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.