Virtual Economy: A Complete Overview

BY DR SOHA MAAD

Introduction

This article presents a complete overview of virtual economy. Following a background overview of the rise of digitalization and virtualization of the economy, an introduction to the basic economic principles that can help in understanding the concept of virtual economy is presented. The article then present a complete overview of virtual economy. This covers the definition of virtual economy, interaction between real and virtual economy, resources in a virtual economy, the economic theory of virtual worlds, the definition of a digital economy, virtual versus digital economy, virtual economy technologies, steps to build a virtual economy, virtual economy for businesses, and virtual economy and the rise of the metaverse. The article concludes with a future outlook and prospect of virtual and digital economies.

THE RISE OF digitalization and virtualization of the economy

The beginning of the 21st century was marked by an amplification of the processes of digitalization and virtualization of the economy. New market leaders do not simply digitize traditional business processes, but use digital platforms and digital technologies as the basis of their business model. Their main assets are information (databases), algorithms to process databases, and employees’ skills in working with data. Moreover, the products and services produced are digital and are often provided online, 24 hours a day, 7 days a week. Although information has always played an important role for society and business, the extent of its use and its role for the successful development of companies are increasing. Given the intangible nature of information, processing information databases is becoming the main factor in expanding the volume of the entire economy.

The explosion of digital technology is rising the interests and expectations of shareholders and investors. As a result, the shares of technology companies, and the entire stock market are growing steadily. The Standard & Poor S&P 500 index has grown more than 4 times over the 10 years from spring 2009 to spring 2019, while the growth of the US economy and the global economy was 10 times less.

Alongside these developments, there is a transition from the dominance of intangible assets over tangible assets as shown in Figure 1. From 1975 till 2015 the structure of companies’ assets included in the S&P 500 turned upside down. In 2015 intangible (virtual) assets began to completely dominate, accounting for 87% of assets for companies that are included in this stock index.

Basic Economic Principles

This section presents the basic economic principles that can help in understanding the concept of virtual economy and how to build it.

Micro Economics

Micro economics is the social science that studies the behavior of individuals and firms to better understand their decision-making mechanisms. It analyzes market mechanisms that establish relative prices among goods and services and how the decisions made affect the utilization and distribution of finite resources.

Users interact with each other in the goods market. Producers make up the supply side, and consumers buying their products and services make up the demand side. A market could be competitive and open or monopolized by a handful of users.

Macro Economics

Macro economics studies how the entire economy behaves. It analyzes interrelations among the different sectors of an economy to better understand how the whole functions.

There are two primary areas of research in Macro economics:

The Business Cycle: understanding the causes and consequences of short-term fluctuations in national income
Increasing National Income: understanding what factors decisively affect long term economic growth

Macro economics focuses on the way the economy performs as a whole and analyzes factors like output, consumption, savings, Gross Domestic Product GDP and inflation. A governing body uses these factors to develop economic policies.

Inflation

Inflation is the rate at which the prices for goods and services is rising, and therefore, the purchasing power (or intrinsic value) of a currency is falling. Inflation happens when the money supply grows faster than the rate of economic growth. Main causes of inflation are demand growing faster than supply and price rises due to higher costs of production or raw materials.

Deflation

Deflation is a decrease in the general price level of goods and services. Deflation happens when excess production occurs, consumption decreases, or when the money supply decreases. Deflation happens naturally over time when the money supply of an economy is fixed. Cryptocurrencies that have a fixed supply will experience deflation.

Deflation can cause an increase in unemployment.

Currencies

A currency is money in circulation that is used as a medium of exchange. A currency is common within a nation. Cryptocurrencies are common in enclosed digital environments. Cryptocurrency exchanges enable users to change their holdings from one currency to another without having to switch to fiat in between.

Governance

A set of rules and mechanisms are needed to govern any economic system. Governance is the way in which rules and actions are structured, sustained regulated and held accountable.

