Business owners interested in understanding the profitability of a market or industry, prior to releasing a product, should be very aware of the forces affecting competition. These forces, are generally accepted as indicators to predicting profitability. Understanding these forces also exposes which forces in an industry may be advantageous to being profitable, and which are challenging the opportunity. Since I sell a line of pre-fabricated retail stores in Second Life, I’ve had to consider things such as pricing, feature sets, texturing, and correctly sizing the buildings for my target market, compared to existing substitutes or alternatives. Using the XStreetSL web site to sell my virtual goods, I have experienced a phenomenon in doing virtual business manufacturing that is completely different from the real world: my competitor’s products never go away, they only get cheaper and cheaper until they are offered for free! What I am suggesting in this post, is that the lack of entry and exit costs (not to mention direct costs) associated with selling virtual products, negatively affects both pricing and product life-cycles in the virtual product industry. Combine this supposition with the exchange ratios of virtual currencies to real world currencies, and being a product manufacturer is a very difficult industry in which to find sustainable profitability.

A man by the name of Michael Porter, devised a fantastic way to look at an industry and understand the competitive forces driving not only competition, but profitability. He proposed five such forces: threat of entry, threat of substitutes, supplier power, buyer power, and industry rivalry. I’m going to focus on the threat of entry (and lack of exit) because this is what I see having a great influence on competitive pricing and product life-cycle factors of virtual world business. As I’ve discussed in a previous post, the lack of capital requirements; those direct costs associated with virtual world business processes, alters the competitive landscape and strategic planning required when/if considering moving into the virtual world of capital goods. Let’s look now at some of the issues I feel support the challenge to be profitable in the virtual economy.

It’s important first to understand that this discussion deals primarily with doing business in Second Life and on their XStreetSL virtual goods web site. Second Life is currently a leader in supporting “user-generated” content to be sold in-world, and online. Therefore, while the phenomenon is taken directly from my experiences with Second Life, it should be used as a learning tool for other, and future virtual goods markets, as a means to help protect this industry as a whole, and to support the continued virtual product development by content creators. I hope Linden Lab eventually takes note on this topic as well.

When any entrepreneur wants to set up shop in the real world, capital is needed. The greater the vision and initial supporting infrastructure, the more capital required to start. This understanding falls under the “threat of entry” competitive force. This funding component of the competitive force keeps everyone and their neighbor from competing with Intel, Amazon, Best Buy, etc. Alternatively, the capital requirements to set up a business in a virtual economy, doesn’t require an equalled amount of funding. We can say therefore, that due to low capital requirements, the threat of entry is very high for existing/established producers in virtual economies. Interestingly, many of Porter’s other factors under the threat of entry are reduced to zero, or not applicable at all in virtual economies.

But due to the zero costs associated with exiting a virtual economy, in addition to the very low cost of entry, the threat of competition, let’s say, doubles for existing producers. If I were to start a bank in the real world, my up-front capital requirements would be very high. I would also have to consider my exit costs were this bank to fail. Would I be able to pay back my initial investors? What would be the book value of my assets versus the debt the business carried when it collapsed? I don’t have to consider these things in virtual economies because the providers of the technology that allow me to sell products, have nullified these costs. If and when my virtual competitors decide to move on, they just walk away, leaving the actual costs to the technology providers to continue storing unsupported products in their product catalog, on their servers, using their bandwidth, and server processing. Even worse, the collection of unsupported products in these product catalogs continues to grow over time–increasing not only the range and threat of substitutes, but affecting a reasonable pricing model for new product entries.

The product life-cycle also generally determines the price at which a product will still demand interest. Business owners often release a new product and have a choice to make, “Do I set the price high to attract early adopters and drop my price over time, or do I set the price low to more quickly gain market share and raise my price over time?” I’ve seen both strategies utilized in virtual economies surprisingly. I say surprisingly, because using the early adopter pricing model doesn’t translate back to quicker ROI due to direct and indirect costs associated with creating a virtual product. It would make more sense to set the price low to quickly gain market share and increase brand awareness because the direct and indirect costs associated with product manufacturing is quite low itself. Over time, and as the brand name grew in recognition, a price increase could be justified.

