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Beer, Peanuts and Money on the Net
Why a free service like Tiscali may not make it all the way to the finish line
By Hal Varian
Feb. 19 issue — Some internet gurus would still have you believe that free access to the Net is a basic right of man. They are wrong. As economists like to say, there is no free lunch, not even in cyberspace.

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  TO UNDERSTAND WHY, consider the free lunch itself. Bars offer free (often salty) food to encourage people to drink more. This is what economists call “selling complements.” Other examples are razors and blades, left shoes and right shoes, or phone and Internet service. Consumers care only about the total price of the package, so giving away 50 cents of peanuts to sell an extra dollar of beer makes economic sense.
        The logic is clear when complements are sold by one business, like a bar. But what happens when they are sold by different companies? Then there are deals to be made, and this is happening all over Europe. For telephone companies, free Internet Service Providers (ISPs) are like salty peanuts, luring customers. So the phone companies are willing to share a fraction of local-calling revenue with the ISPs, up to 30 percent in some European countries.
        The question is whether that revenue is enough to give people the service they want. Probably not. Most customers aren’t satisfied with peanuts: they want the full Internet buffet (e-mail, calendars, search engines, directories, customer support and the like). So how do free services pay for all that?
        Cheerleaders for the New Economy often argue that “network” enterprises operate under new rules, with special cost advantages. But they do not. An ISP enjoys classic supply-side economies of scale: once it has spent the money to create content, the cost of distributing it is tiny. If ISPs can bring in lots of customers, they don’t have to make very much money on each customer to break even. This phenomenon is often confused by New Economy gurus with demand-side economies of scale or “network effects,” which raise the value of a good to customers. Telephones and fax machines are classic examples—the more customers have them, the more valuable they are to any one customer.
        There’s nothing truly new about the Internet enterprises in any of this. There aren’t even big demand-side economies of scale in selling basic Internet access, unless you add on services. For example, consider AOL’s Instant Messaging service. The more people use Instant Messaging, the more likely others will adopt it. The largest ISPs can benefit from both supply-side and demand-side economies of scale, but only if they develop the right services.
        One strategy is to get big quickly by giving away free Internet access and develop services later. This is what Tiscali is trying to do in Europe. However, it will be difficult to pull this off since the company’s share of revenue from local telephone calls caps the cost of services Tiscali can provide. Furthermore, as telecommunications deregulation spreads in Europe, local-calling rates are likely to plummet. For-fee ISPs like AOL are lobbying hard for flat-rate local calling, which would be great for their business. (If you sold only razors, wouldn’t you want to cap the price of blades?)
        So Tiscali has its work cut out. Flat-rate local calls are the norm in the United States and no one has been able to make the free-ISP model work there.
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       A few companies hoped advertising revenue would cover costs, but that has failed. AOL charges other businesses (like Bloomberg financial services) for the right to appear on its Web sites and gain access to its loyal customer base. Why are they loyal? Because AOL has enough money from its customer fees to keep its customers happy.
        Still, low prices are a classic way to jump-start an Internet business. AOL built its base in the United States by offering 200 hours of free service. Microsoft upped the ante and now offers two years of free access—in the hope of hooking customers on Microsoft services like greeting cards and maps. So the race to grab subscribers is in full stride, and those companies that build customer loyalty will win in the long run. There’s no way a free, barebones ISP can keep the pace. So grab the free lunch while you can. It won’t be around forever.

Varian is professor of economics and dean of the School of Information Management and Systems at the University of California, Berkeley.

       © 2001 Newsweek, Inc.
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