Fiscal policy is the policy a government follows to collect money and then spend to influence the economy. Revenue collection is primarily through taxes, and expenditure can be done in several ways including through direct investment and by providing subsidies for certain sectors. Fiscal policy is used to stabilize the economy over the course of a business cycle.

Central Banks

A central bank is an institution that manage a state’s currency, money supply and interest rates. A central bank holds a monopoly on increasing the monetary base in a state.

Monetary policy is the process by which a central bank controls the cost of short-term borrowing or the monetary base, often targeting an inflation rate or interest rate to ensure price stability and trust in the currency. It is set by the central bank.

What is a Virtual Economy?

A Virtual Economy is an economy that exists in a virtual world where users can exchange virtual or real assets, products and services in the context of a game or platform environment. Users can participate in virtual economies for entertainment or for real economic benefit.

Virtual economies originally emerged in MUD (Multi-User Dungeon) games as early as the late 1970s. Today the largest virtual economies exist on MMORPGs (massively multi player online role-playing games) such as World of Warcraft & Guild Wars.

A virtual economy can exist on any platform on which real money can be spent on user created digital assets, products, services and interactions.

INTERACTION BETWEEN REAL AND VIRTUAL ECONOMIES

There is a growing overlap between virtual and real economies. Assets that exist in virtual economies are often traded in the real world using real money. These transactions are usually conducted on online auction sites and are referred to as ‘Real Money Transactions’ (RMTs).

Many platforms actively promote the idea of linking virtual goods to real world money. Some gaming platforms, however, discourage and even prohibit the exchange of real-world money for virtual goods, as it is believed to be detrimental to gameplay.

Resources in a Virtual Economy

The characteristics of resources in virtual economies are:

Rivalry: Possession of a resource is limited to one person or a small number of persons within the virtual world.
Persistence: Virtual resources persist across user sessions. In some cases, the resource exists for public view even when its owner is not logged into the virtual world.
Interconnectivity: Resources may affect or be affected by other people and other objects. The value of a resource varies according to a person’s ability to use it for creating or experiencing some effect.
Secondary markets: Virtual resources may be created, traded, bought, and sold.
Value added by users: Users may enhance the value of virtual resources by customizing and improving the resources.

Economic Theory of Virtual Worlds

Virtual worlds have properties similar to those in contemporary economies. Therefore, basic economic theory and notions can often be used to study virtual worlds, this involves:

Pricing: items are priced according to supply and demand rather than by the developer’s estimate of the item’s utility.
Marketplace: Real money commerce in a virtual market has grown to become a multibillion-dollar industry. Hundreds of companies are enormously successful in virtual markets, with some virtual items being sold for several million dollars.
Currency: Many games, both online and offline, use a common or standard type of currency that can only be earned in-game and used to spend on in-game items that cannot be traded with other players or converted to real-world funds.
Premium currency: Many online games, particularly those that use the freemium model, offer at least one additional form of currency beyond its standard one, called premium currency.
Taxation: Most scholars agree that the sale of virtual property for real currency or assets is taxable. Theoretically, virtual world transactions could be treated as a form of barter, thus generating taxable income.
Regulation: Conversion between in-game and real-world currency has led to direct comparisons with other online games of chance as ‘virtual winnings’. This is why gamers and companies engaged in this conversion may fall under gambling legislation.
Virtual crime: Monetary issues give rise to virtual world problems similar to those in the real world.
Black market: Online created worlds has official and sanctioned method (black market) to convert real world cash to in-game currency.
Stability: to maintain a stable economy, a balance must be struck between currency sources and sinks. Generally, games possess numerous sources of new currency for players to earn. With the proper balance of growth in player base, currency sources, and sinks, a virtual economy could remain stable indefinitely. As in the real world, actions by players can destabilize the economy.
Virtual Assets: A non-fungible token (NFT) is a unit of data on a digital ledger called a blockchain, where each NFT can represent a unique digital item, and thus they are not interchangeable. NFTs can be used to represent in-game assets which are controlled by the user instead of the game developer.
Capital: In virtual economies, the value of in-game resources is frequently tied to the in-game power they confer upon the owner. This power allows the user, usually, to acquire more rare and valuable items.