Now, I can hear some of you saying that some new products have blown away the competition, have been “disruptive” in nature, and therefore justify the early adopter pricing model from day one. I agree with you, and say that for a limited time, this pricing model for such disruptive products, is a good strategy. I remember when I saw the first few “sculpted” products released with “baked on” texturing into Second Life. These products commanded a high price tag and justifiably so. New products offering new “creation” techniques will be quickly copied however, and offered at a lower cost to similar substitutes. Sculpted prims and baked textures isn’t a manufacturing or trade secret, it is a skill set that can be learned using 3D software. As this new technique is perfected by more people, the product’s pricing containing this attribute, will rapidly decrease to keep sales up. This is due primarily to the diffusion of technological ability over time, and the lack of administrative costs associated with changing prices on product lines: no store clerks have to change signs, no new signs have to be printed, no new marketing material need be created, inventory data bases don’t need updating. Just click in the “price” box, update the price, and press submit. The result? A rapidly decreasing price for the product, and a shortening of its own life-cycle.

Armed now with these realizations, I would suggest to the real-world companies supporting the sales of virtual products, to support the creation of ways to increase the entry and exit barriers to businesses in virtual economies. XStreetSL box rentals do provide a minimal amount of correction to this phenomenon, but the proliferation of “freebies” and freebie dungeons offering full permission, or transferable free objects in-world, cancels out these minimal rental costs. Companies supporting virtual transactions and marketplaces would realize increased virtual sales revenue numbers as prices less-quickly drop to zero. These same companies would also see increased real-world revenue through a pay-for-listing model, or other solution that requires businesses to rent virtual store space on their Internet catalog sites. Just taking a small percentage of the sale doesn’t increase exit costs *cough*. Lastly, by supporting active virtual businesses listing products on virtual Internet catalogs, this will increase the chance that the strong survive (producers that is), and customers have an increased chance of getting support for the products they’ve purchased. This could be a win-win-win solution here. One win for the real-world companies by increased virtual sales revenue and real world revenue generation, one win for the active virtual producers through alleviation or reduction in entry and exit barrier threats to competition, and one big win to consumers through improved product support, and as a benefactor of producers continuing their innovation and product line over time.

Update (10/31/09): A thread on this very topic appeared on the Second Life blogs 4 days after my discussion. Most of the responses show that “price dumping” is rampant and a big concern for many content developers and merchants on XStreetSL. You can find the discussion here.

Update (11/19/09): Linden Lab releases its Roadmap – Managing Freebies on XStreetSL on November 18th, which creates entry and exit costs to trade on XStreetSL.

Why is this? It is because of the basic fact that there is no cost involved to copy data. Put simply, I hit copy/paste and its done. Let’s look into the ramifications of this in the metaverse and see what it means business-wise.

Every object in virtual reality is just that, virtual. The designers of virtual worlds first create the framework, then the tools that allow objects to be created. Once these tools are available, you can begin creating your virtual product line. So here you are sitting at your computer, thinking of all the cool things you are about to build or create. Did you just finish placing that materials order for the products you are about to make? Did you order the drill press or lathe to work on your designs? No? Well of course not, these things that usually fall into the bucket of costs, just aren’t necessary.

Ok, let’s go back to the tools for just a second we’re going to use to build our virtual widgets. These tools are offered for free, or as part of the software to experience the virtual world. Because we are going to use these tools to build many products hopefully, the time it takes us to learn the tools and even a fee if you might pay for them, are indirect costs; your learning curve and fee to purchase a license will be spread across all of your products you create. Yes, if we created just one product, we would have a direct cost for the tools, but we’re thinking product lines here. With me so far?

