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I hate to be a naysayer, but I there are some aspects of this that I find fun-diminishing. For the record, I'm ok with Friendly Fire. It's an effective tactical choice. But there's the rub: it's a choice. It should be used judiciously and for maximum effect. Here's what I mean:
(Apologies in advance for the Wall of Words)
1. By using the diminishing returns mechanism (which I hate), you are forcing certain tactical choices rather than allowing or even rewarding creative tactical choices from the players. In the TT game, fireball is a powerful spell, but its power grows with caster level. It'll scorch a big bunch of folks, but is unlikely to outright kill anything of equivalent level. Two, three, four of them dropped on a group will kill...but it should. If wizards are going to cluster as artillery, stealthed rogues will form hunting parties to kill them. That's part of smart tactics. Cavalry causes infantry to bunch up for protection, while artillery causes them to spread out for the same reason.
2. Reconnaissance by fire is also a valid tactic. Can't see the sniper? Blast the area where you think he is hiding. I'm ok with AoE flagging the caster as attacker. He made a conscious choice to drop boom somewhere without (completely) knowing what was there. I'm also ok with hidden players staying in stealth, subject to damage effects or amount of damage (loss of concealing foliage, smell of burning hair, screams of agony, etc.).
3. Magical Turbulence is making the issue more complicated than it ought to be. I suspect that following that path will also utilize dev resources that could be utilized elsewhere. IMHO, the system should reward players for smart choices, rather than protect them from stupid ones. There are other ways to balance that don't even leave the issue to the players: make AoEs scale with level and start with lower damage, use longer refresh time or fewer uses, have magical armor debuffs against AoE, etc.
4. While I appreciate the devs striving for game balance and "doing something cool", the less PFO looks like Pathfinder, the less many fans, myself included, will be interested.
To summarize: Friendly Fire=good; Diminishing Returns=bad.
Completely unsolicited suggestions, many of which echo other posters:
While casting an AoE, a special animation procs. Those with high Spellcraft will see a specific glyph they know to be an AoE, like fireball.
While casting, caster sees the area of effect (ball, cone, etc.) that he can aim and place. The area of the aim turns yellow if NPCs are in the effect. Caster can still choose to cast.
AoE procs the attacker flag against unseen PCs, but there is no rep hit until follow-up actions. There is rep hit for damage to NPCs, regardless of visibility.