Second-Degree Price Discrimination: Why Freemium Pricing Drives Growth in Software Markets
The freemium pricing strategy has developed into one of the more popular pricing strategies utilised today in the digital world by providing free basic access to a particular product while charging users for additional features. This form of pricing is known as second-degree price discrimination. Businesses use this pricing strategy to allow customers to select the tier that best matches their needs and willingness to pay. By creating multiple product versions, firms can implement differential pricing through customer segmentation.
Second-degree price discrimination occurs when firms offer different versions of a product at different prices, allowing consumers to self-select based on their willingness to pay. By using examples of second-degree price discrimination, business owners are able to see how to utilise this pricing strategy and provide products to their customers without knowing much about the specific customer. Instead, they can provide their customers with various product options that have different service levels, feature sets, and limitations of use.
Freemium pricing is incredibly effective due to the fact that customers tend to exhibit a varying level of demand for a particular type of product or service. For instance, a college student who occasionally signs documents electronically may have determined that, based on their needs, they would be best served with a free account that would provide them with the e-signature service they require. On the contrary, a law firm that regularly handles high volumes of contracts may need features such as workflow automation, signing audit trail, application integration as well as administration controls.
The two-tiered pricing model of freemium is helpful because it allows customer segments to self-select and allows for successful capture of all segments. The economic perspective that drives this model is based on consumer heterogeneity. There are many factors affecting the amount of money people have to spend on products or services, including their individual financial situations, size of their company, and their willingness to pay. The problem comes into play when an individual is priced out of purchasing a product/service due to their income and at the same time, there is a large amount of money that could be captured from customers who would be willing to pay a higher price for the same product/service. Price discrimination allows companies to capture additional revenue from customers with higher willingness to pay while still serving price-sensitive consumers.
Another aspect to consider is the very low marginal cost of software. When a cloud-based product is created, it usually only requires a small amount of extra computing power or data storage for additional users; this is a small cost compared to the startup costs incurred in creating the product. Because of this, businesses can widely distribute their cloud-based products to as many people as possible while focusing on increasing their user bases rather than maximising profits in the short term.
Data back up the effectiveness of the freemium business model. In the case of products created using the freemium model data by Mixpanel, an analytics company, the average conversion rates of users from free to paid is usually between 2-5%. Many companies that use the freemium model have conversion rates that exceed this. While it may seem inefficient to convert only a small percentage of free users to paid plans, it can be very lucrative for companies because they attract new users at an almost zero acquisition cost except for their marketing and infrastructure needs.
An example of this is Spotify, which has seen tremendous success over the last several years, having reported more than 678 million monthly active users as of the first quarter of 2025. This total includes approximately 268 million Premium subscribers. With free ad-supported services, Spotify offers users access to its platform and all of its features, while allowing premium subscribers to enjoy listening without the interruption of ads, high-quality audio from enhanced audio quality, and the ability to listen to songs offline. By doing this, Spotify allows users to evaluate the value of premium features before purchasing a subscription, meaning users can determine if the features included in the premium subscription are worth the cost of the subscription, which is a form of second-degree price discrimination.
The same model of second-degree price discrimination is apparent within software development. Many companies offering electronic signature (eSignature) services allow users to sign or request a limited number of electronic signatures for free; however, many companies reserve document management in bulk, team collaboration, branding, and advanced security features for those who have paid for their subscription. For example, PandaDoc’s Free Plan demonstrates this approach by providing users with essential electronic signature functionality at no cost. This attracts users with basic needs while encouraging organisations requiring advanced document workflows and collaboration tools to upgrade to paid plans.
In addition to enabling users to gain significant benefits from using free products, freemium-style pricing provides significant surplus for the customer. Customers who may never purchase a premium subscription still receive some benefit from using the service for free, which increases the number of customers participating in the market. In addition, businesses are able to capture more producer surplus through charging higher prices to customers, who value increased capabilities more than customers, who may purchase only basic subscriptions. By enabling customers to purchase at a price that is closer to their willingness to pay, freemium-style pricing provides a far more effective means of allocating resources than a single-price strategy that prevents lower-priced customers from participating in the market or from charging business customers at an arbitrarily low rate.
Freemium-style pricing strategies have also allowed businesses to realize tremendous competitive advantages. Because switching platforms typically involves transferring documents, retraining employees, and integrating new systems, it is common for businesses to seek to build relationships with their customers. Free plans help reduce barriers to adoption and create opportunities for customers to test the software without the commitment of payment. When customers become comfortable with the software and incorporate it into their daily work functions, upgrading is often much less of an issue than switching to a competitor's product.
Therefore, second-degree price discrimination will likely continue to be a major trend in today's software marketplace. By pricing their products in accordance with customers' willingness to pay, companies will be able to expand usage of their products, recoup significant costs from the development of their products, create long-term recurring revenue through subscriptions, and assist millions of new users in gaining access to powerful digital solutions that previously would not have been affordable.
