Since I moved to New York, I have frequently noticed people giving away free daily newspapers at the entrance to the subway. I never take one - watching the other passers by, it looks like a few people take the newspapers, but that most people pass them up. These papers clearly follow a volume strategy - they try to give copies out to a ton of people, and if only a few percent take the bait, they have pretty good distribution. However, there's a question as to how much value that distribution has. You see a lot of discarded copies strewn all over the place, so I'm going to make a guess that the value provided by such free periodicals is quite low (I can't think of the last time I threw a magazine or newspaper I paid for on the ground after I finished reading it).
Back in the days when I did read such things, I remember seeing mostly low-quality stories pulled from news wires, accompanied by a high density of ads. Basically, these "newspapers" are fake content created as a backdrop for selling ads. Everyone kind of knows this, but there is nominal value created, so it sort of hobbles along. Commuters need something to read on the train, and advertisers need a medium for their ads, so they are willing to pay for exposure. Overall, these content factory newspapers stay in business - at least for now.
But I've actually noticed something else going on in the subways. A significant number of people are fooling around on their iPhones or Android devices, playing Angry Birds or reading content (there isn't any internet access on the New York subway, so web surfing is limited). I have started to use the subway as an opportunity to read books on my Kindle app. So, it seems like there are now many "better" ways to consume content than the free newspapers, and I predict that the free newspapers will lose most of their readers over time (if they aren't already in decline). They have been eclipsed by a better form of advertisement-laden content (remember that Angry Birds shows you ads as well). This article provides some interesting analysis on the effect of smartphones on free dailies.
So, let's move away from the free dailies and look at the bigger picture - the most important point is that a lot of "free" content provides little value, and is quickly discarded. And, if you give your content away for free, people had better be willing to use it for a significant amount of time (or else it will be discarded on the subway station floor before they even get around to reading the ads).
Now we will examine "freemium" software, the recent craze in software that involves building your user base by giving away some version of the product for free. The marginal cost of delivering a single copy of the product is zero (or so proponents of freemium software argue), so you should go for a massive scale by giving away a limited version of your product (or even the full version in some cases). In the short term, you don't worry much about revenue. Once you have enough users, you can unveil paid upgrades, or maybe just flip your company for a bundle.
The problem with this point of view is that there is a difference between having a lot of user accounts and having a lot of people who are willing to pay for your product. At the last company I worked for, we had a lot of users, but it turned out that a relatively small percentage actually used our service regularly. Interestingly, of those active users, the free-to-paid conversion was quite high. But there were a lot of "copies" of our service "discarded on the subway floor," and the actual profits from paying customers weren't enough to sustain the company, even after a couple of years. Those "free" users were relatively expensive to support in the aggregate, as were all of the engineers building the software. In the end we pivoted to another product (which was significantly more successful).
I know of many other companies who have products that a lot of people have downloaded but few people really want. Some of these are currently littering my smartphone. They were probably hot for about five minutes, and maybe they raised a nice-sized round at an attractive valuation, but they are essentially dead in the water if they can't increase user engagement a bit (should have taken the acquisition offer when some big company wanted to buy them for several million).
So, there's a big problem. If your product doesn't actually get users to spend a significant amount of time on it, the lifetime value of a user is going to be pretty low. Whether or not the end-user actually pays you money to use your service, they will pay you with their time if they like it enough (which converts reasonably well to money). The main reason Facebook makes so much money, even with a revenue model that could be significantly improved, is that users are extremely engaged and spend so much time on the site. I find myself coming back to Facebook whenever I hit a lull in my day's activities. I never actually click on the ads, but even if a small percentage of people do so, that's a lot of revenue for Facebook.
Moving back to free software, I pretty strongly believe that if software is worth anything, someone is actually willing to pay you for it. And by "pay for it," I mean pulling out a credit card and giving you actual money on a one-time or monthly recurring basis. If they are only willing to use it for free, then it's likely that they won't be using it for long, and soon it will be cast aside for the next shiny bauble that comes along.
So how do you remedy this if you are developing a product? My business partner and I do this exercise that I call "identifying the customer." This often happens when we are trying to figure out what direction to push product development in, and need to identify who the features are going to target. Basically, we determine who is most likely to give us money for the product, and then figure out how we can better serve those people. As I have pointed out on several occasions, someone can't be the "customer" unless they get enough value from your product that it is worth it for them to pay. The "customer" may not even be the people who uses your product the most, but is the person who gets the most upside from its use. I believe that Google's "customer" is their advertisers, and not the hundreds of millions of people who do searches every day. So, in summary, don't make your product "free." Figure out who is willing to pay for it, and then get them to do just that.