The Razor's Edge - Brief Article

A CENTURY AGO, KING CAMP GILLETTE CREATED A BUSINESS CLICHE - AND MADE A FORTUNE - BY PRACTICALLY GIVING AWAY HIS PRODUCTS. DOES HIS IDEA MAKE ANY SENSE TODAY?

This fall marks the centenary of Gillette, the company that invented not only the safety razor but also the business model that has fueled much of the high-tech boom over the past two decades.

Born in 1855, King Camp Gillette was a 40-year-old salesman for Crown Cork & Seal, the author of an anti-capitalist tract called The Human Drift and a failed inventor when he had the epiphany that would rewrite economy textbooks worldwide. He was standing before his mirror, ready to shave, when he realized that the Star razor in his hand was useless. "It was not only dull," Gillette would write later, according to his biographer Tim Dowling, "but it was beyond the point of successful stropping and it needed honing. As I stood there with the razor in my hand, my eyes resting on it as lightly as a bird settling down on its nest, the Gillette razor was born."

The stubble-chinned utopian had just dreamed up the world's first disposable razor blade. It took him five years to find someone who could provide a machine that would automatically hone thin sheets of steel to the required sharpness, and at first the blades sold for less than they cost to make. Undaunted, Gillette forged ahead and eventually had a second epiphany: He would give away a razor and sell the blades. By 1910 Gillette dominated the razor business, and its founder was a millionaire.

Certain types of companies, of course, have always given away or subsidized one product in order to sell another. This magazine is one of them: The Industry Standard, like most consumer magazines, sells subscriptions at a loss in order to make money on advertising. Radio stations and traditional TV networks operate on a similar principle.

Adobe Systems' John Warnock was one of the First to realize that this model made sense in the digital world. Founded in 1982, Adobe gave away its basic Acrobat Reader software to better sell its high-margin creative tools, such as Acrobat Distiller. Adobe is now the second-largest U.S. PC-software company with annual revenues exceeding $1.2 billion. Other companies quickly followed suit, including Oracle, which gives away its development tools to promote sales of its database software, and Sun Microsystems, which supplies Java for free and sells workstations and the Sun operating system. Even IBM, once the quintessential hardware company, has made a successful transition to a service organization while watching the margins on many of its computers decline steadily. (Microsoft, which gives away its Internet Explorer to retain customers for Windows, is a different case, to which I'll return shortly)

In the wake of the dot-com meltdown, though, contrary examples abound: Webvan, for instance, tried to give away home delivery (for orders over a certain amount) to sell more groceries. It burned through more than $1 billion in less than two years and shut down last month. Likewise free Internet service providers, which gave away access in order to sell advertising - that category is essentially dead. Free online media outlets such as Salon and Inside.com have suffered the same fate. In fact, the failure of the giveaway model in many categories can plausibly be blamed for the bursting of the dot-com bubble.

So what types of businesses can profit by giving away stuff? It turns out that this question has recently been explored by a couple of obscure but dedicated economists (is there any other kind?): Marshall van Alstyne of the University of Michigan School of Information and Geoffrey Park of Tulane University. In a paper published last year entitled "Information Complements, Substitutes and Strategic Product Design," the pair presented a theoretical model that explained the razor-and-blades strategy and provided a road map for companies that might pursue it. Their work is full of complex equations and terms like "free strategic complements" and "cross-market externalities," but I think I've managed to glean a few core principles.

No. 1 is that the company must have a compound product, one that can be split into pieces, some of which are given away and some of which are sold at a large profit. Cell phones are a good example: As the cost of the handset has dropped, companies have found it more profitable to essentially give away the device and charge for the calling plan. But, as van Alstyne points out, the paired products must have "strong complementarity" - that is, the one must be unusable without the other. A cell phone without service is no more useful than a razor without blades. Red Hat gives away its Linux-based operating system so it can sell consulting and maintenance contracts, but many customers - particularly the techno-geeks who tend to favor Linux - don't need the services that Red Hat provides. There may not be enough complementarity in that model, which helps explain why Red Hat's share price lost about 86 percent of its value in the past year.