Put your money where your mouth is

Companies often talk really big and fail to deliver, so it’s not surprising that people tend to stop believing the things coming out of the PR factories of large corporations. A better way to ascertain the direction of a company is to see where they are spending their money, both on employee hires and acquisitions. I noticed an interesting acquisition made by Microsoft recently (from the Stuck In Customs blog):

Target: Massive
Acquirer: Microsoft
Transaction: N/A (Announced 5/4/2006)

Target Description: Massive operates a network for dynamic video game advertising that allows for all forms of downloadable media and advertising content to be contextually integrated into the game environment, including image, audio, video, and game object formats.

In-game advertising is becoming a serious factor in future game development. Gamers have been resistant to the tainting of their gaming experience with advertising, but I think it is likely that advertising is going to play a key role in the business model of the video game industry in the next three years or so. It looks like Microsoft is ensuring that it has technology to make this a reality.

Completely ad-supported games would be a very interesting business model. For one thing, there’s significantly less deadweight loss compared to a fixed-cost game. Suppose for a moment that we can assume that in-game advertising cuts your enjoyment of a game in half. This can be thought of as paying a price in proportion to the amount of utility you obtain from playing a game, or similarly, it is proportional to the amount of time you spend playing the game. For the purpose of this example, let’s also assume that whatever lost utility you have while playing a game is gained by the advertising company in the form of advertising revenue. This is probably a flawed assumption, but it will be useful to assume this. We now have a downward sloping marginal revenue curve and a horizontal marginal cost curve, as in the figure below.

Remember from my previous article that normal pricing for creative works results in monopolistic pricing that produces an inefficient market failure, since the economically efficient price would be zero (since there is zero marginal cost). The graph above makes some very large assumptions, but the result looks very interesting. There is zero deadweight loss. A more accurate model, however, would have to take quite a few things into account, including the fixed cost of producing the game.