What is a Digital Economy?

Below we present the evolution of the term “digital economy” as defined by various world entities:

OECD definition (2013): “The digital economy enables and executes the trade of goods and services through electronic commerce on the Internet”.
European Commission EC definition (2013): “The digital economy is an economy based on digital technologies (sometimes called the internet economy)”.
British Computer Society (2014): “The digital economy refers to an economy based on digital technologies, although we increasingly perceive this as conducting business through markets based on the internet and the World Wide Web”
European Parliament (2015): “A digital economy is a complex structure of several levels/layers connected with each other by an almost endless and always growing number of nodes. Platforms are stacked on each other allowing for multiple routes to reach end-users and making it difficult to exclude certain players, i.e. competitors”.
House of Commons (2016) “The digital economy refers to both the digital access of goods and services, and the use of digital technology to help businesses”.
Group of 20 (G20) Digital Economy Task Force (DETF) (2016): “A digital economy is a broad range of economic activities that include using digitized information and knowledge as the key factor of production, modern information networks as an important activity space, and the effective use of information and communication technology (ICT) as an important driver of productivity growth and economic structural optimization”.

VIRTUAL VERSUS DIGITAL ECONOMY

A virtual economy is a more ambiguous and multifaceted concept than the digital economy. It has a longer history of development and is closely intertwined with digital technology.

The World Bank and Infodev research report by Lehdonvirta and Ernkvist [6] suggests three approaches to the definition of the virtual economy. The first approach considers the virtual economy as a speculative activity based on the use of money capital. The second approach considers the virtual economy as a higher level of digital economy. The third approach considers the virtual economy as part of the digital economy in the form of virtual online worlds.

Within the first approach, the definition of a virtual economy is closely related to the monetary form of capital.

According to the second approach, the virtual economy is part of the three interconnected levels: Information and Communication Technology (ICT) infrastructure, Virtual Economy and Digital Economy, as shown in figure 2. In the three levels hierarchy, the virtual economy is a higher level, which is based on the digital economy and ICT infrastructure.

In the third approach, the proliferation of digital services from e-commerce to social networking services in developed as well as developing countries has given rise to new digital needs and problems. The rise in demand and supply to meet digital needs, and the markets where the demand and supply meet, together comprise the virtual economy.

Typical characteristics of a virtual economy include:

centred around commodities that are digital yet scarce;
demand arises from the increasing use of digital services in business and leisure;
supply is created through the expenditure of human effort.

The various approaches to the definition of digital and virtual economies can be combined in the framework of the concept of dataism, whereby the universe consists of data flows, and the value of any phenomenon or entity is determined by its contribution to data processing.

Figure 1 depicts the evolution from Antique economy (old concept of economy) to a new databased economy (new virtual intangible and financial economy based on the concept of dataism).

VIRTUAL ECONOMy TECHNOLOGIES

Technologies and concepts which can be used in virtual economy creation include:

Blockchains

A blockchain is an immutable digital ledger in which data and transactions are recorded chronologically. Blockchains hold batches of valid transactions in blocks. Each block is linked to the blocks before and after it using cryptographic hashes.

Decentralization is at the heart of public blockchains. Every user of a public blockchain can participate by downloading the entire blockchain as well as the associated software. Decentralized data storage enables each user to have the exact same copy of the evolving blockchain ledger.

Cryptocurrencies

Cryptocurrencies are digital assets which were primarily designed to be mediums of exchange. Cryptocurrencies are powered by blockchain technology, and are therefore decentralized in nature. Cryptocurrencies use extremely powerful cryptographic security mechanisms to secure financial transactions.

