(FORTUNE Magazine) – "Paul" and I are seated on a plush couch in the atrium-style living room of his starter mansion north of Dallas. A 71-inch flat-screen HDTV dominates the far wall. His Porsche 911 Carrera and his wife's Lincoln Navigator nestle in the garage. It's a good life and would not be a surprising one for a 33-year-old corporate litigator like Paul, except that he quit his law partnership two years ago. Since then he's been self-employed at an even more lucrative calling: He plays a medieval-themed online videogame called EverQuest. Because so many young people now spend so much of their lives immersed in the simulated 3-D worlds of games like this one, the noncorporeal emoluments they accumulate in these environments--virtual swords, cloaks, gauntlets, in-game currency, etc.--acquire real value to them, and they will pay real U.S. dollars--and euros, yen, won, and yuan--to acquire them. So Paul buys and sells virtual items and currency for a living. "The valuation is always difficult," he concedes. "When you think about people paying real cash for something you can't even touch, smell, taste--that's tough."

Launched in 1997 and now owned by Sony Online Entertainment, EverQuest is one of a category of increasingly popular computer games known as massively multiplayer online role-playing games (MMO for short). Though EverQuest has about 300,000 player-subscribers worldwide, a 2004 entry into the market called World of Warcraft (made by Vivendi subsidiary Blizzard Entertainment) has become the industry's transformative, breakthrough blockbuster. WoW, as it's known, has already garnered 4.5 million subscriptions worldwide and is expected to gross $500 million this year alone--more than most hit movies ever earn at the box office.

Paul is one of a growing number of people who either make their living or supplement their income through businesses catering to needs that arise only in virtual worlds. Anshe Chung, for instance, is the in-game character, or "avatar," created by a German woman who teaches school near Frankfurt. Since March 2004, Chung has accumulated more than $200,000 worth of in-game currency and "land holdings" by conducting businesses inside a serene synthetic world called Second Life. Chung buys "land" there, builds communities using tools provided by the game developers, and then rents or resells plots to other players. Second Life is a world simulated by 1,400 servers run by a San Francisco company called Linden Lab. The money Chung earns is convertible to dollars over an exchange run by Linden Lab.

Estimates of the size of the nascent market in virtual property range widely--from about $200 million to $1 billion worldwide--but most industry observers agree that it is increasing at a breakneck pace, possibly 100% year over year. Because it involves commerce between imaginary worlds and the real one (known to some gamers as "meat space"), it raises knotty questions. The things Paul and Anshe trade, for instance, are merely the graphical manifestations of data entered into spreadsheets owned by Sony and Linden Lab. Do they constitute "property" recognizable by U.S. courts? If so, whose?

While Linden Lab grants its players intellectual property rights in everything they create, Sony lawyers say that all the items earned or created in EverQuest remain Sony's. Indeed, the company purports to ban doing what Paul does in the click-through contracts players agree to when they log in to the game. (That's why we've agreed to assign Paul a pseudonym; Chung requested anonymity to preserve the freedom that is the raison d'être of role-playing games.) But Sony can't stop the trading and probably no longer wants to. In July it launched its own virtual-to-real currency-exchange service for certain player populations who use a later version of the game, called EverQuest II, and it will soon expand the service to many of its other games as well.

Though we readily accept the puzzling valuations that our society attaches to real-world things like diamonds, Louis Vuitton bags, pet rocks, or bottled water, many can't get their minds around the notion of paying for flickering shadows that can never be extracted from the planar surface of an LCD monitor. Yet so much of our economy revolves around buying prestige, status, and fun--rather than food, shelter, and clothing--that there is scant basis for wonder. This weird new commerce reflects simply the growing importance that virtual worlds are playing in the lives of our children, our colleagues, and--like it or not--ourselves. The more time we spend as avatars in synthetic worlds, the more money we will have to shell out keeping up with the Joneses' avatars.

In the late 1970s two English computer science students invented a text-based, multiplayer role-playing computer game called MUD, for Multi-User Dungeon. It offered many of the same allures as the older, tabletop role-playing game Dungeons & Dragons, which can exert a frighteningly powerful hold on its players. Over time multiplayer games (with maybe a dozen players interacting) gave way to "massively" multiplayer games (thousands of users), and text-based games were supplanted by graphical ones. In the mid-1990s, game companies began marketing commercial MMOs, whose main revenue stream came from monthly subscriptions.

When you charge people a monthly subscription for an addictive product--typically $15 a month--you have a formula for business success. Consider, for instance, the case of longtime MMO fan Amy Goldenburg, a personable, married 31-year-old business manager for a high-tech consultancy in Austin. Since World of Warcraft's U.S. launch in October 2004, Goldenburg has logged 52 days of playtime, according to an in-game odometer-like display. The ticker counts only actual minutes logged on, so Goldenburg has literally played 1,248 hours over the past year, or more than 31 40-hour workweeks. "And that's for that character," Goldenburg clarifies, a little sheepishly, admitting that she sometimes plays other avatars, too, whose game times are not included in the 52-day tally.

