Valuing Free Customers

Two sided markets are an important concept in economics and business. They have some exciting characteristics and present some great problems in deciding on corporate strategy. One issue is: how much should a company pay to acquire a customer who isn’t paying anything?

The Value Of Customers Who Don’t Pay Anything

We usually do lifetime value calculations based upon the amount that a customer pays less what they costs all suitably discounted to take account of when the money is received, (money now being generally more valuable than money later). There are, however, a bunch of customers who give value to a firm without ever providing any revenue directly to the firm. What would an auction house be without buyers even though sellers often pay the fees. A similar thing happens in the (admittedly more complex world) of realtors. The whole thing doesn’t work without people who aren’t paying anything (at least directly) to be customers.

Paying for “Free” Customers

How much should a firm pay to acquire a customer who isn’t planning to pay anything (directly) to the firm? Sunil Gupta and Carl Mela address this issue in a 2008 HBR piece.  They build a model for “Auctions.com”, a major international online auction house, using historical data. This data allowed them to investigate how the “growth in the number of both sellers and buyers was affected by (a) the firm’s marketing strategies — advertising, pricing, and so on; (b) direct network effects; and (c) indirect network effects”. (Gupta and Mela, 2008, page 104). Direct network effects are where buyers (sellers) attract more buyers (sellers) whereas indirect network effects are when each group attracts the opposite group — buyers attract sellers and sellers attract buyers.

Their model allows them to assign value to customers who aren’t paying anything — but are creating value for those who do pay something. Having a buyer on the site creates an incentive (the indirect network effect) for a seller to join the site and sell stuff — providing the firm’s revenue though the seller’s fees. What should we spend on recruiting customers who don’t pay us is a fascinating business problem that these scholars highlight and provide a way of solving.

Read: Sunil Gupta and Carl Mela (2008) What is a Free Customer Worth?, Harvard Business Review, November, pages 102-109.