Tokens

A token represents a unit of value of an asset or utility issued by a private entity. Tokens are digital and usually reside on top of a blockchain platform. Tokens are usually fungible, meaning that a token issued by a company holds the same value as all the other tokens that it has issued. There are various types of tokens:

Utility Tokens: Utility tokens represent a unit of value and can be redeemed for a good or service provided by the issuing company.
Security Tokens: Security tokens are tradeable financial assets issued by a private company. Security tokens represent either debt, equity or derivatives.
Expiring Tokens: Tokens can be programmed to expire at a certain time or when particular conditions are met. These tokens may or may not have economic value or certain rights attached to them.
Limited Use Tokens: The use of tokens can be limited by the issuing authority. Tokens can be programmed so they can only be spent in certain places or when certain conditions are met. The limited use feature can help set the economic value of the tokens.
Non-Fungible Tokens: Non-fungible tokens (NFTs) are a special type of cryptographic token that represents something unique. Each non-fungible token is different from other tokens, not directly interchangeable with them and valued differently.

Non-Fungible Token Enabled Asset Ownership

The ownership of virtual and real world assets can be embedded into non-fungible tokens.

Digital Scarcity

Scarcity is what makes a good valuable. Digital media can be easily shared and replicated, with or without the consent of the owner of the media’s intellectual property.

Non-fungible cryptographic tokens have enabled digital scarcity to exist. A non-fungible token cannot be replicated. An image held in a non-fungible token could be copied, but the ownership of the original image can only be held in that one token.

Digital scarcity is becoming an increasingly important topic in the fields of entertainment and Digital Rights Management.

BUILDING A VIRTUAL ECONOMY

According to the HackerNoon Ultimate Guide for Creating Virtual Economies by Shaan Ray [3], in a virtual economy, value is created by users, so the logical place to start the process of the design of a virtual world is with the user.

There are various steps for building a virtual economy [3], these include:

Step #1 Creating User Profiles

Creating a user profile involves defining users’ types, functions and permissions

Users’ types:

Virtual platforms can have various types of users, for example:

Instagram and Twitter both have one type of User
Uber has 2 types of Users: Drivers and Riders
Games can have multiple types of Users

Defining users’ types is not a complex task. It can be just a list of users and their types.

Users’ Functions:

Functions are the actions that users can take on a platform, for example:

Twitter’s functions are: tweet, retweet, tweet at users, delete tweet, reply to user tweets, follow users, block users, message users, edit profile, make account private, etc..
Instagram’s functions are: Upload posts, delete posts, add a location to posts, add descriptions to posts, comment on other pictures, follow other users, like posts, forward posts, message users, block users, etc..
Uber’s functions are: select destination, select pickup location, order a ride, cancel a ride, select number of riders, select which type of car (pool or private), report incident, add tip and so on. From a driver’s perspective, the functions are turn on drive mode, accept ride, message rider, cancel ride, among others.

Next to each user type, we can list all the functions that the user can perform.

Users’ Permissions & Constraints

Not all functions are accessible to all users. A number of permissions and constraints are put in place by the creators of an application, and usually individual users are able change some permissions and constraints can be set by editing the settings, for example:

Instagram users can edit their settings to allow or limit interactions.
Uber Drivers and Riders have very well defined, rigid functions with limited ability to set permissions and constraints themselves.
Games can get extremely complicated with varying levels of skills, permissions and constraints that can be set, earned, bought and lost during gameplay.

Next to each user function, we can put a detailed description of the associated permissions and constraints. The description should include details such as:

Is the function allowed or not?
Can the user tweak the settings at all?
Is it conditional? If yes then to what extent?
Does it depend on something else?
Can permission be bought or earned?
Are users interacting with someone else through this function or is something interacting with them through this function?

Step #2 User Value

We have to specify how users create, earn and exchange value.

Creating Value

Value can be created on every platform and we have to clearly define how value can be created. Users create value by engaging in a set of actions on a platform. The specific actions that each user can take are defined in the User Profiles. Multiple user types are engaged in divergent actions and therefore create different forms of value.

Value is closely related to the users’ functions, so we have to map values to functions.

