Edward Castronova invented the field of virtual economics in 2001 with his highly influential paper “Virtual Worlds: A First-Hand Account of Market and Society on the Cyberian Frontier.” His early books “Synthetic Worlds: The Business and Culture of Online Games” (2005) and “Exodus to the Virtual World: How Online Fun Is Changing Reality” (2007) continue to capture attention two decades later.

Castronova’s ideas are built on a foundation of deep insights and years of research. He holds a PhD in Economics from the University of Wisconsin-Madison, one of the top economics programs in the country. His research as a mid-career professor – four books and dozens of articles – show that people in virtual worlds are economically rational, and that virtual macroeconomies operate like real ones. Now a senior professor, he serves as consultant and board member for a wide variety of enterprises.

Castronova believes that the world is on the cusp of the fully decentralized economic revolution that he first foresaw in the dawning years of the 21st century.

In our conversation, we talked about the economical, legal, and societal implications of virtual worlds and his motivations to (literally) make a case for the real-world value of virtual items.

The Economical, Legal, and Societal Implications of Virtual Worlds

Dirk Songuer: Edward, thank you so much for taking the time, I really appreciate it.

You always state that your paper “Virtual Worlds: A First-Hand Account of Market and Society on the Cyberian Frontier” started out as a joke. When did it become serious?

Edward Castronova: When I say it was a joke paper, it was supposed to be an inside joke for economists. There was a tradition of those of kind of silly papers, and at that time I thought: Why not just write something silly?

But as I looked at how the numbers were shaking out, it was the first time in my life that I felt a desire to characterize what I was observing in broader terms. Also, I wanted to make it more personal. The paper has these vignettes of experiences that I had in EverQuest. Both of those moves violated the norms of economics. It’s something economists don’t do.

But I thought this is the kind of subject matter where we can’t really put ourselves in this box and write a paper only for economists. So, it being an inside joke for economists started to fade away, and the idea of making it a more broadly available paper started to surface.

Dirk Songuer: Did that change the audience, or did you still write it for economists?

Edward Castronova: I didn’t really have an audience in mind other than myself. And in the end, I didn’t think it was “haha, funny” – I thought it was very “ironic funny.” Here we had these people who had rejected society so completely that they had taken a huge amount of economic value from reality into the digital space.

It’s such a criticism of the real world and I embraced that. This ended up being the animating spirit of the paper. Not a joke, but more of an ironic commentary.

Dirk Songuer: When I when I talked to Richard Bartle, he said that it was almost impossible to publish a scientific paper about virtual worlds in the early 2000s, as they were not academically-respectable at the time. How was the reception to your paper?

Edward Castronova: We used to joke how every paper and every book that any of us were writing had to have this section at the start, about the amount of money that video games were making, to legitimize our work. So, I really sympathize with Richard’s comment.

With this paper there were two interesting facets. Firstly, I would say that there clearly is a “numbers fetish” amongst academics. If you can really quantify something and put numbers on it, it suddenly gains more respect. And I understand that. Valid empirical evidence is good.

The other reason why it worked, and why it was accepted amongst the non-quantitative scholars and fields, was that it resonated with their own qualitative research. I think they took it as a quantitative confirmation of something that they had been writing about qualitatively.

But there was more going on than that. In fact, economists were not interested in the paper. From their standpoint all I did was point at a market and showed that it was operating the way markets do. And so, most economists just shrugged their shoulders and said: “Who cares that a video game economy operates like a real economy?”

But they would have been the ones that could have attacked my methods! Whereas the people who found my paper interesting hadn’t the slightest clue about statistics, or about modelling. I found they were completely incapable of engaging in serious discussion on the empirical methods in the paper. But they all talked about it.

At the time, I felt it was really unfair. I had put down this claim, everyone said that it was an important claim, but no one was in a position to unpack and attack it.

Dirk Songuer: What would you have liked them to do?

Edward Castronova: I saw these worlds as a tremendous research opportunity. I tried to get funding for a project where academics would build a virtual world to do controlled experiments in. It wouldn’t be very good, but it also wouldn’t have to be. It would be using virtual worlds as Petri dishes. But I was never able to generate a lot of interest in that idea from mainstream social scientists. I think this is because there is no paradigm for something like that.

I would say in terms of using virtual worlds as academic simulations, the connection wasn’t made. And it still hasn’t been made. We’re all just awaiting the point where that might happen.

