Breaking The Wheel

A crossed out rubber stamp, because the law of one price says copies are bad!

The Law of One Price – A Business School Mini-Lesson

Finance is hardly the most riveting topic, especially compared to video games. But, if you want to run an effective studio, you need to understand it. The implication of financial theory don’t just apply to your bank account. It should impact the calculus behind any strategic decisions. In this post, I talk about the “Law of One Price” and why it should give you pause before trying to imitate a successful game’s design.

There’s No Such Thing as a Free Lunch: The Law of One Price

I took three quarters of graduate-level finance when I was working through my MBA. The textbook for the classes was a massive tome called, appropriately enough, Corporate Finance, by Jonathan Berk and Peter DeMarzo. Not exactly a page turner. But one of the authors’ central tenants in the book is what they dubbed “the Law of One Price”:

If equivalent investment opportunities trade simultaneously in different competitive markets, then they must trade for the same price in both markets.*

To translate that into user-friendly English, in an active and (relatively) free market, if two investments are identical in terms of risk and reward, they’ll trade at the same price. Why? Because if they don’t, two things would happen.

By Reading This Post, You Will Learn:

  • The definition of “the Law of One Price”
  • The theory behind it, specifically the impacts of arbitrage and supply/demand dynamics
  • How it applies to the notion of a “fast-follow” strategy

Arbitrage and Demand

The first impact of violating the Law of One Price is arbitrage, which is the act of taking advantage of a price difference. Let’s say Investment A and Investment B have the same expected risk and reward, but Investment B is cheaper through some pricing fluke. I can buy Investment B at its current price and then sell it at the price of Investment A and make myself a nice profit with zero risk and very little effort.

This arbitrage-driven demand triggers the second pricing dynamic, demand. Both due to the attractiveness of the potential arbitrage and because Investment B is simply a better value at its lower price, Investment B will be in higher demand. As demand goes up on Investment B, so does it’s price. Likewise, the reduced demand for Investment A will suppress its price. Eventually, the prices for Investments A & B will meet and the equilibrium will be re-established.

This is why real-world arbitrage opportunities are fairly rare. The market simply corrects them too quickly.

Riveting. What does this have to do with games?

The Law of One Price isn’t limited to financial investments. Its implications extend into market strategy, particularly if you invert the equation. If two investments with the same price must have the same balance of risk and reward, then it also follows that if two investments have the same price, but one has lower risk, then that lower risk investment must also have reduced upside.

Here’s where I’m going with this: if you want to make a profit, you can’t do what everyone else is doing. Because what everyone else is doing is safe. It’s established. It’s a (relatively) known path forward. Apple assumes a lot of risk when it unveils a new product category. That’s why it has made so much money.

A toilet-paper manufacturer, on the other had, has a sure-bet product. Everyone needs toilet paper, but it’s also easy to manufacture, which means lots of competition, which means low prices, which means you live and die by your marginal costs. You only survive by selling A LOT of units while profiting a penny or two a piece.

The Fast-Follow is a Fool’s Errand

In the case of games,we have the phenomenon of the “fast-follow”. Suchandsuch Studio, LLC is making a bajillion dollars with their zombie volleyball simulator. A bunch of other companies see this and say, “Hey, I want a bajillion dollars too!” and then proceed to make largely the same game, under the mistaken belief that they can replicate Suchandsuch’s success.

The Law of One Price puts a dagger in that notion’s heart.

If you see someone making a lot of money in some genre, that doesn’t mean that you too can make that much money. Why? Because that genre is now a proven, known quantity. Meaning it’s results are easier to replicate by other companies. Each company thinks it sees an arbitrage opportunity. By their logic, Suchandsuch has taken care of the risk by proving the design works. Now we can apply a similar budget, with less risk and get all that juicy upside.

Reality Is A Nasty Hangover

But that perception of a reduced-risk payday attracts lots of competitors. More competitors means reduced value from the perspective of gamers. This manifests as either a reduced price or reduced sales. Which means you’re back to the dynamic where the company that profits the most is the one who can get it done the cheapest. Much like the toilet paper company, you’ve gone from being a risk-taker to being a commodity producer.

Companies that want to leverage a successful design either need to assume more risk (ie, modify the design with new, unproven mechanics) or increase the price (ie, spend more money on the project to create a larger amount of content) if they want to see greater upside potential on a game.

So if you see Supercell making a bajillion dollars on Hay-Day, the correct move is not to follow their lead and make a Hay-Day clone. Because EVERYONE is going to try to make a Hay-Day clone. You won’t be able to replicate Supercell’s success. You’ll just find yourself in the middle of an expensive brawl with a bunch of other imitators.

Recommended Reading If You Enjoyed This Post

The Morale of the Story

If you want to increase your potential upside, you either have to get way more cost effective at producing games or you have to assume more risk. And taking on risk to increase profit potential means you have to do something hard and discover something no one else has discovered. There is simply no other way.

And, if you want to avoid risk, you have to accept that you’re going to live and die by your margins.

Key Takeaways

  • The Law of One Price dictates that two investments with the same risk and upside will be sold for the same price in free market.
  • The Law of One Price is driven primarily by the dynamics of arbitrage and demand.
  • From a game development perspective, a game that carries decreased risk will carry a decreased upside potential relative to a game with a similar budget but more risk.
  • Games with proven designs will be attractive to risk-averse companies, but the more companies that imitate a successful core mechanic, the less valuable that mechanic will be to gamers.
  • To increase profits, you either need to assume more risk or decrease costs.

*Berk, Jonathan; DeMarzo, Peter. Corporate Finance (Pearson Series in Finance) (Page 71). Pearson Education. Kindle Edition.
Creative Commons License
“The Law of One Price – A Business School Mini-Lesson” by Justin Fischer is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License.

If You Enjoyed This Post, Please Share It!

Leave a Reply

%d bloggers like this: