Guest article: Are secondary markets profitable for item sales based businesses?

The question whether secondary markets limit the profits of a monopolistic seller has generated a lot of controversy over the years. The “conventional wisdom” is that secondary markets eat manufacturer profits because used goods create competition for new goods by acting as close substitutes. Instead of buying a new good, consumers can choose to buy used goods instead; especially so if they offer better value in terms of price. However, it has also been shown that secondary markets have other implications as well and therefore the conditions under which secondary markets are detrimental to the profits of a monopolistic supplier are subject to debate. In this essay, I will review some of the previous microeconomical work on secondary markets and then seek to determine how their results apply the context of virtual asset markets. The key question would be “how do secondary markets affect primary market profits?”

Introduction

Trading virtual items for real money first emerged in 1999 as secondary market trading, when players involved in MMORPGs started selling their in-game possessions to other players for real money on online auction sites. As a change to the initial development trend, the growth of the real money market of virtual goods has recently been increasingly driven by primary market trade, operators selling virtual assets directly to their players. Secondary market trading of virtual assets emerged concurrently with the first virtual worlds, but their possible implications have become more topical since the emerging of item payment business models and the question of their implications on service provider profits has often been raised.

Real money secondary markets can be found in almost all virtual worlds; however, secondary market trading is usually not endorsed by the operator. If the operator has chosen not to provide a sanctioned market for secondary market transactions, trading usually take place on outside platforms, such as online auction houses. Some service providers have chosen to take active steps to curtain secondary market trading, such as monitoring players, enforcing anti-trading rules included in the end user license agreements and harshly penalizing players who are caught engaging in the secondary market trade. In spite of this, efforts to completely eliminate a secondary market have been unsuccessful, possibly because extensive monitoring is too costly and because the alternative would require barring exchanging items between players altogether, which in turn would seriously damage game play.

Should a real money primary market for virtual goods exist in the world, the service provider holds a complete monopoly over it with no possibility for competitors to enter the market. Price discrimination possibilities for the monopolist most certainly exist as virtual world users have heterogeneous utilities, but it would seem that the service provider would not be able to identify the types of individual users. Quantity discounts and bundling can be observed in some virtual worlds, which would support the assertion that service providers are able to practice second degree price discrimination. As for the existence of secondary markets, there are examples demonstrating that a real money secondary market for virtual items is quickly established regardless of the existence of a primary market, should the game mechanics allow item transactions to take place [6]. As the environment is absolutely monopolistic, the only possible source of competition would be from the secondary market sales, as used goods perform as substitutes for new goods.

One aspect that could be enhancing the service providers’ power on the secondary level is the switching costs that users encounter. As currently all virtual worlds are separate entities with no possibility to transfer assets from one world to another, players are committed to the worlds they choose to participate in. Leaving with no intention of returning means forfeiting all previous time, effort and money spent on the particular virtual world. If switching costs exist, it would be logical to assume that they affect the elasticity of demand by making it more rigid. The monopolistic service provider could thus optimize its profits after gaining a sufficient user population by raising prices. As a counterargument, however, as the user population in virtual worlds is dynamic, raising prices could effectively cause new players not to join the world, as they would not be subject to the switching costs in the choosing phase.

In the next part, I will concentrate on analyzing the effects of establishing an operator-controlled secondary market to a virtual world environment with a primary market. The aim is to see how the secondary market would affect the profits that a service provider obtains from the primary market.

Real-world research

The question whether the existence of secondary markets limit the profits of a monopolistic seller has generated a lot of controversy over the years. The “conventional wisdom” is that secondary markets eat manufacturer profits because used goods create competition for new goods by acting as close substitutes. Instead of buying a new good, consumers can choose to buy used goods instead; especially so if they offer better value in terms of price. Consequently, the existence of a secondary market limits the amount of buyers in the primary market and thus reduces the amount of profit a monopolistic seller can extract.

