Video Games, Price Architecture, and the Zero Marginal Cost Revolution

The Digital Revolution has Changed How We Produce and Pay For Goods, and Video Games are on the Frontier of New Pricing Models

The views expressed in this blog are entirely my own and do not necessarily represent the views of the Bureau of Labor Statistics or the United States Government.

In 1986 Nintendo released the original Legend of Zelda for their flagship at-home console the Nintendo Entertainment System (NES). The game was one of several genre-defining titles from the legendary Shigeru Miyamoto that revolutionized the early gaming industry and helped propel modern gaming to the mainstream. In 2017, The Legend of Zelda: Breath of the Wild came out for the Wii U and Nintendo Switch. The game was again regarded as a revolutionary title: clocking in at 13GB (more than 100,000 times the size of the original Legend of Zelda) and earning zealous praise for its open world environment and gameplay. Despite the decades of technological advancement and cultural shifts between them, both games had similar nominal prices — the original Legend of Zelda hit store shelves for $49.99 while Breath of the Wild was available for digital download at $59.99. Inflation-adjusted, the price of Breath of the Wild is almost half the price of the first entry in the series.

Video games are on the forefront of new pricing, production, and distribution models that are shifting the way we pay for goods and services. Digital games, in some cases, have zero marginal cost — the cost for a producer to distribute an additional game file is $0, unlike the usually positive marginal cost for physical goods. More than that, advancements in technology have allowed video games to monetize additional services through microtransactions, subscriptions, cosmetic sales, digital marketplaces, and creator content. The result is pricing schemes that are based around human behavior and psychology rather than marginal costs and competitive equilibriums. Video games embracing the revolution of price architecture: a new world where goods and services do not have a single purchase price but rather a variety of custom prices and price structures designed to fit the specific needs of consumers and producers.

Sticky Prices and Price Architecture

The price of a game has absolutely nothing to do with the quality of a game. Madden costs as much as Mario Odyssey. Assassin’s Creed is $60 and Read Dead II is $60. Cyberpunk is an unfinished game: doesn’t matter, $60. Doom Eternal is one of the best shooters of all time and also $60.

It’s like if you walked into a car dealership and you could buy a Rolls-Royce for the same price as a used PT Cruiser.

-Videogamedunkey, “Video Game Pricing”

AAA games are the famous high-quality, big-budget games like Legend of Zelda, Halo, Call of Duty, and so on. They all tend to stick to the same retail price despite extreme variance in genre, quality, and budget. In 1986, the nominal price of a AAA Nintendo video game was $49.99, and nominal prices have never strayed higher than $59.99 or lower than $49.99 since the NES era.

Prices for AAA games from the three big console developers Nintendo, Sony, and Microsoft have remained in almost lockstep since 2001. With the exception of Nintendo games during the Wii era and recent experiments by Sony on a $70 price point, AAA games have been locked to a nominal $60 for nearly two decades. This is despite massive explosions in budget (Cyberpunk 2077 had an estimated budget of $316 million), revenue (Grand Theft Auto V has estimated gross revenue north of $6 billion), and quality. Why haven’t video game prices changed?

First, its important to understand the anchoring and signaling effects that govern video game prices. Anchoring is when human decisions are biased by a reference point or prior information. The classic example of anchoring is discount/sale prices: when someone sees an item listed for $1000 and on sale for $500 they are more likely to believe the item is a good deal than if the sticker price was simply $500. In the AAA video game market, anchoring bias keeps all games stuck at the $60 price point. Any game above $60 is generally seen as a bad deal - just see the extreme backlash to the attempted introduction of the $70 price point. Signaling is the compliment to anchoring in the video game space. Games are experience goods, just like movies, vacations, and other forms of entertainment. These types of goods are almost impossible for consumers to evaluate before purchase — unlike say food items or clothes, you cannot experience a game before playing it and will likely not repurchase the item if you enjoyed it (remasters and rereleases notwithstanding). As a result, companies use prices as signals of quality; when a company sets a game’s price at $60 they are implicitly telling consumers “this is our highest-budget, highest-quality offering” as opposed to lower price points that represent independent games or lower-budget offerings.

Secondly, video game companies employ price discrimination and product differentiation to a degree rivaled by few industries. Price discrimination is the practice of charging different prices to different consumers (think student or senior discounts) while product differentiation is the practice of distinguishing products to target different consumers (think different flavors of soda).

Price discrimination is extremely common in the video game market, as video games regularly go on sale shortly after their release. Grand Theft Auto V released for $60, but today you can easily buy it for $30 (and sometimes cheaper) on the video game marketplace Steam. Video game companies are segmenting their consumers by the most and least willing to pay and essentially charging those with the higher willingness to pay additional money for the privilege of playing the game first. This practice of categorizing consumers into groups and charging the groups different prices is known as third degree price discrimination. The price decreases in this practice can get almost ridiculous - Fallout 4 released only 6 years ago and sells for 1/4 of its original asking price. As time goes on prices trend lower and lower to capture the last remaining consumers as the quality of newly-released games increase. Additionally, second degree price discrimination, where consumers are incentivized to self-categorize through their purchasing decisions, is less common but still occurs in the gaming industry. Downloadable content (DLC) and different iterations of a game series are often bundled together at a more attractive price for consumers who want more content from the company.