Players like Goldenburg explain why game companies are hoping MMOs will take off in the U.S. the way they already have in South Korea, China, and Taiwan (see "Meet the Next Disney"). What the game companies didn't anticipate, though, was that the games would also spawn a thriving market outside their control.

Regardless of whether MMOs are set in fantasy Middle Earth, medieval Camelot, or intergalactic space, they all have recognizably capitalist internal economies whose centerpiece is some sort of auction house or bazaar where players can buy and sell in-game valuables using in-game currency--gold in WoW or platinum pieces in EverQuest, for instance. These in-game economies were designed long before game developers realized that real-world entrepreneurs would be poaching their turf. In EVE Online, an MMO marketed by CCP, an Icelandic company, the developers created a "hypercapitalistic" society in outer space that might have been envisioned by a committee of Cato Institute economists and Russian organized-crime figures. In EVE, corporations compete--via industrial espionage, sabotage, fraud, and assassination--to corner the market for precious ores used to manufacture industrial products and military hardware. "Capitalism incentivizes people to build, to excel, to do something skilled, to strive to sort of succeed," says Hilmar Pétursson, CCP's CEO. "If we were to build in communism, that wouldn't make for interesting game play, because in perfect communism, everybody has the same, everybody's happy --no game."

Most MMOs also provide players with a way of making what amounts to a wage. By performing some minor feat--killing a giant rodent, say, or mining ore from an asteroid--the player gains modest quantities of the realm's currency. Valuable items (a cloak or sword) may also fall off slain prey. And as the player performs tasks, he wins "experience points," which enable his avatar to move up a level and gain additional powers. Here's the thing: An avatar must climb 60 levels to achieve the maximum powers in World of Warcraft--70 in EverQuest--so for some players, this process of "grinding" out experience becomes tedious.

Players who wanted to circumvent this process began buying in-game currency, items, or even entire high-level avatars from other players over eBay. Player A would send player B real U.S. dollars, and B would have his avatar deliver the promised goods to player A's avatar within the game. In the case of an avatar sale, player B would send his user name and password, turning over his entire account. Like any eBay transaction, the deal hinged to an alarming degree on trust, and fraud was rampant.

In 2001 a then-obscure economist--and, yes, avid gamer--at Indiana University began studying the economy of Norrath, the virtual world that players of EverQuest inhabit. "I thought, wouldn't it be a funny joke to write about the economy in a videogame," says Edward Castronova, a soft-spoken, bald academic with an earring. "It stopped being a joke after a couple months writing down prices and volumes." When he calculated Norrath's wealth, using then-prevailing exchange rates available on the Internet gray market, and then compared it with the per capita GNPs of real nations, he reached a remarkable conclusion: "Norrath is the 77th-richest country in the world, roughly equal to Russia." The article, probably one of the most downloaded in the history of Munich's Center for Economic Studies and Ifo Institute for Economic Research, put so-called real-money trade (RMT) on the map. (Castronova's book, Synthetic Worlds: The Business and Culture of Online Games, comes out this month from the University of Chicago press.)

Among players, RMT was controversial. "I'm pissed if someone can buy themselves ahead of me in what's supposed to be my fantasy game," says Greg Boyd, 31, an intellectual property lawyer at Kenyon & Kenyon in New York City who has been playing the games since the early 1990s. RMT could also distort a game and devalue its currency, he notes. There have been many Internet reports, for instance, of alleged gaming sweatshops in Mexico, Indonesia, China, or Romania, where workers are said to be paid low wages to play the game and engage in "farming"--the process of repetitively killing a certain monster solely for the purpose of accumulating items for resale. Farmers can sometimes even automate the process by devising "macros"--a programmed series of keystrokes--that will perform the wealth-yielding tasks on their own. In his 2001 article, Castronova calculated that gamers could make a wage as high as $3.42 an hour through farming on EverQuest. Castronova now thinks that a better figure, which he recently computed for the WoW environment, would be closer to $1.17 an hour--still sufficient to attract poor workers in developing countries. Though no journalist has actually seen a sweatshop--the accounts come from e-mails from alleged insiders--there is no question that farming occurs. Game publishers say they monitor and terminate accounts when they see anomalous, repetitive conduct occurring around the clock.

If farming affords an income well below minimum wage, how can our friend "Paul," of Dallas, quit his law partnership to play EverQuest for a living? "It's a business model I developed when I didn't know what a business model was," Paul says in a clear, confident litigator's voice. When he was 12, he would buy collections of baseball cards and then sell the cards individually for a profit. Today Paul buys EverQuest accounts from players who are retiring from the game, typically over a website called playerauctions.com. He then sells the acquired avatars' items to players through EverQuest's in-game bazaar in exchange for "plat"--i.e., "platinum pieces," the game's currency. Then he exchanges plat for dollars through Internet Gaming Entertainment, a broker specializing in the secondary market for game currency (see "Yield of Dreams"). He has about 20 EverQuest accounts, he says, and keeps at least seven avatars trading "24/7." Each can be programmed to sell up to 80 items at prices he sets. So he can market up to 560 items around the clock. The most he's ever received for a single item, he says, was about 3 million plat, which might fetch between $840 and $1,200, depending on where plat is trading against the dollar when he exchanges it.

