Free: An excerpt from Chris Anderson's book

20 Jul 2009

I'm in a huge banquet hall in Guangzhou, China, sitting in the front row of a spectacular show. We've already had the acrobatics, the kung fu exhibition, the dancing girls and the comedy act. Now it's time for the real star, Taiwanese pop sensation Jolin Tsai.

The audience cheers as she sings some of her best-known numbers, her gown shimmering in the lights against a backdrop of her face blown up to room size on a huge video screen.

This is not a concert, however. It's a sales meeting of China Mobile employees and partners. We've had a day of speeches on the telecom business and it is just customary to finish off with a fancy show. For her performance, Tsai was probably paid more than she earned from CD sales all year.

China is a country where piracy has won. Years of half-hearted crackdowns under diplomatic pressure from the West have had no apparent effect on the street vendors or countless sites that host MP3s for downloads. Every year there are some ceremonial piracy busts, and some of the bigger sites occasionally have to pay fines, but none of this has stopped average Chinese music consumers from finding pretty much everything they want for free. So rather than fighting piracy, a new breed of Chinese musicians is actually embracing it. They know that piracy is a form of zero-cost marketing, which brings their work to the largest possible audience. That in turn maximises their celebrity (at least for the brief duration of any Chinese pop star's fame), and it is up to them to find ways to convert that celebrity into cash during that valuable time.

Xiang Xiang is a 21-year-old Chinese pop star, most famous for her cheeky hit "Song of Pig". Her last album sold nearly four million copies. The problem is that almost all of them were pirated versions. Or rather, that's her label's problem. She's fine with it. As far as she's concerned, that's four million fans she wouldn't have had if they'd had to pay full price for the album, and she likes the feedback and adulation. She also likes the money she gets for personal appearances and product endorsements, all made possible by her piracy-enabled fame. And then there's the concert tour, which should take her to 14 cities this summer. The pirates are her best marketers.

Piracy accounts for an estimated 95 per cent of music consumption in China, which has forced record companies to rethink completely what business they're in. Since they can't make money from selling music on plastic discs, they package it in other ways. They ask artists to record singles for radio play instead of albums for consumers. They serve as a personal talent agency for the singers, getting a cut of their fees for doing commercials and radio spots.

Even the concerts are paid for by advertisers in deals brokered by the labels, which pack as many of their artists on stage as they can to maximise the revenues from sponsors. The main problem is that the singers complain that the endless touring, which provides their only income, is tough on their vocal cords. "China will become a model for the world music industry," predicts Shen Lihui, who runs Modern Sky, one of the more innovative Chinese music labels. The company's CDs rarely make money because the popular ones are quickly pirated. But the label has other ways of making money, producing videos and now, increasingly, websites. It also runs a three-day music festival that attracts fans from around the country. Ticket sales form part of its revenues, but sponsors are where the real money is: Motorola, Levi's and others.

That's not to say that you can't sell music in China: you can, as long as the songs are less than 20 seconds long. The ringtone business is huge: China Mobile, the largest carrier, reported more than a billion dollars in music revenues in 2007. Most of that was kept by China Mobile, of course, but that's still real money.

Ed Peto, a Briton living in Beijing, is trying to find another way to turn music into a business. His company, MicroMu, signs emerging indie artists and gets brands to sponsor the entire operation with a monthly fee. The way it works may sound strange to a Western record label, but it makes perfect sense to a product marketer in China, who is actually the paying customer in the equation.

MicroMu records artists as cheaply as possible, either live in front of an audience at a sponsored show or in an inexpensive studio space or a rehearsal room. They film everything surrounding these sessions and make a range of branded video content from this.

Each recording is released through a blog post on the MicroMu site, complete with links to free downloads of individual MP3s, full album downloads, credits, artwork etc. Then the company also hosts regular live events, including university tours. Brands such as drinks and jeans companies sponsor MicroMu, but not the individual artists (to avoid tarnishing their indie credibility). A percentage of the sponsorship money is divided up among the artists according to how many downloads they get through the site. "The moment you put a fee on accessing music in China is the moment you cut off 99 per cent of your audience," says Peto. "Music is a luxury for the middle class in China, a flippant expenditure. This model works against that. We simply use free music and media as a way of saying that 'everyone is welcome', building a dialogue, building a community, becoming the trusted brand of the grassroots music movement in China. To do this, though, we have to become all things to all men: record label, online community, live events producers, merchandise sellers, TV production company."

