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Doug Levin and I just co-wrote a blog post titled Virtual Goods: A Market Assessment describing the virtual goods market, specifically looking at the role that social games and brands are playing in the rise of social games. Here is an excerpt:

According to market-research firm In-Stat, VG revenue is expected to hit $7.3 billion this year alone. This figure far exceeds estimates from many leading research and investment banking firms, and is in large part tied to the overwhelming success and growth of social games. At this market level, virtual goods have evolved into a major revenue stream from the media and entertainment industry. As consumers spend more of their leisure time online, VGs are reaping the benefit and becoming a key aspect of lifestyle spending. Accordingly to Nielsen, U.S. consumers already spend a higher share of wallet on game content –of which VGs are a key part – than on print media, premium TV packages, movie rentals, and music.

Last week, Doug Levin, the CEO of Ayeah Games and a leader in the Boston start-up community, posted an article about the drivers behind the massive disruption that virtual goods are causing in the interactive entertainment and social media worlds.

In Virtual Goods Cause Disruption, Doug cites six factors that are changing the landscape of the consumer Internet. These factors include the emergence of social gaming, the transition of gaming from a niche activity to a mass media service, and the influx of capital from investors hungry to replicate the success of Zynga, Playdom, and Playfish.

In the past, disruptive innovations have generally taken the form of new technology that has a transformational impact on an industry. The classic example is the development of mini steel mills that eliminated economies of scale from steel production and allowed smaller companies, such as Nucor, to compete effectively with incumbent players. Doug’s article highlights the fact that disruptive innovations need not be limited to new technologies—innovations in distribution and business models can be ever bit as powerful.

People value entertainment, and thanks to virtual goods, we’ve finally entered an era where content developers can profitably develop and distribute their creations.

For the next two weeks (until October 29, 2010), Virtual Goods World is offering a two-day pass to the conference for just £950, a savings of £1,245. Register now to take advantage of this unprecedented offer.

For many years, European companies have played a pioneering role in the field of virtual goods. Several of the first successful virtual goods-based businesses outside of Asia, such as Habbo Hotel, were launched by European companies, and today Europe represents a rapidly growing market from both a content development and user distribution perspective.

Virtual Goods World has attracted an impressive array of speakers including CEOs from many of the most innovative companies in the space including Sulake, Outspark, and Sparkplay Media. Register today to be part of an in-depth conversation on how to leverage the explosive opportunity in the virtual goods space.

For a limited time, get $200 off the registration rate for Engage Santa Clara, the premier conference on virtual goods, virtual worlds, games, and toys. Use discount code “speakervip” when you register. This offer expires on September 20.

Engage Santa Clara takes place September 22-23, 2010 at the Santa Clara Convention Center. The show includes two primary tracks: Virtual Goods and Games, Technology and Toys. Plus all attendees receive a free copy of the Branded Virtual Goods Report, a report that I co-authored with Zeenat Rasheed from Viximo and Brett Orlanski from Virtual Greats.

The Virtual Goods track delivers what developers need to know to leverage virtual goods. Covering social games, Facebook apps, virtual worlds, mobile applications and more.

The Games, Technology and Toys track covers business models, design, development and investment issues surrounding social games, mobile games, virtual worlds and more.

More details are available here.

Europe has played a key role in the evolution of virtual goods outside of Asia. Habbo Hotel, created by Finish developer Sulake, was one of the first proof points that virtual goods could work on a mass scale outside of Asia. Today, Habbo Hotel gets about 15 million visitors a month and generated $60 million in revenue in 2009, primarily from virtual goods.

In addition to virtual worlds, Europe has played a key role in the development of the social game market and many view European social networks as a key front in the expansion of social gaming outside of Facebook. In a recent interview with Lloyd Melnick on Social Games Observer, Playdom’s General Manager of International Operations discussed how the company views European social networks, such as Germany’s StudiVZ and Poland’s Nasza Klasa, as a key part of its expansion. Melnick cites the fact that strong monetization on Orkut, Google’s social network which has a heavily international audience, is an indicator that international users monetize as well as if not better than U.S. users.

