ParisTech Review

The video game industry provides a rare example of a hypercompetitive market. Economists are keen to scrutinize these unstable universes haunted by the ghost of Schumpeter, where competition is so strong and visibility so low that the usual rules of industrial economy no longer apply. The speed of technological change, the intensity of competition, the weakness of regulation, and the fragmentation of consumer tastes have led to a situation characterized by structural imbalance, where any given competitive edge never lasts for long and where a dominant position may turn to be a handicap.

Nearly two decades ago, specialized researchers identified the keys to success: to set temporary benefits as goals, and instead of seeking stability and balance, to systematically break the status quo by promoting disruptive innovation. Easier said than done… especially when these innovation dynamics are just one bit of the tale. While the development of a strong in-house culture of creativity is essential, it only begins to make sense when it is articulated with extremely aggressive business practices. The deal is not simply about going through the unavoidable skirmishes with the competition, but to actually develop strategies in the literal sense of the term: the art of war.

Consoles vs. PC
To understand the originality of these practices, let us start by mapping out the battlefield.

Even though, in its infancy, the industry suffered a tremendous crash (1983-1984), it has experienced vigorous growth over the last two decades, driven mainly by Asian countries, Europe and the United States. Its total turnover (aggregating hardware and software sales, due to the interpenetration of both worlds) was of 31.6 billion in 2006; in 2011, it already amounted to nearly $ 70 billion according to the Institute of audiovisual affairs and telecommunications in Europe (IDATE), and the outlook for 2014 suggest another sharp rise, with annual growth rates in the double digits.

In 2009, the global market for video games already totaled twice the figure for recorded music, 125% of magazines, and three fifths of the film industry, DVD included. By 2015, it will probably constitute the first market of entertainment.

Its powerful growth in certain segments is marked by cycles of two or three years, but over time it is constant, indicating a market that is not yet mature. This growth is related to the dissemination of a true video game culture, both geographically (steep growth in Asia) and sociologically (broadening the audience beyond 11 to 15 year old boys, especially – but not only – due to the aging of the first generations of gamers).

The dissemination of that culture is itself linked to two competing dynamics. The first is the success of consoles, since the famous Playstation was launched in 1994. The second is the development of online games, on PC at first, then via smartphones and tablets in recent years. These two dynamics are impacted by underlying tensions (strong competition between manufacturers for consoles, among publishers for gaming) and technological breakthroughs (the advent of social networks, connected TV, motion sensors…), which contribute to both disrupt the market and expand it.

This is, in essence, a supply market, marked by cycles that relate to the emergence of new equipment or new technical possibilities (3D, successive generations of consoles, the advent of smartphones, the advent of connected TV…). One of the most notable aspects of this market is the frequency of trend reversals, resulting in a striking heterogeneity of analyses made on the subject. Laurent Michaud, head of the Digital Home & Entertainment division at Idate, noted in 2011 that “the influence of the console market segment is having less and less impact in the sector. In value terms, online gaming on personal computers has caught up with the segment of home consoles gaming and surpassed it.” But, in line with PwC experts, he predicts that consoles will rebound, since their decline is due to the end of a cycle.

If one seeks to determine recent trends, the dynamics currently having a hand in the major market segments can be identified. In 2009, according to Idate, physical media accounted for 76% of value sales, against 16% for online games and 8% for games downloaded on mobile phones. The share of the latter two segments has been increasing significantly and should continue to grow in the coming years (31% for online games and 11% for mobile phones in 2014), at the expense of traditional products. Third generation mobile phones, which have spread with lightning speed, can produce games with a quality close to console games. But the arrival of a new generation of home consoles, multiplying online applications, should reinvigorate this part of the market.

A moving theater of operations
By and large, the industry is significantly benefitting from such a stark competition between its major segments, given that it is flourishing. But on the other hand, companies, from executives to teams, are subject to a stress of exceptional intensity. The famous annual survey conducted by PriceWaterhouseCoopers among over a thousand CEOs around the world can provide an outline: 43% of E & M companies’ executives prognosticate changes in their tech investments in the next 12 months, against 24% across all sectors; 64% of them are planning a new strategic alliance or joint venture in the coming year – again, a record. And 79% of them – yet another record – plan to focus their innovation portfolio on new business models.

The “media and entertainement” category of the PwC survey is very broad and includes areas in crisis (music, information) or undergoing profound revamping (publishing). Some are marked by very hard power struggles. But the video game industry stands out owing to the extremely rapid pace of developments and to violent reversals of fortune.

