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Last time, we looked at some of the pricing implications of the Diablo 3 auction house fee structure and why Blizzard implemented these fees. This time, we’ll propose some other fee systems and consider some economic ideas that have relevance to the Diablo 3 auction house.

One of the basic ideas of economics that gets thrown around a lot by laymen is “supply and demand“. They are really two separate ideas that can be used in conjunction with each other to predict market behavior. Let’s delve into some of these economic ideas to approach the auction house and its fees.

To make a basic graph of what “supply and demand” looks like, we need to understand how suppliers and consumers react to pricing. Intuitively, if something (lets say a super-awesome sword) can be sold for a high price, people are going to do what they need to in order to get it so that they can garner a large sum of money. Conversely, if the sword is offered at a lower price, less people are going to be willing to sell it. At higher prices, more swords will be offered for sale, and at lower prices, there will be less swords. As for consumers, they will buy more swords the lower the price is, as they will be able to more easily afford them at lower prices and be more willing to part with less of their hard-earned cash. At higher prices, people will only buy swords if they really want them. Thus, at higher prices, less swords will be bought, and at lower prices, more swords will be bought. If we asked sword-producers how much they would sell a particular sword for at a variety of prices and graphed it, then asked sword-consumers how many swords they would buy at a variety of prices, we would get a graph like this:

The important idea is that the supply curve has a positive slope, whereas the demand curse has a negative slope.

The point at which they intersect is the equilibrium point, where there will be the same number of swords for sale as swords bought. On this graph, this is at 100 swords and $6. Any higher and there would be more supplied than demanded, and leftover unsold units. Any cheaper and there wouldn’t be enough swords to go around. Notice that 99 people would have paid a higher price and are rather happy that they only have to pay $6, whereas 99 suppliers would have sold for lower prices and are glad to sell at $6. The fact that you would have paid $9 for a sword but only had to pay $6 means you essentially have $3 extra to buy other things that make you happy. We have a term for this “happiness” in economics, called welfare. Here is how we show how much welfare, or happiness, is made by the economy in our example:

The red area is “consumer surplus“, or how much happiness is gained by buyers, and the green area is “producer surplus“, or how much happiness is gained by sellers. Lots of happiness for lots of people is very good.

Now, we were operating under the unstated assumption that people were able to freely trade with each other with no other costs, in this case, without fees. What happens when we throw in a $1 fee for trading a sword?

As you can see by my awesome and 100%-to-scale graph, the equilibrium price has changed to $6.50. It isn’t quite the previous equilibrium price + fee essentially because the higher prices caused some buyers to become uninterested and leave the market. Additionally, now only 90 swords are traded. This is definitely less happiness than before, but where does the happiness go? Well, some of it goes to Blizzard, and some of it dies a cruel death.

Blizzard is able to get a good deal of revenue out of this, which covers some of its costs and provides benefits to the traders, but undoubtedly also represents some company profit.

The purple area is lost welfare called “deadweight loss“. It represents sales that would have been made without the fee, as well as the lost profit from sellers and less money left in the pockets of buyers. It is normally associated with a tax or price ceiling, but its effects can be evident in the case of these auction house fees. Here, it is (relatively) small, but actually calculating it requires a lot of data to determine the exact shape of the supply and demand curves.

Like I said last time, I believe that the $1 fee is going to deter a lot of people from using the RMAH (real-money auction house) for cheap items, especially sub-$2.60. The above graph showed the effect of a $1 fee on a $6 item, let’s consider the cheapest items, where I think most of the demand lies. Take a look at this graph with some possible values for what effect the fee could have on trading:

Without any fee, 50,00 items would be traded at $1.50. With the fee, only 6,000 items are traded at the higher price of $2. What does the deadweight loss, welfare, and Blizzard revenue look like?

That is a lot of happiness that nobody is going to have – lost to people not trading as much and sending most of the money to Blizzard instead to each other. Blizzard should care about this – deadweight loss represents a big economic loss due to their policies and fees.

Of course, the specific numbers are fictional and not even Blizzard knows actual numbers until trading starts happening, but the general idea is still valid, especially if a very large number of the trades are demanded at low prices. The $1 isn’t as big of a deal if the price was, say, $100.

The deadweight loss is much smaller for more expensive items since the fee does not scale with price. Also note that if the relative quantities are realistic with actual values, Blizzard makes way more money ($60,000 versus $19,000) on cheaper items, even with the inhibitive $1 fee on cheap items.

We don’t know what Blizzard’s average per-trade costs are for providing the customer service and security that they might use as a “floor price”, but I really think that they could have come up with a better fee structure than “$1 for all items”. The 15% for commodities scales much better and works well for cheap items. If the fee on $1.50 items was $0.25 instead of $1, we would have a graph that looks more like the above one than the previous chart. There would be more happy customers, and they would probably have higher direct revenues from the trades, too.

Could the market failure be high enough to cause third-party services and “black market” trading? I think it is rather unlikely that they would become dominant, but I think that they will exist. Depending on the cost of gold, the $2.60 threshold could cover a lot of items. Ultimately, its a buyers market, and if you can get a full set of gear for $5 on a third party site or $10 on Blizzard’s in-game auction house, are you really going to go to the third-party site? Convenience might trump price.

I think we’ll see a change in the fee structure after the RMAH has been live for a few months. The most traded item on the RMAH will probably be gold, because prices will be lower there due to its superior fee structure (as well as other in-game demand for gold).

Right now, a bigger threat to a working economy is the poor state of the auction house. It is offline often and buggy. The interface is very poor for finding items and comparing them to the items you already have. The 10 item cap helps prevent flooding of the AH with poor quality items, but does it inhibit productive trading? Leave your thoughts in the comments and we’ll take a look at the interface problems another time!

If you are interested in learning more about deadweight loss, check out this video from Khan Academy:

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