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Source link: http://archive.mises.org/6933/the-coming-second-life-business-cycle/

The Coming Second Life Business Cycle

August 2, 2007 by

Second Life’s economy could reasonably be compared to that of a small foreign country dependent on tourism. Consumers are inhabitants of the real world who take what are essentially pleasure trips to Second Life. However, writes Matthew Beller, it appears very likely that Second Life will experience at least some form of economic recession. Depending on its severity, it might result in Linden’s losing many of its customers. If Linden wants to prevent this from happening and foster a stable, growing economy within Second Life, it should apply the lessons of Austrian economics to its policies. FULL ARTICLE

{ 27 comments }

Wade McGriff August 2, 2007 at 9:18 am

Very Interesting!

It will be even more interesting to see if other virtual worlds pop up that will eventually realize that the the logical structure of the human mind applies to all human action, even human action within the realm of a virtual world.

Charles Smyth August 2, 2007 at 9:42 am

Interesting points. That said, all you Austrians out there would be better employed in getting capitalism to work for real :-)

Juan Sanchez Villalobos Ramirez August 2, 2007 at 10:13 am

I like your ideas and would like to subscribe to your newsletter. Anyone know if there are private property rights in Second Life or if the terms of service allow for the inflation?

Wade McGriff August 2, 2007 at 10:19 am

Good one. : – )

I know about the term capitalism these days…..

However, if you are referring to the ability of freedom of choice and exchange to bring about satisfactory affairs, then I would be curious to know what you would propose that would bring about a more satisfactory state of affairs?

Of course, I can speak for myself…..if I am able to freely satisfy my wants, then it is certainly a satisfactory position to be in. Any situation where I am not able to do this (freely satisfy my wants) is unsatisfactory in my view.

Wade McGriff August 2, 2007 at 10:25 am

One last point…

I know you were probably joking Smyth….

I just can’t pass up the opportunity to develop Austrian ideas more : – )

We can’t be vain even if we must argue with ourselves.

billwald August 2, 2007 at 11:40 am

Seems to me that the complaints about fiat money would be resolved if government was required to use a double entry book keeping system. Even the Mafia knows that honest accounts are required to increase wealth.

Second how about someone comparing the economic effects of tourism to the economic effects of religion. Does tourism produce less of an ecomonic good than religion?

Adem Kupi August 2, 2007 at 1:40 pm

Good article. Unfortunately, there have been other interventions into the SL economy as well (special deals for certain users, etc.). As a long time Second Life user, I suspect that Philip Rosedale himself did not want to implement these changes but was pressured by his investors to do so.
Philip seems quite libertarian actually.
An amusing side note:
The last names of Rockwell, Kinsella and Reisman have all appeared in SL.

Steven Howard August 2, 2007 at 3:39 pm

A very interesting article. However, your analysis appears to omit the effect of Linden Labs activity in making available new lands through the auction system. It is surely no coincidence that the expansion of L$ in late 2006 occurred just as Lindens entered into an aggressive land expansion programme which hundreds of new regions sold each month.

Land prices which had risen to anywhere up to L$30/m2 crashed back to around L$10/m2 over a period of two or three months as these new regions came available.

Eido Cohen August 2, 2007 at 4:20 pm

I have no qualms with the article’s analysis that Second Life is heading toward an economic due to an artificial over-supply of Linden dollars coupled with an increasing budget deficit, leading to either massive inflation or a recession. However, there were several contentious points made in the article. To wit:

1) “It is an Internet-based three-dimensional virtual world where its 8 million unique residents can interact with one another.”

This statement is not only misleading, it is demonstrably false. First, as shown in multiple sources, including valleywag.com and wired.com, most users often register once and never come back, or else register multiple avatars, and due to limitations of Linden Labs servers and software, there are only 20,000 users active at any one time. Therefore, it is far from the truth to use Linden Labs’ aggregate figures and state unequivocably that “8 million unique residents can interact with one another”.

Given that the comments system limits the size of your posts, I’ll post further below…

Eido Cohen August 2, 2007 at 4:32 pm

2) “Second Life’s economy could reasonably be compared to that of a small foreign country dependent on tourism.”