Initially game publishers were just as outraged by RMT as some of their customers were. For one thing, when players got ripped off they would complain to the publisher, leading to costly customer service calls. (Sony Online Entertainment says that 40% of its customer service calls relate to problems with RMT.) Legally there was an even more ominous prospect. If the company countenanced RMT, it might be acknowledging that players gained ownership rights over things they earned or created using the company's intellectual property. That could have dire consequences down the road. If, for instance, the company altered, upgraded, or discontinued the game--wiping out the virtual wealth it had encouraged its players to accumulate--might it become liable to those players?

Most companies banned RMT in their click-through licenses and demanded that eBay take down auctions for such items; eBay complied, but private auction sites like IGE sprang up to fill the void. Boyd and James Rosini, an IP partner at Kenyon & Kenyon, say that those companies are operating in a gray area. They might be facilitating infringement of the publisher's intellectual property rights, for instance, or inducing breach of its licensing agreements. "There are myriad colorable claims that could be brought" by a game company that might want to challenge the practice, says Boyd, who sounds as if he's waiting by the phone. (IGE's president, Steve Salyer, disagrees. "I've sat with the best legal minds in the U.S. over this issue," he said at a conference recently, "and I'm certain players and IGE are within their rights to conduct the business they conduct.")

There are signs that game publishers may choose to absorb this new market rather than fight it. In July, Sony set up its own RMT service, Station Exchange. In the first three months of operation--limited to a small fraction of players in just one game--Station Exchange hosted $540,000 in RMT, with Sony taking a 10% commission on every transaction.

Until now, we've been focusing on MMOs that fit people's preconceptions of videogames. Players, who range in age from 18 to 35 and skew 80% male, kill dragons or pilot spaceships. But there's another category of MMOs, known as social games, that attract an older, more female base. Some are so open-ended that they arguably aren't games at all.

"It's not a game," says Philip Rosedale, 37, founder of the virtual world called Second Life. "It doesn't have a specific narrative or gamelike goal. There's no 'leveling up.' There's no killing anything.... I started the company because I dreamed about a space where I, as a creative inventor, could make things in a faster time frame than in the real world." In Second Life, players--or, what, émigrés?--get tool kits that enable them to build and create almost whatever they want, so that the world is "emergent," i.e., it becomes whatever its participants want it to be.

"I started small with nothing," writes Anshe Chung in an e-mail, "and worked my way through five distinct careers." Chung is the avatar of the German schoolteacher who has amassed more than $200,000 worth of in-game currency and "land" in Second Life. "I started ... as a private entertainer, somebody people who are bored or lonely could seek out for company. When more familiar with the creation tools in SL, I began to design and sell my own fashion line." After three months Chung had earned enough Linden dollars, the world's internal currency, to buy land there--i.e., server space. (Each server simulates 16 acres of land.) She would develop the land and then rent it out or resell it. Because of Second Life's rapid population growth--it now has 75,000 subscribers--land speculation has been its most lucrative vocation. Chung now develops private islands and sets up communities restricted to, for instance, East Asian, Victorian, or Gothic architecture, or to French-speakers, or to gays and lesbians, or to fuzzy avatars known as the "furries."

Today Chung so dominates the real estate industry in Second Life that a competing land-speculation company known as Cyberland has tried to even the playing field by going "public." Cyberland has issued about 500,000 shares to 524 players. They trade on a private stock exchange set up by Cyberland's CEO, though so far Cyberland is the only company listed. (Total volume was eight trades last week, with 840 shares changing hands.) In September, Cyberland increased its quarterly dividends from 2% to 3% of gross revenue.

Catherine Fitzpatrick, a 49-year-old Russian translator in New York (she did Boris Yeltsin's memoir, Midnight Diaries), has made a modest profit on her Cyberland shares, but she makes most of her Second Life income--about $100 to $200 per month--as a manager of "rental properties" there. "I had an ambition to make the Seven Wonders of the World," she says in a bored, deadpan voice, and she did make the Lighthouse of Alexandria and the Hanging Gardens of Babylon. But then Fitzpatrick decided that some of the windowless structures would not transpose well to Second Life, where avatars like to fly into the spaces they visit. "The ancients didn't fly," she observes.

It's unsettling, isn't it? Personally, I get a headache when I talk to any of these people for very long. I asked Castronova why people are so nonplussed by the notion of making money this way. "We really want to say, 'It's kid stuff. It's not important,'" he offers. "We say, 'I'm working hard, but somebody's goofing around on a videogame and making enough to live on?'"

But for Chung, the transition has evidently been smooth. "Second Life is the fourth online world where I became the richest avatar," she writes. "Only this time the wealth is real :-)"

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