As goes China, so may go the rest of the world. Record sales in the United States fell by nearly another 10 per cent in 2008, and the bottom is nowhere near in sight. The day may come when many labels simply capitulate and follow the Chinese model, letting music go free to become marketing for the artists, whom they monetise in non-traditional ways, such as endorsements and sponsorships.

There are already some glimpses of this: the deal Robbie Williams has with EMI is based on a share of all his revenues, including touring and merchandise. And talent agencies such as the giants CAA and ICM are considering becoming music labels, to cut out the middleman. In a world where the definition of the music industry is changing every day, the one constant is that music creates celebrity. And there are worse problems than the challenge of turning fame into money.

&gt;The Gucci knock-off economy

Piracy doesn't stop at film, software and music in China. Just get off the train in Shenzhen and you are immediately bombarded with knock-off Rolex watches, Chanel perfume, Gucci bags and countless ersatz toys and gadgets. Like the pirated CDs on the street corners, these aren't actually free, of course, they're just very cheap, and the original creators aren't seeing a penny of the sales. The intellectual property rights are free; you just pay for the commodity atoms. But as with music, the roots and consequences of this piracy are more subtle than they appear.

Piracy extends to virtually every industry in China, a combination of the state of development of the country, its legal systems and a Confucian attitude toward intellectual property that makes copying the work of others both a gesture of respect and an essential part of education. (It's often hard to explain to Chinese students in the United States what's wrong with plagiarism, since reproducing the masters is so central to Chinese teaching.) Today, an entire industry exists in China to clone designer goods overnight: software allows factories to take photographs of Fashion Week models from the web and produce simulations of designer clothing within a couple of months - often beating the originals to the stores.

In the Western press, Chinese piracy is seen as little more than a crime. Yet within China, pirated goods are just another product at another price, a form of market imposed versioning. The decision whether to buy a pirated Louis Vuitton bag is not a moral one, but one about quality, social status and risk-reduction. If people have the money, they'd still rather buy the real thing, because it's usually better. But most people can afford only the pirated versions. Just as the Cantopop download sites create celebrity while they displace sales, the pirates aren't just making money on somebody else's designs; they're also serving as a form of zero-cost brand distribution for those designs. A fake Gucci bag still says Gucci, and it's everywhere. This has mixed consequences: a combination of the negative "replacement effect" (the pirated versions absorb demand that the authentic versions might have tapped) and a positive "stimulus effect" (the pirated versions create brand awareness that can be tapped elsewhere).

In 2007, the China Market Research Group surveyed consumers, mostly young women, in big Chinese cities and found an essentially pragmatic approach to piracy. They understood the difference between the original and pirated products, and preferred the originals if they could afford them. Sometimes they would buy one original and then complete their outfit with fakes.

One of the researchers, Shaun Rein, reported that some young women making $400 a month said that they were willing to save three months' salary to buy a $1,000 Gucci handbag or shoes from Bally.

One 23-year-old female respondent said, "Right now I can't afford to buy a lot of real Prada or Coach, so I buy the fake items. I hope that in the future I will be able to afford the real thing, but right now I want to look the part."

Looking the part doesn't always mean just buying convincing fakes.

It has also created a market for fake evidence that the product isn't fake. There's innovation for you. You can buy large-sum price tags to attach to your low-sum clothes (it's not uncommon to see people wearing sunglasses with the price tag still attached), and there is even a secondary market in fake receipts. The products are one thing, but the status that goes along with them is much more important.

A 27-year-old woman working at a multinational admitted that she did buy fakes but said, "If you wear a lot of fake clothing or have a lot of counterfeit bags, your friends will know, so you are not fooling anybody. It is better to have the real thing."

This highlights the difference between digital and physical goods.

Pirated digital products are every bit as good as the originals.

But pirated physical products usually aren't. After years of scandals involving knock-off Chinese baby and pet food with inferior and sometimes poisonous ingredients, Chinese consumers are hyper-aware of the risks associated with purchases made in the grey economy.

The throngs of Chinese consumers traveling to Hong Kong to buy certified luxury goods are testament to the effect of the ubiquitous pirating of designer products on the mainland: consumers are very aware of Western luxury brands, they associate them with style and quality, and they're keen to buy the real thing when they can. And, increasingly, they can.

Piracy didn't destroy the market - it primed the market for an emerging tide of middle-class consumers. Per capita income has more than doubled in China in the last decade, from $633 in 1996 to $1,537 in 2007, and shows few signs of slowing. There are now around 250,000 millionaires in China, and the number is growing every day. Today, China (including Hong Kong) is the third-largest market for legitimate luxury goods in the world. In economic terms, piracy stimulated more demand than it satisfied.

