Valve Corp., the Bellevue-based video game company behind hit franchises like Half-Life and Portal, is a giant in the digital distribution of PC games. The company’s Steam distribution system, with more than 35 million users, is sometimes called the iTunes store of video games.

Valve is also a private company, in both the corporate and literal meanings of that word.

So it was more than a little illuminating to listen to Valve co-founder Gabe Newell give a spontaneous, 8-minute dissertation on the modern economics of video games at a recent conference in Seattle — explaining, in detail, how the company conducts behind-the-scenes pricing experiments to try to understand why we buy games when we do.

Newell cited some surprising sales data as he debunked a popular theory about game piracy, explained how the economic principle of price elasticity applies to video games (and how it doesn’t), and shared details on the company’s experience with “free to play” games such as Team Fortress 2, where the business model is based on the sale of virtual goods.

For your weekend reading, here’s an edited transcript from the WTIA TechNW panel. (Also see this follow up with Newell’s predictions about Apple and the future of the game console market.)

Valve

Gabe Newell: It’s interesting to touch on a number of pricing and service issues, because it will help convey the complexity of what we’re seeing in the entertainment space, and there’s probably also going to be lessons in it for other people trying to create value on the Internet.

One thing that we have learned is that piracy is not a pricing issue. It’s a service issue. The easiest way to stop piracy is not by putting antipiracy technology to work. It’s by giving those people a service that’s better than what they’re receiving from the pirates. For example, Russia. You say, oh, we’re going to enter Russia, people say, you’re doomed, they’ll pirate everything in Russia. Russia now outside of Germany is our largest continental European market.

Ed Fries: That’s incredible. That’s in dollars?

Newell: That’s in dollars, yes. Whenever I talk about how much money we make it’s always dollar-denominated. All of our products are sold in local currency. But the point was, the people who are telling you that Russians pirate everything are the people who wait six months to localize their product into Russia. … So that, as far as we’re concerned, is asked and answered. It doesn’t take much in terms of providing a better service to make pirates a non-issue.

Now we did something where we decided to look at price elasticity. Without making announcements, we varied the price of one of our products. We have Steam so we can watch user behavior in real time. That gives us a useful tool for making experiments which you can’t really do through a lot of other distribution mechanisms. What we saw was that pricing was perfectly elastic. In other words, our gross revenue would remain constant. We thought, hooray, we understand this really well. There’s no way to use price to increase or decrease the size of your business.

But then we did this different experiment where we did a sale. The sale is a highly promoted event that has ancillary media like comic books and movies associated with it. We do a 75 percent price reduction, our Counter-Strike experience tells us that our gross revenue would remain constant. Instead what we saw was our gross revenue increased by a factor of 40. Not 40 percent, but a factor of 40. Which is completely not predicted by our previous experience with silent price variation. …

Then we decided that all we were really doing was time-shifting revenue. We were moving sales forward from the future. Then when we analyzed that we saw two things that were very surprising. Promotions on the digital channel increased sales at retail at the same time, and increased sales after the sale was finished, which falsified the temporal shifting and channel cannibalization arguments. Essentially, your audience, the people who bought the game, were more effective than traditional promotional tools. So we tried a third-party product to see if we had some artificial home-field advantage. We saw the same pricing phenomenon. Twenty-five percent, 50 percent and 75 percent very reliably generate different increases in gross revenue.

The most recent thing that also is really puzzling is that we made products available for free on numerous occasions, without significantly impacting the audience size. We recently said, we’re now going to do something different, we’re not only going to signal that it’s free but we’re going to say, ‘it’s free to play,’ which is not really a pricing signal, even though that’s what you would ordinarily think it is. And our user base for our first product that we made free to play, Team Fortress 2, increased by a factor of five. That doesn’t make sense if you’re trying to think of it purely as a pricing phenomenon.

Why is free and free to play so different? Well then you have to start thinking about how value creation actually occurs, and what it is that people are valuing, and what the statement that something is free to play implies about the future value of the experience that they’re going to have.

And then the conversion rate, when we talk to partners who do free-to-play, a lot of people see about a 2 to 3 percent conversion rate of the people in their audience who actually buy something, and then with Team Fortress 2, which looks more like Arkham Asylum in terms of the user profile and the content, we see about a 20 to 30 percent conversion rate of people who are playing those games who buy something.

So that’s a fairly surprising and fairly recent statistic, which is that there seems to be something about the content that significantly changes how your monetization occurs, with apparently much broader participation than you would see out of something like FarmVille.

