The Changing Basis of Competition in the

Video Game Console Industry

High Technology Entrepreneurship Prof. Ron Adner May 2002

BOUABBANE Slimane DEKEL Elan HERAULT David MAGRI Francesco SHIGIYA Kaori WOLKEN Hannah

Introduction The introduction of the Microsoft Xbox and the Sony PlayStation 2 has signified yet another dramatic change in the basis of competition in the video game console industry, an industry which has grown dramatically in recent years, and at over US$20 billion per year1, is now larger than the market for Hollywood movies. This is the fourth major shift in the game console industry, and the battle is currently being contested by two of the largest and most successful companies in the world, Sony and Microsoft, neither of which was in the game console market until relatively recently. However they both have top notch brands, marketing expertise, and immense resources, and it will be fascinating to watch them battle for control of the game console industry.

Stage One – The Early Days In the very early days of the video game console industry, consoles were single-game machines that replicated the simple video games of the time, such as Pong. In 1976 Atari launched the 2600, the first console with removable game cartridges, and along with Mattels Intellivision and Colecos ColecoVision, helped to generate interest in the home video game market for a few years. However arcade technology improved much faster than console technology, and interest in the home consoles began to wane.

Stage Two – Nintendo This lasted until Nintendo launched the Nintendo Entertainment System (NES) in 1985. Nintendo introduced a number of innovations to the industry, such as replacing the joystick with a pad controller, accurately reproducing arcade games, and aggressively pricing the consoles

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Including both game consoles and the game software

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with the hope of making profits from the sale of the games2. The NES caused the game console market to grow rapidly, and game developers started developing games specifically for the home market. Competition among game console producers revolved around speed and graphics capability, with manufacturers touting the latest 8 or 16 bit CPU’s, and other parameters such as the number of colors or sounds. Competition also revolved around the video games which were more often than not produced by the console manufacturers themselves, and characters such as Mario Brothers became tightly identified with the platform that they ran on. In this stage of the game console industry, consumers were generally children and “gamers”.

Stage 3 - Marketing & Distribution The third stage of competition in the game console market was launched when Sony, a world leader in consumer electronics products, entered the market with a video game console in 1994, and put the full weight of its marketing strength and entertainment industry experience behind it. The Sony PlayStation was a huge success, surpassing the sales of Nintendo, the market leader, in 19983. Sony achieved this astonishing level of success because they succeeded in selling video games to the mass market, instead of just to the traditional market of children and “gamers”. In this third stage of the battle for control of the video game market, marketing and distribution strength became the overriding factor for success, far more than the technical sophistication of the console, or even the games themselves. Sony also introduced a new model for game development, as until the advent of the PlayStation, most video games were produced by the game console makers; even today Nintendo is primarily a game developer. However Sony allowed 3rd party game developers to develop for the PlayStation in exchange for royalties on the 2

“How Video Game Systems Work”, Jeff Tyson, http://www.howstuffworks.com/videogame2.htm 3 “Console Wars”, Game Industry Report, Merril Lynch, March 2001 2

sale of every game. In fact, as the PlayStation rapidly gained market share, Sony gained a valuable network externality as game developers chose to spend their limited resources developing games for the most popular platform, and decided not to develop on the less popular ones, such as the technically more advanced Sega Dreamcast.

Stage 4 – The Digital Entertainment Hub In 1997 growth in the game console market started to slow due to the high penetration of game consoles. In parallel to the slowdown in growth, digital technologies such as DVD movies, MP3 music files, digital photography, and internet connectivity, have become increasingly popular among consumers. Internet enabled multi-player games are very popular on PC’s and are on track to become standard on the internet enabled Xbox4 and PlayStation 2. The popularity of these technologies has been matched by a dramatic drop in their prices due to both technological developments and economies of scale. The game console developers have therefore identified a new potential path for growth; their consoles would become the control (and convergence) centers for all the consumers digital entertainment needs, from video games, to music, to movies, to internet access. We believe that in the short run, what will differentiate one platform from another will be much the same factors as in the previous stage of competition; namely marketing and distribution strength. However, we believe that in the long run there will be several crucial differentiating factors. The first will be the number of interesting and compelling internet-based extensions to the standard console, such as multiplayer games, episodic games in which new scenes are downloaded from the net, or other interactive entertainment content. The second will be the number of compelling non-game applications available, such as software to manage and display 4