Leaders in the virtual goods, social media, and social gaming industry will gather at the Virtual Goods World Europe 2010 conference in London. The conference will last three days from November 15 to 17 and will feature CEO-level speakers in the industry including Timo Soininen, CEO of Sulake, Mari Baker, CEO of Playfirst, and John Earner, General Manager of Playfish EMEA. The conference will focus on the opportunities and challenges presented by the explosive growth in virtual goods, and will cover a range of topics to help social networks, game developers, and brands turn this growth into a reliable revenue stream.

Social games have transformed Facebook from an advertising-oriented business to a virtual goods powerhouse. Today, the majority of social game revenue is generated on Facebook, but Facebook makes up only about 30% of social networking traffic. The next wave of growth in social games will come from beyond Facebook, and social games will change the way we think about the social networking business. My guest post on Mashable, Why Games Are the Killer App for Social Networks, discusses how social networks can take advantage of this explosive opportunity.

Yesterday, Brian Balfour, founder of Viximo, posted a great article pointing to lessons that the virtual goods industry can learn from Starbucks. In many ways, coffee from Starbucks is like a virtual good whose value is determined by intangible factors such as branding, premium positioning, and affordable luxury. As a result, Starbucks is a great model for how to sell virtual goods. Brian digs into how Starbucks maximizes revenue during the holidays through holiday-focused product, strong social context, and savvy management of pricing and promotions — all strategies that are directly applicable to selling virtual goods.

Near perfect price discrimination has been touted as one of the major advantages of virtual goods as a business model. Intrinsically, virtual goods provide a form of first degree price discrimination where users with a higher willingness-to-pay consume greater quantities of virtual goods. This means that site and game operators can capture a higher share of the value delivered to their end users and achieve a higher overall ARPU (average revenue per user).

While first degree price discrimination is a well understood topic in the virtual goods industry, there is another form of price discrimination that can be just as powerful — third degree price discrimination, better known as dynamic pricing. Dynamic pricing involves changing prices based on moment-to-moment or user-by-user changes in demand.

I’m really excited to present “Show Me the Money: Maximizing Virtual Goods through Dynamic Pricing”, a guest article written by Rex Fisher, VP of Business Development at Digonex Technologies. Digonex is a pioneer in the field of dynamic pricing and have helped companies in digital media, event ticketing, retail, and manufacturing improve their profitability through dynamic pricing.

Show Me the Money: Maximizing Virtual Goods through Dynamic Pricing

It’s no secret that the virtual goods industry has exploded in the past two years. The growing popularity and sales of in-game items, including avatar customization and virtual gifts such as pets and coins, has industry analysts predicting the market will top one billion dollars in 2009 alone in the US and nearly seven billion in China. The specific marketplace as a whole is a huge economic opportunity just for in-game items.

What many may not know is virtual goods represent the next big opportunity for large companies, mainstream brands and social networking platforms who are struggling to meet revenue goals in a difficult advertising climate.

So how can organizations maximize this market opportunity to offer users meaningful ways to emotionally interact with friends, family, colleagues, etc. online, while keeping their target audiences engaged with their products and services, and dramatically impacting their bottom line? The answer lies in dynamic pricing.

This article will outline the features and benefits of dynamic pricing and illustrate how modern pricing structures can help organizations such as casual multiplayer online games (MMOs) and virtual world developers implement sound pricing strategies, maximize revenue opportunities and significantly drive the future of the virtual goods industry.

Dynamic Pricing: A Primer

Dynamic pricing is critical to maximizing profits and growth in the virtual goods industry. While sophisticated pricing models are still a relatively new concept, the impact that dynamic pricing can have on selling and purchasing behaviors is significant. Dynamic pricing is already becoming prevalent in many industries including manufacturing, event ticketing and digital media (i.e. downloadable music). Let’s take a look at closer look at the basic principles of dynamic pricing.

Consider your last fill up at a gas station. We all know that gas prices typically jump on Friday and fall on Monday in response to demand. Do weekend gas prices keep some people from buying gas? Absolutely – just not enough people to affect pricing. Of course, demand for gasoline is relatively inelastic. It is not always the case that an increase in demand should lead to an increase in price.

