Virtual Goods: the next big business model

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$20 Million For Prosper: P2P Lending

This guest post is written by Susan Wu, a Principal with Charles River Ventures, where she focuses on digital media, software, and infrastructure. Susan is coproducing the Virtual Goods Summit this Friday at Stanford University – most of the companies mentioned below will be presenting.

img_susan2.jpgPeople spend over $1.5 billion on virtual items every year. Pets, coins, avatars, and bling: these virtual objects are nothing more than a series of digital 1s and 0s stored on a remote database somewhere in the ether. What could possibly possess people to spend real, hard earned cash on ‘objects’ that have no tangible substance?

The virtual worlds space has received tremendous press attention in the last year, fueled in no small part by Wild West stories of fortune and anarchy in worlds like Second Life and the plight of the Chinese gold farmer in World of Warcraft. But people aren’t paying attention to the bigger story. While people preoccupy themselves with mocking the absurdities of some of these virtual worlds, the reality is that there are many businesses out there making meaningful amounts of money in virtual goods:

  • Tencent is one of the largest Internet portals in China with over 250 million active user accounts. They generated $100 million+ in Q1 of 2007 and over 65% of their revenue comes from virtual goods.
  • Habbo Hotel has over 75 million registered avatars in 29 countries and 90% of their $60 million+ yearly revenue comes from virtual goods.
  • Gaia Online does over 50,000 person to person auctions and 1 million message board posts a day- making them the 3rd largest auction site and the 2nd largest message board on the Internet. Their average user consumes 1200 page views a month. They employ 3 people whose sole job it is to open snail mail envelopes full of cash that people send in for virtual goods.
  • There’s a commonly held misperception that virtual goods are only for online gamers. Both Dogster and HotorNot are succeeding with a hybrid ad/virtual goods business model. Currently, over 40% of HotorNot’s revenue comes from virtual goods.
  • Major mainstream brands are now buying advertising in the form of virtual goods in social networks. Gaians can now purchase and pimp their virtual Scion xBs. Coca Cola and Tencent partnered to allow Tencent’s users to trade codes taken from real Coke cans for virtual objects in the Tencent network. Wangyou, a Chinese based social network, has also been extremely aggressive in experimenting with branded virtual goods.

It seems incomprehensible to many that people would spend so much money on virtual objects. A Techcrunch article on Facebook’s new virtual gifting service was met with jeers:

  • “the whole virtual gift via icons idea seems tacky…i just don’t see it”
  • “I think if any of my friends knew I paid $1 to post a puppy icon on a friend’s facebook profile, they would quit talking to me… that seems really creepy.”
  • “Who buys money for that junk? I feel sorry for anyone who wastes their money on such futile nonsense.”
  • [and that was just from the first 16 comments]

So why do people spend real money on virtual objects? There are four major reasons:

Virtual objects aren’t really objects – they’re services

Virtual objects aren’t really objects – they are graphical metaphors for packaging up behaviors that people are already engaging in. As James Hong from HotorNot tells it, his virtual flower service has 3 components: there’s the object itself represented by a graphical flower icon, there’s the gesture of someone sending the flower to their online crush, and finally, there’s the trophy effect of everyone else being able to see that you got a flower. People on HotorNot are paying $10 to send the object of their affection a virtual flower – which is a staggering 3-4x what you might pay for a real flower! Of the 3 components, the two that James says are most important to his users are the trophy effect and the meaning of the gesture itself. As the barriers between peoples’ online and offline selves continue to erode, this market for virtual goods is going to explode. People are going to continue to seek out ways to show real emotional engagement online. Virtual gifts are a particularly compelling way to package your attention.

Virtual objects create real value for people

Each day, thousands of transactions take place via markets such as eBay for virtual swords, currency, or clothing across a multitude of virtual world environments. For people who purchase virtual items such as swords or armor, buying these items increases the overall satisfaction she receives from spending time in this virtual world / online community / online game. For example, struggling along as a level 20 character might give her 20 units of personal satisfaction per hour, whereas progressing as a level 20 character with a very powerful sword could confer 50 units per hour. In this case, she would be willing to pay the equivalent of whatever amount generates an incremental 30 units of personal satisfaction for the sword.

I’m an avid player of multiplayer online games. A couple of years ago, I spent 10 real dollars to buy 1 million gold in a game [yes, it was legal and part of a world where real money trade is not prohibited.] My friends mocked me and told me I was throwing money away, so I tried to explain it to them: 1 million gold would give me 20 hours of entertainment. If I were to go to the movies, 10 real dollars would buy me 2 hours of entertainment. Assuming that 1 hour of movie watching entertainment gives me the same personal satisfaction as 2 hours of game playing enjoyment, I would have been willing to pay $50 in exchange for that 1 million of virtual currency. In fact, I felt like I had gotten a bargain paying only $10!

Probably the most powerful way that virtual objects create real value is through self expression. RockYou is now serving 150 million+ widgets a day – widgets that people put on their Facebook profiles to differentiate themselves – much as they do in the real world with accessories and bling. The US retail market for apparel is ~$300 billion – there’s good reason to believe that people’s strong drive to personalize and differentiate in the real world will proliferate online as well. Widgets are a form of virtual good – though most widget companies are ad supported today, I see widgets fueling a massively distributed microtransaction economy in the not too distant future.

The cost of buying objects can be cheaper than “earning” them

Who hasn’t heard of the Chinese gold farmers in World of Warcraft? Typically, these farmers are young students who spend up to 12-14 hours a day playing the game. They can then sell these goods or characters to US based players for US dollars. The term ‘farming’ refers to the fact that they spend hours performing the same tedious in-game action over and over again to yield a certain payoff. This industry has arisen to take advantage of arbitrage opportunities that result from the disparity in opportunity costs. The Chinese farmers value their time much less than American players. This isn’t a moral statement, it’s just one of economic fact. While it might take both players 60 hours to progress a character up to level 40, the opportunity cost for the American player could be $900 (60 hours * $15/hr,) whereas the opportunity cost for the Chinese player could be $30 (60 hours * $.50/hr). The American player is willing to pay up to $900 for a level 40 character, creating profit opportunities for the Chinese player. [Note to all the flamers: I don't sanction farming in environments where it's clearly prohibited by the game designers. I'm just trying to explain why this makes sense to some of the buyers and sellers.]

You can make money off of virtual objects

Last year we were inundated with stories about Second Life’s first real estate millionaire. Though it might seem ludicrous to spend as much money on a virtual island that you could otherwise use to purchase real acreage in the physical world, the buyer in this case could actually be quite financially savvy. Buying an island in this virtual world is accompanied by the assignation of certain rights – such as mining for other virtual assets and real estate development. The buyer could in turn subdivide the island into multiple parcels and make a healthy return reselling the land to other players. Of course, this type of investment strategy requires market liquidity; that is, a sizeable and willing market of buyers willing to pay your desired price. With the rapid growth in number of players in virtual world environments and burgeoning market infrastructure, market liquidity is likely to increase with time.

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