Oh yeah, that was me. And a lot of others. Well, we were wrong. The mobile app store market (Apple, Android, etc) is brimming with a bonanza of micro-business opportunities for producers and consumers alike. I am consistently amazing by the range of offerings available today, the vast majority of which remain free of charge. But what is more impressive is the growing array of applications and games available for mere pennies. Sure, some are more than a buck — but not that much more. I was just looking through the 40+ apps that I’ve got on my Droid right now (not really sure how many I’ve downloaded overall since I’ve deleted a lot) and I would guess that I paid for at least 25% of them–many after being “upsold” by first trying the free versions and then buying. Yes, I know there continues to be a debate about what counts as a “micropayment,” but the fact that so many more people are paying just a couple of bucks or less for content in these mobile app stores suggests that its only going to easier for people to pay even smaller sums for content in coming years.

What got me thinking about all this was slide #75 in Mary Meeker’s latest slideshow about Internet trends. The Morgan Stanley web guru notes that users are more willing to pay for content on mobile devices than they are on desktop computers for a number of reasons, but the first of which she listed was: “Easy-to-Use/Secure Payment Systems — embedded systems like carrier billing and iTunes allow real-time payment.”  The important point here is that the combination of these slick, well-organized online app stores + secure, super-easy billing systems have combined to overcome the so-called”mental transaction cost problem,” at least to some extent. We’re not nearly as reluctant today to surf away when something says “$0.99” on our screen. Increasingly, we’re hitting the “Buy” button.

The really interesting question, of course, is to what extent we can expect this model to grow and become more widely utilized for other types of content.  A lot of folks in the news business remain hopeful that a micropayment model can help them monetize their content in an age of business model uncertainty and highly disruptive change.  I’m skeptical that micropayments are going to “save the news,” since funding hard news and “broccoli journalism” is really expensive, and micropayments alone will never cover the costs. But perhaps they don’t have to. Micropayments could become just one part of an array of new business models that media operators could tap in an effort to reinvent themselves and thrive going forward. Subscriptions, advertising support, foundational / philanthropic funding, and more could also be part of the answer. We just don’t know what will work going forward. But I’ve grown at least a tad bit more optimistic that micropayments can at least be considered part of the conversation again.

I’ve always generally agreed with the conventional wisdom about micropayments as a method of funding online content or services: Namely, they won’t work.  Clay Shirky, Tim Lee, and many others have made the case that micropayments face numerous obstacles to widespread adoption.  The primary issue seems to be the “mental transaction cost” problem: People don’t want to be diverted–even for just a few seconds–from what they are doing to pay a fee, no matter how small.  [That is why advertising continues to be the primary monetization engine of the Internet and digital services.]

That being said, I keep finding examples of how micropayments do work in some contexts and it has kept me wondering if there’s still a chance for micropayments to work in other contexts (like funding media content).  For example, I mentioned here before how shocked I was when I went back and looked at my eBay transactions for the past couple of years and realized how many “small-dollar” purchases I had made via PayPal (mostly dumb stickers and other little trinkets). And the micropayment model also seems to be doing reasonably well in the online music world. In January 2009, Apple reported that the iTunes Music Store had sold over 6 billion tracks.

And then there are mobile application stores.  Just recently I picked up a Droid and I’ve been taking advantage of the rapidly growing Android marketplace, which recently hit the 20,000 apps mark. Like Apple’s 100,000-strong App Store, there’s a nice mix of paid and free apps, and even though I’m downloading mostly freebies, I’ve started buying more paid apps. Many of them are “upsells” from free apps I downloaded. In most cases, they are just 99 cents. A few examples of paid apps I’ve downloaded or considered buying: Stocks Pro, Mortgage Calc Pro, Currency Guide, Photo Vault, Weather Bug Elite, and Find My Phone. And there are all sorts of games, clocks, calendars, ringtones, heath apps, sports stuff, utilities, and more that are 99 cents or $1.99.  Some are more expensive, of course.

