When Should Software Firms Commercialize New Products via Freemium Business Models

In the software industry, a challenge firms often face is how to effectively commercialize innovations. An emerging business model increasingly embraced by entrepreneurs, called freemium, combines “free” and “premium” consumption in association with a product or service. In a nutshell, this model involves giving away for free a certain level or type of consumption while making money on premium consumption. We develop a unifying multi-period microeconomic framework with network externalities embedded into consumer learning in order to capture the essence of conventional for-fee models, several key freemium business models such as feature-limited or time-limited, and uniform market seeding models. Under moderate informativeness of word-of-mouth signals, we fully characterize conditions under which firms prefer freemium models, depending on consumer priors on the value of individual software modules, perceptions of crossmodule synergies, and overall value distribution across modules. Within our framework, we show that uniform seeding is always dominated by either freemium models or conventional for-fee models. We further discuss managerial and policy implications based on our analysis. Interestingly, we show that freemium, in one form or another, is always preferred from the social welfare perspective, and we provide guidance on when the firms need to be incentivized to align their interests with the society’s. Finally, we discuss how relaxing some of the assumptions of our model regarding costs or informativeness and heterogeneity of word of mouth may reduce the profit gap between seeding and the other models, and potentially lead to seeding becoming the preferred approach for the firm.