Robbie Bach, Xbox CEO, Analyst Presentation, April 23, 2002

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digital photographs or MP3’s. The third will be the compatibility of the platform with the numerous peripheral devices and technologies that exist and that will be developed in the future, such as web-cams and MP3 players. Technical features are far less important as differentiating factors in this stage, and in fact Sony simply calls the 128 bit RISC CPU at the heart of the PlayStation 2, the “Emotion Engine”, in order to attract non-technical consumers who are wary (and weary) of technical jargon5. However, it is crucial for the console manufacturers and software developers to keep the console user-experience simple, reliable, and fast, and not slow and buggy like an overloaded Windows PC. If not, the annoyed consumers will defect en mass to Nintendo6, which is steadfastly continuing to develop pure-play gaming devices such as the GameCube, which doesn’t even have a DVD player. This is the basis of competition that is going to mark the fourth stage of competition in the game console market. Gone forever are the days when the only use of the game console was to play video games. As Sony and Microsoft increasingly market their consoles to the mass market, as opposed to just children or hard core “gamers”, the importance of additional functionality and interoperability will become more and more significant. Microsoft and Sony both hope that in the future, consumers will want to have one device in the home in which all of their digital entertainment content will be accessed and stored. Microsoft and Sony are using the game console as a way to infiltrate the living rooms of every household in the world, in order to be ready for the day in which the average consumer will indeed be ready to store all of their music as MP3’s, will be downloading DVDs from the internet, and will be instant messaging grandma from the TV in the living room.

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“Game Consoles: Great Technology Marketing”, Paul Jackson, Forrester Research, January 2, 2001 “Game Consoles Connect”, Forrester Research, January 2002

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Software Giant vs. Consumer Device Leader However Sony and Microsoft are approaching this goal in from different directions. Sony has traditionally been a supplier of consumer electronics devices, and sees the concept of a home entertainment platform as a way to integrate all of the Sony devices that currently exist independently. For example, the PlayStation will be used as the central device that replaces or links its digital cameras, digital video cameras, hi-fi equipment (including MP3 players), DVD players, and provide the additional functionality of cable television set-top boxes and PVR players (such as the TiVO). But Sony has tended to use its strength to try to enforce its own standards on the marketplace, such as the failed Betamax format, and the Sony MemoryStick flash card. The Sony PlayStation and PlayStation 2 both use Sony’s own proprietary operating system, which requires developers to invest significant resources in learning and in porting their software. Microsoft is approaching the market from the perspective of the developer of the Windows operating system, the most popular software platform in the world today. Microsoft plans to turn the Xbox, and its sister product – the Homestead platform for home entertainment devices – into the home entertainment equivalent of the Windows platform7. Microsoft is positioning itself as the provider of the operating system, which will provide an easy-to-use standard that developers of applications and devices can use to create products. As nearly all entertainment content and consumer electronics devices today are in digital format, the “glue” that will link them all together in the future are software applications. Providing a platform that is well known to programmers and device manufacturers the world over is a huge advantage for Microsoft and which may give it the edge in the battle for third party developers.

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“Xbox may spawn entertainment hub”, David Becker, Cnet, January 15, 2002

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In our view, in this fourth stage of development in the competitive environment of the game console industry, what will differentiate the consoles is the number and quality of relationships with third party interactive content developers, software developers and electronic device manufacturers. The battle now taking place is between a consumer electronics manufacturer and a software developer, and it will be interesting to see which will be able to build the necessary network of partners in order to gain the leadership position. In our view, the battle has moved into an arena in which Microsoft has both huge experience and core technological and strategic strengths, such as the Windows platform and a huge network of software and hardware developers that have for years been deeply committed to the Windows platform. Sony has a major advantage in its significant entertainment industry holdings, but on the software side it is venturing into untested waters, and it may be difficult for it to compete unless it manages to change the basis of competition yet again.

Conclusion The competitive environment in the video game console market has evolved from its early days in the 70’s in which it was sufficient to develop simple single-purpose, even single game, devices, to the 80’s in which the Nintendo NES revolutionized the industry by creating a platform that accurately reproduced arcade games and by introducing the concept of the platform as a loss-leader, to the 90’s in which Sony used its marketing strength and experience as a developer of mass-market electronics devices in order to bring game consoles to the mass market. Today’s battle is even more ambitious, as the console developers attempt to become the centrepiece of every households digital entertainment needs. Instead of technical prowess or sheer marketing ability, what will define the winner in today’s market is their ability to create a network of third party software, hardware and content developers that embrace their platform.

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Exhibit A

Timeline of Changes in Console Industry Competition

’85-’94, Consoles as loss leader, accurate reproductions of arcade games

Sales

‘94-’01, Consoles sold to the mass market

’01 - , Consoles as Digital Entertainment Hub

’75-’85 Introduction of Consoles

Time

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Bibliography 1. “Console Wars”, Game Industry Report, Merril Lynch, March 2001 2. Robbie Bach, Xbox CEO, Analyst Presentation, April 23, 2002 3. “How Video Game Systems Work”, Jeff Tyson, How Stuff Works, http://www.howstuffworks.com/video-game2.htm 4. “Microsoft’s Xbox: A Play for Christmases to Come”, Carl D. Howe, Forrester Research, November 15, 2001 5. “Europe’s Game Console Price War Starts Early”, Paul Jackson, Forrester Research, April 22, 2002 6. “Dreamcast Failure Highlights Deeper Sega Problems”, Eric Scheirer, Forrester Research, January 31, 2001 7. “Game Consoles: Great Technology Marketing”, Paul Jackson, Forrester Research, January 2, 2001 8. “Game Consoles Connect”, Forrester Research, January 2002 9. “Xbox may spawn entertainment hub”, David Becker, Cnet News.com, January 15, 2002

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