A good article just posted at the Wharton site about the dynamics of free (pricing) and what it does to markets. This is becoming a hot topic at the moment, and this article summarizes some of the issues nicely.
Indeed, the appeal of “free” has been shown to be so extraordinary that it bends the demand curve. “The demand you get at a price of zero is many times higher than the demand you get at a very low price,” says Kartik Hosanagar, a Wharton professor of operations and information management who studies pricing and technology. “Suddenly demand shoots up in a nonlinear fashion.” Josh Kopelman, a venture investor and entrepreneur who founded Half.com, has written about what he dubbed “the penny gap.” Even charging one cent for something dramatically lessens the demand [generated at] zero cents.
Consumers’ sense of entitlement to free content online “has had catastrophic effects — meaning both large and quick — that I don’t think anyone would have predicted,” says Hoch. “It’s had a yet unknown catastrophic effect on the news. It’s had a catastrophic effect on music. Clearly the concept that you can make it up in volume is bogus, because you can’t. Music CD sales have gone from $13 billion in the U.S. to about $7 billion since 2001 while legal digital downloads generated about $1.5 billion in sales.”