Virtual Goods: Scam, Fad, or The Next Big Thing?

3788160788 D3A2807C01The idea seems strange at first: Do people actually pay real money to buy virtual “stuff” that only exists in an online game or on a social networking site? Virtual goods, the latest hype in the world of digital business, can take on many forms: digital flowers that you can send to your Facebook friends, better weapons and equipment for online games, or a new outfit for your Second Life avatar.

According to some estimates, Facebook could make about $75M in revenue this year from virtual goods. Social game maker Zynga is even bigger in this space, with most of its estimated $250M in sales coming from the game add-ons it sells to its users. The total U.S. market for virtual goods could reach $1 billion this year. But that’s almost chump change compared to the Asian market, where one Chinese social network alone apparently sold $1B in virtual goods last year. Chinese authorities now even have to regulate this exploding sector.

So why would anybody in their right mind pay hard-earned money for something that is basically just a pile of pixels? Well, most probably for the same reason that makes people pay $450 for a regular pair of jeans just because it says “Gucci” on the label: To impress other people.

It’s no secret that people spend more and more time online, be it on social networking sites, playing online games or even in virtual worlds like Second Life (which is doing better than most people think) or teenage girl hangout IMVU. Online interactions with other people (under real names or nicknames) are an increasingly significant part of many people’s lives. And obviously, the natural need to define your social status carries over into the online world.

Most of these online platforms have managed to establish something like a social hierarchy that strongly depends on virtual status symbols. If you want to be cool in Second Life, you need to own a fancy island and have a nicely equipped avatar, which will cost you a bunch of “Linden dollars” (you can get that virtual currency for real U.S. dollars, of course). If you want to avoid being humiliated by a monster in an online role playing game in front of your virtual friends, you’ll need good weapons, which are available for cash. Oh, and all these annoying “Mafia Wars” and “Farmville” updates that you get on Facebook? Just shows you how many of your friends are already trapped in one of these games. And yes, they’re probably spending money on that stuff.

It’s easy to see why platform owners like virtual goods: Margins on this stuff are amazing. Once the software is written, the costs are minimal. And for that reason, the idea of virtual goods spreads to more and more platforms. For instance, Apple now allows iPhone developers to sell virtual “things” right inside an app.

Probably nobody will claim that virtual goods will make the world a better place, but people get what they want, and sellers make a killing. So everybody should be happy about this rapidly growing new market, right?

Well, there is a dark side to the virtual goods market. First of all, some game vendors don’t make their users pay directly for all goods. Instead, people can sign up for “offers” (e.g. a Netflix trial subscription) and get some in-game currency in return. The problem is that many of these offers are scams or at least use unscrupulous business practices like hidden subscription sign-ups. After getting a wrist slap from TechCrunch, Zynga and other game makers just announced that they will police their vendors more strictly and weed out questionable offers.

The other problem is that almost all virtual goods just work inside a particular game or platform. That’s a restriction that is even more extreme than the hated DRM of digital music which allows you to only play your (legally purchased) music on compatible devices. What happens if you get fed up with a game? In some cases, you can sell you virtual goods, but that’s not always possible. Even worse, if the game company goes bankrupt, you probably lose your “investment”. But the most significant problem is that platform owners can suddenly change the rules. Second Life maker Linden Labs for instance banned virtual banks in its system a while ago, costing several people very significant amounts of money. It’s therefore not surprising that some governments are already considering to regulate virtual currencies and virtual goods markets.

We will probably see quite a bit of growth in virtual goods over the next few years. But the real danger for this market is probably none of the issues mentioned above, but the possibility that people simply could lose interest after a while. To some extent, most forms of virtual goods have the typical characteristics of a fad. It’s a frequent cultural phenomenon that large groups of people spend a lot of money on a seemingly pointless (or at least not particularly remarkable) product or activity, just to lose interest after a few months. Not surprisingly, virtual goods are most popular with very young people, a target group that is particularly susceptible to fads of all kinds. Remember Tamagotchis? Virtual pets looked like THE next big thing at the time. Now they’re just embarrassing.

The economic problem with a fad-driven business is of course that fads are entirely unpredictable. There are entire industries (like the toy industry) that try to produce fad after fad, but it’s very difficult to consistently come up with something that will take off in the mass market. It’s therefore really hard to build a sustainable business on this foundation. That’s bad news for investors and startups in this sector.

So there are good reasons not to believe the hype, even if some industry analysts already provide the usual hockey-stick growth curves. For instance, Piper Jaffray predicts that the global market for virtual goods will grow from $2.2B this year to $6B in 2013. Maybe so, but almost all analysts overestimated the growth of social networking revenues a few years ago. And just to put things in perspective: $6 billion is a big number, but for Google, this would just be a nice single quarter of ad sales. And for Microsoft, it’s less than half a year of net profits.

(Picture: Ivan Walsh, CC license)

5 thoughts on “Virtual Goods: Scam, Fad, or The Next Big Thing?”

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