The term "avatar space" or "avatar market" is sort of a misnomer to me.
I think there are really two spaces here... the gaming/virtual world space and the personalization/expression space. On one end of the spectrum is Second Life and on the other end are ringtones.
The immersive, virtual world that is Second Life and all these MMPORGs will have far less users and a very high ARPU (Average Revenue Per User). I'd also bet that the overall ROI in the whole space will be much less, and the volitility among the bets will be high, because when they score, they score big, but they also require a lot of capital to get off the ground and maintain. I'm sure one or two virtual worlds will totally tank after swalling up lots of VC money.
The more immersive and time consuming the experience is, the more binary your userbase will be. Do you know any "casual" Second Life users? Most people either love it or get overwhelmed by it in the first few minutes... and at a $20 monthly price point, its hard to be casual. Building a whole virtual world is like building a web service and also building the underlying database backend, instead of just using what's out there and off the shelf. I already have a "virtual world"... and its loose bits and pieces of my blog, MySpace, Flickr, AIM and Facebook. That's why I like MyBlogLog, if it has the potential to tie these together. (You'll notice that your face now appears next your comments if you're a MBL user.... btw... does anyone know any good templates for MT Comments? I botched mine and would like to fix it, containing the whole comment in an individual box.)
On the other end of the spectrum, for less than a third of what it takes to build the average MMPORG, whole companies are being built around taking advantage of more lightweight users of avatars... like as a visual representation on chat clients or as a way to be expressive on a profile. You could look at these avatars as "virtual lite", but I think of them as "ringtones plus"... or "MeTones".
There are a lot of people integrating avatars and virtual stuff into their offerings... everybody "want's in" and doesn't want to miss out. I think the key is knowing how this fits into your community. If you're doing an ad supported strategy and you touch a lot of users a little at a time, a whole virtual world doesn't make much sense for your audience. If you've blown out a demographic and you see these people for long periods at a time, and there's a very strong sense of community loyality... you might offer more than just a little personalization. Either way, the key is to realize that users should be able to take their identities out of your world and play on other places on the web, and that you need ways for your users to interact with others outside of the world. I may not spent a lot of time in Second Life, but it would be cool to receive e-mails and instant messages from people with their characters, or do the same with a character of my own, even if I'm not in the actual world itself. Because, if I need my whole network to be in this virtual world, just like a bad social network, its just not going to work.