We don’t understand what’s going on. All we know is we’re going to keep running these experiments to try and understand better what it is that our customers are telling us. And there are clearly things that we don’t understand because a simple analysis of these statistics implies very contradictory yet reproducible results. So clearly there are things that we don’t understand, and we’re trying to develop theories for them.

It’s just an exciting time but also a very troubling time.

Fries: That’s some incredible data. … You talk about doing experiments. This is probably the biggest change that’s affected the gaming business over the last few years. It’s not just that we have digital distribution to our customers. It’s that we have this incredible two-way connection that we’ve never had before with our customers.

We’ve gone from a situation where we dream up a game, we spend three years making it, we put it in a box, we put it out in stores, we hope it sells, to a situation that’s incredibly more fluid and dynamic, where we’re constantly modifying the game with the participation of the customers themselves.”

*** Follow-up: Valve’s Newell predicts Apple will shake up game consoles ***

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Comments

  • Zee

    Nice post!
    zee

    http://walisystems.com

  • Didierm

    A mod I was working on for Bioware’s NeverWinter Nights never went better than when I was doing weekly updates, with the input for the community about the changes they wanted to see. There are two pitfalls though: Hand out the design to the loudest speakers, which carry a risk for the game balance and larger appeal, and not having enough bandwidth to keep that rhythm of updates going. With regular updates, you also have a built-in piracy protection system. It does not matter if the updates are small every week, but customers want to see you still care about their game to continue investing their won precious time in it…

  • Stevostin

    All of this seems surprising because the only sort of data he seems to consider are the numerical one. No attempt to include anything that isn’t “hard” evidence. I don’t think it makes sense, because event stockpiling hard carrot and hard tomates doesn’t make any rocksolid analysis either. So why at least not consider that your typical TF2 gamer (F2P era) just isn’t your typical Farmville gamer, and that BTW both games just aren’t exactly the same, one of both seeming to be actually more value for the no money than the other ? 

    Also learning that advertised promo are the main part of the sale is a bit like reinventing the powder. A lot of business works like this and this was already true in my field ten years ago. Why do you think they keep high prices for release that really scare a lot of potential customers ? So that they can make very attractive, yet profitable to them, deals. 

    • Bengt Gregory-Brown

      Perhaps he only considers the hard numbers because he’s speaking with the business hat on, not a gamer hat. From the perspective of games being interchangeable commodities, the economic modeling focuses on the raw pricing and purchase data.

    • Ilovechocolatemuffins

      Hard numbers mean objectivity. A rock solid analysis requires quantifiable data to back up the claims. I don’t see what the problem is. =)

  • Simurr

    @Stevostin When he was talking about the sale it sounded more like it was to test the theory that having a promotional/sale discount would front load your revenue, so you get a lot of sales right away but then everyone who wants the game has it and gross revenue should decrease.  That isn’t what happened.

  • Mconnot

    Funny, Zynga has been perfecting this for the last 4 years.

    • Noporcru623

      yeah bc f2p is the only thing zynga does…valve actually makes quality games so the market is very different and therefore requires separate study

  • Gavin Courtney

    Here’s a pricing experiment – how about lowering your prices in the UK to match Amazon.  Currently games on Steam are generally 50% to 300% more than they are Amazon, and even when games are 50% off on Steam they’re often still more expensive than Amazon.  I never buy anything from Steam because of the high prices, and I expect that’s the same for many people in the UK and Europe.

    • Me

      You realize this isn’t a Valve thing right?

    • That guy who makes comment

      Then you MAY have one of two problems. The serial code not working on steam OR no updates or support. Not to mention waiting for the game to come in.

      I use steam to play with friends online cause we have moved all over the country it’s easier to play together. I’m vexed that EA is setting up their own system to compete, it splits the gaming community. What if every publisher did that, the community Valve’s Steam built would be torn apart.

      • hamlovinhunk

        The problem with that idea, is assuming that other companies haven’t already tried it. There are multiple services competing with Steam, but none of them offer any or all of the features that Steam does. It’s on top, because it’s the best. The REAL problem with Origins is that Valve and EA tend to get pissy around each other, which is resulting, in effect, in ‘exclusive titles’.

  • http://twitter.com/YourVeryOwnGod Ваш Любимый ▲

    Steam sales can’t go wrong in any way. Lots of people can get the game at low price and enjoy it. Even if they thought it was pricey before, but really wanted to play it, etc, etc.
    So, in a nutshell it’s a win-win situation. Developers-publishers-Valve get their money, you get your game cheap.
    There are people who are bitching about Steam and how sales are profitable for companies, but those are just greedy kids, who like to count money in someone else’s pocket, talking.
    If someone offers you something at half-a-price, be greatful.

