The Problem with Grey Market Games

I recently came across an article discussing the banning of “legitimate” Modern Warfare 2 purchasers from playing online over Valve Software’s Steam servers.  The article focuses on an increasingly common problem for the software industry: grey market goods.  For those that are unfamiliar, grey market goods are essentially genuine goods that are traded through unauthorized channels.  For example, many (if not all) manufacturers engage in price discrimination in global markets in order to sell their products at the optimal price for any given region.  It is often the case that consumers in the United States can afford to pay a relatively higher price than consumers in poorer parts of the world for the same good.  In order to maximize profits and reduce consumer surplus, it makes sense to divide the total global market into market segments and offer goods at a lower price in poorer regions than in wealthier regions.  When this type of market segmentation exists, grey markets tend to materialize.  In these markets, distributors purchase goods in lower-priced regions (typically Asian countries) and then import those goods into the United States for resale.  Consumers of grey market goods typically pay a much lower price for an often identical product (packaging and warranty support are usually the only differences) and the grey market distributors pocket the difference.

Traditionally, grey markets were uncommon because they were limited to goods that had substantially lower prices in foreign market segments as well as low importation costs.  This is because the importation of grey market goods into the United States can become so costly that grey market distributors cannot sell at a substantial discount, thereby eliminating any incentives to engage in grey market activity.  In the case of computer software, dealing with high importation costs is no longer an issue.

With the rising popularity of digital distribution, grey market software can now be sold over the Internet in a matter of seconds with nearly zero overhead.  Grey market distributors purchase bulk licenses for Asian-region software at a substantial discount and then resell these licenses to Western gamers for prices much lower than retail.  This is exactly what happened with Activision’s latest hit, Call of Duty: Modern Warfare 2.

After a few days of play, the purchasers of grey market licenses are now being banned from accessing Valve’s servers in order to play the game online.  Valve’s official line is that anyone who purchased only a CD key transacted with an illegitimate seller and he or she will need to purchase a valid license through Steam or a brick and mortar retailer.  Gamers, to say the very least, are not pleased.  Their anger seems to be directed at anyone who had any involvement with Modern Warfare 2–be it Valve, Activision, or Infinity Ward.  But who is really at fault?  And how can developers, distributors, and publishers avoid angering their customers in the future?

The heart of the problem seems to stem from consumer confusion over just what they are getting when they conduct a transaction for computer software.  While traditional media sales (books, movies, CDs, etc.) tend to involve an actual purchase of a good, nearly all computer software transactions employ an End User License Agreement (“EULA”) in order to characterize the transaction as the transfer of a license to use the software rather than an outright sale.  This legal technicality effectively eliminates the software from being covered by the first sale doctrine and gives software publishers immense post-sale control over their products.  Whether or not these types of agreements are good for consumers is still up for debate and certainly beyond the scope of this post, but one simple fact remains:  Modern Warfare 2 players are not purchasing a copy of the game–they are acquiring a limited license to play the game.

In an effort to create distinct market segments and effectively engage in price discrimination, the Modern Warfare 2 EULAs contain region-specific licensing terms.  As a result, the licenses sold in bulk (and at a substantial discount) in foreign markets are only authorized to be used in those markets.  So, when Valve discovered that distributors of Thai Modern Warfare 2 licenses were selling them to players in the United States, Valve enforced the terms of the EULA by banning owners of these grey market copies from their servers.  Gamers who purchased these Thai CD keys were enraged that their “legitimate purchases” were being banned when, in fact, they were not legitimate purchasers at all, but illegitimate licensees.  While I can easily understand why these gamers are upset–no one likes feeling ripped off, this is not a new phenomenon for grey market goods.

Past purchasers of tangible grey market goods (think Japanese-manufactured cameras and watches) were well aware that the substantial savings one could receive from purchasing grey market goods were not without certain inherent risks.  The most common risk associated with grey market goods was the lack of post-sale support.  If a consumer’s grey market camera breaks, they may be able to ship it to an overseas warranty repair center at substantial cost, but more than likely they will simply have to purchase a new camera.  The premium paid for a camera at a legitimate domestic retailer came with the added benefit of warranty support and/or other services.  Grey market consumers of old were well-aware of this trade off and it seems to me that the sale of grey market Modern Warfare 2 licenses should be treated the same way.

Gamers that purchase grey market licenses are simply given a CD key for the game.  These gamers then type this code into their Steam client (also subject to a separate EULA containing region-specific language) and download the game from Valve’s servers.  Then, in order to play the game online, gamers must again connect to Valve’s servers and communicate with Infinity Ward’s proprietary match-making service, IWNet.  Each of these occurrences (downloading the game and playing online) require additional post-sale services from the game’s manufacturer and/or developer.  Post-sale service was not expected by purchasers of tangible grey market goods, so why should purchasers of grey market computer software expect this service when they run a program in violation of their EULA?

Initially, it may seem difficult to understand why it is fair for the developers of Modern Warfare 2 to ban grey market licensees, but it makes more sense when you consider the effects of these players in the aggregate.  Distributing a game as complex as Modern Warfare 2 can be a costly endeavor–bandwidth, development, and server maintenance is not free.  In order to cover these costs, Activision and Valve have to decide on a pricing scheme for their software.  An integral part of this scheme is price discrimination.  Price discrimination allows Valve and Activision to cover the substantial costs of developing and maintaining a game like Modern Warfare 2 by making the software available at a profit-maximizing price in different market segments.  With $50 million in development costs and $200 million in advertising for Modern Warfare 2 alone, not to mention the ongoing maintenance costs, it is easy to see why this profit maximization is important.  Unfortunately for gray market licensees, this can only be done when market segments remain segmented, which means banning Thai-market CD keys from being used in the US.

The real bad guys in this scenario seem to be the individuals that gamers are praising as heroes–the modern day Robin Hoods bringing cheap gaming to all, grey market distributors.  These merchants are well-aware of Modern Warfare 2’s licensing terms and should be held accountable for selling these licenses to players outside of their region.  While one could easily claim that these online merchants are unaware of their customers’ locations, this argument tends to fall apart when you view their websites.  Maybe it’s just me, but I find it peculiar that a website selling Thai-market CD keys is entirely in English, has an American flag in the upper left corner, and lists their prices in US dollars by default.

So, what can be done?

First, gamers that have purchased a now-banned CD key should demand their money back from these grey market merchants.  Second, Valve should hold these distributors accountable for their actions.  If Valve can track what region a CD key is intended for, they can also find a way to track which merchants purchase these keys in bulk.  Those caught selling their keys to out-of-market gamers with regularity should be denied the ability to purchase keys for future games.  Had this been done before (Valve’s Team Fortress 2 also had a series of grey market bannings), perhaps we would not be running into this issue now.  As it stands, gamers are losing money to shady overseas merchants and game developers are forced to deal with the aftermath.  While it may take some time for any real change, I can only hope that the public outcry will at least create more savvy shoppers.  Heck, we may even catch a person actually reading an EULA or two in the future.