I don’t have any idea how big this marketplace is in the aggregate, but according to AndroLib, “fully 62.2% of the apps available are completely free, compared to just 37.8% that are paid apps. That’s in stark contrast to the [Apple] App Store, which now has over 100,000 individual apps, of which (by some recent counts) a hefty 77% are paid applications — although only 30% of total App Store downloads are for paid apps.” That suggests that micropayments are doing quite well in mobile marketplaces. And this Wall Street Journal piece I was reading just yesterday, “Mobile-Payment Services Grow,” suggests there are lots of innovative things are happening in this space right now.

Of course, this gets into the semantic issue of, “what is a micropayment”? Does 99 cents qualify? I don’t know. I’ve never found any widely accepted definition of the term. Moreover, even if it’s true that a lot of people are buying “small-dollar” apps in mobile marketplaces, that doesn’t mean micropayments can fund all media going forward. It’s unlikely, for example, that we can fund quality journalism one micropayment at a time. People are just not going to pay a quarter (or even a penny) every time they want to read an article.  They might, however, be willing to pay a small monthly or annual access fee for some sites or services.  But with the exception of The Wall Street Journal and a handful of other media services, that model just doesn’t seem to have legs right now. [Although take a look at Dale Jefferson’s amazing newspapers app in the Android marketplace. Very cool. Perhaps media providers will learn from aggregation efforts like that and find a way to charge a small fee for access. But at less that one British pound — the cost of Jefferson’s app — I can’t imagine that funding a lot of content. They’ll need plenty of ads and other revenue streams to make up for what they are losing.]

Anyway, I’m not saying I have any answers here, just that my mind is still open regarding the possibility of micropayments as a method of funding online services and content. It may end up being easier for the former rather than the latter, however.

Progress Snapshot 5.10 from The Progress & Freedom Foundation

A recent telephone poll conducted by professors at Berkeley and the University of Pennsylvania concluded, “Contrary to what many marketers claim, most adult Americans (66%) do not want marketers to tailor advertisements to their interest.” The study’s authors claim that their poll is the “the first nationally representative telephone (wireline and cell phone) survey to explore Americans’ opinions about behavioral targeting by marketers.” They also assert that the poll indicates that “if Americans could vote on behavioral targeting today, they would shut it down.” Advocates of regulating online data collection have trumpeted this poll as evidence consumers demand legislation to protect their privacy. “This research gives the F.T.C. and Congress a political green light to go ahead and enact effective, but reasonable, rules and policies,” declared Jeff Chester, a leading critic of online advertising.

But what is most surprising about this poll is not that 66% of users said they do not want tailored online ads, but that 34% of users said they did! The key, initial question of “whether or not you want the websites you visit to show you ads that are tailored to your interests,” presents no trade-off. The fact that anyusers said “yes” indicates that many users paused to do the rough mental math about the unarticulated trade-off between the benefits of receiving tailored ads and the costs of that tailoring.

The methodology of opinion polls necessarily affects respondents’ mental calculations, rendering polls not just easily manipulated, but inherently unreliable as indicators of real preferences. Every poll reflects the bias of its authors to some degree by the way questions are worded, the order in which they are asked, the sample surveyed, etc. The easiest way to bias the results of a poll is to omit any mention of the trade-offs at issue. This poll simply buried the issue of trade-offs in a heavily loaded follow-up question: After telling respondents that marketers “often use technologies to follow the websites you visit and the content you look at in order to better customize ads,” the interviewer asked whether the respondent would allow advertisers to “follow [them] online in an anonymous way in exchange for free content.” Only 10% of users said they would allow this voluntary exchange.

What does this tell us about whether, and how, government should further regulate online advertising? Precious little: Not only does this poll overstate the costs of targeted advertising, understate its benefits, and ignore the tools available to users to address their privacy concerns but, like any opinion poll, this one tells us more about the psychology of decision-making under the artificial uncertainty of polls than about the choices users would actually make in the real world.

