Free to play business model versus traditional retail purchase; how it is more profitable to have item shops

There has been a large and growing movement in the video game industry towards the free to play business model. World of Warcraft, Team Fortress 2, World of Tanks, and League of Legends are a few prime examples. To compensate for being free to play, firms run in-game item shops that charge for additional gameplay content or provide services such as making the grind easier. The question for the economist is then, why are firms acting in such a manner?

Like many things, the answer is not so straight forward. There are multiple reasons all acting in conjunction, but let’s first examine this with some microeconomics. Below is your traditional monopoly and profit maximization. I use a monopoly model because a lot of games are monopolies. You may have substitutes in the form of other games in a genre, but realistically speaking, Halo is Halo. Marginal cost is constant for simplicity, but also because software (video games included) really don’t have a marginal cost. The cost of letting someone download a copy of your game is virtually negligible. Profits below ignore fixed costs.

As we can see, there is a fair amount of dead weight loss. Monopolies restrict output in order to raise price which means not everyone is able to play the game. By comparison, the free to play model has no dead weight loss although quality may suffer which is something that will be discussed later.

Price in this model is set at marginal cost. In the case of games, the marginal cost is basically zero, hence, free to play. Profits for the firm is then determined by the giant orange triangle. Here it gets a little more complicated. Profits made by the firm is determined by how well they can extract consumer surplus through price discrimination via item shops. In terms of item shops, this is the revenue of producing item shop content minus the cost of producing it and the marginal cost of production (because the firm did not cover that cost by selling on quantity).

The reason for why there is such a large range in the pricing for item shops is not because making premium content such as Pulsefire Ezreal is very expensive (it probably does cost a bit more than the usual stuff), but because it’s targeted at people who have high consumer surplus. For all the software developers out there, do be careful about what you market to your consumers. Eve Online’s monocles are still a laughing stock among gamers.

As we can see, if the firm can minimize the cost of item shops, there is much potential profits to have. Furthermore, the lower the marginal cost, the more effective free to play is in terms of producing profits.

There are other factors outside of the graphical models above. For instance, firms have a definite incentive to cheat on item shops by simply restricting content already in-game. Similarly, the restriction of content can reduce the quality of the product (i.e. Runescape). Information-wise, a free to play model lets consumers sample the product. If we think of information as an additional cost for the consumer, the free to play model basically removes it altogether. Demos exist for this purpose, but they’re not as effective having the full game.