Dynamic pricing allows prices to adjust up or down based upon consumer demand which enables companies and social game developers to offer prices that are market-driven. Additionally, dynamic pricing models can be utilized to encourage gamers toward a particular business goal for virtual goods companies. Perhaps that goal is to increase per customer sales growth, broaden sales diversification or extend visitation to virtual retail environments. Whatever the focus may be, dynamic pricing is capable of generating tremendously improved results over static pricing.

How it Works

Dynamic pricing solutions typically collect transaction data at selected intervals then aggregates and analyzes that data based on customizable criteria. Upon completion of analysis optimal product pricing is delivered for the product catalog. These pricing updates can happen automatically, keeping the product prices in synch with current demand on a day-to-day or even hour-by-hour basis. It is always important to set the business parameters within which a dynamic pricing effort will operate. For example, setting appropriate boundaries on price variation is crucial. Wildly fluctuating prices can produce a negative customer experience and impact profitability while controlled price variation can actually improve the customer experience and stimulate sales.

Digonex Artwork.JPG

Finally, dynamic pricing models are optimal for providing a more flexible, reliable way to allow organizations to maximize revenue opportunities. A full price range, non-tiered dynamic pricing model continually delivers optimal prices inline with a company’s overall business strategy. While the virtual goods industry is experiencing remarkable growth, dynamic pricing gives organizations the ability to maximize profitability today to ensure they’re set up for success tomorrow.

Maximize the Value of Virtual Goods with Dynamic Pricing

Dynamic pricing benefits industries that have high-demand uncertainty (e.g. digital music, event ticketing, e-books and e-commerce) or offer perishable products, such as hotel rooms, airline tickets or virtual goods which have a specific shelf life. In fact, that life span can be mere days or even minutes depending on the product and consumer demand.

To understand the benefit of dynamic pricing, it’s critical to understand that the virtual economy is based solely on demand – not supply and demand. While supply may not be a constraint for a game developer there is the potential to leverage supply constraints as a strategic factor to increase demand and ultimately, profits.

For example, social gaming companies such as Zynga and Playdom will regularly offer virtual products for a limited time or in-limited supply that provide the player with a significant advantage in the online virtual game they’re playing. These products are typically sold for “points” which must be earned by completing tasks in the game or purchased for real money. Limited products typically sell out in a matter of days and when they do they are usually gone forever. Those gamers that do not obtain the limited products are left to contend with those that did. When a supply constraint is placed on a virtual product it is absolutely critical to get the price right. Price too low at any given point and the product will saturate the market or sell out within hours. Price too high and demand is reduced to a fraction of what it could optimally be.

There are several pricing challenges associated with virtual goods. Virtual marketplaces are extremely fast-paced with most products having less than a 72 hour post release window to generate the majority of their sales. The optimal price for a virtual good can fluctuate more than 100 percent over the course of that 72 hour window. The speed of virtual markets require product analysis and price adjustment in a matter of minutes, not hours, in order to achieve maximum profitability. Additionally, sales stimulation or cannibalization can have a tremendous impact on almost any virtual good. For example, the price and selection of couches can drastically affect demand for coffee tables in virtual worlds. It is also important to note that many online games have secondary markets that heavily influence demand in the primary markets.

Dynamic pricing offers several additional benefits for virtual goods organizations including:

  • Ability to use constrain supply as a tool to stimulate demand. When correctly implemented, dynamic pricing can be leveraged in conjunction with supply to accomplish a number of business goals for a virtual goods organization with significantly greater success.
  • Virtual goods companies can leverage dynamic pricing models to capitalize on limited windows of opportunity and drive significant revenue for a specific digital good such as points or coins as referenced in the Zynga example above.
  • Dynamic pricing enables virtual goods organizations to reduce sales cannibalization for particular goods and adjust prices accordingly.
  • Lastly, dynamic pricing, vis-à-vis automated price optimization tools, give revenue optimization and merchandizing teams an automated solution that can help them do their jobs better, maximizing time and resources within an organization.

Conclusion

The virtual goods industry has experienced a tremendous amount of growth over the past couple of years. As the industry continues to evolve and expand, it will be important for companies to develop sound pricing strategies including the adoption of behaviorally-based pricing tools in order to maximize revenue opportunities and ensure long term success.