User Uncertainty About Concepts Like “Tailoring” and “Following”

Even the word “tailoring”—though benign compared to other words the study’s authors could have used ( e.g., “track,” “monitor,” “record”)—is so vague as to leave respondents wondering what it really entails. One can only speculate as to what users thought the word meant (since the poll did not ask), but it seems likely that some of these scarier words probably flashed through the minds of respondents in the instant before they answered the question. Indeed, the word “tailoring” conflates both the costs and benefits of personalized advertising in a single, vague word. Given this ambiguity, it’s hardly surprising that most users would say “no”—not just to receiving tailored advertising (66%), but also to receiving tailored discounts (49%) and news (57%). If users had been asked about receiving “relevant” (rather than “tailored”) ads, the responses probably would have turned out somewhat differently—just as an additional 17% of users agreed to receiving tailored “discounts,” whose value to users is more readily apparent: saving money on potential purchases.

The second set of questions asked users whether it “Would be OK… if these ads [discounts/news] were tailored for you based on following what you do on the website you are visiting… [24% said yes] OTHER websites you have visited… [34% said yes] and OFFLINE—for example, in stores? [25% said yes].” Again, the term “follow” was not defined. A third set of questions explained to respondents that marketers “often use technologies to follow the websites you visit and the content you look at in order to better customize ads.” The interviewer then asked whether the respondent would “definitely allow, probably allow, probably NOT allow, or definitely not allow advertisers” to “follow you online in an anonymous way in exchange for free content”—and only 10% of users said yes. Thus, it appears that users are more, not less, hostile to tailored advertising when reminded of the trade-offs involved (35% yes in the first set of questions, 10% yes in the third). What explains this paradox?

The most obvious explanation is that, by the time the respondent got to the critical question about “allowing” tailored advertising, they had heard the word “follow” at least five times: once in each of the three questions about whether tailoring was OK, once in the introduction about how marketers customize ads and once in the question itself—each time increasing uncertainty as to how “tailoring” really works and more than negating any suggestion of “anonymity.” Furthermore, asking users whether something should be “allowed” implies that there are undisclosed reasons why it should not be. This much is simple psychology—obvious to anyone who wanted to craft a poll that would support a particular regulatory agenda.

But behavioral economics research tells us something even more profound about the way our brains work: human beings hate making choices, and loathe uncertainty even more. Indeed, such “mental accounting” or “mental transaction” costs appear to be the primary reason why, after a decade of efforts to develop a micropayments system that can fund online content and services, no such system has emerged—and thus why Internet publishers instead rely primarily on advertising revenues ($23.5 billion in 2008) to fund “free” offerings for consumers. In this case, merely forcing consumers to consider the costs of “tailoring” and being “followed,” and decide whether these things are “OK” or should even be “allowed” strongly tips the scales in favor of the outcome desired by the study’s authors because these considerations and decisions are significant psychological costs in themselves, which likely outweigh the diffuse benefits of tailored advertising, which users simply do not appreciate.

Indeed, the scale tips so strongly that the study suggests that 73% of Americans object to having ads tailored based on “what you do on the website you are visiting.” Would not this objection apply to purely contextual advertising “tailored” to the keywords entered by a user in a search engine or to the keywords that appear on a particular page to which a user has navigated within a site? If so, this study isn’t just about the bogeyman of “behavioral” advertising, but about essentially all online advertising, which is to some degree “tailored.” Indeed, must lawmakers protect us from the tailoring of news (71%) and discounts (62%) within websites? Or, if data collection is the real harm to consumers, what about the fact that hundreds of millions of people happily share far more personal information every day on social networks or using grocery discount cards? Opinion polls simply cannot answer these questions.

The Direct Benefit of Tailored Ads: Relevance

Whatever Americans tell pollsters about “tailored” ads, they also complain about irrelevant ads: A previous poll found that 72% of consumers “find online advertising intrusive and annoying when the products and services being advertised are not relevant to [their] wants and needs” and 85% say that less than 25% of the ads they see while browsing online are relevant to their wants and needs. Real-world experiments confirm that users reveal a clear preference for more relevant advertising. In a 2004 experiment, click-through rates (CTR) for behaviorally targeted ads were between 94% and 225% higher than for contextually targeted ads. A 2009 study found that the difference could be between 670% and 1000% percent, depending on how well-tailored the ads were. In other words, users in the real world were two to eleven times more likely to click on highly-tailored ads. Truly, actions speak louder than words: Users clearly “vote with their clicks” for ads they find relevant—i.e., they vote for “tailoring.”