There are two categories of value that emerge on a platform or virtual environment:

planned value which developers have created by design.
unforeseen value that is created by users acting unexpectedly.

Earning Value

Value can be earned and value can be bought. Value is often traded on unsanctioned auction sites that the platform creators are not even aware of. Several platforms and games allow their users to purchase value within their own ecosystem.

We have to define how users can buy value because that will help in properly defining how to create an exchange and keep a pulse on the virtual economy platform.

We have also to define and map out rewards. Rewards are an extremely important strategic component of virtual economies as they serve two critical functions:

Rewards can strategically be added or removed from a virtual environment to curb inflation or tackle deflation.
Rewards can be used to encourage or discourage types of economic activity on the platform.

Some rewards can be dependent on other factors in the environment, such as time spent on the platform, rank or hierarchy, while others can be open to all participants.

Exchanging Value

Once value has been created it will be traded. If users can create and exchange value easily on a platform this will lead to the growth of the platform. Happy users that gain from a virtual economy platform will spread the word and encourage others to join the platform.

We can make in-app environments and tools available to our users in order to enable the productive exchange of value. The tools and strategies include: digital and fiat currencies, in app stores, shops and auctions.

Currency Exchanges

Value is most commonly exchanged in return for currency. Users should be given different currency options to choose from. It could be regular dollars, a cryptocurrency or even an in game or in app currency.

App Store

A store includes things that can be bought and give rewards. The store can be a marketplace or an auction area. A store can be available all the time, or will it be open only for certain times in a particular location or level.

Offline Transactions

There will still be some exchange of value offline regardless of how optimized the in-app exchange mechanisms are.

The key to having a robust economic system is well informed users. We have to find ways to inform users how they can exchange value on the platform through messages within the app, emails to users, or intelligently designed pop-ups during gameplay. Users should know:

How they can buy or sell
What they can buy or sell
Where they can buy or sell
How each item they buy or sell can benefit them

Step #3 Mapping Relationships and Interactions

A map of relationships and interaction should be built based on the Virtual Economy Triangle. Most successful virtual economy platforms will connect two or more types of users and service providers. There are three types of individuals or organizations involved in the Virtual Economy Triangle:

The platform itself
Third party service providers on the platform
All categories of users on the platform

Step #4. Economic Planning

Having comprehensive economic planning and governance mechanisms in place is essential. Platform economies may experience inflationary or deflationary pressures and are often prone to abuse by different types of users. Having a well-defined tools and strategies is important. The economic and governance systems will depend on the nature of the platform.

Step #5 Structure and Governance Mechanisms

A governance mechanism should be created for the platform. A lot of blockchain platforms have robust governance mechanisms where the community partakes in discussions before key decisions are made votes are cast regarding the direction that the platform will take. Governance decisions should be different from economic decisions, because lumping both together often results in abuse by well organized groups of users.

Step #6 User Benefits & Incentives

Incentivizing users for higher engagement and rewarding them for being on the platform are two important growth strategies.

Step #7 Best Practices

Best practices to create a virtual economy involve taking into consideration:

Core Interaction: The key to creating a virtual economy is keeping core platform interactions at the heart of design and then building everything else around it.
Platform Design: Platforms are usually built according to certain design principles. The core business interactions of an application dictate what functions it should enable.
Iteration: Virtual economy design and management is an iterative process.
Interoperability: Interoperability is a trend that is really emerging in the world of blockchain platforms. Platform designers ensure interoperability of the platform with other worlds.
Accessibility: Making platform accessible to everyone reduces the friction of onboarding new users.
User interface: Simplicity in user interface design is a timeless feature, the importance of which cannot be overstated.
Design for Value Exchange Mechanisms: Value exchange mechanisms are the different ways in which users can exchange value. It could be through messaging or it could be by following another user. Designers should implement and embed value exchange mechanisms seamlessly in the virtual environment.
building a robust virtual economy: this involves recalibrating the virtual economy often, optimizing the platform, and communicating with users regarding changes, features and updates

Virtual Economies for Businesses

A lot of successful companies own platforms in which virtual economies exist. By creating virtual economies in a game-like environment for their users to interact and collaborate in, company platforms can experience rapid growth in their primary business activity.