Product differentiation is the other common tool companies utilize in the video game market. Video games come in different editions, bundles, and packages that cater directly to different consumer groups. Pre-ordering a game, for example, often comes with bonuses ranging from in-game benefits to trinkets and toys. More importantly, companies will often sell different editions of the same product with varying in-game content and physical accoutrements. Take Assassin’s Creed: Odyssey for example; the game launched with five distinct editions ranging from the standard $59.99 package including only the full game to the $119.99 ultimate edition including a season pass for future DLC alongside additional in-game content and benefits. Beyond the five packages, there was a “Medusa Edition” exclusive to Europe for £99.99, a “Spartan Edition” for $159.99, and a “Pantheon Edition” for $219.99. Each edition came with bonus missions, an artbook, an official soundtrack, additional DLC, world map, and a different set of statues and dioramas. These wide range of editions let the dedicated consumers who love the game and company to buy additional content while allowing less interested consumers to still buy the game. Increasingly, however, the $60 price point and even buying a game upfront at all is an increasingly outdated method of paying for video games.

The Zero Marginal Cost Revolution

“…Valve introduced the gaming industry’s original loot crate: an unlockable mystery box with a 1% chance of granting the player an unusual hat, items so comically ostentatious that they would instantly catapult you to the center of attention on any server you joined. Unusuals were desired by all but obtainable by few. The only way to get your hands on one was to spend hundreds of dollars unboxing or to trade with someone who spent hundreds of dollars unboxing. Naturally this meant that unusual hats didn’t come cheap. The most coveted hats and particle effects started to sell for thousands…”

-EmpLemon, “Rare Items”

With the rapid growth of the internet, digital payments, and smartphones, video games have radically changed their primary pricing mechanisms. After the smash success of Valve’s Team Fortress 2, the company introduced unlockable, tradeable hats and cosmetic items in a 2010 update. After the update, keys could be used to unlock a randomized item from cases or crates, and the unlocked item could then be traded among players or sold on a public marketplace. Each crate and case had a small chance to unlock a extremely rare items — “unusuals” — which could go for incredible amounts of money on the marketplace. Valve took a cut of all sales on the marketplace and sold the keys themselves for predetermined amounts. This pricing model was incredibly successful for Valve, leading them to make Team Fortress 2 free to play less than a year after the update and create a more advanced version of the system for their game Counter Strike: Global Offensive.

The digital revolution has enabled many companies to completely ditch traditional models where consumers purchase games up front for a predetermined price. There is no longer a single price for most video games, but rather a complex network of prices and elaborate price architecture. Companies can sell DLC and additional content expansions for previously-released games. Online games, particularly massively multiplayer online role playing games (MMORPGs) like World of Warcraft, charge monthly subscription fees. Mobile and free to play games make money through microtransactions, payments made for in game benefits or cosmetics. The vast, vast majority of video game revenue now comes from microtransactions and subscriptions. $73.8 billion was spent on mobile games and $22.78 billion was spent on free to play PC games in 2020, compared with a meagre $17.8 billion for AAA console games and $6.7 billion for AAA PC games. Games are increasingly transitioning to “live service” models where developers continually build new content for an existing game and sell an integrated bundle of DLC, microtransactions, subscription fees, and other items to recoup continual costs. This is all part of the zero marginal cost revolution occurring throughout the digital economy: the cost of allowing another consumer to download an additional game file, YouTube video, or piece of software is functionally zero, allowing firms to price goods and services in ways never before seen.

In the traditional economics model, firms’ marginal costs decrease as economies of scale allow them to produce more for less. Eventually, however, they reach a point where marginal costs continually increase. In a competitive equilibrium, all firms produce at the point where marginal costs equal average costs. Notwithstanding the flaws in applying this model to the real world, the zero marginal cost model completely shakes up the economic landscape. The marginal cost of selling an additional video game as a downloadable file is functionally zero, especially if the file is hosted on a third-party service like Steam or the Google Play Store. The marginal cost of selling additional in-game items like cosmetics or virtual currency is also functionally zero. The firm only needs to recoup their fixed costs (the costs used to develop the original game) in order to be profitable. The result of this arrangement is no equilibrium - quantity trends towards infinity and prices trend towards zero. Hypothetical video game markets are closer to monopolistic competition, where firms sell different products that are close substitutes, than the perfect competition in these models. Even still, it is obvious that prices do not trend to zero as quantity trends to infinity. Instead, companies design their own price architecture and set prices.