Further reinforcing this conclusion is the fact that better tailoring increases not only click-through rates but also “conversion rates”—the percentage of users who actually complete the action desired by the advertiser, whether that be making a purchase or signing up for a list. A 2008 experiment found increased conversion rates of 400-900% (2008). This indicates that relevant ads really do help consumers find things they like—and that they like the fruits of tailoring, however they respond when asked about “tailoring” as an abstract concept that conflates costs (“How are they following me?”) and benefits (“What’s in it for me?”).

The Indirect Benefit of Tailored Ads: Free Content & Services

Even less apparent to poll respondents than the direct benefit of tailoring (increased relevance) are the indirect benefits: In particular, greater relevance to the user means more effective communication for the advertiser, and increased ad revenue for most online publishers per ad on their sites. Thus, there exists a clear quid pro quo: in effect, users “pay” for content and services by sharing information about their interests. Even more fundamentally, users “pay” for content by seeing ads. But both quid pro quos are implicit: Users can simply choose not to “pay” by using readily available tools in their browser to blocking ads and/or tracking. In essence, today’s system allows users who don’t like ads—tailored or otherwise—to opt out at little or no cost, much as if they simply decided not to pay for a product they bought at their local grocery store.

This creates a serious dilemma, given that advertising increasingly stands alone as the lifeblood of online content and services. Indeed, ads have long funded the costs of generating content for radio, television, and newspapers (with subscriptions paying only for distribution). The basic reason is simple economics: In competitive markets, prices tend to fall to the marginal cost of production. The Internet has simply borne this theory out in full:

1. Producing the first unit of content (e.g., a news story or video) remains costly, so while the marginal cost of every additional unit is essentially zero,average cost is not.
2. The failure of micropayments online seems to confirm that, no matter how low the technological transaction costs are, the mental transaction costs involved combined with even tiny payments will exceed the perceived value of most content.
3. The world of media scarcity in which consumers could choose from only a few sources of content (e.g., news, entertainment) has given way to a world of staggering media abundance and the choices of users are no longer constrained by the tyranny of physical limitations like distance and printing costs.
4. Because pure information cannot be copyrighted (and fair use allows significant referencing and quotation), very little content is so unique that users cannot find a ready substitute elsewhere if a site (or even cartel of sites) attempted to charge.

These forces have given birth to the world of “Free,” where few (if any) users will pay for something they can get for nothing. While there are a number of ways to fund content and services, advertising is far and away the leading business model for the new economy: Indeed, overall advertising market is expected nearly to double its share of total U.S. ad spending from 8.7% in 2008 ($23.4 billion) to 15.2% ($37.2 billion). But with 44% of advertising revenue going to search engines (which show highly “tailored” ads simply based on search terms), hundreds of thousands of publishers—from the mightiest to the tiniest—rely on $7.6 billion (33% of the total) in “display” ad revenue. Yet this base is tiny: Most websites earn a fraction of the revenue generated by offline ads: roughly $0.60 to $1.10 per thousand impressions (CPM) online versus average CPMs of $4.54 (radio) to $10.25 (broadcast). This unprofitability of online advertising, and the fact that certain kinds of online content (e.g., video and online services) does not provide the textual keywords necessary for basic contextual targeting is driving publishers to ad networks that offer behavioral targeting, which is expected to grow from $525 million in 2007 to $4.4 billion in 2012—when it will represent 25% of all display ad spending.

In short, advertising is indispensable to the future of online media, but it is also currently inadequate to sustain “Free” culture. As Adam Thierer and I warnedearlier this year: “The advocates of regulation pay lip service to the importance of advertising in funding online content and services but don’t seem to understand that this quid pro quo is a fragile one: Tipping the balance, even slightly, could have major consequences for continued online creativity and innovation… Something must give because there is no free lunch.” In 2001, long before Google mattered and before he worked for them, Kent Walker (now Google’s general counsel) put it best in a seminal law review article:

Privacy is both an individual and a social good. Still, the no-free-lunch principle holds true. Legislating privacy comes at a cost: more notices and forms, higher prices, fewer free services, less convenience, and, often, less security. More broadly, if less tangibly, laws regulating privacy chill the creation of beneficial collective goods and erode social values… Such regulation would likely increase both direct and indirect costs to the individual consumer, reduce consumer choice, and inhibit the growing trend of personalization and tailoring of goods and services.