According to Linden Labs, Second Life has approximately 700 square km. of land as of June 2007 and 9195 owned islands as of July 2007. But, due to constraints in the software, as per Wired Magazine: “…even the popular islands are never crowded, because each processor on Linden Lab’s servers can handle a maximum of only 70 avatars at a time; more than that and the service slows to a crawl, some avatars disappear, or the island simply vanishes.”

And, by figures in the CIA world factbook, the smallest 78 countries and/or outlying territories in the world (out of a total of 264) are all islands or archipelagos (with the exception of Liechtenstein, Monaco and Vatican City), with the next country up being the tiny country of Luxembourg (with an area of 2586 sq. km). Number 197 is the Federated States of Micronesia, with a total land mass of 702 km. This is equivalent to the present virtual land area of Second Life. There is also visual similarity, as both Micronesia and Second Life are sub-divided into hundreds/thousands of separate islands.

Furthermore, the total supply of Linden dollars is approximately L$2.6 billion, which is just under US $10 million at the current exchange rate of 270 L$ to US$. This is below the economies of the financially weakest countries in the world and is more equivalent to a small U.S. town. Even Linden Labs says “To be sure, this is still a very tiny economy relative to countries, states, cities or even towns in the real world…” as they state in their February 9th official blog entry.

So the economy of Second Life could “reasonably be compared to that of a small foreign country dependent on tourism”, only insofar as this small country physically looks like the archipelago of Micronesia with the economy of a 500 person town in the “middle-of-nowhere”, USA.

Eido Cohen August 2, 2007 at 4:34 pm

3)”Consumers are inhabitants of the real world who take what are essentially pleasure trips to Second Life, perhaps to… gamble at a casino.”

A week before Mr. Beller’s article was published, Linden Labs banned online gambling within Second Life in order to comply with U.S. law.

Kevin B August 2, 2007 at 5:01 pm

Eido Cohen: “A week before Mr. Beller’s article was published, Linden Labs banned online gambling within Second Life in order to comply with U.S. law.”

New York Times, May 2008
US Intelligence suggests that the small nation of Second Life has been aiding al Queda and is currently seeking weapons of mass destruction. A White House correspondent suggested today that, unless Second Life cooperates in the war on terror, President Bush may be forced to send troops to the tiny virtual country.

Quenton August 2, 2007 at 5:14 pm

As a long-time player of various MMORPGs I can certainly say that Austrian Economics makes the leap from theory to fact in these virtual places. Sure, the rules are set and strictly enforced by the game code, but within those confines the free market thrives.

As an example, during my 3 years playing Ultima Online one could very easily observe things such as inflation and scarcity take their toll on the marketplace. Up until the past few years housing in UO was very limited. Lets take housing as an example.

Housing was done is this manner:

You would buy a “deed” from a computer-contolled avatar. The prices for these deeds were pretty cheap compared to the money supply, and as a result they were easily obtainable by almost everyone. The supply of deeds themselves was infinite, you could buy as many as you had the money for. The money was supplied to the economy by way of killing monsters (who’s supply was also infinite). The only investment required was the time it took to kill them.

Real scarcity only came in to play when it came time to use your deed to place a house on some land. Land was very, very finite. A player did not have to purchase land, they only had to go find an empty area where there wasn’t already another house. So here we have a sitation where anyone could place as many houses as they had the (small amount) of money for and could find space for. Any amateur economist could tell you what would happen in this situation.

The land was soon all taken up with housing. Houses that were already in place began being sold from player to player at a substantial premium over what the deeds to place them had cost, since no new houses could be placed due to lack of space.

There were also so many houses that walking in some areas was difficult, if not impossible. The developers eventually put restrictions on housing placement (mostly in the form of required distance from other houses). This reduced the amount of usable land for housing, but did not change any of the other factors. The next result was also predictable.

The only way a person could use one of the cheap house deeds was if new land became availible due to old houses ‘collapsing’ (they would dissapear if the owner did not log in for about a week). As a result groups of people would ‘camp’ around a house about to collapse and fight each other with sword and spell so that they could place a new house there once the old one was gone. It was usually the larger gangs who won out in these instances.