  • Proleric

    Ironically, I read this after a couple of nightmare days trying to install Steam (which I don’t want) because it turns out to be a DRM requirement for Portal 2, even when purchased from Amazon on DVD. Let’s hope that the “discovery” that good customer service is the surest antidote to piracy leads to the discontinuation of Steam validation of single player games.  

    • Dave

      Portal 2 isn’t a single player game.

    • Dave

      Portal 2 isn’t a single player game.

    • http://profiles.google.com/vulpisfoxfire Christopher Forsyth

      Only problem with this is that validation is only a tiny part of what the Steam connection does–and even then, it’s a one-time thing unless you’re using the multiplayer features of the game. You *can* go into ‘offline’ mode and play as you like without it checking home. Of course, you then miss out on the major portion of why the Steam connection is there–bugfixes, patches, updates, and in some cases added material without a separate DLC needed.

  • Proleric

    Ironically, I read this after a couple of nightmare days trying to install Steam (which I don’t want) because it turns out to be a DRM requirement for Portal 2, even when purchased from Amazon on DVD. Let’s hope that the “discovery” that good customer service is the surest antidote to piracy leads to the discontinuation of Steam validation of single player games.  

  • Sumguy

    B eauti ful Gabe, now where the F–k is Half-Life2 Episode 3, before we all die>?

  • Ddfr

    If revenue stays the same when you shift price, that isn’t “perfectly elastic” it’s “unit elastic.”

    If demand was perfectly elastic, a tiny reduction in price would produce an infinite increase in quantity demanded and hence in revenue.

  • http://theblakefirm.com Texas Business Attorney

    Great to see such in depth discussion about pricing that goes beyond speculation to hypothesis smashing experiments.  Pricing and its relationship to marketing is one of the most mission critical aspects of digital products and media, yet it is still very mysterious.  Hope to see more of this!

  • http://pulse.yahoo.com/_NN6NEO4REDPJF6AK4LAFFTM7HY Nathan

    This company is one of my favorites.  There are so many companies that are out to nickle and dime their customers – this is not one of them!  My biggest complaint against the modern gaming industry is, if you buy a game, they assume you stole it.  When you install it, they question you, and if you lose the DVD it comes on, your out of luck.  I bought a game from these guys and lost everything (computer wiped out and lost the CD).  I was able to download it again for free from Steam.  They TRUST their paying customers, and in return they get my business.

  • http://pulse.yahoo.com/_NN6NEO4REDPJF6AK4LAFFTM7HY Nathan

    This company is one of my favorites.  There are so many companies that are out to nickle and dime their customers – this is not one of them!  My biggest complaint against the modern gaming industry is, if you buy a game, they assume you stole it.  When you install it, they question you, and if you lose the DVD it comes on, your out of luck.  I bought a game from these guys and lost everything (computer wiped out and lost the CD).  I was able to download it again for free from Steam.  They TRUST their paying customers, and in return they get my business.

  • Régis Décamps

    He seems to think people are watching the price of the game they want. Of course sales are not going ot be impacted when a price changes secretly…

  • http://altuseconomics.com Ross Newman

    They get an A on games and and F in economics. Its not a perfectly elastic demand curve that yields constant revenues. The demand curve in this case is a rectangular hyperbola: P X Q = Constant

    The elasticity of the demand curve is unitary = 1.0

    • Zeratul Zum

  • chris

    Interesting to note that a set of TF2 earbuds are worth more than real earbuds

  • http://www.singhrahul.com/ Rahul

    People don’t always do piracy just for saving money. Sometimes they are not left with any option. I am from India and here there is no easy way of getting the latest books and technology products as soon as they are launched in US and elsewhere. For example, i wanted to buy some iOS development books here, but there is simply no way to purchase them. I am not talking about an ebook here , but an actual book. So i had to order the imported edition which took around 1 and 1/2 month to get delivered which is simply too late. Lack of availability also results in piracy.

  • Anna

    Everyone jumps at Russians. We are not pirates, only dimwit cowards who never stick their nose out of their own country could have thought so. We are incredible, smart, and talented people whom all of you silly western companies want to hire.

  • Michael Cline

    I really, REALLY hope that Valve continues working with Oculus after the Facebook acquisition. If they help Facebook the way they helped Oculus… Facebook is sitting on lifetimes worth of data just BEGGING to be analyzed by scientists instead of businessmen.

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