The idea that knock-offs can actually help the originals, especially in the fashion business, isn't new. In economics, it's called the "piracy paradox", a term coined by two law professors, Kal Raustiala and Christopher Sprigman.

The paradox stems from the basic dilemma that underpins the economics of fashion: consumers have to like this year's designs, but also quickly become dissatisfied with them so they'll buy next year's designs. Unlike technology, say, apparel companies can't argue that next year's models are functionally better - they just look different. So they need some other reason to persuade consumers to lose their infatuation with this year's model.

The solution: widespread copying that turns an exclusive design into a mass market commodity. The designer mystique is destroyed by cheap ubiquity, and discriminating consumers have to go in search of something exclusive and new.

This is what Raustiala and Sprigman call "induced obsolescence".

Copying allows fashion to move quickly from early adopters to the masses, forcing the early adopters to adopt something new. In China the early adopters are the emerging rich and middle class, whereas the masses are a billion people who can still dip their toe in the luxury market with a clever fake. The two products - real and knock-off - are simply targeted at different market segments. Each feeds the other. And it's not just in China.

&gt;The power of Brazilian street vendors
On a busy corner in São Paulo, Brazil, street vendors pitch the latest "tecnobrega" CDs, including one by a hot band called Banda Calypso. "Brega" doesn't have a direct translation, but it roughly means "cheesy" or "tacky", and the music, which comes from the poorer northern state of Pará, has an unruly party sound, traditional Brazilian music driven by a techno beat. Like CDs from most street vendors, these are not the official offerings from a big label. But neither are they illicit.

The CDs are created by local recording studios, which tend to be run by local DJs. They, in turn, get the masters from the band itself, along with CD liner art. The local DJs work with local party planners, street vendors and radio stations to promote the upcoming show. Sometimes the local DJs are actually all of these combined, producing, selling and promoting the CDs for the show that they themselves are organising.

Banda Calypso doesn't mind that it doesn't get any money from this, because selling discs isn't Calypso's main source of income. The band is really in the performance business - and business is good.

Moving from town to town this way, preceded by a wave of supercheap CDs, Calypso can fill hundreds of shows a year. The band usually plays two or three shows a weekend, travelling around the country by minibus or boat.

But it's not all road and river trips. Hermano Vianna, an anthropologist and scholar of Brazilian music, tells a story about Calypso to illustrate their success. While planning a feature on the band for his Globo TV music show, Vianna offered a Globo-owned airplane to get the band to and from a show in a remote area of the country. Calypso's reply? No need, we have our own plane.

In a sense, the street vendors have become the advance team in each town that Calypso visits. They get to make money from the music CDs, which they sell for as little as $0.75, and in turn they display the CDs prominently. Nobody thinks of the vendors' cheap CDs as piracy. It's just mar keting, using street economy to generate (literal) street cred. As a result, by the time Banda Calypso comes to town, everyone knows about it. The band gets huge crowds to its "soundsystem" events, where it not only charges admission but also for food and drinks. The band's crew also records the show and burns CDs and DVDs on the spot, selling them for around $2 so concertgoers can replay the show they just saw.

More than 10 million of Banda Calypso's CDs have been sold, mostly not by the band itself. And they're not alone. The tecnobrega industry now includes hundreds of bands and thousands of shows each year. A study by Ronaldo Lemos and his colleagues at the Centre for Technology and Society at Rio de Janeiro's Getulio Vargas Foundation found that between the shows and the music, this industry generates around $20 million in revenue a year.

Ninety per cent of the bands have no record contract and no label.

They don't need one. Letting others get their music for free creates a bigger industry than charging ever could. This is something that Brazil understands better than most: its culture minister until 2008, the pop star Gilberto Gil, has released his music under a free Creative Commons licence.

As in China, the drive towards Free in Brazil goes far beyond music. In 1996, in response to Brazil's alarming rate of HIV infection, the government of president Fernando Henrique Cardoso guaranteed distribution of the new retroviral drug cocktails to all HIV carriers in the country. Five years later, with the Aids rate dropping, it was clear that the plan was wise but - at the prices being charged for the patented drugs - unsustainable.

So Brazil's health minister, Jose Serra, went to the key patent holders, the US pharmaceutical giant Merck and the Swiss firm Roche, and asked for a volume discount. When the companies said no, Serra raised the stakes. Under Brazilian law, he informed them, he had the power in cases of national emergency to license local labs to produce patented drugs, royalty-free, and he would use it if necessary. The companies caved in and prices fell by more than 50 per cent. Today, Brazil has one of the largest generic drug industries in the world. Not free, but royalty-free, an approach to intellectual property rights that the industry shares with the tecnobrega DJs.

