Exactly a year ago, Facebook started testing virtual gifts. Reaction to Facebook’s foray into virtual gifting was mostly negative, sometimes violently so. Consider what some people had to say on TechCrunch:

  • “I don’t really see this idea taking off.”
  • “The icons are a little too cute to be interesting, and really valueless.”
  • “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.”

The wisdom of the crowds would suggest that Facebook Gifts was a massive flop. But, that just hasn’t been the case. By some estimates, Facebook has earned $15 million in virtual gift revenue since the launch of Facebook Gifts. That is not an insignificant percentage of the $150 million in revenue that Facebook made in 2007.

So what’s going on here? How did Facebook make millions of dollars from “valueless icons”? Why are people around the world spending billions on stuff that isn’t “real”? The answer is simple, but it signifies one of the most profound shifts in the history of commerce.

Why people spend money on virtual goods

Why do people spend money on virtual goods? Its a case of straightforward economics. The marginal utility attributed to the virtual good by its consumer is higher than the marginal utility of an extra dollar, five dollars, or whatever the price of the good. In other words, the girl on Facebook who can’t be there for her best friend’s birthday would rather spend a $1 to send her friend a Birthday Cupcake Facebook Gift (that will arrive on the exact day and be seen by everyone who visits her friend’s profile) than spend a $1 (or more) on a greeting card (that will be seen only by her friend and likely go into the trash a few days later). Both Susan Wu and Jeremy Liew have excellent posts that describe, in more detail, the ways that virtual goods deliver value to their consumers.

Atoms vs. Bits

All of this is symptomatic of a profound shift from the economy of atoms to the economy of bits. In The Long Tail, Chris Anderson discusses how the economy of bits has, by eliminating inventory costs and reducing fulfillment costs to the pennies required to transmit digital content, transformed the hit-driven nature of the media industry and enabled a market where millions of niche consumers can be connected with millions of niche products. But the economy of bits is not a phenomenon limited to old forms of media, such as music and movies, which can be efficiently digitized — it extends the very definition of media to things that could not have existed before such as avatar apparel, virtual real estate, and interactive widgets.

To fully comprehend this transition, its important to realize that the fundamental forces of value behind the economy of bits and the economy of atoms are the same. We do not attribute value to a physical good based on the properties of the atoms that comprise that good. A great novel is worth far more than the few ounces of wood pulp that comprise it. A LIVESTRONG wristband means more than the silicon its made from. An exquisite, hand-painted replica of Picasso’s Les Demoiselles d’Avignon may be indistinguishable to all but an expert’s eye, but it will neither hold the same value as the original or cause the original to depreciate.

The same is true for virtual goods. The value of a virtual good is not defined by the properties of the bits that comprise it. Les Demoiselles d’Avignon is made from easy to find, relatively inexpensive oils and canvas, but it would be a mistake to determine its value from those materials. In the same way, it is a mistake to devalue virtual goods because they consist of bits that are easy to replicate and nearly free to transmit. The value of virtual goods stands on the same pillars that lift the value of physical goods: functionality, social context, brand, scarcity, and aesthetics.

As more of our lives move online, we’ll gain more and more utility and entertainment from goods that exist only in digital form. Our notions of “real” and “virtual” will forever change, and a large chunk of our attention and money will forever shift into goods that we, once upon a time, could barely comprehend as valuable. That shift is what this blog is about.

Goodbye atoms, hello bits.