Thus, as Jim Harper and Solveig Singleton concluded in their 2001 paper With a Grain of Salt: What Privacy Surveys Don’t Tell Us:

privacy surveys in particular… suffer from the “talk is cheap” problem. It costs a consumer nothing to express a desire for federal law to protect privacy. But if such law became a reality, it will cost the economy as a whole, and consumers in particular, significant amounts that surveys do not and cannot reveal.

We Need a Behavioral Economics Experiment, Not Just Another Poll

The Berkeley-Penn poll could certainly have done more to present these trade-offs to respondents and less to color their responses by inflating mental transaction costs. But even the most “fair” poll cannot meaningfully simulate the trade-offs inherent in the real world. If we really want to know how muchsubjective value consumers place on a particular aspect of their privacy, we must look to the preferences they reveal in the process of making real choices.

Of course, the best experiment is the one being conducted in the real world every day. No laboratory experiment can ever fully replicate all of the conditions of the real world, but a behavioral economics experiment could tell us more about the revealed preferences of Internet users than any poll. Unlike the real world, an economist could vary certain conditions in a lab experiment to tell us how various changes to current industry practice, user empowerment, or user education might actually affect real consumer choices. At a minimum, any experiment would require the following to inform policymaking about online advertising and privacy.

First, the experiment should vary the mechanisms by which notice is provided to users as to how tailoring works ( e.g., placement, interface, wording) and what those notices actually say.

Second, test subjects must make real choices in real use of the Internet with trade-offs in real money and their own time between either paying for access to a particular site or getting access for free in exchange for receiving tailored ads based on at least the three variables presented as questions in the Berkeley-Penn study: (i) users’ browsing activity on that site; (ii) their browsing activity on other sites; and (iii) offline activity or demographic information.

The second variable is critical because it addresses the value created by behaviorally tailored ads, which could be wiped out by regulation. Search engines are able to sell highly effective advertising based solely on information provided directly to the site (search keywords, which are highly indicative of user interest), and some sites can sell lucrative advertising based on purely contextual targeting because their content contains keywords that advertisers value highly ( e.g., a site for digital camera enthusiasts). But the vast majority of websites, and especially non-commercial websites, would produce little ad revenue if advertisers could only guess at the likely interests of visitors based on the keywords on that site. This, in a nutshell, is why so many sites stand to gain so much from behavioral targeting—particularly in the Internet’s “Long Tail.” To be useful, an experiment must reflect this dynamic.

In the real world, of course, it might be possible for the user to opt-out of tracking without losing access to content because today’s quid pro quo is implicit and most sites operate on a “No Cost Opt-Out” basis for tracking and even seeing ads. But in order to tell us how much consumers really care about tracking, the experiment must place some value on access to content that is supported by free content and services.

Third, the experiment must examine the extent to which user empowerment affects user choice: If some users are uncomfortable with having their browsing activity tracked, is it because they are concerned about all tracking or only tracking of certain sensitive activities, such as researching medical issues or—everyone’s favorite—viewing pornography? How does the availability of privacy management tools change user choices about ad-tailoring? Do Americans really want tailoring banned, or do they just want the ability to exercise easy choice about when they want to participate? How would those choices change when they come at a cost (e.g., seeing more ads) and privacy-sensitive users cannot simply free-ride off the value created by users whodon’t opt-out of targeted advertising (and also don’t block ads)?

Such an experiment would, by its very nature, be imperfect—but far less imperfect than any poll about opinions on privacy. Until a proper experiment is conducted by trained behavioral economists, all we can say with confidence is the following:

1. Users don’t understand exactly how ads are tailored;
2. Users seem to be concerned about “tailoring” or “following” in the abstract;
3. Users are generally unwilling to pay for online content and services; and
4. Better tailoring of ads means more funding for content and services.

There is only one approach that can address all these concerns: educate users about how online advertising works and how they can implement their own privacy preferences, while constantly striving to further empower users to make privacy management easier.