The Economics of Freemium games

Economics is occasionally derided as a phony science. Frankly I struggled with it at school and university so to me this description really resonates. How can the graphs and formulae in the textbooks ever really capture the behavior of complex organizations and impulsive consumers?

However, exposure over the last few years — first to the social gaming phenomenon and now to the exploding mobile-gaming industry has made me realize that maybe those dusty textbooks might contain some valid insights.

If you study the Android and iOS app-stores a few things become apparent. Games rather than productivity or other apps dominate the free, paid and top-grossing charts. This is entirely consistent with the behaviour you will observe on any bus or train. Playing games on the latest generation of phones and tablets is the dominant use case, accounting for approximately 60% of all hours spent on these devices.

A second observation is that a disproportionate share of the top-performing games are developed by European rather than U.S. companies. That is an interesting topic in itself and I may return to that in another post. Lastly and perhaps counter-intuitively, the games which consistently make the most revenue are all freemium. That is, they have no upfront download fee, but various optional in-game purchase options.

Why has freemium become the winning business model? To understand, we need to rewind a few years to when the games industry was dominated by high-priced content distributed on DVDs through retail channels. In this world, consumers would read reviews and then decide which games to invest their money and time in, much like how they would decide which film to watch.

Subsequently, some consumers are delighted by the game and perhaps with hindsight would have been willing to pay much more than the box price. Others would be annoyed and resent having paid so much. An important third group, many of whom might have been prepared to something but not the full price, would not engage with the game at all.

In economic terms, the game company only exploits a portion of the overall demand curve for their product. Also most consumers either pay too little or too much based on their own perception of the product.

Freemium games by contrast are an almost unique case where companies can perfectly price-discriminate down to the level of the individual consumer. Customers are not confronted with any upfront price barrier. On mobile devices, downloading and trying a game for the first time can now be an almost frictionless process.

Afterwards, the games company can extract an increasing amount of revenue from customers, according to each customer’s specific willingness to pay. Even those who choose not to pay anything play a crucial role in the success of a title by helping to spread awareness of the game and boost its ranking and visibility in the app stores.

Does this model exploit consumers? Some argue that it does, but the more compelling arguments support the opposite view. By offering many consumers a free gaming experience, a much broader audience who might never pay for a game get to experience the product. Every paying player also knows precisely what utility is provided by paying, and can make a much more informed decision about whether and how much to spend. Since spend perfectly matches the derived utility, both consumer and company are happy.

Beyond just allowing consumers to set the price, the best games also offer consumers the ability to craft the game around their own preferences. A whole new vocabulary has emerged to describe the different kinds of virtual products and services which game developers deploy to make their games appeal to different segments. Decorative objects appeal to those who take pride in how their avatar or game environment looks.

Purchasing more energy to play further in a game appeals to those who are time-constrained and unable to wait for their energy to refill. For those with more time to play and a competitive instinct, a greater portion of spending may be invested in performance enhancers. This category itself subdivides into durable items which persist, such as weapons or buildings, and potions which give a short-lived performance advantage at some vital stage in a game.

So freemium games represent an economics experiment in its purest form. Companies allow consumers to set the price and even determine the precise characteristics of the product. The amount that consumers pay precisely matches the utility they derive. By achieving this perfect economic balance, freemium mobile games are transforming the entertainment landscape and proving that perhaps occasionally the field of economics does have some helpful insights.

This post first appeared on the Wall Street Journal’s Accelerators section - http://blogs.wsj.com/accelerators/2013/03/03/the-economics-of-freemium/

  • http://twitter.com/EricSStevens Eric Stevens

    My favourite point about he freemium model is its ability to reduce the likelihood of piracy. Freeconomics explains that people ‘bootleg’ media because they don’t think they should pay ‘that’ price and it has continually defined the future of what media costs or how to pay for it. It also provides an opportunity to revise business models and seek alternative methods of generating revenue, see the music industry for example. Revenue is mostly from concerts, merchandise and sponsors nowadays, as opposed to mp3 and cd sales…but it works.