In the increasingly competitive landscape of major OTTs like DisneyStar, Amazon Prime, and Netflix, my mind turned to a different player: VLC, the media player.
It made me wonder:
How could software as reliable and efficient as VLC be free?
So, when I jumped into this rabbithole, the first thing I found out was that,
Contrary to popular belief, VLC is not exactly free.
“But Aditya, I've been downloading VLC Media Player for free on every computer I've had since I've had computers. How can VLC be both free and not free simultaneously?”
The explanation lies in the Pareto principle, where 20% of donations to VLC subsidise the service for the 80% of individual users who use it for free. While VLC does not charge individual users, large organisations and businesses using VLC contribute donations, often for specific controls, customisations, and continuous support.
This business model isn't unique to VLC.
Canva, for instance, provides free services to light users, while 67% of their 100 million users pay for a premium subscription.
Even Google Maps, which individual users access for free, is a paid service in case a business would like to use it. Google has been introducing ways for developers to embed ads on Google Maps. Google also offers a service available to enterprises to pay for the rights to use the Google Maps API behind protected logins and intranets (currently against the free terms of service).
From a business perspective, it is natural to wonder how this arrangement makes sense. Because the money a small business owner makes by using Canva for free doesn’t reach Canva.
When YouTube uses VLC to stream its content to users efficiently, the money made from ads and other services it provides as a video platform are all accrued to YouTube. Sure, YouTube will pay a small donation, but if VLC operated like any other business, it would have earned way more by offering itself as a paid service to different businesses, right?
But thinking that way is myopic. Here’s what you are not considering.
By offering its service or code for free, an organization like Canva or VLC comes to dominate the market for that need.
You can think of it as a network effect. More people use a specific service because everyone around them uses it. But the network effect explanation makes itself clearer in the case of a service like WhatsApp. As all your friends are using WhatsApp, it makes sense for you to use it as well. The value of the messenger increases the more people are using it.
And everyone is on WhatsApp because it is free and works well. But a business that uses WhatsApp Service Provider (WSP) pays to use the service. And businesses will readily pay WhatsApp that money because all their customers are using WhatsApp.
So, by initially offering the service for free and creating network effects around the use of that app or software, you amass large distribution and market penetration. This distribution then helps you derive much more value in the long term than if you had charged for the product from the get-go.
What Google did with Android is a prime example of this.
Android was an open-source operating system (OS) that was created to compete with Apple’s iOS. Google could’ve bought Android and sold it to multiple phone manufacturers. But Google simply open-sourced Android, and manufacturers could easily come up with much cheaper hardware and simply use Android with a few customizations on top.
Soon, smartphones from Samsung, LG, HTC, and other Chinese brands flooded the market.
Google suddenly had millions of smartphone users using Google Play Services and all the apps bundled within it. Today, Google not only benefits from all this valuable data it is collecting 24x7, but it also earns commissions on apps sold on Google Playstore.
So, if businesses thought myopically, they would restrict distribution by demanding all customers pay for it. But by doing the exact opposite, they turn in more revenue by eventually dominating the market. Even if a minority of their users are paying, it can still lead to millions in revenue.
However, this pricing strategy can only apply to software products, not physical, tangible goods.
For physical goods, scaling up production benefits from economies of scale, sure, but the cost of the product never approximates to zero.
In contrast, software products, once developed, can be distributed widely with virtually zero marginal cost. This unique characteristic enables software companies to offer free services to some users, while simultaneously charging industrial clients for usage and insights.
The marginal cost of production refers to the cost incurred to create an extra unit of the product.
For example, if you manufacture T-shirts, you can produce 100 T-shirts for ₹10,000 at ₹100/t-shirt but if you have to produce 10,000 T-shirts, you will need another ₹6,00000 - ₹8,00000 depending on the economies of scale the T-shirt business benefits from.
But once a software code is written and works optimally, it can scale infinitely. If it's hosted on a server, the server costs will go up, sure. But if it's a downloadable piece of software that runs on individual machines, you can build it once and replicate it infinitely without paying a dime.
All further product development can then be funded by the tiny minority of users who choose to donate or pay for a premium product/plan with more features.
Funnily, even Stoa Daily, in a way, can afford to be free because of the same principle.
15,000 readers receive this newsletter for free. In the future, even 50,000 might. And this daily newsletter will be subsidized by the people who pay the fee for the program!
The success of this model, however, hinges on businesses having a long-term vision and a capacity to build an excellent product.
But in any case, the Pareto pricing principle is a compelling strategy to think about, at least for software businesses. It offers them a potential pathway to market dominance and creating substantial long-term value.
If you enjoyed reading this piece, this one will serve as a great complement to aid your understanding even further.