Dirk Songuer: But in practice, your paper started the field of virtual economics. And through that, also started a trend to employ economists in game design and development.

Edward Castronova: I said that there really weren’t people who could criticize my methods. I learned that directly because I was on a gaming forum once and people were talking about my paper. They kept saying things about the economic aspects of it that were fundamentally wrong. I was making my fingers bleed correcting them, and I eventually realized that I’m trying to teach economics 101. That’s when I really realized: “Oh my goodness, this community doesn’t understand anything about economics!”

But also, whenever I encountered a PhD in economics who was thinking about games, they didn’t understand the game part at all. And so, my understanding is that the tactic of hiring economics PHD’s to run game economies did not work out.

My feeling today is that the people who have been brought up within the games industry and are running virtual economies are probably better economists than many “traditional” PhD economists. Just because they know how an economy works from creating one. Traditional academics never actually had the ability to move around the “levers” and watch how people act.

This emergence of digital economies showed some very interesting differences in terms of disciplinary expertise, and these are still developing and not resolved.

Dirk Songuer: If designing and operating virtual worlds leads to a better understanding of their economies, why are so many virtual worlds struggling with implementing and maintaining a healthy in-world economy?

Edward Castronova: Well, since I have never been inside a game company, I can’t speculate too much on the game design process.

I think it comes from a single-minded focus on fun. Which is not bad, but when you start thinking about what makes an economy fun, you tend to focus only on positive reinforcement: “People should get treasure! Taking away treasure is not fun!” The consistent error is to be far too generous to the players and fail to properly calibrate the inflow with the outflow. It’s very much a matter of not understanding the long-term indirect consequences of design decisions on the broader economy.

I think that’s why it keeps coming up. You have young people who are very, very good at making fun games, but they have never thought in systemic terms about things like money supply. And there is this tendency to fix issues by dropping more loot and goods into the virtual society, not really thinking too hard about taking it back out again.

Dirk Songuer: Recently we saw many games where the virtual economy was the core of the experience. I’m thinking of the Web3 space, where every virtual resource also represents a tokenized real-world item – at least conceptually.

And we’ve seen these games struggle as well, even when the economy is the driving factor, and not necessarily only “fun.”

Edward Castronova: It’s still the same tunnel vision but aimed at something else. This group is all profit oriented. They are only interested in fun to the extent that it creates a profit stream and to make tons of money. And again, if that’s your focus, then you get wrapped up in topics like blockchains or automatic market balancing mechanisms. And both in games and in the Web3 sector, the nuts and bolts of the economy are seen as a boring design area.

In games, developers sometimes say “Well, we must have an economy, but we don’t want it to cause any problems.” In other words, they don’t see the economy as an exciting field of developing new things. They see it more as a mandatory thing that players expect. And in the Web3 space, or basically in any area of innovation that isn’t games, the actual economy of it, the flow of resources, the faucets and the drains, those things have also been considered secondary. It’s basically a lack of focus.

More practically, nobody really has a tool or a way of knowing what the actual numbers should be. One of the big questions I get in my consulting is: “What should the first price be?” And in a system, these are related. “If this price goes up, that price is going down. But if I have this much money coming into the system, what should the price of that item be?” I’m always like: “I don’t know, start the economy and then move the dials and levers.” If your economy has no history, that’s a tough problem.

Dirk Songuer: That’s a fair point. When I think about game designers, they oversee designing the game mechanics, the “physics” of the world. And a big part of that is game balancing – the act of setting a value to a resource in relation to others: “How much gold should this sword cost in relation to this shield? How much should the raw materials cost to craft it?” The economy of resources within such worlds are completely artificial.

Edward Castronova: Let’s say they are “synthetic”. The term “artificial” has this sense of being fake. But synthetic is constructed. That’s why I’ve always preferred the word synthetic to virtual – it’s crafted.

Dirk Songuer: Correct, the economic modelling is serving a clear purpose, to drive the experience of a player towards a design goal. The example might be to provide “fun” to players, as discussed. But this purpose can also be outside of acceptable norms that we have in real life. Virtual worlds can be about fraud, theft, and other unfair or undesired practices – because these conflicts can be entertaining in a play-environment.

When you think about linking virtual and real experiences, how can we possibly square this conflict?

Edward Castronova: Just this morning I was at a seminar about the ethics of violence and the same question came up. So let me talk about it in general terms. We can look on various unfair practices in the real world, and then look at the same practices in a game, and everyone might say: “Oh, this is the funniest thing in the world.”

So, there are a couple of things going on there. I wrote a paper about the social question, the “Soziale Frage” from the early 19th century. German historians, philosophers, and political theorists were talking about what a society should do about the poor. And I thought, well, how is this reflected in the way video games are designed? Because here you can design anything: You can have perfect equality if you want. You could also have grotesque monopolies.

And I think that the essential feature of video games is the fact that all players start with exactly the same resources All the economic and social justice concerns are relative to that. Does a character deserve to have that sort of wealth? Well, if that character succeeded at a skill check that I couldn’t succeed in, or that character spent significantly more time than me, or that character had friends and social resources, then I accept it is wealthier than me and has better items. Because we all started out the same.

I think that’s why so many unfair things are accepted within the magic circles of virtual worlds. Because of the entry conditions: No one is born into virtual wealth. Again, that goes back to this idea of keeping real world influence out of virtual worlds. Because if people bring in their outside money, suddenly the social justice arguments of the outside world also matter within the virtual world. Here we might have a person who’s doing very well in the virtual world because he happens to be the son of a dentist in real life. And through that, he has unlimited resources and is buying his way to everything.

That’s why I think we have to look at the pure case of a video game world that is completely separated from the real world. And there, I think, the social question has a completely different flavor because of the “equality of beginning”. And once you have equality of beginning people really don’t care about equality of outcome. That’s what we see. People are just not angry that some other player has more stuff. They’re just not. I mean, they look at the processes by which someone gets something, and they say: “Yeah. OK. You know, that was fair.”

Dirk Songuer: And that means it’s fine if the theme of the virtual world is outside the real-world social norms? That you can make money by shooting somebody else in a war game, get credits for it, buy a loot box, and then sell the contents for real money?

Edward Castronova: So long as all players have the same wage rate, in other words, they have the same return to an hour of input. And the same return of skills, meaning the players abilities in all mechanics. So long as those things are balanced, I think players perceive inequality as not problematic at all. Which is different from the real world, obviously.

But imagine the real world where it was the case that everyone started with exactly the same income, same parents, same quality of upbringing, same opportunities. I think a lot of the bitterness towards wealthy people would go away. You wouldn’t look at them as not deserving, right? We do now because it looks like some very incompetent people somehow end up being incredibly wealthy and some very nice people are poor. If you had perfect equality of opportunity in the real world, I think our social tensions would just plummet.

This gave me a new lens on social inequality and what really drives social tensions. And I think it’s not so much that the rich are rich, and the poor are poor. It’s that some people start rich and some start poor.

Dirk Songuer: It sounds like you don’t want to bring real-world economics into game design, but game design into real-world economics.

Edward Castronova: I think game design and economic sciences have a lot to share. The basic tools you learn in economics are directly applicable to game design, because you become adept at imagining an agent, and then model that agent’s decision environment. In economics, political science and sociology create such models in order to develop a theoretical explanation for observed real-world behavior.

But the same tools can be used to help that agent have fun, right? I think this is pointed out very well by the “Paradox of Puzzles”: What makes a puzzle fun? If it only has two pieces, it’s not very fun – you just put them together. If it has a billion pieces, it’s not fun either, because you can’t put it together. Somewhere in there is the optimal number of pieces, and the optimal problem is not the easiest one.

Game designers understand that solving the agent’s problem is not actually to remove all constraints, which is what economists always think about. You know, “Just give them more money. Just allow them to make more choices.” The game designer understands that the if you want to make people happy, the choice environment you craft for them should not be risk free. It should not be costless.

And that’s just an example of something in which economists and game designers are using the same tools, but coming to really different ideas about what to do with these tools, or how to treat the agent within that environment. That is one way in which game design and economics connect. But also, I think there is an extensive overlap between public policy and game design. Because what really is the difference between a game design group that’s running a live ongoing environment and a government?

One of the major fields in my dissertation was government economics and public finance. I’ve done a lot of looking into governments and for almost 20 years I thought about this overlap. The institutions are different of course, but all the basic tasks are the same.

Dirk Songuer: Raph Koster called virtual worlds “machines replicating and underlining the necessity for real-world concepts and structures like constitutions, laws, governments, police forces and so on.” In your mind, how do virtual world operations and real world governments overlap?

