With the recent blockbuster success of Pokemon Go, people are asking how a free game has managed to pull in more than $160 million in its first month.

Welcome to the “freemium” business model, which over the past decade has quietly completely changed entire industries.

In the video above, Vox outlines the simple mechanics of how an app which you don’t have to pay for can make you pay real money for virtual goods (often called in app purchases or microtransactions).

It’s all about one of the greatest business model innovations of the past few decades, called a “freemium” service.

“Freemium” products are free to get started with, but with premium additions you can purchase to improve your experience

You may have heard of several news stories of the past few years where people are racking up huge bills with in-app purchases, often by children.

In fact, I even found an example of a 15-year old who spent $46,000 in a free-to-play game.

Fortunately, this doesn’t happen as often anymore, especially as smartphone makers Apple and Google and the industry have put in place new regulations to make it much clearer that apps may not be completely free, and allowing parents to turn off the in app purchasing functionality.

The way Freemium works

Even though children aren’t running up huge bills anymore, the business model is only growing stronger and more dominant.

Many of the world’s most popular games use this model, including arguably the most played game in the world, League of Legends, which made more than $1 billion last year despite being free to play. The producer of smash hit “Clash of Clans” made $2.6 billion in 2015, with $930 million profit. And as much as I hate to admit it, the Kim Kardashian: Hollywood game has allegedly made over $100 million [Editor: Sad times for that last fact :(]

And while many people do never spend a single cent in the games, the small proportion of people who do end up paying money often end up spending significantly more than if the game had been free to start with. According to the video above, only 1.9% of players actually make in-app purchases, but they spend so much they are classified in the same way Las Vegas calls their most valuable players: Whales.

You could illustrate a typical freemium experience like this:

It’s all down to the fact that the games are designed with lessons from behavioral psychology in mind.

While people can play almost all of these games from start to finish without paying anything, there are often restriction built into the game which are designed to cause a degree of limitation and frustration to progress for free players. The most common of these are:

  • A limited number of moves which can be done per day
  • A countdown timer which makes you have to wait for your actions to complete (often for several hours or even a day)
  • Seeing premium items which don’t offer a gameplay benefit but change the look of a character, and can only be unlocked by spending credits

Almost all of these games use a “game credit” or currency, like gems, gold coins, stars, or hearts which you can spend to unlock items or remove frustrating limits.

And in order to purchase these credits, you pay using your digital wallet, paypal or credit card. These will often come in “bundles” of numbers which aren’t easily divisible in your head, like 12, 30, 75 or 150. And this weird exchange rate tricks your brain into making it seem like you’re spending less each time you use these credits.

This means that if you pay $29.99 for a pack of 75 gems, and it costs 4 gems to unlock a virtual outfit, how much did that item actually cost you in real money? It’s too hard for your brain to compute, and so it almost isn’t translated back to a real dollar amount, feeling instead like you aren’t spending real money. It’s similar to when you travel and are unsure of how much you are spending in a foreign currency.

Previous studies have shown that people will be more likely to spend money on an item using a credit card than with cash, because with cash you physically see and feel the money leaving you and you have a complete understanding of how much it is. Even with a credit card, it feels further removed.

Why Freemium isn’t all bad

If you think I’m painting freemium games in a negative light, you’d be wrong. The business model has actually helped

The business model has actually helped numerous small companies make the most of the maturing app marketplaces, especially with increasing broadband penetration, more efficient payment gateways and digital wallets. It enables smaller companies to have a more direct path to consumers and build long-term relationships with their customers.

The best examples of this, and where freemium is becoming the dominant business model is in video games. Historically, in order to reach the largest number of consumers you needed to have your game published through a mega-publisher like EA, Activision or Ubisoft, who could print the disks, put a marketing budget behind them and finance the production. But this often meant the creators giving up a larger degree of creative freedom.

Now, a smaller studio can release a game independently and get payment directly from the people using it over a longer period of time. The studio also needs to continuously improve and add value to the game, since if people stop using it, the studio will stop earning. So there is a mutually beneficial relationship of the games improving in quality over time, and a sustainable revenue stream for the studio while they maintain creative control.

I also think that this business model allows the market to regulate itself, with apps and games that are deliberately trying to extort their players quickly being overtaken by those which are actually designed to give a great experience to players who will never spend a single dollar in the game (the vast majority of people), and provide an actual premium experience to those who are willing to pay for it.

It’s something I advise all of my innovation consulting clients to do:

Make sure your baseline offering is already great, and then think of ways you could add even more value on top of that

But for now, I hope my friends don’t get injured trying to catch that next rare Pikachu near a cliff.

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Chief Editor of Ideatovalue.com and Founder / CEO of Improvides Innovation Consulting. Coach / Speaker / Author / TEDx Speaker / Voted as the world's #7 Innovation blogger in 2014, I help individuals and companies build their creativity and innovation capabilities, so you can develop the next breakthrough idea which customers love.