How to earn billions by giving something away for free

Few people can have escaped the phenomenal success of Fortnite: Battle Royale in the last year. Launched in late 2017, the game had achieved 125 million players by June 2018 and is expected to make over $3 billion in sales this year alone.  While creativity and technology are essential to the success of a video game, economic decisions can also play a key role. One of those decisions is choosing the right pricing strategy.

In some markets – typically commodity markets with lots of firms producing identical goods – there is no real choice to be made and firms simply follow the market price. But video games are not like that; creating a new, popular game gives you the power to choose your own price.  However, there is a trade-off between a high margin and high volume, so finding the optimal price is not straightforward.

One obvious starting point is the price of competing games. The typical price of video games such as Call of Duty is about £50, with games aimed at younger players such as Minecraft retailing at about £20.  In contrast, Epic Games gives Fortnite away for free and only makes money through in-game purchases: a different outfit for your characters, a new dance move, or a better looking pickaxe. Why would the creators of Fortnite have chosen this pricing strategy? What are the advantages and disadvantages and how does it affect the design of the game?

Typically, both cost and demand factors influence the optimal price. In a competitive market, prices are competed down to the marginal cost of supplying another customer. In the video game industry, this cost is essentially zero (do not confuse this marginal cost with the very high fixed costs of developing a new game). This low marginal cost is one factor pushing towards a low price, but because video games are not a competitive market, the nature of demand is far more important.

One feature of the video game market is that there are significant switching costs hindering competition. Switching costs occur when a customer prefers to keep on buying from the same firm rather than switch to competitors who may offer otherwise better or cheaper products. These costs are particularly important for services like banking or utilities where it is takes time and effort to switch suppliers. Switching costs mean that it is in the interests of firms to offer low initial prices to attract new customers, then increase prices later. How does this apply to video games? Players are attracted by a cheap or free new game, get hooked, and then are willing to pay more in order to keep on playing or enhance the experience.

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Network effects in action (AKA: gaming is more fun with friends!)

Another striking feature of games like Fortnite is the importance of network effects. Network effects arise when consumers value a product more highly, the more other people there are using it too. For example, there is no point being on WhatsApp if no one else you know is on it. In Fortnite, gamers play together in large teams of friends.  This means that Fortnite potentially profits from every additional player (and remember, marginal costs are negligible) even if that particular player never actually pays a penny themselves. These network effects are another factor the optimal price down towards zero, but only if Fortnite’s pricing structure allows them to make enough money elsewhere.

One way to think of Fortnite’s price structure is as a type of price discrimination. For any good or service, different customers will value the good at different amounts. Firms would like to exploit this variation by charging more to those customers with high valuations, while still offering the product to other customers at a more affordable price. In some cases it is possible to do this by giving discounts to price sensitive groups such as students or pensioners. Another approach is to offer different versions of a product, such as airlines offering economy and business class tickets, which vary hugely in price even though the additional cost to the airline of business class tickets is relatively small.  In-game purchases in video games can work in a similar way. Offering these purchases allows Fortnite to extract large amounts of money from those with a high willingness to pay, without excluding other players. 69% of players have made in-game purchases with an average spend of about £65 – but 31% have paid nothing at all.

What sort in-game purchases does Fortnite offer? One key to the game’s success seems to be that it does not allow players to buy items that increase the chance of winning as that would make the game less interesting. Instead Fortnite sells a huge range of different “skins” that change every possible aspect of your character’s appearance.  Another interesting feature is that, unlike most video games, Fortnite does not offer players any choice over the appearance of their initial character. For example, the gender and race of the character are randomly assigned. This is a case of purposely selling low quality goods, even though it would cost very little more (or in some cases actually less) to provide a higher quality. For example, Tesla’s cheaper 60kWh car actually has the same battery as the 75kWh vehicles but the battery has been purposely limited to provide only 60KWh of mileage. This only makes sense as part of a price discrimination strategy.

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Players can buy skins that change elements of their character’s appearance. (Image from https://www.youtube.com/watch?v=du0VAkN8EIA)

Economic and design decisions like this have made Fortnite the most profitable free-to-play video game of all time. Readers who know much more about Fortnite than the author will surely be able come up with many more examples of how this success has come about and how the pricing structure and game design complement each other.

YOUR TASK

Take a video game that you already know, and imagine you were relaunching it. What would be the advantages and disadvantages of giving it away for free? If you were giving it away, how exactly would you make money? How might this decision change the design of the game?

Or maybe be you are more interested in theme parks? There are some amusement parks that let you enter for free and then charge extra for individual rides (a bit like in-game purchases in Fortnite). However most theme parks charge a high entrance fee which then gives you free access to all the main attractions. Why do you think this is? As an owner, how would you choose between the two price structures? What items might you charge extra for at a theme park and why?

Send your work in to inspire@sjc.ox.ac.uk for a chance to win a St John’s goodie bag!

DoornikDr Kate Doornik is responsible for organising economics teaching at St John’s. She teaches first and second year core microeconomics and macroeconomics courses. Her research uses microeconomic theory, especially game theory, to study how contracts work – and particularly what happens when they don’t work well.

 

Further Reading

https://www.cnbc.com/2018/05/25/fortnite-video-games-esports.html

https://onechocolatecomms.co.uk/changing-economics-video-games/

https://www.oxera.com/agenda/snowball-effects-competition-in-markets-with-network-externalities/

https://www.economist.com/free-exchange/2016/02/29/disney-discovers-peak-pricing

https://marginalrevolution.com/marginalrevolution/2017/09/teslas-damaged-goods-problem.html

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