Then there's open source, in which Brazil is a global leader. It built the world's first ATM network based on Linux. The prime directive of the federal Institute for Information Technology is to promote the adoption of free software throughout the government and ultimately the nation. Ministries and schools are migrating their offices to open-source systems. And within the government's "digital inclusion" programmes - aimed at bringing computer access to the 80 per cent of Brazilians who have none - Linux is the rule.

"Every licence for Office plus Windows in Brazil - a country in which 22 million people are starving - means we have to export 60 sacks of soybeans," Marcelo D'Elia Branco, co-ordinator of the country's Free Software Project, told writer Julian Dibbell. From his perspective, free software isn't just good for consumers, it's good for the nation.

Coda: Free in a time of economic crisis

After the 2001 stockmarket crash, the business models of the economy were laid bare. What were we thinking when we stuffed our portfolios with companies that sold pet food online? A few years later, when the markets recovered and we looked back, we found it was hard to see the effect of the crash on the growth of the net. It had continued to spread, just as before, with hardly a dip as the markets cratered. This had been a Wall Street bubble, not a technology one. The web was every bit as important as even the most starry-eyed forecasters had predicted - it just took a bit longer to get there than the stockmarket multiples had assumed.

Now the markets have crashed again, will Free be more like web traffic and grow regardless - or more like online pet food?

From a consumer perspective, Free is far more attractive in a down economy. Expect the shift toward open-source software (which is free) and web-based productivity tools such as Google Docs (also free) to accelerate. Consumers are also saving money and playing free online games, listening to free music on Pandora, cancelling basic cable and watching free video on Hulu, and killing their landlines in favour of Skype. It's a consumer's paradise: the web has become the biggest store in history and everything is 100 per cent off.

What about those companies trying to build a business on the web?

In the old days the model was simple: (1) have a great idea; (2) raise cash to bring it to market - ideally free, to reach the most people; (3) if it's popular, raise money to scale up; (4) repeat until bought by big company.

Now steps 2 to 4 are no longer available. So web start-ups have to do the unthinkable: come up with a business model that brings in money while they're still young.

This is, of course, nothing new in the world of business. But it is a bit of a shock in the web world, where "attention" and "reputation" are the currencies most in demand, with the expectation that a sufficient amount of either will turn into money someday, somehow.

The standard business model for web companies that don't have a business model is advertising. A popular service will have lots of users, and a few ads on the side will pay the bills. Two problems have emerged with that model: the price of online ads and click-through rates. Facebook is amazingly popular, but it is also an amazingly ineffective advertising platform. Even if you could figure out what the right ad to serve next to a high-school girl's party pictures might be, she and her friends probably won't click on it. No wonder Facebook apps get less than $1 per 1,000 views (compared to around $20 on big media sites).

Google has built an enviable economic engine on the back of its targeted text ads (see page 79), but the sites on which they run rarely feel as flush. Running Google's Adsense ads on the side of your blog, no matter how popular, will not pay you minimum wage.

What about the oldest trick in the book: charging people for goods and services? This is where the real innovation will flourish in a down economy. It's now time for entrepreneurs to innovate, not just with products, but with new business models.

Take Tapulous, the creator of Tap Tap Revenge, a popular (free) music-game app for the iPhone. Many people were ready to pay when Tapulous offered paid versions built around specific bands, such as Nine Inch Nails, along with add-on songs.

But extracting a business model from Free is not always easy, especially when users expect gratis. Take Twitter: after taking over the world, it now has to make money to cover bandwidth bills.

YouTube is still struggling to match its huge popularity with revenues. News-sharing site Digg, for all of its millions of users, still doesn't make a dime.

Does this mean that Free will retreat in a down economy? Probably not. The psychological and economic cases remain as good as ever - the marginal cost of anything digital falls by 50 per cent every year. "Free" has as much power over the consumer psyche as ever.

But it is not enough. It also has to be matched with Paid. Just as Gillette's free razors made sense only when paired with expensive blades, so today's entrepreneurs will have to invent not just products that people love, but also those they will pay for. Free may be the best price, but it can't be the only one.

Chris Anderson is editor-in-chief of US Wired. Extracted from FREE: The Future of a Radical Price, by Chris Anderson (Random House, £18.99). © Chris Anderson 2009