Take cosmetic items: multiplayer titans like Fortnite and League of Legends allow you to directly purchase skins that change the look of your character. In line with Team Fortress 2’s model, Overwatch and Battlefront II both sold cosmetics through randomized loot boxes that could be purchased through a store (though neither allowed the marketplace and trading that Valve did). These are all Veblen positional goods, meaning that they derive their value from the social status conferred on the owner and that demand increases as the price increases. Essentially, people buy unusual hats because being the owner of an unusual hat confers social status whenever you join a server, and that status is directly proportional to the price of the hat. That is how you end up with the unusual “Burning Flames Team Captain” hat selling for nearly $20,000.

Microtransactions can also include significant in-game benefits. For many single player games that can include additional lives, experience boosters, time skips, or in-game currency. In Hearthstone, a digital multiplayer card game, you can get the card packs necessary to build good decks either with significant hours of in-game work or or direct purchase. There’s a positional aspect to this as well: in so called pay-to-win multiplayer games some players are willing to put down significant money for the privilege of easily being able to defeat the players who were unwilling to pay. Games will often implement additional time sinks or deliberately slow levelling progression in order to worsen the experience of non-paying users. These kinds of games tend to be disproportionally reliant on “whales”: a small selection of extremely dedicated or addicted players that spend absurd sums of money on microtransactions.

Some games sell extreme amounts of DLC to build on the original game’s experience. Take Train Simulator 2021, a $59.99 game with 633 different DLC packages of different trains and tracks, some of which cost as much as the original game itself. Or take developer Paradox Interactive: they have released 34 different DLCs over eight years for Europa Universalis IV, changing the game so much that the current version is almost mechanically unrecognizable from the original release.

Companies nowadays combine these models in complex methods of price architecture. Team Fortress 2 is still free to play but has built on the cosmetics ecosystem by charging for additional gamemodes and adding new kinds of cosmetic items. Overwatch has an upfront price alongside cosmetic microtransactions. Destiny 2 has an upfront price, annual passes, DLC, and in-game microtransactions. World of Warcraft has an upfront cost, subscription cost, paid expansions, cosmetic microtransactions, and in-game boosts. MMORPG EVE Online even has a team of economists managing its in game currencies to prevent instability and maximize the company’s profits. Roblox is perhaps the most ambitious price architecture currently employed in video games: the game acts more as a creative network for users to design their own games and servers where they can charge premium currency (Robux) and earn real money, after Roblox takes a 70% cut.

Even the ecosystems around video games have interesting price structures. Video game consoles are usually sold under a “razor and blades” model where the console is deliberately sold at a loss to facilitate additional game sales. Nowadays you can play a selection of games on demand through Netflix-style subscriptions to Microsoft’s Xbox game pass or Sony’s PS Now. Platforms like Steam, the Epic Games Store, the Apple Store, and Google Play Store take significant chunks of revenue on digital transactions. When marginal costs are zero, the usual equilibrium price point can almost never be reached and the pricing possibilities become endless.

Conclusions

The critical thing to understand is that the zero marginal cost revolution is not constrained to the video game market. Adobe sells its creative cloud through a subscription model with bundling options. Twitch and YouTube now make money through ads, paid chat messages, subscriptions, and custom emojis. The platform you are currently reading on takes a cut of all subscriptions made through the site. The only cost to the firm of producing an additional unit in the digital world is the server space necessary to complete the sale and store the files. While the platforms have near-zero marginal costs, the creators on these platforms truly face zero marginal costs. They pay nothing for the hosting and distribution of their content, whether it reaches 100 or 100 million people.

Understanding new price architecture will require new economic models, and ensuring fair practices is going to require a different approach from market regulators. Video games are a highly addictive medium, especially given the targeting of children and adolescents. Pay-to-win microtransactions exploit addictive behavior and gambling proclivity while cosmetic microtransactions exploit social status needs. It is common for “default skins” in Fortnite and “free to plays” in Team Fortress 2 to be bullied by other players for not having expensive skins, something that can be emotionally devastating for small children and force parents to spend money on the game. Microtransactions are designed to prey on human’s psychological biases: loot boxes exploit gambling tendencies while digital currencies create psychological space between the real dollar cost of items. Regulators are beginning to crack down on the egregious practices of the video game industry: many countries require probability disclosures, China has instituted buying limits for minors, and Belgium has banned loot boxes entirely. Even old-fashioned competition is forcing reform in some of the most egregious price architectures; Microsoft, Google, and Apple have lowered the cut they take of sales through their platforms after competitive pressure from Epic Games and others, though Steam has yet to follow suit.

The zero marginal cost future is not a post-scarcity future — tons of labor and capital go into the production of digital content of all stripes, and content creators will still be paid. However, it is a world in which many of the usual stories of prices in economics break down and different methods of analysis needs to be employed. As the digital economy continues to grow, and as the physical economy implements many of the same innovations, understanding the new systems of prices and price architecture will be critical to understanding the economy.