Edward Castronova: A government has to do something called interest elicitation to understand what society wants and needs. It can do so by surveys, but usually by polls. That’s how they find out. Game designers have the same problem: Do I read the forums? Do I do surveys of my players? Do I play the game myself to see what it’s like? That’s all interest elicitation.

Policy communication is another problem. The press releases of governments are very similar to the patch notes for virtual worlds. There are similar questions around legitimacy. Players will question a game’s canon and lore. They will attack the legitimacy of the of the design team that’s running the game. And of course, we see the same attacks in politics. And obviously there are political parties in games, too. There absolutely is political division among players about how they want the game to evolve.

I believe the difference between real-world governments and game governments is that the future belongs to the game governments. What you can see is that the amount of time that people spend looking at screens is going up, and I don’t think that’s going to stop. And as a result the people who are currently designing for virtual interconnected worlds are already creating the government structures for a lot of people.

Dirk Songuer: In some interviews, you described yourself as a former cyberpunk. Leaving aside the dystopian aspects, the cyberpunk movement had a profound impact on the Internet and the early World Wide Web. Especially the notion to see it as a space separate from the real world.

If you think about John Perry Barlow’s “Declaration of the Independence of Cyberspace”, it was about the metaphor of virtuality being an actual space I enter, and not a platform I act on.

Governments of the Industrial World, you weary giants of flesh and steel, I come from Cyberspace, the new home of Mind. On behalf of the future, I ask you of the past to leave us alone. You are not welcome among us. You have no sovereignty where we gather.

John Perry Barlow, Declaration of the Independence of Cyberspace.

Dirk Songuer: But then your paper and your arguments showed that, economically and “mechanically”, all these virtual worlds are indeed part of reality. Because real world money moves in and out, making virtual worlds just another real-world market.

Edward Castronova: Well, let me go back to that time period and talk about the blending of the virtual and the real.

My first reaction to Barlow was that I liked what he said, but I recognized immediately that it wasn’t a technological necessity. The independence of the Internet was contingent on politics. I saw that immediately. We had many debates, with some people saying that the players should have property rights so that they can have a voice in determining the future of these places.

I oppose that strongly, because when you allow a group of self-interested people to directly influence the world, they will destroy whatever the designer’s intent was. The whole point of going to these places was to go somewhere purposefully designed to be different from the real world. If you give people property rights, then the play space is no longer a play space, it’s just an extension of the real world.

So, I immediately thought that keeping real world influence out of virtual worlds was a high priority, and that the only way to do that would be in law. You would need to have laws that declare virtual worlds as a special kind of place. It has certain obligations, and it has certain rights. One of its rights is to not give property rights to its players. Its responsibility then is to keep people from using the platform for malicious activities, like terrorism or slave labor. You could maybe do something similar to how the law regards corporations, which creates a fictional person, or juridical personality. Maybe we should have laws that create a fictional space.

I advocated for that in 2003. What happened over the years is that the Internet has not been able to maintain its independence. Instead of having a bright line between Internet activity and the real world, the state has moved through the fuzzy boundary and is now in control over what happens on the Internet. I think the Barlow generation would be appalled, shocked, to see what has happened to their “free and uncontrollable space.”

Dirk Songuer: Was it ever uncontrollable, though? Legally, the Internet always was “somebody’s server in some basement somewhere”.

Edward Castronova: I’m not surprised at how things worked out.

Barlow thought it was uncontrollable and it turned out that the Internet is very controllable because there is a physical something somewhere, and a person is running it. That’s why my own immediate reaction to “A First-Hand Account of Market and Society” was to write a follow-up paper called: “The Right to Play.”

In it, I emphasized that, because of their basic nature, the play spaces will succumb to reality. And that in order to maintain them as play spaces there needs to be an evolution in law. That didn’t happen. So, I’m not surprised at all.

A couple of years ago I was writing about all this enthusiasm around crypto. I thought that the political risk crypto is facing is immense. At any moment the governments could just shut Bitcoin down. All these people that think they got this thing that routes around government control or corruption – No, you don’t. Humanity can’t rely on the Internet to avoid the problem of living in community with other people. It’s just unavoidable.

Dirk Songuer: Speaking of follow-ups. In 2008, you wrote “Synthetic Worlds: The Business and Culture of Online Games”. In the book, you looked at what happens when communities form in virtual worlds, and how they interact with real-world governments and businesses. Looking closer, the focus is more on sociology than economics. Why that shift in perspective?

