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.


The effects of theft or destruction of goods on a monopoly

Firms are always complaining about theft and how there are enormous economic impacts associated with it. From the recent Stop Online Piracy Act (SOPA) and the Protect IP Act (PIPA), it is clear that the politicians have been paying a lot of attention to the issue. For an economist, there’s a lot of questions to be had here. Below is a basic profit maximization model modified to accommodate destruction or theft of goods.

Before I begin my analysis, I must make clear that the model assumes that α, the percentage of goods received by the firm, is a completely independent variable, meaning it is not affected by other variables. One could account for the obvious notion that price and the willingness of people to steal (and conversely the amount of goods paid for) by having α be a function of price. However, that adds a fair amount of math, and so we’ll leave that out. Furthermore, the demand function is linear.

If we look at where MC is low, the effects of destruction and theft on quantity produced is minimal. It makes intuitive sense. If it’s cheap to produce a good, then who cares if half of what you make gets destroyed; just make more! So at a MC of 2, even when the firm only receives half of what it makes, the quantity produced is barely affected with a change of only 1.

Now when MC gets high, the firm produces a fair amount less. But when the firm receives only half of what it makes along with a high MC, there is another massive reduction in quantity produced. From this relationship, it seems that if government desires to benefit society, they should focus on removing theft, piracy, or destruction of goods on firms with high MC than firms with low MC.

Another interesting note we should examine is how profits have changed for the firm. Remember how the firm with low MC produced nearly the same amount despite receiving payment for only half of its goods? Its profits have fallen by about 50%. As we can see, firms have a huge incentive to complain about theft. In the case of firms with low MCs, theft hurts them more than it hurts society.

Software firms fit the model very well. For the most part, software tends to be monopolistic and in many cases, full blown monopoly. Their MC is also very low. If we take the above model to be true, then it’s no wonder that a lot of the lobbying has been about online piracy. Software firms have a lot to lose in profits.

Not marked for resale and why it may not be a bad thing

If you have ever bought goods in bulk such as a box of ice cream sandwiches, you may notice on that on the label it says, “not marked for resale.” Obviously, the manufacturer does not want people to buy and distribute their goods, and equally as obvious, it’s making them more profits when they sell by bulk. I should note that the reason for why they’re earning more money is not because it’s cheaper for them to sell by bulk (although in certain cases that may be true), but because they are second degree price discriminating. This particular form is called menu pricing, and it works by separating high demand and low demand consumers by offering different packages at different prices. Someone like a mother of four who wants a lot of the good will buy the bigger package at a lower average price per unit while people such as a single bachelor who want less buys the smaller packages. To stop people from buying the larger package and reselling it to turn a profit (this is called arbitrage), they print the no resale labeling. Now whether or not this is enforceable by law, I am uncertain, but uncertainty alone can discourage people from attempting to resell.

At first glance, this may seem like the companies are inefficient since they are not selling close to their marginal cost when selling the small packages, and it may well be true because there might be fewer low demand consumers buying. Conversely, under regular monopoly pricing, the firm may set a price that excludes much of the high demand. It is unclear unless we compare what would happen when there is no price discrimination. The deciding factor is simply a matter of quantity. Do they sell more or less under menu pricing? What we do know is that menu pricing is not always bad.

The different ways an economist can look at a burger joint menu

Economists have developed a wide array of models to explain market phenomena. For better or worse, sometimes the views overlap and even conflict. It’s this diversity in interpretations that makes economics both an intriguing subject to study and something of a pseudoscience.

So an economist walks into a burger joint and looks at the menu. To keep with the tradition of economists using creative names, we’ll call this first economist, A. A notices that there are a variety of items with different size options at various prices. In particular, the average price per unit of food has a negative correlation with combo size. That is, a small combo has a higher price per unit than a medium combo which has a higher price per unit than a large combo. He concludes that the firm is using a type of price discrimination called menu pricing.

After A sits down, economist B walks up to take her order. B looks to the menu and orders the number 4 which a sandwich consisting of a patty, lettuce, and tomato slices. She always orders a number 4. In her mind, the burger joint had offered the different types of meals to appeal to different consumers. By reducing the distance between a consumer’s desired preference and the actual meal offered, the firm can charge a higher price to each consumer. This is the Hotelling spatial model applied to horizontal product differentiation.

Economist C has fallen on hard times so he has in his pocket a coupon that lets him get two sandwiches for the price of one. Recognizing that the firm is willing to sell the sandwiches at half its price, he concludes that the burger joint has a fair degree of market power because the marginal cost of making another sandwich has to be at least half of the price value. His buddy, economist D, notes on how effective the advertisements were at bringing them to the restaurant. He notices how the firm is so effective at reminding him of why their burgers are good, but it does not bother him because afterall, if the food was really bad, he could always go to the hot dog stand across the street.

Finally, economist E enters the restaurant. He is hungry and so he orders a number 1 and proceeds to have his lunch without another thought.

Why Steam is so successful

Online digital distributor giant, Steam, has become a household name for gamers across the world. Shrewd business practices on the part of Valve, the makers of Steam, has kept the users of Steam generally happy and its competitors out. The very nature of Steam prohibits most users from using other digital distribution services. Who wants to run a handful of memory demanding programs in the background? In this respect, Steam already has a major advantage because it was the first to embed itself on our desktops.

To better understand why so many people use Steam, we need to first address the concept of network externality. Certain goods and services increase in value as more people use them. Take for instance, the classic example of the telephone. When one person has a telephone, he has no one to call. When there are two people, they can call each other. Each additional person raises the value of the telephone. Economists call this effect, network externality.

Valve understands very well how network externalities impact markets. Thanks to Steamworks, Valve has taken a step further to cementing our feet. Steamworks is the community building function of Steam; it encompasses everything from your friends list to your profile. Most of all, it’s a free service with the caveat that you have to purchase at least one game on Steam. Consider the telephone example. If you were the only person using Steamworks, how valuable would the service be? Since so many people already use Steam, the network externality must be immense, strong enough to prevent a competitor such as Impulse, another digital distributor, from entering. Impulse can technically match everything Steam does, but it cannot replicate the network externality effect without a substantial user base.

It is interesting to note that Steam is not flawless in its design. Origins, Electronic Arts’ digital distribution software, has begun hitting Steam in the one area where it is not invulnerable, titles. Origins has taken the approach of pulling away its loyal and diehard consumers in the hopes that it can build its own user base. While it is notably more successful than Impulse, it is unlikely that Origins will be able to sport enough exclusive titles to pull people off of Steam. Electronic Arts and Valve can realistically only make titles published under them exclusive. For the vast majority of titles, Electronic Arts and Valve will have to compete for sales licenses.