The predictions of experts and stakeholders are almost always thwarted. Googling an overview of the opinions expressed a few years ago is very instructive in this regard. “I think the PC gaming market will cease to grow, while sales of console games will increase by 50%” explained for example in 2006 Michael Pachter of the expertise firm Wedbush Morgan Securities. “PC gaming will become a niche, albeit of a comfortable size, but still a niche.” Bill Gates, at the time, went along the same line. Back then, both entrepreneurs and experts had a strong case: in 2006, the dynamics of MMOs (Massively Multiplayer Online Game), which had dominated the landscape of online gaming since 1995, seemed to falter. But in 2006 Facebook was beginning to rise and Zynga did not exist; a year later the first iPhone was released, and after it, smartphones revolutionized uses. Six years later, the landscape is completely different – and any prognoses are just as haphazard! One can easily imagine why it’s so difficult for leaders in the industry to envision the future – even for only two or three years’ time.

Resource dynamics
In this confusion some elements are constant. Thus, the very high loss ratio, discussed in a report from the Zalis consulting firm (in French): “Every year, about 5,000 video game titles are launched worldwide on console platforms and PCs. Of these 5,000 titles, only about 200 will allow a return on investment. Of these 200 titles, about twenty titles only will really enrich publishers.” Among these blockbusters, the study showcases the famous Grand Theft Auto which sold 12 million copies in one year.

This best-selling logic, which was reinforced with the development of console games in the early 2000s, is significantly increasing the size of investments (development and marketing) and also of risks incurred. Small video game publishers, particularly in Europe, suffered greatly during this period because for the most part they lacked sufficient investment capability. All the more the strength to those who, like VU Games, are backed by a multinational company capable of absorbing shocks and of taking risks.

Publishers have learned to operate in such a world of uncertainty. Development costs are hardly compressible as consumer expectations keep growing and investments in new technologies absorb productivity gains on older technologies. But the world of online games and social networks – this is particularly true for smartphones and tablets – has allowed the emergence of different business models, including the famous Angry Birds. The latter is as good an example as it gets: the games are offered for free, and depending on their success a premium version or more advanced features will be offered, with which the publishers will make a profit – and upon which they can allocate greater investments on the fly. Risk taking is thus reduced, particularly in relation to the launch of a console game, which involves placing a physical product, with considerable pricing, in the distribution channel and eventually on a shelf.

In substance, the challenge here is to manage and optimize what could be called resource dynamics: in a situation where very few games are profitable and where investments are therefore structurally very risky, the point is to connect the latter as much as possible to the actual success of a given game.

Console wars and the Nintendo strategy
This problem affects not only game publishers, but also hardware manufacturers. And in this market segment a real console war is ongoing.

The sector has been dominated since the late 1990s by three major players engaged in a fierce competition that could be described, until 2006, on the model of the arms race: ever more power, ever more technology.

Early in the period, Nintendo was the leader for handheld consoles thanks to its Gameboy, in competition with Sega. In 1994, Sony reinvented home consoles and became market leader with the PlayStation. Sega launched the Saturn, which marked the transition to 3D rendering, then the Dreamcast – whose commercial failure led them to withdraw from the market. Microsoft arrived in full force with the Xbox, Sony responded with the PlayStation 2, which broke all records with over 140 million units sold. The Nintendo DS and the PSP followed, then the Xbox 360, the Nintendo Wii and the PlayStation 3, and finally the Nintendo 3DS. Consoles are now in the eighth generation. Each represents a business cycle, but also a major risk, which de facto excludes specialized players (like Sega) in favor of tougher conglomerates.

Launch phases are marked by an intensification of issues regarding resources: on the one hand the risk of producing too much and aggravating a possible commercial failure, not to mention industrial overcapacity, whose reabsorption will be expensive, and on the other hand the risk of not providing enough consoles at launch may lead to miss the start of the market cycle, a span of three or four weeks where a successful product sells massively. In fact, stock-outs are common during launches – bringing to light the difficulty inherent to arbitraging.

At each launch, what is at stake for a manufacturer is nothing less than its existence on the market – with huge investments, an underlying imperative for technological disruption for every console generation, and in the final analysis, a headlong rush that forces firms to renew their device pool every four or five years. The three majors are thus each forced to act both as insiders, by making the most of their dominant market position, and as outsiders, literally reinventing themselves with each new product.

