product or service for "free" to all customers at all times.⁹ In both traditional and digital markets, a "free" product is usually accompanied by a related, paid product. The relationship between the "free" and paid products or services (or between the customer groups paying zero and non-zero prices) is typically what incentivizes firms to offer products or services to certain customers for free in the first place. That is, a firm may find that giving Product A away for free leads to profitable increases in demand for Product B and ultimately higher profitability overall. This could be true whether Product B is an entirely different product from Product A, a higher quality version of Product A, or simply sales of Product A made later in time or sold to a different set of customers.

Evidence from behavioral economics provides further rationalization for the zero-price choice. Studies suggest that there can be a discontinuous change in demand when a product is priced at zero. In other words, demand for a product can jump sharply when its price is lowered to zero. When this discontinuity is present, firms have an additional incentive to offer free products.¹⁰ An example often cited relates to one online retailer's introduction of free shipping in several countries, which triggered a dramatic increase in orders. In contrast, because the price of shipping in yet another country was mistakenly reduced to one cent rather than zero, the number of orders there remained relatively flat.¹¹

There are several different types of economic arrangements in which the price of one product is free. These arrangements differ in terms of the relationship between the free and paid products, whether the consumers of the free and paid products overlap, and whether the zero prices are sustainable in the long run.

A. MULTI-SIDED PLATFORMS

The first type of product that is frequently offered for free is "access" to one side of a multi-sided platform. Economists use the term "multi-sided platform" to refer to a business or firm that adds value by acting as an intermediary between two or more distinct types of agents or customers whose demands for access to the platform (which facilitates interactions or transactions) are interdependent.¹² For example, social media platforms connect users and advertisers; streaming services connect content creators, content consumers, and advertisers; credit cards connect consumers and merchants; health insurers connect patients and healthcare providers.

A multi-sided platform may offer "free" access to one side while charging the other side because the demand from one group is directly or indirectly related to the demand from the other group: the value that customers on at least one side of the platform place on the platform will depend upon the demand for the network by customers on the other side. Economists refer to this form of demand

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interdependency as "indirect network effects" between the customer groups, or "cross-side effects." For example, in the case of credit cards, the demand by merchants on one side and cardholders on the other is interdependent: the card is worth more to the cardholder when it is accepted by a greater number of merchants, and the value to the merchant of accepting payment cards from a particular brand is higher when more cardholders prefer to pay with cards from that brand. Similarly, the larger the audience on a streaming service, the more valuable the platform is to content creators and advertisers. The greater the variety in content, the more valuable the platform is to listeners or viewers.

Indirect network effects have important implications for how platforms price access to their services to each side of the platform and for overall consumer welfare. Demand interdependency means that a platform can increase the total usage of its platform and its profits by charging relatively more to the less price-sensitive group of customers and relatively less to the more price-sensitive group of customers.¹³ In some cases, this can also increase the utility of both customer groups. Thus, in equilibrium, a platform will have an incentive to charge the less price-sensitive group of customers a higher price than the more price-sensitive group of customers, which may optimally result in the more price-sensitive group paying a zero price.¹⁴ For example, a social networking site that allows consumers to join for free would attract more consumers than if it charges an access fee. In turn, the additional consumers would increase the site's value to advertisers, possibly even to the point where the increase in advertising profits more than covers any...