In the virtual world, products don’t expire or spoil. Food spoils and eventually must be discarded, but products don’t spoil in the metaverse. This is one reason why deciding to make refrigerators as a product line in the metaverse is a really bad idea. Novelty maybe, but not a serious business venture. When a restaurant purchases food, that cost is spread over every dish made, any waste created in the process (oops, I just dropped his steak on the floor), and any left overs to be refrigerated for tomorrow’s service.  If I wanted to create a plate of food in virtual reality, I never have to worry about it spoiling. If I need more, I just copy what I’ve already made. The only cost here was my time to create the very first item. See where this is going?

This last statement brings up the overall point of this post. The only cost associated with making virtual products is the time it took to make item #1. This is a very important fact to consider when comparing real life to virtual life product manufacturing. I did not have to buy any machines to make item #1. I did not have to purchase any food or a place to store the extras, nor did I have to arrange with a materials supplier to deliver to me JIT (just in time) the necessary inputs to making my widget. The only direct cost was the time it took me to make the very first product item. Every copy from here on out, has no costs associated with its creation.

From this point on, making more of the same is just a matter of copying the original. In Second Life, setting up a vendor (sort of like a vending machine for your products) creates copies for you the instant your product is purchased so you only ever need one copy of your product. Here’s where the real life business people who manage large factories fall out of their chair. In the virtual world, you don’t need a warehouse! There are no costs associated with storage of materials or products.

Armed with this knowledge now, it’s apparent that starting a business in the virtual world has minimal costs associated with it. Unlike in real life, the virtual environment is very friendly to starting up operations. Rarely does it cost anything more than your time to learn how to use the tools and possibly a premium membership in the virtual world should you choose. But this low start-up cost means something else very important to understand, low barriers to entry–competition and price wars are just around the corner.

Happy virtual business start-ups to you all!

Limited Product Range
The first thing that grabbed me about doing business in Second Life, was the realization I had that all my ideas about being a business person in-world were thrown out of the window, and somehow simplified (or less kindly, severely limited in scope) because of the resulting technological environment. I hinted at this as a business constraint in an earlier post. In the real world, business people must operate in an environment shaped by political, economical, social, and technological factors. In Second Life, businesses are shaped primarily by technological factors alone.

Regret and penniless follows the person entering the business metaverse thinking he or she is going to make the next alternative fuel to power the world. For those of you Second Lifers, this is an obvious admission. But to those still trying to understand what these new virtual worlds offer, it should be eye-opening. About as far as any real world “green” organization could come to finding value in virtual worlds, is dissemination of message and awareness, and possibly giving out for free a cool gadget with clever branding. The technology of virtual worlds is by far the most influential determinant of its business possibilities.

As I thought about the most common attribute that businesses might find valuable in virtual worlds, I arrived at the following supposition. Second Life and other virtual worlds are a more immerse extension to the Web 2.0 phenomenon. It adds greater interactivity, real-time social and behavioral components, and another communication platform for businesses to consider besides the most popular Web 2.0 sites currently. Besides that, I can’t find overwhelming examples of companies that have found success within the metaverse (other than the ones owning the rights and technologies). Look to years 2005-2007 when notable companies opened up their own virtual spaces within Second Life. Try to find them in-world today or anything but subjective opinion on the ROI.

To be fair, companies that sell products might have failed trying to create awareness or an “experience” in Second Life. But companies that offer services, or market new ideas might be better aligned with what this technology offers. I think it explains in plain English why there’s a push by Linden Labs to promote the technology to NGO’s, educators, and non-profits.

Consumer Demand
How valuable would be the marketing and segmentation data on Second Life users? I don’t mean that sarcastically as in, enormously valuable. I mean it as in, is there any real value to having segmentation data on hand of Second Life users, for real life companies? The most common way to segment markets was by race, sex, age, religion, economic status, region, etc. But segmenting consumer markets by behaviors is rapidly gaining popularity in the digital age. Just check out how Amazon serves you product suggestions based on previous purchases. I’m sure you can think of many other examples now where marketing is based on behavior versus age group or some other socio-economic indicator. Since behavior is now linked with consumer preferences, and ultimately we are trying to answer the business question, “What makes a buyer spend money?”, let’s take a stab at understanding how consumer demand influences business opportunities in Second Life. Play along with your preferred metaverse.