Edward Castronova: Some things were happening for me personally. I got a job where I didn’t have to be an economist anymore. It turned out I never liked being an economist. So when I got the opportunity to be a media economist focused on games, I said to the chair: “Can I just do games?” and he was like: “Yes, you can come here and just be a games scholar.” And that was it. I still had the economics toolbox that I could use, but I didn’t have to. By the time I was writing “Synthetic Worlds”, I didn’t know which field I was even in.

I’ve heard people say that it’s a work of anthropology, of sociology, or the work of a constructivist. I don’t even know what all these words mean. You know, I was just writing what I thought. The book really was a reaction to some phenomena that had started to happen, and I felt that huge changes were coming. I was trying to warn people that our world is going to change. I was in this sort-of “Cassandra mode.”

Dirk Songuer: What kind of change, and why was it important enough to issue a warning?

Edward Castronova: In 2003 I was invited to this hacking conference called BlackHat. They had organized a mock trial about the theft of digital items in a virtual world. They wanted me to serve as an expert witness for the prosecution, and my job was to argue the real-world economic value of these virtual items.

At the time I was living in Los Angeles and the conference was in Las Vegas. I remember my girlfriend, soon-to-become wife, was driving and I was just leaning back in the car, watching the desert going by, thinking about avatars and reality. I started to see the future; how bizarre this is going to be.

And then we arrived in Las Vegas. What is more virtual than Las Vegas? We’re going into this thing, and it was just like in the video game I was playing: The Moss Eisley Cantina in Star Wars Galaxies. Here they are: The little dudes playing their little musical instrument things. Suddenly the lines between reality and virtuality were totally blurring for me.

The next day I went into this mock trial. I didn’t realize this at the time, but there must have been about 4.000 people in the room. In the scenario, the judge was predisposed to say that this is all virtual and nobody cared about theft in virtual worlds. But then it went totally off the rails. The judge and I were sitting in our chairs arguing about the case, and people told me later that I just kept swatting away his arguments: “No, it’s actually like THIS! And THAT!” And the trial ended strongly validating the view that virtual items have genuine economic value.

After this twisted, quasi-religious “blending of worlds”-experience I fell into a completely different mode about what I was doing with my academic career. And I think it shows. “Synthetic Worlds” was just coming out and I was writing my next book: “Exodus to the Virtual World.” In it, I argued that based on what I knew about human nature, humanity is going to go into the screens. All that was going on in my mind during that period.

Dirk Songuer: Did that also change you personally? What has been on your mind since then?

Edward Castronova: At one time I was a big proponent of virtual living. I thought the real world was really letting people down. I still believe that. But I was all in favor of virtuality taking over and encouraging people to do that. And every time I had a career problem, I said I’ll just quit and play video games.

But over the years, as I’ve seen that the state control over Internet space has increased, my perspective is gradually changing. Like, I don’t know about putting your brain on the Internet too much. You know, I’m starting to become very hesitant. I used to be a big fan and now I think maybe we shouldn’t be doing this.

What also happened over the years is that I went from being a cyberpunk to being a traditional religious person. I became a Catholic in 1995, at the age of 32. And as virtuality evolved, I started to see very serious consequences for humanity as a whole. I was amazed at the way that the issues in virtual worlds related to ancient Catholic doctrine that had been established hundreds of years ago about the nature of the virtual realm. And nobody really thinks about the consequences of virtuality for the soul.

If anyone is writing about it, they tend to write from a movement that we call SBNR: “Spiritual, but not Religious”. They are thinking about the ethics, the meaning, or the significance of virtuality from the standpoint that there is a world spirit, and that the universe is a consciousness they want to join. They’re mainly transhumanists. They are very specific about our future, our soul, to the extent they believe in it. They take the essence of ourselves and step into the digital space.

As a Catholic, I don’t believe a word of that, but that’s the only thing that I’ve seen being written about. I look at it very concretely: There was this guy in history, his name was Jesus. And Europe was largely born out of a confluence of what he said and did, what the Roman Empire was, and what Germanic warriors were. And from that we got this thing called Western civilization.

And now this Western civilization thing, including its culture and values, is about to hop off into the screens. What does that mean for the soul? Like, you know, in a very crunchy way, and not in a dogmatic, doctrinal sense. I don’t really get that question often in interviews, but I have started to write for Catholic religious audiences, and it has been quite interesting.

What does Catholic thinking over the last 2000 years assert about the prospect of a church that is an entirely mediated space, and not physical? And that is a fascinating thought.