How Internet Companies Make Decisions

People tend to get really freaked out about things like changes to Terms of Service, or new ad placements on their favourite web services. We’ve seen this a bunch of times recently with Google, Facebook and now Instagram, and I thought I’d take a moment to briefly run over why these kind of decisions are made.

The Internet: A Primer

The Internet, at its core, reduces the time of transmission of information. That’s pretty much what all it does.

That transmission of information occurs across infrastructure like servers, switches and cabling that must be operated and maintained.

Infrastructure is expensive. For it to exist, there must be funding, and in most cases, that funding should come from the infrastructure itself or the information that passes through it. If the infrastructure didn’t at least indirectly pay for itself, no sane business would maintain it.

Infrastructure makes its money charging for the information that passes through it. So the question becomes, “how do we make money with information?”

The Magical Secret to Making Money Online

There are two primary ways to make money with information. Sell something, or help someone else sell something.

If you own a tee-shirt store and you build a server and create a website to find new customers, that’s selling something.

If I own a tee-shirt store, and you can find me someone to buy tee-shirts, so long as the cost of customer acquisition is low enough to justify the investment (it costs less to connect through you than it does to connect by other channels, which has many complicating factors), it’s worth doing.

The rest of the system is simply built to facilitate those economics. Instead of personally building servers, hosting providers do that for me. Instead of creating a website myself, web designers do that for me. Analytics providers, and online payment gateways and search engines, and almost all of the other businesses associated with the net are there because in one way or another, they facilitate transactions between buyers and sellers. Somewhere, somehow, money is changing hands, and everyone gets a cut.

But getting people to pay for something can sometimes be hard, so the Internet started a new economy around “free”.

The Economics of Free

By providing a service for free, you reduce the barrier to participation. People love getting something for nothing. If you have millions of users, you don’t need to make a large amount of money from each user to start seeing substantial dollars. But millions x $0 doesn’t pay the bills, so you still need to find a way to make money. If you’re not providing a product or service people will pay for, the only other option is to try to connect those users to products and services they ARE willing to pay for. And that’s exactly what companies try to do. They sell ads, they do affiliate marketing, they sell user’s information to third parties.

Early on in Internet history, there were a few examples of companies that used investor dollars to try to build a free popular web service first, and then figure out how to leverage that popularity later. Yahoo, Facebook, YouTube, Google, and Twitter are all examples, and all of them that wound up making money, eventually found ways to connect buyers and sellers.

Some companies still follow this model. I don’t recommend it, but it’s possible.

And that’s where you get Instagram. They built a large following based on the economics of “free” and were then purchased by another company that either thought they could connect Instagram’s users with sellers, or wanted to absorb their technology to improve their ability to connect their own users with sellers.

So when your favourite free service starts loading up their site with ads, or changes their terms of service to allow them to make money, they’re simply trying to survive the economics of “free”.

There’s a whole other piece about the creation of free content by users (who are not businesses) and how service providers either sell that “something for nothing” as their product (great photos you can use in your ads) or use that free content to better connect buyers and sellers (Andrew writes about the web, try to sell him hosting services), but if you think about it, that’s not particularly complicated.

So that’s how it works.  Maybe the next time your favourite free service does something to try to make money, you’ll understand why.

Posted December 19, 2012 at 7:00AM