Theoretical papers on real world secondary markets have reached several conclusions on what their effects are towards the primary market, although from several different sets of assumptions and factors considered. Early papers written in the 1970s and 1980s by Liebowitz [4], Miller [5] and Rust [7] demonstrate that eliminating the secondary is profitable when new and used goods are close substitutes. Newer papers from authors such as Anderson and Ginsburgh [1], Hendel and Lizzeri [3], Ghose, Telang and Krishnan [2] and Shulman and Coughlan [8] have expanded the earlier models by adding variables and relaxing constraints. However, all of the previous agree that establishing a market for used goods causes substitution effect that unambiguously reduces the amount of new goods sold in the first period. Still, the overall effect on primary market profits is not as unambiguous. Anderson and Ginsburgh suggest that secondary markets have an expansive effect on the primary market, as the secondary market offers additional value to new-good buyers in the first period. With the existence of a secondary market, they can obtain a one-period valuation of a good as well as the opportunity to cash in the product in the second period. Further, Shulman and Coughlan claim that used goods serve as an indirect price discrimination mechanism, offering the channel an additional product to capture low-valuation consumers in the second period. As Shulman and Coughlan’s presuppositions on market characteristics fit best the market environment in virtual worlds, I will use their article to analyze the outcomes of implementing a secondary market to a virtual world.

Implementing a secondary market

Building on the two assumptions outlined above, Shulman and Coughlan illustrate that a retailer-operated used good market leads to higher profits for the manufacturer and the channel as a whole. They find that when the retailer runs a profitable secondary market, channel profits are higher than when no secondary market exists. An additional assumption they make is that the consumer population is renewable over time, e.g. that willing new consumers enter the market each period. Their proposition is that, specifically, sales of new goods unambiguously increase in period 1 with the existence of a secondary market; sales of new goods in period 2 decrease due to the substitution effect; and total new-good sales across the two periods may increase or decrease with a secondary market. If the total new-good sales across the two periods decrease with a secondary market, incremental unit sales of used goods in period 2 more than compensate for the loss in new-good unit sales.

The primary market channel in virtual worlds is simpler compared to the model by Shulman and Coughlan. Instead of passing the goods on to a retailer, the operator plays all the roles from designing the items to selling them on a self-governed marketplace. With the retailer gone, the monopolistic service provider extracts the whole supply side welfare. Considering the results given by Shulman and Coughlan, this implies an increase in overall profitability for the service provider. Shulman and Coughlan also give a similar scenario in their paper and conclude that a clever manufacturer could harvest further gains through a used good market run by its own retailer. Therefore, assuming that the presuppositions made by Shulman and Coughlan stand and match the virtual world environment sufficiently, it is likely that establishing an self-controlled secondary market would indeed be profitable for the service provider.

In conclusion

While the analysis I have presented is very straightforward and lacks depth, one reason for establishing an operator-controlled secondary market in terms of maximizing service provider profit appears to be fairly compelling: secondary markets seem to exist in virtual world environments regardless of whether the service provider endorses them or not. Therefore, by not establishing a controlled secondary market the service provider forfeits a part of the available welfare – consumer surplus in form of transaction taxes – to an outside party such as an online auction house. Attempting to curtain secondary markets seems pointless in the given framework, as even outside, well-functioning secondary markets increase profitability of the primary market according to Shulman and Coughlan compared to the situation where no secondary market exists. Furthermore, trying to prohibit secondary market transactions would result in monitoring costs, making it even more disputable in terms of service provider gains.

As an additional consideration, given that the service provider establishes a controlled market for used goods, it could perhaps extract more of the consumer surplus by optimizing the transaction tax gathered from secondary market transactions. Assume that users have two possibilities of trading their used goods: an outside online auction house and the operator-controlled marketplace. Trading in the operator-controlled marketplace has several benefits over the outside option: if the market is introduced inside the game environment, transaction costs for the user are reduced, as the process is faster and more convenient. The user does not have to exit the virtual world to buy the RMT asset he desires. The transaction is also safer than in non-supervised environments and the user gets the traded asset straight away without losing any time. Furthermore, associating in the operator provided secondary market is safer for the user as the transaction are supervised and controlled by the operator: there is little risk of being scammed. Because of these benefits, we can assume that the user would be willing to pay a higher price when using operator-sanctioned secondary marketplace. Thus, if the operator sets a higher transaction tax in the operator-controlled market, players are willing to utilize the market as long as the perceived benefits are worth more than the increase in price. A profit maximizing service provider would then set a transaction cost that is T+B-e, where T is the sum of the outside transaction costs; B the perceived benefits for users from using the operator-controlled market and e an extremely small figure.