There are several benefits for companies that create a virtual economy for their consumers to participate in. These include:

Earning opportunities for users: Virtual economies are becoming increasingly popular because they create earning opportunities for their users. Users are able to interact in new ways, create value and earn real money on these platforms.
User engagement and platform growth: Platforms which are able to gamify their interactions have higher rates of engagement and user retention. Applications with virtual economies can experience a high growth because their users actively spread the word and encourage more people to join.
Collaborative Interactions. Some platforms allow third party advertisers and business service providers to participate in their environments. Businesses and service providers in virtual environments often develop collaborative rather than adversarial relationships with users.

Virtual economies suit certain business types more than others. Blockchain companies, gaming companies and platform-based businesses stand to gain the most from a well- designed virtual economy.

Blockchain Companies

Blockchain platforms are decentralized peer to peer networks. Blockchain companies offer a platform where users can interact with one another, exchange value and collaborate. Cryptocurrencies are built using of blockchain technology, and units of cryptocurrency can be exchanged automatically when certain conditions are met in a smart contract. Complex blockchain platforms create virtual economies where scarce digital assets can be created, utilized and traded by users. Several different categories of users can exist depending on the functions and complexity of the blockchain platform. Blockchain platforms with an intelligently designed environment will enable every user type to gain some value by being a part of their environment.

Gaming Companies

Multiplayer online games inevitably create huge virtual economies. Persistently open online worlds are continuously evolving with thousands of regular players creating and exchanging value with one another. Users can interact, collaborate, organize themselves and compete with each other on a large scale. Games already have virtual economies that enable players to create in-game assets and objects and then trade them with each other, sometimes for real money.

Platform Companies

Many types of platforms exist. Social media platforms include Instagram and Facebook.

Platform companies are a lot more rigid in their interactions compared to blockchain and gaming companies. However, interactions between users on microwork and sharing platforms are becoming more game-like to maintain motivation and user engagement. A lot of value may be created by allowing users to develop new functions and interactions. Enabling virtual economies to develop around more traditional platforms could increase interaction and enable growth.

VIRTUAL ECONOMIES AND THE RISE OF THE METAVERSE

Huge amounts of money are being poured into the metaverse, an alternative world where you can work, play and meet people without ever leaving your home.

Non-fungible token NFT, is a virtual economy technology that can be used in many different ways. It is one of the building blocks of Web 3.0 (decentralized, blockchain-based internet), as a way to empower content creation and monetization, record and transfer ownership, and to create new investment assets.

In the metaverse, NFT can play a pivotal role in building a viable economy: from Play-to-earn gaming in virtual or augmented reality, investment opportunities like trading real estate and digital items in virtual spaces, innovative e-commerce services, and many other possibilities for the future metaverse market dynamics.

The most important purposes of implementing NFT in the metaverse are:

Proof of identity and authenticity
Interoperability
Building the infrastructure for UGC (User-generated content)
DeFi (decentralized finance)
GameFi (game finance)

FUTURE outlook and prospect of virtual economies

Digital capital is becoming the main source of economic growth. Without virtual and digital components, it is already impossible to think of the economy today. At the same time, the boundaries of these concepts are blurred and a hybrid world will develop further, where the virtual, digital and real economies will deeply determine each other. There is a two-side movement:

Virtualization and digitalization of the material economy
Materialization of the virtual economy

The reality of the virtual and digital economy manifests itself when the final consumers of economic goods (digital and material goods and services) are either people or organizations.

The metaverse economy offers the potential of a wide range of revenue streams, with some estimates predicting it could become an $800 billion-dollar market in just two years and that it could contribute $3 trillion dollars to the global economy in the next decade.