There is no question that traditional media is in disarray right now. Major news outlets from CBS (NYSE: CBS) to Gannett (NYSE: GCI) to The New York Times (NYSE: NYT) are being forced to transition to a different model because of the underlying economics of their mediums (in most cases, a digital model).

But transitions to digital by media and other types of companies have left many questioning what the magic formula for profits is. At a recent event sponsored by Hooks Books and The Motley Fool, Chris Anderson, editor of Wired magazine and author of the new book Free: The Future of a Radical Price, offered a solution to the conundrum.

It's called "freemium."

That term, first popularized by venture capitalist Fred Wilson, describes a business model that combines free with premium and is based on the underlying assumption that the most effective price is free. Anderson says that companies can use the powerful marketing tool of "free" to garner the largest possible audience, and then convert a portion to additional premium services for which companies would charge a fee, or "premium." From there, one figures out his optimal free-to-paid ratio. "You give away 75% to 90% of your goods and sell the rest," Anderson said.

Applying the freemium model to mobile phones, you would get the cell phone but pay for the minutes. For the music industry, you would give away your music for free, people would sample it, some would pay for the mp3, and some would attend the concert -- the premium part of the equation.

"We're learning that the freemium model is a much better model," Anderson said. Rather than taking the old business model with the media and applying it to everything digital (media and services), Anderson says, "freemium is the new business model for the 21st century." (What do you think? Can freemium succeed as a workable business model? Weigh in below in the comments section.)

Anderson's rationale for why the model will work
Anderson explains the reason this model will work is because people are psychologically drawn to free, and offering content or services over the Internet has no "real" costs associated with it.

According to Anderson, the Internet is the first deflationary industrial economy we've ever created. He says that digital is the first to progressively fall 50% every year -- and has been for 50 years. Once the Internet took the constrained processing from Moore's law, a rule stating that the number of transistors on a chip doubles every 24 months, and added storage and bandwidth -- both of which fall faster -- Anderson says we created a medium that basically says everything can be available in a free form.

As a result, Anderson says media companies have infinite competition, and the marginal cost of production and distribution is zero. "Whatever the cost is today, it's going to be 50% as much as a year from now, and fall 50% every year forever because of Moore's law." Continued...