Monday, January 4, 2010

What's Next For The Virtual Economy

By Taylor Buley
Monday, January 4, 2010

The virtual world got a huge boost in 2009 from social gaming, as hordes of Facebook users became virtual farmers, virtual Mafiosos or virtual restaurant owners while playing online games. Max Levchin, chief executive of San Francisco-based social gaming company Slide, says virtual world participants, not the creators, are the primary economic engine, and that Moody's may one day even rate bonds issued in a virtual world.

Levchin, a PayPal co-founder, talked with Forbes about what a new decade will mean for the virtual worlds his company is working to build.

Forbes: About 10 years ago at PayPal you started to work on some of the problems of the virtual economy. Are we any closer to a virtual economy today than we were a decade ago?

Levchin: Ten years ago in the Western world, there wasn't a place on the Internet where you could possibly--without chuckling--say, "I have an account there, I store currency in it and it's got real value." The rise of virtual economies and the recent phenomena of trust is still very much evolving, but it's clearly starting to be here.

What has changed since you first dabbled with electronic payments?

The fact that payment mechanisms fit into it is driven by demand. The reason we didn't succeed at PayPal 10 years ago trying to build micro-transactions was that everybody thought eliminating transaction fees was the stepping stone to virtual currency--if I could just pay you 10 cents, without the inefficiency of transactional costs that Visa or MasterCard impose, then we would have virtual environments and people would pay for in-game items.

But 10 years later, looking back, it's pretty clear that what happened now vs. then was that there wasn't sufficient demand. You just don't need payment systems for things that have no real demand. Today there are hundreds of millions of people playing within trustworthy online worlds and they want to gain status, progress faster or achieve something within these games, which are now more like economies.

You're saying that it was a misplaced assumption to believe that you needed a virtual payments system to beget a virtual economy, and that recent examples suggest that it's the other way around?

Exactly what everyone said 10 years ago would never happen, happened. Apple, with iTunes for example, solved the micro-transaction problem with iTunes by essentially extending credit to consumers, taking on the repayment risk. That's why you don't immediately get charged for your songs on iTunes--they're trying to batch the transactions so that the fixed portion of the transaction cost can be amortized across multiple songs or games that you buy.

The micro-transaction has almost gone away. People transfer $5 from the real world to a virtual world because even though they have no immediate plans to spend $4.50 of it, it's worth making the exchange. It's just like when you travel abroad: You need to eat, clothe yourself and buy souvenirs, so you exchange currency and essentially invest yourself into the economy that you're joining.

Do you see virtual worlds ever developing to the point where there will be investment in virtual worlds by people who don't play the games?

It may sound crazy, but it's the exact kind of conversation you would have with a prospector during the 1800's: "I have a plot of land where there's a vein of gold as big as my fist, but I don't have the money to develop it."

Look at pork belly futures. I don't really care about pork, and I don't know what pork bellies actually look like, but I know that in one of my investments I have pork bellies long outstanding. Why? Because it's a good investment.

Right now, I wouldn't spend money on a Facebook game if I'm not playing it. But if a Facebook game was going on for many years, and I knew that people who invested their money in virtual goods later on sold them back for 10 times their money? That sort of level of abstraction is another 10 or 20 years away.

Do you see the operators of these virtual worlds as the primary economic engines? How much content is user generated?

At some point, the quality and the cost of operating that reaches optimal scale and the only way to make the thing grow is get more people in. World of Warcraft's operator says this thing is $100, but more people join and it's now worth $200. If you buy it, then I have $100 I can go spend on something else, but the reality is that no value has been created. It's either underpricing by World of Warcraft, or the item appreciated by an expansion of the audience.

The more sustainable version of this is where World of Warcraft operators create a market for publicly made quests. That is actually true value creation. You sat down and wrote something and maybe you didn't work very hard, but either way there's a real value exchange where the world became an economy with contributors--both contribution and extraction of capital vs. buying things that are only as valuable as the size of the audience.

So then users are the primary creator of values in a virtual economy?

I think that's where this stuff has to wind up. The things of value inside these worlds have to be primarily created by the participants. That's where our plans are.

The real open question is whether these virtual worlds are a stepping stone between the shift from real economy to a completely virtual economy. It's entirely possible that I'm wrong--lots of games are just games. But 25 years from now Moody's might be willing to rate bonds issued inside of virtual worlds. There's no real technical reason why that couldn't happen, it's just an issue of liquidity and commitment. Will people treat those things as a real part of their life or not? All indicators show that they will.

For further reading:
"2009 in Review: How Microtransactions and User-Created Virtual Markets Reshaped Business", Pixels and Policy, December 29, 2009
"Virtual Goods Start Bringing Real Paydays", The New York Times, November 6, 2009
"Wall Street Vs. 'Virtual Street'", Forbes, August 21, 2009
"From Pet Penguins To Flame Throwers: The Biggest Sellers In The Virtual World", Forbes, May 6, 2009

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