The idea of a new online social interaction site intrigues only so many people in the real world. I’m willing to bet my Lindens that the majority of Second Life’s users are there for fun and social entertainment than to take classes or read a notecard on how a company is going to save the trees. The two favorite past times within Second Life are shopping and socializing at clubs. In fact, I wouldn’t consider these two activities “past times” because they are more like “primary times”. To see this in action, just look on the map to where clusters of people are, or use the Events calendar to display how many clubs are hosting an event versus how many art studios are inviting everyone to come see the fantastic displays.

Second Lifers have a “let’s party” attitude while in-world. Their behavior then creates demand for products and services around entertainment experiences. This is consumer demand then; limited in interest, and bound by the constraints the technology provides. Many club owners have said to me, “If I could only create the virtual equivalent to alcohol, I’d be rich!” But of course, we are back to our first limitation, the technology.

Opportunities & Risks

Opportunities:

• May exist for organizations that appeal to social settings, rely heavily on finding dedicated interest groups and consumer advocates through social mediums.
• Capital investment is minimal, project is considered a test-bed rather than a full-blown project.
• Volunteers are generally agreeable to, or familiar with the Second Life environment and its residents
• An example might be Red Bull, the energy drink owning a night club with interactive wall media highlighting videos from the web site, or recreating its “Flugtag” events in-world for builders and spectators. A quick online search brought up a page where Red Bull was an in-world sponsor at the DropZone, a mix of skydiving, amphitheater, night club, and other features. Unfortunately, I could not find this area within Second Life and the advertised website doesn’t exist. Sounds like this project ran out of funding.

Risks:

• Due diligence for those companies wishing to bring product “experiences” into Second Life is a must. Look to past performers and their track record.
• The audience may be too limited to spread your message or product awareness with measurable returns, for the investment.
• Technology constraints may prove a deterrent to satisfactorily providing a positive product experience.

Second Life mimics real life where society needs and relies on money exchanging hands to support economic growth. As more real-world currencies are converted into Lindens (the financial unit of exchange in Second Life), more money becomes available for exchange between participants. “The Fed” (US Federal Reserve Bank) in the U.S. greatly influences the cost of borrowing money and setting its value through financial policy. In Second Life, Linden Labs has many of the same controls over the costs of capital, exchanges, its value, and availability of currency.

Economic Policy & Controls
Financial systems attempt to provide a stable and valuable currency used for the exchange of goods and services. Linden Labs (LL) places controls over its Second Life currency to achieve similar results; to provide stability by offering a set exchange rate from real world monies into Lindens. It is this set rate where LL acts as the US Federal Reserve, making policy and setting guidance on the actual value of its in-world currency. All other currency exchange, mainly through the LindeX exchange system at this point, are influenced by what LL offers directly and conveniently for currency conversion. Linden Labs has even gone outside its territory, controlling the value of its Second Life currency by placing bans on logins to people exchanging Second Life currencies outside of its LindeX.

The Second Life economy is also controlled by Linden Labs’ policies on stipends (regular payments to account holders) and LindeX trading “circuit breakers”. Stipend payments have varied over the years to qualified resident accounts, but the overall effect is to moderate the amount of in-world currency available. There is no incentive for savings in Second Life because you don’t earn any interest on your Lindens. What money you have, either goes to other residents, or back to Linden Labs to pay for your account and/or land tier fees.

The LindeX currency exchange has become more sophisticated over time as well. Back in 2006, an official blog by Phillip Linden discussed the ability of the LindeX to halt or suspend trading based on exchange rate fluctuations. The effect is no doubt to provide stability of the currency, minimize any “runs on the bank”, or inflationary pressures from speculators or real world economic factors. A review of LindeX market data reveals that at some point late in 2006, the value of the Linden has remained very stable, trending slightly downward over time.

Real Estate
Even in the virtual world, businesses need land to display their products and market their services. The real estate market has been one of the reportedly most profitable jobs in the early days of Second Life, but here too, LL flexes its control over the economy. Second Life’s economy is further influenced by land auctions and the availability of land, both controlled by Linden Labs.