All of this meant that pre-placed houses commanded an extrordinary premium since so few people had the time or ability to compete for any ‘new’ land that became availible. Where as a small house deed would cost a mere 10,000 gold, pre-placed ones were usually 150,000 for one located out in the wilderness to 1,000,000 or more for one located next to a heavily traveled road (houses could be used as store to sell your wares). Large houses, towers, and castles were so rare that they usually only exchanged hands for real-world currency (thousands of real dollars in some cases).

Things started changing when restrictions came into play that limited how many houses a single character could own (just one) and when they finally doubled the availible land suitable for housing. Prices finally came down after many years of rapidly rising housing prices. I haven’t played in years but I assume that since new land is being added constantly that the general trend has probably been declining prices.

Housing was not the only example of a truly dynamic market in the game, but it was definately the most interesting.

Gigs Taggart August 2, 2007 at 10:02 pm

Hi All. I’ve posted a somewhat rebuttal to this in the form of an open letter to the author, on my blog, which is mostly about Second Life and economics.

To those that mentioned gambling, I have an entry on that too, long story short: I don’t think the sky is falling.

My blog

Ged Larsen August 3, 2007 at 12:13 pm

I believe your analysis is flawed.

You stated: “In September of 2005, Linden collected as much as US$98,000[2] from premium members, which is equivalent to about L$26 million at the L$’s current exchange rate. But during that month, it created L$36 million in order to fund its fiscal deficit.”

To come to the US$98,000 estimate, your footnote explained: “[2] Assuming that all 9,826 premium members paid US$9.95 per month, Linden would have collected US$98,000. Premium members who pay quarterly or annually have a cost of US$7.50 or US$6.00 per month, which would result in lower US$ revenues to Linden.”

What you neglect to mention is that there is a much larger US$ collection by Linden Labs in the form of US$ tier payments. The premium membership fee is a pittance, when compared with US$ tier payments.

I believe that at present there are >8,000 mainland sims online. The MINIMUM amount of tier this generates is US$195 x 8,000 = US$1,560,000, but that is a gross underestimate, because the mainland tier schedule is heavily discounted per square meter for those who own ENTIRE sims. Those paying tier for only an addition 512 sqm are paying at more than 3-fold that US$ rate, per sqm.

There are also 9,195 private island sims available, generating US$ revenue to Linden Labs at either US$195 or US$295 per month (depending on whether the island was put online before or after Oct 2007). Low-ball estimate: US$195 x 9,195 = $1,790,000.

The ACTUAL budget deficit (or surplus) that Linden Labs is running will depend on how much of this US$ intake for land tier exceeds the costs of running the servers that represent this land.

This US$ influx to Linden Labs “represents inflows of real wealth into Second Life,” which offsets the L$ creation and distribution, so I don’t believe the the “perpetual budget deficit” you write about is as significant as you make it appear.

Ceeq Laborde August 3, 2007 at 6:14 pm

Ditto Get Larsen, while your analysis appears accurate in principle, it is totally flawed in outcome due to omittance of a large number of other sources and sinks to the economy. Please investigate the Second Life economy in a more thorough manner and do update your valuable analysis.

Vanmind August 3, 2007 at 10:29 pm

Back in the early-to-mid 90′s when I started pitching my idea for a realistic virtual world with specie-backed e-currencies and actual income potentials for participants, people called me a lunatic. I even said that current e-currencies were “little more than glorified gift certificates.”

When Second Life came out, I called Linden Labs a bunch of kindergarteners. I stand by that claim, and I encourage anyone who appreciates this evolution to get in touch with me so we can put the pretenders & those copying my original innovations out of business altogether.

Todd Marshall August 4, 2007 at 8:28 am

The governing equation for maintaining a media of exchange is:

DEFAULTS = INTEREST + INFLATION.

This article is critical of fiat money. It defines this as media not backed by real value, like gold.