An excellent example of this strategic turnaround is provided by Nintendo’s Wii, which corresponded with the time a new front was created, in 2006. The race for power that pitted Sony to Microsoft hardly left much breathing space for the Kyoto firm. With the Wii, its choice wasn’t to up the technological ante nor the ability to host very complex games, but rather to focus on simplicity, explicitly targeting the women’s market and more generally non-specialists. Its simplistic design and the relative ease of its games allowed Nintendo to sell nearly 90 million units. The secret of success, the decisive innovation, consisted in choosing the right battlefield, and not to stay on that of the opponent.

But are these successes sustainable? After it became the market leader, Nintendo has been losing ground faster than its competitors who have revived the race for power and gained ground regarding mainstream players, who are always eager for new tech-related experiences.

Shifting alliances and strategic reinventions
More recently, the success of social networks has allowed the development of new strategies, which are themselves constantly evolving.

Be it on consoles, smartphones or PCs, more and more games are being downloaded online, and controlling their distribution has become a key issue. New stakeholders have emerged, others reinvented themselves. It was thus that Valve, a game publisher famous for their Half Life series, launched a service called Steam, and in becoming a distributor, made a superb deal: it is now the leader of a market of nearly one billion dollars, owing in particular to a strategy of openness to other publishers that allows it to boast an offer of over 1800 titles.

Other platforms follow different strategies. The American publisher Electronic Arts is currently working on strengthening its Origin platform, which generates 100 million in revenue. But the stake is not so much to become a distributor as to ensure control over the distribution of its own games, both to avoid giving too much room (and money) to a partner, and above all not to be caught in the clutches of a distributor exerting a near-monopoly. The same kind of showdown can be found in the world of American publishing, where Amazon has acquired such bargaining power that is in a position to dictate its terms to the most powerful publishers. It is manifest that Electronic Arts has learned the lesson.

A specificity of console games (vs. PC games) is that royalties are paid by publishers upstream, at the time devices are manufactured by consolers: risk is thus borne by publishers. This is one of the reasons that led Valve and Electronic Arts, among others, to bypass traditional distribution networks to directly distribute their products.

Zynga constitutes a third example. First developer of social games globally with nearly 250 million players, the publisher of Farmville has developed a model based on free content where the game proper is available for free, however each player can acquire real and virtual accessories. Zynga was hitherto closely related to Facebook. The company recently went public, and has recently announced it would develop its own platform… which will in itself be a social network, with a system of integrated accounts in which each player will have his profile. And just like Facebook, Zynga will not only host partner studios but also developers it will provide with a programming interface – in order to to benefit from their eventual success and to capture a portion of their income.

The emergence of Zynga is part of the rise of publishers and more broadly of software companies, at the expense of hardware companies and more generally of those who, whether online or on a console, have so far defined and controlled technological territories.

Power and control vs. mobility
The next step for publishers and online distributors might indeed be to slip onto another battlefield, of the war being waged between major console manufacturers. They have long maintained control over the games that could be used with their products, either by ensuring exclusivity, or via a very lucrative licensing system – ensuring control of the most interesting bit of the value chain.

There are some signs that suggest that this configuration has run its course. Valve’s Portal 2 can thus be played both on PC, Xbox 360 and Playstation 3. Under these conditions the publisher takes the lead over the hardware maker, who no longer has any exclusive rights and from now on only controls the least profitable part of the value chain.

Mired in endless confrontation, ceaselessly busy monitoring each other and marking their turf, perhaps Nintendo, Sony and Microsoft haven’t watched their backs enough. There is a real risk for them of losing their territories to the benefit of cross-channel players that will accelerate the shift in value location – from hardware, from now on undifferentiated, to software, and from the core of games to their periphery – accessories and other paraphernalia.

In the end, the rivalry between the major industrial console manufacturers, who used to dominate a world of subjugated publishers, can evoke the confrontation between blocs that marked the Cold War: control over territory, power, technology were then the most effective strategies. Let us indulge in prediction, even if it risks being belied in the next few years: tomorrow’s world will be in the hands of deterritorialized actors (neither PC nor console or cellphone, but all at the same time), equipped with small arms, whose main qualities will be mobility and responsiveness, essential in the pursuit of targets – value segments – that are constantly moving. Actors that do not concern themselves with territory control (a market, a technological system), but with crossing it freely. Terrorists, or pirates? No: simply merchants.

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• Fabien Benetou

  Interesting; you should also have a look on cloud gaming (with sites like OnLive.com but also many others e.g. http://en.wikipedia.org/wiki/Cloud_gaming#Solution_providers), especially since Internet service providers keep an eye on it.

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