Pricing of Virtual Goods

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Definition of Virtual goods
When referring to a ‘virtual good’, we’re referring to non-physical objects that are purchased, only to be used within online communities or games. These are not digital goods such as books, music, movies or even apps which can be used in the real world but merely in-game or in-app purchases. Nature of these in-app purchases could be anything from clothes and accessories for your character in the game to purchases of the next level in the game.

In order to understand pricing of virtual goods, we need to first understand how some of the economics of in-game purchases. 1. Massively Multiplayer Online Role Playing Games (MMORPG) have their own in-game currency. For eg: Second Life has Linden Dollars, World of Warcraft has gold and silver etc. These can be earned within the game or can be bought with real money in order to buy other in-game virtual goods that you might need. Here, the game currency and real currency have an exchange rate and all virtual goods are priced relative to the in-game currency 2. Games such as Farmville and Cityville, don’t have such individual currencies but virtual goods can be directly bought directly using real-world currency 3. Similarly, apps and games on app-stores also employ in-game mechanics to trigger purchases of additional levels and/or hints etc.

Understanding costs associated with Virtual goods
To understand the relevant costs associated with a virtual good, we need to understand what it takes to create a virtual good. However, the costs are not of creating the virtual good per se, but of hosting and maintaining the larger online community or game. These would largely be fixed overhead costs. The marginal cost associated with the production a virtual good is quite negligible. However, the fixed costs for the different kinds of games would differ. 1. For MMORG and social games such as Farmville and Cityville, costs would be in terms of maintenance of servers, salaries of programmers etc. 2. For individual game developers who develop games for Apple’s app-store and the android market, the costs involved are in terms of fixing the periodic bugs and improving gaming experience and cost of hosting the app/game in an app-store. All app-stores take a percentage cut of the revenue that you earn through your app. These can be pretty steep if the app does not enjoy economies of scale.

It is essential for us to understand here that, pricing virtual goods in these games are an alternate and rather innovative way for the game developers to earn revenue rather than charging players to just play the game. This is how an expert described their cost structure “When you buy seeds in Farmville, you pay for a virtual item that is nothing but an image on your screen. You pay for the electricity to fire up that image on your screen and even for your Internet broadband connection to play Farmville. For Zynga, the money of the Pink Tractor has almost no cost and is an almost hundred percent profit! So understand costs, but don't adopt 'only' the costs plus formulae to make money. You may well be missing the Pink Tractor hidden in the mud.”

Consumers
“Studies show that "Second Life "residents" have done more than $1 billion in transactions with one another to date and spent one billion hours online. In 2008, Second Life users spent more than $360 million on virtual goods ranging from land to designer shoes to lavish homes. The Second Life economy almost doubled in size - 94 percent up - between the second quarter of this year and the same period in 2008". Similarly online game maker Zynga made $1.16 bn in 2011, almost all of it through customers paying real money in exchange for virtual goods and in game advertising. Off this about 68 percent of online game revenue came from durable virtual goods, while consumable virtual goods accounted for 32 percent. The rationale of the gamer in buying virtual currency/goods can be best explained with the help of an...
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