Well, such perception of backing is false. It costs less than $600 to create a new ounce of gold, but if it’s used to back all media of exchange, each person could only have less than one ounce.

Try running your life on just $600.

Austrian economics says no problem … just treat the gold as if it has more value for use in exchange … e.g. $10,000/oz. Then there would be enough to serve as a media in the real economy.

Doesn’t work guys. It’s impossible to get a proper backing for media of exchange so why try? By saying it’s worth more than it costs to get is the same as saying it’s worth nothing on its own.

Does this Second Life (Linden) know what the DEFAULTS are on the money it loans (creates)? If not, it is a sham just like the U.S. and Fed system.

If Linden does know what DEFAULTS are in his economy he has only to charge INTEREST to equal them, thus maintain INFLATION at zero.

Kevin B August 4, 2007 at 2:39 pm

Wow, Todd.

What has escaped your imagination is that you could run your life on $600. Prices would merely lower.

Penny candy? More like $0.001 candy. Wouldn’t that be nice?

Jonathan Bostwick August 8, 2007 at 1:34 am

“Your eye might be drawn to the sudden acceleration in L$ growth at the end of 2006 coincident with a significant increase in LindeX sales (where Linden is creating new L$ and selling them for US$), but that is not necessarily a bad thing.”

I’m curious why you feel selling L$ for US$ would have a different effect on the economy than creating L$ out of the air.

Is fractional reserve banking the only threat to it’s economy?

Doug August 8, 2007 at 1:22 pm

Has it begun?

“Money Trouble in Second Life
Second Life’s financial sector is being rocked by a series of upsets that could spell trouble for the virtual economy.”

Article is here: http://www.technologyreview.com/read_article.aspx?id=19193

Jeb August 9, 2007 at 11:14 am

Is it possible that Linden has a third way out which would not involve recession? If the inflation results in a significant enough boom, a fair number of new people will join SL in order to take advantage of these profits. These new people will create additional income for Linden, which may be enough to generate a surplus which the company could use to increase their US currency reserves.

Is this possible in theory? in practice?

Jonathan Bostwick August 10, 2007 at 5:44 pm

They would have to charge the new subscribers more US$ than they give out L$, in order to shrink the account deficit.

Nicole August 15, 2007 at 11:48 am

http://www.wired.com/gaming/virtualworlds/news/2007/08/virtual_bank

“Bank Failure in Second Life Leads to Calls for Regulation
By Bryan Gardiner 08.15.07 | 2:00 AM

The recent collapse of Ginko Financial, a ‘virtual investment bank’ in Second Life, has spurred calls for more oversight, transparency and accountability, especially when it comes to business practices in the metaverse….” (continued at wired.com).

The interesting thing is that the article says other banks operate similarly to Ginko Bank, the one that failed. So there might be a string of connected bank failures.

Philip Mundhenk April 16, 2009 at 1:29 pm

An excellent article and many worthy comments. I’ve long assumed some economists must be looking at Secondlife as an interesting laboratory. This is the first example I’ve actually seen. Glad to see the good guys are paying attention. :) And after reading this I’m glad I’ve spent my few virtual dollars on real virtual stuff rather than virtually banking them. J

A minor point:
Re “… an infinite supply of ‘primitives,’ … ” -
Actually, not at all. Prims ARE the principal scarce resource in SL. And their supply is not limited arbitrarily like a fiat currency but by a relationship to real resources. If you want more prims you have to have more virtual land. To have more virtual land the Lindens have to bring in more real world resources in the form of hardware, electricity, and technicians’ time.

- Philip Mundhenk
(alias Milton Hayek, proprietor of The Liberty Pub in Secondlife)

Josh October 1, 2009 at 11:51 pm

It being 2 years since this article was originally posted, how has the prediction gone? Care to review your assumptions and how they were right/wrong and what happened?

AlexanderThe Benelli December 11, 2009 at 4:57 am

This is a very nice article, however I’d also love to see a follow up. So far, no “cracks” can be seen in the SL economy, however, the same problems remain beneath the surface, so what are LL’s options for the long term future?
AlexanderThe Benelli (SL nick name)

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