Dynamic pricing provides a powerful alternative for virtual goods companies seeking a solution to effectively monetize products and maximize profits.

Any dynamic pricing solution should continuously identify the “sweet spot” where prices follow perceived market value and generate the maximum economic return. This can greatly impact purchasing and selling behaviors which, in turn, can significantly drive the future of the virtual goods industry.

Engage! Expo, taking place September 23-24 at the San Jose Convention Center, provides insight into the best practices, current trends, and effective strategies of social media and user engagement. We have 200 free expo-only passes available. This is a great chance to walk the floor and get some fantastic networking in. Grab one before they’re gone. Full show details are here at http://www.engageexpo.com/sj2009/.

I’ll be doing a talk called “Virtual Goods: The State of The Industry” to kick off the agenda to the Virtual Goods Conference. I’m looking forward to seeing everyone there!

Earlier this month, leaders from the barely two year old social gaming industry gathered in San Francisco at the Social Gaming Summit 2009. It’s hard to believe that in only two short years, Facebook launched the first social networking application platform, most of the other social networking players have followed suit, and an estimated 14,000 social games have proliferated across those platforms.

The 500+ attendees at the Social Gaming Summit included representatives from top social networks, major game developers, and a wealth of infrastructure vendors, such as Offerpal Media and Zong, who have sprung up to support this rapidly growing industry. The emphasis was largely on issues of player acquisition and retention with particular emphasis on monetization and deployment of virtual goods as a key contributor to revenue generation.

Until recently, Internet companies in the United States have lagged far behind the curve in the sale of virtual goods. By most estimates, customers spent about $1.5 billion a year on virtual goods globally in 2007. Tencent Holdings, a publicly traded Internet media company based in China, runs perhaps the largest virtual goods business in the world, with hundreds of millions in annual revenue from virtual goods in online games, social media, and other applications.

In December, Jeremy Liew of Lightspeed Venture Parters made his prediction for the consumer Internet for 2009:

“In Asia people have been paying real money for virtual goods for years. It is the primary business model for games and Internet companies in China and Korea, far more important that advertising. We’re starting to see similar behavior in the U.S., also led here by online games and social networks. On the back of the rise of social networks and games, 2009 will be the first real breakout year for this business model in the US.”

We’re only half-way through the year, and it looks like Jeremy’s prediction is already proving true. It’s estimated that the total revenue generated by companies running applications on Facebook’s platform will outstrip Facebook’s own revenue in 2009. Social gaming is leading the pack here, and rumor has it that major social gaming players, such as Zynga, are making upwards of $50 million on an annualized run rate.

Venture Capitalist Bill Gurley sees this phenomenon as the answer to the monetization problems faced by Facebook, MySpace, and other top social networks which are struggling to meet revenue expectations in the face of an increasingly difficult advertising market. He ended the article by emphasizing that Wall Street was all set to welcome this new business model.

Social Gaming Trends

Leaders from the social gaming industry revealed some important trends in social gaming during the summit:

Virtual goods work with mainstream consumers

Sebastien de Halleux, COO of Playfish, said his Pet Society game sold 20 million virtual Christmas trees and ornaments last holiday. Players paid up to $2 for each virtual item and many players spent more on virtual trees than the average person spends on a real Christmas tree. Sebastien noted that a real Christmas tree is seen only by a handful of family members and close friends, but Pet Society’s virtual Christmas trees and ornaments can be seen by hundreds of online friends. This is just one way in which online behavior is driving new trends in consumer spending.

Brands are playing a vital role in social games

John Pleasants talked about how Playdom’s Sorority Life sold $100,000 worth of virtual Volkswagen’s over a two day period. Brands have struggled to find a strong role in the traditional video game market and advertising on social networks has been plagued by poor performance. However, social games offer brands a powerful promotional and merchandising vehicle and both brands and social game developers have been quick to embrace this opportunity.