Governor Linden sells real estate to the highest bidder in both Linden and US dollar auctions. Auctions regularly show 15-30 parcels for auction, many with no bids (over capacity). An average starting price for land is easily determined by a predictable per square meter cost of 3 Lindens for Linden land auctions and 1.5 Lindens for US dollar land auctions. This pricing has a very important role on the resale value of land. Real estate investors that I’ve run across attempt to rent out the land until a suitable buyer is found for the right price.

The availability of land, also determined entirely by Linden Labs, affects the supply side of the real estate market, and thus price. People looking to flip land are often fighting the same forces that have the upper-hand in setting market prices and availability. Again, LL has a policy with regard to land growth and average pricing. The expansion of new regions within Second Life over the past few years and recent pricing model changes for “open space sims” has had a major effect on land pricing, availability, location, and the economic viability of being a real estate speculator.

Income Earnings
“What can I do to make some money in here?”, the proverbial question of Second Life newcomers. Linden Labs provides economic statistics which many people chew on in the blogosphere, trying to come up with more meaningful interpretations of the data than what glimpses LL gives us. In a healthy economy, we need transactions involving lots of people. The data shows that Q1 for 2009 set a record for user-to-user transactions. I don’t think the given value of $120M is as important as the percent growth of transaction volume for the following reasons: Linden Labs sinks money (Lindens) into its economy through stipends, bolstering the supply of available money for transactions; and we don’t know the value of new, real money entering the system for the quarter which would tell us how much of this $120M is new money and not just recirculated. But the increased financial transaction volume means greater opportunities for capturing a bigger part of this volume. Or does it?

The distribution of wealth is equally important for our understanding of the Second Life economy. It not only sheds light on the capability of buyers, but also the opportunities for having a successful business in-world. Let me give you the 10,000 foot level view–it’s not pretty currently. Let’s say you want Second Life to support you by making enough monthly to cover your car payment. Taking the 6 month average of Second Life users in 2009 who made between $200 and $500 US dollars, we find 2,380 people. If you want more detail, you can see the data yourself. You’ll be in the lucky 0.3% of people making $200-$500 monthly, based on LL’s Q1 2009 “Monthly unique residents with repeat logins” (2380/732,526)*100

Exchange Rates
The prices of products in-world takes some getting used to. Another post will address pricing models and strategies, but for now, suffice it to say, at an exchange rate of approximately 260 Lindens to $1 US, you need to sell a lot of widgets to cover that car payment.

Jobs
A discussion of even a virtual economy would be incomplete without bringing up the topic of jobs. You can find a list of jobs posted on the Second Life website if you are interested, but true to life, unless you are self-employed in the metaverse, you are limiting your potential earnings. Second Life is a pseudo experiment in social gatherings (my words, not Linden Labs) with economic and educational modules thrown in for complexity. You are either a producer of products and services that support the social experience, or a consumer. This greatly limits the range of successful products in Second Life and the overall economic growth rate (unless of course Linden Labs creates the technology in-world that causes our avatars to get sick and allows drug manufacturers to create new medicines for our ailments).

Your standard-fare DJ, host, dancer, works for tips. Success varies based on the number of guests visiting during your working hours and their tipping habits. The seedier side of Second Life seems to bring in higher rewards, and escorts willing to be extremely interactive through use of voice or even web cams might be able to cover more than just a car payment each month.

Being a business owner. Stop, back up. Finding a suitable product in a world limited by the technology that supports it, and learning the tools it takes to create content that lends to the social aspects of Second Life is extremely difficult. Should you make a product and sell it, you will eventually come across a substitute or alternative product to yours at a lower price, or of higher quality. Let the pricing wars begin! But I am a business owner in Second Life as well as a socialite when I have the time. So, it isn’t really a matter of “beating the house” and betting it all. Let’s have fun, understand what our environment looks like, and then try to find new, refreshing ways to go about being successful in business inside the metaverse.