Chris Anderson was first a physicist, then an editor for the Economist. Now he’s the editor of Wired. He also has some interesting hobbies, including a startup based around open source airborne drones. In other words, he’s uniquely qualified to talk about how “free” is transforming the software industry.

Opening up day 2 of the SIIA Software Summit, he presented some exerpts from the forthcoming book Free: The Future of a Radical Price (quite a lot of which is outlined in a series of Wired stories.) Chris was kind enough to give me an uncorrected proof a few weeks ago, and having read that, it’s clear this will be a juggernaut of a book. Free is a disruptive idea resulting from an economy where many of our marginal costs are falling to zero.

There are few places it disrupts more than the software industry, and Chris didn’t mince words with a roomful of industry executives: “The three technologies you guys depend on are becoming too cheap to meter.”

Three things we should waste

The first of these, processing, is an abundant resource. Abundant resources should be wasted, because when the marginal cost of something goes to zero that’s what markets do to figure out what they’re for: Put them in the hands of many so they can experiment.

Once upon a time, nobody knew how to “waste” processing power. With the advent of consumer interfaces, graphics, mice, and so on, it became easy to waste processing power — by taking computers away from the IT guys and into the household, and spending all that abundant processing resource on things like animations and wallpapers.

Now, we’ve figured out what computers are for. We did so through treating an abundant resource as if it were free, making it easy to use and ubiquitous.

The second technology falling to a zero marginal cost is storage. Unlimited disk space enjoys similar economics to processing. Chris points out that his kids’ new Dell (and these are admittedly smart kinds who do Lego stop-motion animation) has a terabyte of data. At the same time, he gets mails at work asking him to delete files from the server, because it only has 500 GBytes. As a result, his organization was wasting time deleting files — when in fact storage is effectively free. Enterprises live in the dark ages of technology; consumers already take storage capacity for free.

We can waste storage by keeping things forever.

The third technology is bandwidth — based on another set of physical properties that are falling in price even more quickly than processing or storage. We’re still trying to figure out how to “waste” bandwidth. But we have some good ideas — it costs Netflix $0.06 to deliver a movie this year, and will cost $0.03 next year.

There’s a strong similarity between free bandwidth and broadcasting. A broadcaster can reach a million people as easily as it can one person once the broadcasting tower is built. There’s a near-zero marginal cost of adding another user. To use up the free resource of broadcast, we invented Mass Media — prime time, radio, and so on.

The downside of broadcast is mass media. “The problem with Everybody Loves Raymond, is that nobody loves Raymond. We like 30 minutes of domestic scenes with likeable characters and happy endings. But the things we’re most interested in are the things that divide us — and they’re the things that don’t work on primetime, or top 40 radio.” In other words, the stuff that we love has no place in broadcast, because we end up with an audience of one.

Where it does have a place is online. “Everyone says Youtube is full of crap, and that’s exactly right: Being full of crap means you’re wasting things.” Chris points out that his kids would rather watch Youtube stop-motion animation of Star Wars than the original George Lucas epic. They value relevance — animations by their peers — over quality.

We’re wired not to squander

As mammals, we’re wired not to waste. Every death is a tragedy; so we protect our young. Dandelions and Bluefin tuna, by contrast, scatter their seeds far and wide, expecting a tiny return on investment. Nature squanders in order to optimize.

But we don’t do that. We consider resources scarce, and valuable.

21st century “free” is different

In the modern economy, free isn’t simply a cross-subsidy — razors and razor blades, printers and ink, and loss-leaders. Instead, it’s about the price when the marginal cost of something goes to zero. Unlike atoms, which were the basis of the industrial economy, bits are the basis of the information economy. They’re nearly free.

This is disrupting everyone. The media business pays journalists $3 word, and they’re competing with laser-focused specialists writing for free. Bertrand said “in a competitive market, price falls to the marginal cost.” But what happens when that marginal cost is zero?

We’ve seen three silver disc businesses — CDs, software, and video — destroyed in the last 20 years. That’s because the disc is the medium itself, not the content. The marginal cost of moving those bits around is zero.

Competing with free

Surprisingly, you can compete with Free. Microsoft has done this several times.

• In the 1970’s, against the notion that only hardware should cost money (by telling hobbyists that software should be priced.)
• In the 1980’s against bundled software like Wordperfect (by making Microsoft Works.)
• In the 1990’s, they did it against China, where they faced rampant piracy (by minimizing it and employing differentiated pricing, and recognizing that Chinese users would one day buy their products); and Netscape, where they faced free browsers and responded by introducing their own.
• In the 2000’s, they’re doing it against Open Source (by emphasizing risk reduction and guarantees, and having a throat to choke; and through their BizSpark program.)

On the iPhone marketplace — a new, more restricted market — only 20% of the apps were free. But the mean price of iTunes apps has dropped from $5 to roughly $3 in the last couple of years. As this moves towards zero, iPhone vendors will find alternate revenue models.

There are lots of models for making money in a free economy — ad-backed, cross-subsidy, freemium, gift economies, and so on. The bottom line is that we have to find a way to give away one thing and sell something else.

Chris points at the free-to-play game industry, where anyone can play but charges to save time, lower risk, gain status, or get things you love. A “teleportation stone” that makes travel faster is a good way to charge those who have money but no time, and make it free for those who have time but no money. The same can be said of music piracy versus iTunes — in the book, Chris makes the point that iTunes is really a time saver.

It’s also critical to figure out where the real value is. In education, for example, the content and curriculum “wants to be free” but the learning experience is an extremely scarce resource that wants to be very expensive. That’s why MIT’s courses are available online, but admission is very expensive.

Chris makes a complex subject interesting, peppering it with anecdotes and concrete examples. Free comes out July 6 and it’s definitely a good summer read.