Virtual worlds are a special market environment because of the perfect control the service provider exercises over everything. For example, while in the real world durability is something hard to precisely control, it is possible in the virtual environment. In virtual environments the operator can choose the durability of virtual items, thereby deciding how close a substitute the used good is going to be for future units of the new good. Due to the perfect control over it, durability could possibly be used to spur new good sales through planned obsolescence, even more so than in the real world.

About the author

Eino Joas is an economics graduate student in Helsinki School of Economics and is currently writing his thesis on the microeconomical implications of implementing virtual good secondary markets into virtual environments. He has been involved in online gaming and virtual worlds for over ten years, initially as an avid gamer and has since taken a professional interest in the field. To this end, he has also worked as a consultant on virtual economies, specializing in establishing and structuring virtual asset markets.

References

[1] Anderson, S. and Ginsburgh, V. (1994) ‘Price discrimination by second-hand markets’ European Economic Review, 38, 1 (1994), pp. 23-44.
[2] Ghose, A., Telang, R. and Krishnan, R. (2005) ‘Effect of Electronic Secondary Markets on the Supply Chain’ Journal of Management Information Systems, Fall 2005, Vol. 22, No. 2, pp. 91-120.
[3] Hendel, I. and Lizzeri, A. (1999) ‘Interfering with secondary markets’ Rand Journal of Economics, 30, 1 (Spring 1999), pp. 1-20.
[4] Liebowitz, S. J. (1982) ‘Durability, Market Structure and New-Used Goods Models’ American Economic Review, vol. 72, 1982 (4), pp. 816-824
[5] Miller, L. (1974) ‘Killing off the Market for Used Textbooks and the Relationship between Markets for New and Secondhand Goods’, Journal of Political Economy, 1974
[6] Nojima, M. (2007) ‘Pricing Models and Motivations for MMO Play’, Proceedings of DiGRA 2007, September 24-28, Tokyo, Japan.
[7] Rust, J. (1986) ‘When is it optimal to kill off the market for used durable goods’ Econometrica, 54,1 (1986), pp. 65-86.
[8] Shulman, J. D. and Coughlan, A. T. (2007) ‘Used goods, not used bads: Profitable secondary market sales for durable goods channel’, Quantative Marketing & Economics, June 2007, Vol. 5, Issue 2, pp. 191-210

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2 thoughts on “Guest article: Are secondary markets profitable for item sales based businesses?

  1. There’s a substantial difference between MMO virtual worlds, like Second Life or There.com, and MMO games, like World of Warcraft. MMOVW may not officially condone real money secondary markets, but they wisely do not oppose them. Second Life accepts Linden dollars as payment for user subscriptions; There.com’s only paid subscription plan is a single $9.95 lifetime payment. They know where their bread is really buttered.

    Game operators, on the other hand, can’t afford to allow secondary markets to exist, because the most valuable items are earned through increasingly complex and difficult game challenges, and players are upset by the idea that other players might buy their way to success in the game. That’s a very traditional attitude with an enormous emotional and ethical component, so despite the economic realities of secondary markets, game operators choose to maintain the goodwill of their players by taking an official position against secondary markets. It may not make a lot of sense – secondary player trading is impossible to completely control – but it’s obvious why they do it. They know perfectly well that market trading comes with payoffs.

    A radical change in the traditional position of game operators must be supported by the players; therefore, the players’ emotional and ethical response has to be adequately addressed. The solution is difficult and challenging to design and execute well, so game operators choose to take the less risky road for more reliable returns. That’s not very surprising.

  2. A radical change in the traditional position of game operators must be supported by the players; therefore, the players’ emotional and ethical response has to be adequately addressed. The solution is difficult and challenging to design and execute well, so game operators choose to take the less risky road for more reliable returns. That’s not very surprising.

    Valid points, but I think if the game is designed (and marketed) with secondary markets in mind from the beginning, many of these issues are avoided. For an existing title, one approach is to do like SOE with EverQuest 2: have non-RMT servers and RMT servers, and give players the choice.

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