The economics of League of Legends’ new feature

It’s no secret that the games industry is enormous and growing quickly. Most estimates put the industry at over $60 billion in 2015. So when one of the most popular online games makes a significant tweak to its business model, you’d expect people to pay more attention.

The game in question is League of Legends, the 800-pound gorilla of the new free-to-play segment of the market. With 85 million players and an estimated net revenue for 2015 of $1.6bn, League of Legends (or LoL as it is called by players) is currently the most profitable game in the world, beating mobile giants like Clash of the Clans and marquee names like Call of Duty.

LoL is built on the classic freemium model. Playing the core game is completely free, and the vast majority of players never pay Riot a cent. Instead they “pay” with their time, providing an endless supply of opponents for those players who do purchase premium features.

Like many freemium games, LoL has two classes of currency. Influence Points (IP) are earned by simply playing the game. Winning a match earns you more IP, but simply participating is enough to add to your total. These can then be traded in to buy one of the game’s 123 unique characters (“champions”).

However buying all the champions this way would take literally thousands of games worth of IP. Impatient or time-poor players can pay Riot for a wad of the game’s premium currency, Riot Points (RP), which can be immediately be traded in for a champion.

But the real money spinner for Riot is the premium content which cannot be bought with IP. The most popular items are “skins” which change the appearance and sound effects of a champion in-game. These skins add extra flavour to the game, and allow players to express themselves in a way that the standard champions don’t offer.

Some skins are amusing and playful, while others are ominous and threatening. Think of it like modifying a standard car with a special paint job, or having a custom surfboard or a bespoke suit made. Although they are virtual goods, the motivations for buying them - ego, appearance, acquisitiveness - are the same.

The most of expensive of these skins cost 3,250 RP - roughly equivalent to R340 at current exchange rates - though the majority cost between R50 and R120. Players can also upgrade or customise other aspects of their profiles and their champions for smaller amounts of money - starting at around R20.

Not bad for products with an effective marginal cost of zero. This explains how Riot is so profitable even though only a tiny minority of users spend anything.

Which is what makes Riot’s most recent change to the game all the more puzzling. In mid-March the company introduced a new feature - Hextech Crafting. This allows players who win games to randomly accumulate components that can then be combined (or “crafted”) premium items like skins.

In other words, Riot has given non-paying customers a way to buy premium content with their sweat rather than with money. In online gaming argot this is called “grinding” - playing a game repeatedly in order to win rewards that are then used to improve some aspect of the game experience.

But, as with most markets, Riot cannot keep its paying customers from participating in Hextech Crafting. Many of those paying customers play just as many (or more) games than non-paying users, which means there is definitely risk that Hextech Crafting will cannibalize existing sales.

An easier way to think about this effect is to think about the loyalty card at your local coffee shop. If you drink ten coffees, they give you the next one free. But what if you would have drunk all your coffees there anyway, because it’s the closest shop? They’ve just given you a free coffee without any net benefit to them.

This is a classic case of what economists call price discrimination. Riot already charges different prices to different customers. The fact that some players pay using their time rather than money is no different from the way people exchange labour for money.

Players can also spend small amounts of RP in order to buy components. So instead of paying R50 for R100 for a skin, a player might end up paying R10 or R15. This might seem trivial, but when a business has 85 million customers, a 0.1% change in revenue makes a big difference. In 2015, 0.1% of Riot’s net revenue was equivalent to over R24 million.

Riot’s economists seem to be betting that the boost to player participation will outweigh any loss in sales. In other words the demand of players who are already paying must be relatively price inelastic, while the demand of free players must be relatively price elastic.

If this is the case, then Hextech Crafting will be too time consuming for the impatient and time-poor players who are already paying for premium content. But younger, time-rich players who cannot afford R150 might be tempted to pay R10 or R15.

There’s another twist to the clever design of this new feature. One of the problems with online gaming is the tendency of players to hurl abuse at one another while playing. This obviously makes playing unpleasant for many people, and Riot has a mechanism for reporting and disciplining abusive players (including banning repeat offenders completely).

Hextech Crafting gives Riot another lever with which to punish these offenders. Rather than banning them outright, it can now stop them from earning components for a set time period. Given how powerful the idea of earning rewards is to gamers, this may turn into a very effective mechanism for driving better player behaviour.

Will this work? Alas, we will probably never know for sure. Riot was recently swallowed whole by Tencent, a Chinese internet giant (which is, incidentally, partly owned by South Africa’s Naspers). As such its numbers will remain bundled up in Tencent’s annual reporting. Maybe an enterprising PHD in economics can convince them to share some data. We can only hope.