Social games have unlocked the latent value in social networks

Despite having large and fervent audiences, social networks have had a hard time monetizing their user bases. Industry experts debated whether the answer would come from traditional display advertising, integrated sponsorships, lead generation, hyper-targeting, or direct user monetization. Well, the social gaming industry are proving that “all of the above” is the right answer.

Virtual goods provide both a way to directly monetize social networking users and a way to weave advertising opportunities into the social fabric of a site or app. But no one anticipated that social games would also unlock a valuable new form of lead generation marketing. Offer platforms, such as Offerpal and Superwards, allow users to earn virtual currency by completing lead forms, and they share the revenue generated from these leads with the application developer. Anu Shukla, CEO of Offeral, cited that 30 to 40% of players will bite on offers. As social networks find ways to become part of the social gaming economy, they’ll open up new revenue channels and drive their ARPU (average revenue per user) to significantly higher levels. In an extreme case, Adam Caplan, CEO of Super Rewards, discussed a social game player who bought $30,000 of virtual goods for use in two different games.

The Future of Social Gaming

The Summit highlights the fact that the Social Gaming industry has and will continue to have phenomenal growth. In a relatively short period of time, social games have proven that selling virtual goods is a viable business model in North America and that social networking audiences can generate significant revenue. Strategy Analytics recently released a forecast projecting that microtransaction revenue will grow from $1 billion in 2008 to $17.3 billion in 2015. No doubt, social gaming will be one of the driving forces behind this growth.

What will social gaming look like when it turns 3? I can’t know for sure, but here are some thoughts:

  • Social networks will monetize by providing virtual currency. Hi5, one of the social networks that followed Facebook’s lead by offering an applications platform has also learned from Facebook’s biggest mistake—not taking a share of revenue from applications and social games that run on its network. Rather than taxing applications for inclusion on its network, Hi5 opened up its Coins virtual currency to be used by app developers. This strategy provides value across the board by giving users a single currency that is accepted throughout the social network, giving developers access to a broadly-adopted microtransaction system, and giving Hi5 a way to share in microtransaction revenue. Facebook followed suit by launching the Pay with Facebook feature last month.
  • Social games will spread to new devices. Although social gaming started within social networks, every major social game developer is bringing their content to new platforms such as the iPhone. With the introduction of in-app payments earlier this month, iPhone developers will now have the perfect microtransaction system to build their content on—iTunes. However, these games are staying close to their roots; many are based on the Facebook Connect API which allows developers to access elements of Facebook’s application platform outside of Facebook on a diverse array of devices. Facebook recently announced that it will provide Facebook Connect on Xbox Live, which means that we’ll start to see social games on video game consoles.
  • Social games will spread to niche and international social networks. Wikipedia’s list of social networking websites includes over 150 sites, and the list leaves off many large international social networks. Social games are key to monetizing social networks, and we’ll see both lightweight and more involved social games become a key part of any social network which is serious about monetizing its users.
  • Traditional game companies will continue to stand on the sidelines. What was the very first hit social game? It’ll probably sound familiar—Scrabble, well actually Scrabulous. Launched shortly after the release of the Facebook Platform, Scrabulous is a social game, based on Scrabble, that was released by two brothers who became the first lucky prospectors in the social game goldrush. Rather than recognizing their good fortune in finding a new, rapidly growing medium for their games, Hasbro quickly got to the business of shutting Scrabulous down and didn’t find time to release its own version of Scrabble on Facebook months later, after major players such as Zynga had staked their claim. None of the traditional game companies have played a significant role in social games to date, and this will likely continue until the major players, such as Electronic Arts and Activision, wake up to the opportunity and start acquiring players like Playdom and Zynga.

Social gaming will continue to evolve at a whirlwind pace, and will be one of the major drivers behind the global explosion of virtual goods revenue. If you’d like to stay up to speed on these developments, I recommend checking out the upcoming Virtual Goods Conference which is part of the Engage Expo (September 23-24, 2009 in San Jose, CA) and the Virtual Goods Summit (October 29-30, 2009 in San Francisco, CA).

About

Virtual Goods Insider covers the burgeoning economy of in-game items, avatar customization, virtual gifts, digital media, and other goods that exist purely in digital form. It is written and published by Ravi Mehta, a veteran of the online gaming and consumer media industries.

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