Pandora and a History of its Freemium Business Model 1

By Jordan Marx, MBA

Chris Anderson, Editor-in-Chief of Wired magazine, coined the term “Freemium” to describe the changing nature of business models for content as it is distributed on the web. The theory contends that as the marginal per person cost of a

digital good becomes close to zero when distributed over the internet, the nature of a business’s economic model needs to change to encompass this new reality. A strategy therefore, has developed, in which an enterprise offers the service for free to many, in the hopes that a few will subscribe to a premium or ad free service, thus helping to subsidize the many that use the tuned down equivalent.  Pandora Radio, an internet radio company that specializes in streaming music tailored to an individual’s unique music tastes, is an interesting test case for this new business paradigm. The Freemium model, has evolved to solve the dilemma of users expecting digital content to be no or low cost.

This is juxtaposed with the problem facing many content providers. Some level of fixed and/or variable costs occur even in e-commerce. How does one provide a unique and useful service, for next to nothing in cost and still operate as a profitable e-commerce company? This is the dilemma facing many today. It is said that two to five percent of users will end up subscribing to the premium option, in a healthy Freemium enterprise.  

An Evolving Model

Pandora’s business model has continued to evolve over the last decade. The Music Genome Project was created in the late nineties by musician and entrepreneur Tim Westergren. Westergren conceived of  a radio format in which music could be continuously catalogued with over 400 different tags. Thus, one could evolve a radio in which a customer picked a favorite musician and from that choice, hundreds of different descriptive words would help to create a playlist that matches the musical tastes of the customer’s favorite musician. Originally, Westergren thought of Pandora as a technology that could be licensed to other companies, such as AOL or Yahoo. For four years, Pandora pursued this strategy with no luck. In a sense, this was a web 2.0 business with an older business 2 business paradigm, perhaps not quite right for a new media company. Pandora briefly switched to a subscription only service utilizing a pay wall that would cut off services after a user utilizes their free sample. Pandora would give a small portion of a free sample, such as ten hours of free service, and then charge for additional content.

An image springs to mind of a shopper at the local Costco sampling a cookie in order to decide whether or not the product, in this case the box of cookies, is worth its cost. The problem is there are real costs associated with the brick and mortar associated box of cookies example, and much cheaper costs associated with the marketing and sale of a digital product. The secret is the consumer is intuitively aware that the marginal cost of an online good is (or should theoretically be) close to zero. When the consumer listens to music, they know they can buy from I tunes, or they can listen to free internet radio somewhere else, or they can just listen to traditional radio, for free. The cost of replication and distribution is so low, many users won’t know or believe they need “your” product until they use it, and perhaps only then, they may decide to purchase content.

The problem with Pandora’s original business model is the need to convince the consumer they need the cookie, and with such a low marginal cost, it pays to give a product away, in the hopes they become convinced that in Pandora’s instance, ad free digital streaming music is worthwhile. Pandora’s new business model follows the Freemium strategy as described by Anderson. Users of Pandora’s services are many, and those that pay are few. The advertisements meanwhile drive much of the revenue in which Pandora counts on, while a small yearly fee adds additional revenue. Westergren is a big believer in the ad supported Freemium model. If an advertiser were so inclined, he could request of Pandora to “put this advertisement in front of men in their thirties, listening to rock music in Kansas”. Pandora and Westergren seem to understand Freemium is and will be the dominant business model that drives commerce on the web. Businesses such as Evernote, a cloud based note taking company, Drop Box, a cloud based file sharing company, and Pandora, have only begun to become profitable once they surrender their traditional conceptions concerning the need to maximize the profitability of each paying customer. In e-commerce, the economic theory of marginal benefit is king. After surrendering these notions and allowing for the marginal cost of user-ship to drive marketing, each of these companies have seen revenues increase. It is a paradoxical relationship, but the theme remains true for many large players in digital commerce.

The Value of Free

Pandora offers a unique customer value proposition. They offer an uncanny algorithmic ability to predict the music their customers want to listen to, and unlimited free musical content for those that don’t mind listening to advertisements. They offer this because they have faith the economics of the digital era will equate to a profit margin for hooked users that desire a better bandwidth equipped data stream, no ads, and the unlimited ability to skip tracks. This strategy, known as the feature-limited Freemium model, or FLF for short, allows the customer the time to get acquainted with the product in a way that the Time-limited Freemium model does not. The challenge associated with the time limited Freemium model, is that consumers switch to another product whose marginal cost is closer to zero, as opposed to paying for the content.

Is the Future Free?

The digital world has come a long way since the hemorrhaging of the more traditional methods of commerce on the web. The digital world is no longer divided between obtaining free content illegally, as in the case with Napster and the more recent issues with Torrent files, or conversely paying for each item at its retail non wholesale value, as if it were produced by a brick and mortar store. The true marginal cost of digital content, is so close to zero, that the benefits of an ad based revenue model with a pay wall for “premium” services continues to be a growing and sensible method of enterprise. Customers expect digital goods to be easily acquirable, and they don’t mind wading through an ad or two to get quality services at low/no cost value. The true challenge is how a small startup, in the face of recession, can pay for fixed costs, while trying to grow large enough to obtain the marginal cost benefit of the “digital product”. In a high risk economic environment, selling a free product may be the solution, but much like poker, it is high risk and all in.

For Further Reading:

Anderson, Chris. 2009, Jan. 31st. The economics of giving it away. The Wall Street Journal.

Gannes, Liz. 2010, Mar. 26th. Case studies in freemium: Pandora, Dropbox, Evernote,

Automattic and MailChimp. Gigaom. Retrieved from http://gigaom.com/2010/03/26/case-studies-in-freemium-pandora-dropbox-evernote-automattic-and-mailchimp/

Laudon, Kenneth, C. & Traver, Carol, Guercio. (2011) E-commerce: Business. technology.society. (7th ed.)  Upper Saddle River,  NJ: Prentice Hall

Niculescu, Marius F. & Wu,  D.J. 2011 May 25th. When should software firms commercialize new products via freemium business models? College of Management, Georgia Institute of Technology.

Rose, Charlie. 2010, July, 1. Pandora founder Tim Westergren. The Charlie Rose Show. http://www.charlierose.com/view/interview/11097

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