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Last week I estimated that Facebook is doing up to $15m in revenue per year from its digital gifts business. I noted that there are three use cases for digital goods. I thought that it might be useful to go into each of those use cases in more detail.

Digital Gifts

Facebook, HotorNot. Live Journal and Dogster are all examples of companies that have rolled out virtual gifts that members can send each other.

Virtual gifts are most effective in the context of communications, especially high volume communications environments where it can be difficult to get attention. By paying real money for a virtual gift, the sender of a message signals that they are more eager than most others to be heard. As James Hong has noted:

The utility gained from this is one of SIGNALING. What is it you are trying to signal? In the case of HOTorNOT’s virtual flowers, one is trying to signal extraordinary levels of interest. A user on the site can say “yes i’m interested” to every other person on the site because it costs nothing (but time) to click “yes” on people’s profiles. However, it is presumed that money IS a limited resource. By spending money in order to purchase a flower, becaues the # of flowers I can afford is finite, it signals to the recipient that S/he is very very EXTRA special. So we chose to price the flowers high…

So basically, because they’re so expensive and less people are willing to send them is what makes someone who RECEIVES them DIFFERENTIATED. The flowers have REAL value to the receipient [sic], and therefore real value to the sender who is gonna get props for sending them…

We found, last time we ran the numbers, that sending flowers increased the likelihood of a “double match” on our system by 4x.. meaning as a signal, they are well received and really work.

Dana Boyd also points out that gifting opens up the opportunity for reciprocation:

Gifts are part of status play. As such, there are critical elements about gift giving that must be taken into consideration. For example, it’s critical to know who gifted who first. You need to know this because it showcases consideration. Look closely at comments on MySpace and you’ll see that timing matters; there’s no timing on Facebook so you can’t see who gifted who first and who reciprocated. Upon receipt of a gift, one is often required to reciprocate. To handle being second, people up the ante in reciprocating. The second person gives something that is worth more than the first. This requires having the ability to offer more; offering two of something isn’t really the right answer – you want to offer something of more value.

This communications context for gifting underscores our finding that holiday themed facebook gifts sold 5x better than average facebook gifts. Holiday gifts come with a built in message. Getting a Santa Hat as a virtual gift is much easier to understand than getting a beach ball as a virtual gift.

Self Expression

Social network users love to personalize their profile pages, whether they be MySpace users, Bebo Users, Orkut users, yes, even Facebook users! Many web sites and virtual worlds have found that users are willing to pay to personalize their web representations, as evidenced by Gaia, Habbo Hotel, Meez, CyWorld, Second Life, Tencent and many more. These are businesses that in some cases are making tens, even hundreds of millions of dollars in revenue by selling virtual goods to personalize virtual avatars, apartments/hompies and the like. As Fred Stutzman notes:

In the SL and Cyworld model, the motivations are built on very sound logic. People like to buy stuff for themselves that makes them look cool. Since online identity is primarily about the representation of self, people will pay to differentiate themselves.

This is not so different from the real world, as evidenced by the continued growth of the luxury goods industries (including apparel, jewelry, luxury cars, watches etc).

Increased Functionality

The third common use case for digital goods is for users to buy increased functionality or power. This is ften within the context of a game. As Susan Wu noted on Techcrunch:

Each day, thousands of transactions take place via markets such as eBay for virtual swords, currency, or clothing across a multitude of virtual world environments. For people who purchase virtual items such as swords or armor, buying these items increases the overall satisfaction she receives from spending time in this virtual world / online community / online game. For example, struggling along as a level 20 character might give her 20 units of personal satisfaction per hour, whereas progressing as a level 20 character with a very powerful sword could confer 50 units per hour. In this case, she would be willing to pay the equivalent of whatever amount generates an incremental 30 units of personal satisfaction for the sword.

I’m an avid player of multiplayer online games. A couple of years ago, I spent 10 real dollars to buy 1 million gold in a game [yes, it was legal and part of a world where real money trade is not prohibited.] My friends mocked me and told me I was throwing money away, so I tried to explain it to them: 1 million gold would give me 20 hours of entertainment. If I were to go to the movies, 10 real dollars would buy me 2 hours of entertainment. Assuming that 1 hour of movie watching entertainment gives me the same personal satisfaction as 2 hours of game playing enjoyment, I would have been willing to pay $50 in exchange for that 1 million of virtual currency. In fact, I felt like I had gotten a bargain paying only $10!

Buying gold, or RMT as it is known in the gaming world, exists for just about all MMOGs, whether sanctioned by the game or not, and has spawned businesses such as IGE and Sparter.

Maintaining Scarcity

One key to the success of digital goods business models is to maintain the scarcity of the digital goods. Since digital goods are digital, they cost nothing to copy. Free copies of digital goods would reduce demand for paying for the same item. In a closed system, it is easier to maintain scarcity. The company controls the supply of all digital goods completely.

In an open system, the situation gets more complex. If users (or app developers) can create content that can be injected into the system (whether it be a website, a profile page, a virtual world or whatever) then this can readily blur the lines for self expression and virtual gift type digital goods. If it is easy, or even possible, for users to mimic digital goods, and if this creates confusion or uncertainty about which goods are “premium”, then digital goods can become devalued. To some extent, this has happened in Facebook, where free gifts applications have proliferated. This has probably dampened the sales of Facebook’s digital goods.

Myspace has never seen a digital goods model take off because the completely open profiles make it impossible to differentiate a paid digital good from a free copy. Both end up being a .swf file or an image, with no ability to differentiate. This may be one of the reasons that CareBadges (a MySpace widget bought by donating to a cause) had difficulty achieving real scale in MySpace.

Even in a closed system, if there is uncertainty about whether a digital good is free or not, this can inhibit the sale of digital goods. Demarcation lines between free and premium need to be clear, consistent, and obvious to even a new user to sustain the value of premium digital goods.

Increased functionality is one area where this demarcation is easy to maintain because this is typically an area that is within complete control of the website or virtual world.

As systems grow, the number of digital goods in circulation can rapidly grow as well. This can slow the demand for further digital goods purchases as longer tenured users decide that they have “enough” self expression or increased functionality. Good system designers will create “sinks” for digital goods to maintain a continued demand for digital goods from even long tenure users. These can include wear and tear on digital goods (Cyworld furniture gets worn as it is sold, HotOrNot flowers die over time), or risks of virtual goods being destroyed when they are upgraded (ZT Online).

I’d be interested to hear from social media and social game designers building digital goods business models to see if they have comments on this taxonomy or examples of successes and failures of digital goods models.