In January, Jeremy Liew at Lightspped Venture Partners estimated that Facebook was generating $15 million annually in virtual gifting revenue. Today, Jeremy posted an update to that initial analysis which suggests that Facebook is selling virtual gifts at annual run rate between about $28 million and $43 million.

Based on the January estimate, Facebook earned an estimated $15 million in virtual gifting revenue on total estimated revenues of $150 million. Facebook is estimated to do between $300 and $350 million in revenue this year, which means that growth in virtual gifting revenue is either keeping pace with or exceeding Facebook’s overall growth.

The analysis also suggests that nearly 80% of Facebook gifts are sold from the first screen of Facebook’s gift store. This tremendous bias towards the “first page of results” will come as no surprise to search engine optimization experts and web behaviorists — the majority of people just can’t be bothered to search below the fold.

As a result of this phenomenon, the relevancy of the first page of results is absolutely crucial to whether or not a user “converts” (i.e., clicks on a search engine result on Google, buys a book on Amazon, or sends a virtual gift). While Facebook is generating a respectable amount of revenue from virtual gifting (revenue most other social networks are leaving on the table), the full potential of their virtual gifting business won’t be unlocked until they follow the merchandising best practices of successful e-commerce sites such as a Amazon.

What’s the first step? Get rid of that one size fits all storefront and use some of the Facebook Beacon targeting goodness to create personalized storefronts for Facebook Gifts shoppers.

Sometimes virtual goods get a bad name. After all, what father wouldn’t load his shotgun at the thought of his daughter getting a Polka Dot Thong on Facebook? And what mother wouldn’t shake her head knowing her teenage son had spent $1 of her hard earned money to send that thong?

Well, virtual goods aren’t all innuendo and frivolity. Sometimes virtual goods can make the real world a better place. Causes, a popular Facebook Application with over 9 million installs, lets users send over 20 different Charity Gifts to their friends. Charity Gifts range from Blankets (a $10 donation to the American Red Cross which is used to purchase two blankets for people suffering from a disaster or emergency) to Baby Chicks (a $20 donation which helps a hungry family in Cameroon start a flock of chicks) to a Laptop (a $200 donation that provides a laptop to a child in a developing country). Charitable donations are made in the recipient’s name and can be displayed on the recipient’s Facebook profile.

The notion of charitable virtual gifts wasn’t lost on the team at Facebook. When Facebook Gifts launched in February 2007, all proceeds for the month were donated to Komen for the Cure. Facebook chose the foundation because Breast Cancer Awareness is the largest cause related group on the site. Today, Facebook Gifts is a for profit enterprise (quite profitable, Facebook made an estimated $15 million in virtual gifts during the first year of the business). However, if you are willing to rummage through a few thongs, you can still find the Pink Ribbon in the Facebook Gifts store.

CarePages is a free website that helps family and friends communicate with a loved who is hospitalized or receiving health care. Patients and their families can create a CarePage which is very similar to a social networking profile page. Owners of a CarePage can leave updates and upload photos, and visitors to that page can leave messages and virtual gifts. Virtual gifts are free to give and organized into helpful categories such as Encourage, Kids, Smiles, and Support.

PrayAbout is a unique social community that has been described as a way to “hack into God’s inbox”. Members of PrayAbout can submit prayer requests. A prayer request is non-denominational prayer that the submitter wishes to be answered. Members can add photos and update their prayers over time. Visitors to the person’s prayer request may leave a message and may light one or more virtual candles for that prayer. Virtual candles can be purchased for about 10 cents to about 25 cents per candle. They can also be earned by inviting friends to the site, receiving candles for a prayer request, and lighting candles for a popular prayer. Lighting candles is a way for the community to virtually hold vigil for a prayer and show their spiritual support to a member in need.

Handipoints is a kid-focused virtual world that puts a different twist on things. Kids earn points by completing chore charts setup by their parents. By completing these “quests”, kids earn “handipoints” that can be redeemed for real world items and bonus points that can used to purchase virtual goods in the Handipoints online world. Online game designers have known for years that players will do almost anything to earn virtual rewards. Handipoints is betting that they may even be willing to do chores.

Virtual rewards provide a very real incentive and virtual gifts add very real value to our online social gestures. We’ve seen virtual goods at work in the most frivolous parts of our lives, but they can have as significant an impact on the things that really matter like standing by a friend in need or teaching kids that positive habits have long-term benefit.

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.