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Value Chain Management and Competitive
Strategy in the Home Video Game Industry
Fernando Claro Tomaselli Luiz Carlos Di Serio Luciel Henrique de Oliveira
São Paulo Business Administration School – Getulio Vargas Foundation (FGV-EAESP)
Department of Production Management and Industrial Operations
Av. 9 de Julho, 2029 - 01313-902 - São Paulo - SP – Brazil. Phone: (55) 11 3281-7780
[email protected] • [email protected] • [email protected]
POMS 19th Annual Conference
La Jolla, California, U.S.A.
May 9 to May 12, 2008
ABSTRACT
The Videogame industry has a high clock speed (FINE, 1998), evolving at a high velocity,
with a lifecycle of five to six years for consoles, which features a new generation of
consoles, where new companies and technologies appear and disappear. As the disk
drive industry studied by Christensen (2001), the short history of the videogame industry is
characterized by the introduction of incremental technological innovations and disruptive
innovation, which leads various companies to success or failure. This article seeks to
analyze the structure and dynamics of this industry value chain, by comparing the strategy
of the leading companies in this market, showing their similarities and differences in an
attempt to redefine the business itself, by managing its value chain, showing that mistakes
in this management process can lead to the loss of billions of dollars in one generation of
consoles or to an almost monopolistic control of the market.
Key words: videogame industry; innovation; value chain; strategy.
1. Introduction
The world has changed from the industrial age to an economy that emphasizes services,
which represents a shift from tangible goods to intangible goods and from the management of
supply chains to the management of value chains. In this system, companies are increasingly interrelated and form partnerships even while competing more intensely with each other, without having
a clear distinction between markets (Kim and Mauborgne, 2004). In this climate, leading companies
arise in different industries, and companies that were never thought to be competitors, such as Sony
and Microsoft, now compete for the home video game market, estimated at more than USD 33
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billion (Cliff, 2006 and Edwards, 2006). Moreover, these companies seek to create a new market
not yet explored, with great potential for growth and profit (Kim and Mauborgne, 2004), and with
the video game console1 as the center of home entertainment that could dominate the digital living
room.
The video game industry is new and dynamic, existing only since the 1970s; its appearance
was inter-related to the personal computer industry. In this industry, home video game consoles
stand out as a segment with great economic significance. The video game console also presents a
number of features of interest to the management field.
Three factors make the video game industry particularly important for study. First, the
industry of video game consoles has a high clockspeed (Fine, 1998), with a life cycle of five years
for consoles, where each cycle introduces an incremental technological innovation that can lead to
the success and failure of several companies (Christensen 2000). Second, there is a unique
integration between consoles (hardware) and its main complementary good, the games (software)
that form an integrated system that enables the study at each cycle of how value chains are
managed, and the influence of new entrant competitors, buyers and suppliers (Porter, 1985) using
the traditional manufacturing approach as well as by an the information economy in a sector
characterized by strong network effects (Shapiro and Varian, 1998) point of view. The third factor,
is that the Internet and the convergence of technologies is changing the way people deal with
entertainment and the industry of consumer electronics. There were solutions for communication
between devices and integration of functions in a single device, such as mobile phones. But this
new era goes beyond the convergence of technologies. It’s characterized by Digital convergence,
the integration of different technologies in the same digital environment, allowing for full
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A video game console is an interactive entertainment computer or electronic device that manipulates the video display
signal of a display device (a TV, monitor, etc.) to display a game. The term "video game console" is used to distinguish
a machine designed for consumers to buy and use solely for playing video games from a personal computer, which has
many other functions, or arcade machines, which are designed for businesses that buy and then charge others to play.
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integration between hardware, software and services, which is rendered possible by connectivity
(Tomaselli and Di Serio, 2007). The video game console is one of the best examples of the union
of these factors.
This paper seeks to identify the factors critical to success in the industry of home video
game consoles and new factors that may arise and contribute to the success of this dynamic and
constantly changing industry. Starting from the analysis of the structure and dynamics of the value
chain industry of video games through comparison of the strategy of leading companies in this
market, searches show similarities and differences in an attempt to redefine the management of their
own business in the value chain. For this analysis, we use references as a theoretical basis to
emerging strategy, value of innovation, management and dynamics of the value chain and the
information economy.
For the development of this research, we consider two specific objectives: mapping the
value-chain and power relationship in the video game consoles industry, and identifying the vertical
and horizontal movements in search of migration to links in the chain of value that have better
earning potential.
2. The Theoretical Background
2.1. The Entertainment Industry
The entertainment industry is growing increasingly global in importance. Issues such as
quality of life and improvements in the quality of individuals’ free time are increasingly relevant in
the context of modern society. Thus, the entertainment industry is increasingly gaining economic
importance. Voguel (2001) says that entertainment is something that stimulates, encourages and
manages conditions of pleasant amusement and adds that the entertainment should emotionally
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involve the individual, either passively or actively (e.g. listening to music or playing the piano), in a
pleasurable experience that is satisfactory for the body and soul.
The concept of entertainment is associated with free time that one can devote to this activity.
The demand for entertainment is related to the cost of the time required to produce and consume,
and to various activities of entertainment competing for the limited time and money of consumers
(Voguel, 2001). Thus, the participants in the video game industry compete not only among
themselves but also with other forms of entertainment, as the hours that a person goes into a
cinema, for example, are hours that he can not spend playing video games.
Voguel (2001) reports that in 2000, Americans spent 120 billion hours and 200 billion
dollars on entertainment. Overall, the total expenditure came in the middle trillion dollars
(increasing each year), and time spent with video games was distributed as follows: 2% on home
video games, 0.2% in arcades2, 0.3% in the cinema, and 1.6% on home video (which was less than
the time spent on TV, estimated at 46.1%).
Increasingly, the video game is occupying the space of traditional media such as television,
especially among the new generations, and the fact that the Internet evolved beyond the personal
computer, allowing access via mobile phones and video games, increases this potential and creates
opportunities for new business models (Venkatraman, 2000), which include, for example, games
online, in networks, via video game consoles, via personal computers and even via mobile phones.
In this new reality, home entertainment products have greater relevance to the consumer
electronics industry and entertainment, and become a central theme in companies’ strategies. Proof
of this was the relevance of the issue during the Consumer Electronic Show (CES), the largest
consumer electronics fair in the world, held in January 2006, where companies such as Toshiba,
Sony, Dell, Intel and AMD displayed versions of their home entertainment products. Several
2
Exclusive video game equipment for commercial use, available in public places such as theme parks, or
specialized establishments.
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companies announced associations with various partners, such as Intel, which partnered with actor
Morgan Freeman for filmmaking, and with the network NBC to broadcast the winter Olympics via
Intel Viiv3 technology. These examples show the current trend towards convergence between
various media and technology.
2.2. Innovation and Competitiveness
Christensen (2000) defines two concepts of technological change: "incremental changes",
which are enhancements of the product on the dimensions of performance usually valued by
customers, and the "radical changes", which redefine the trajectories of performance and bring a
new proposal of value to the customer and additional features. These radical changes are the only
discernible source of competitive advantage and enable the emergence of new markets. Companies
try to boost the technology within their markets and thereby become prisoners of the financial
structure and the organizational culture inherent to the network of value in which they compete; on
the other hand, the emerging companies may discover a new market through new technology.
To be a leader, the company must assume the process of transformation of the sector,
recreate it and regenerate its strategy. Hamel and Prahalad (1996) listed three points to create the
future: changing the rules of engagement in an old industry, redefining the boundaries between
sectors (for example Electronic Arts is the largest manufacturer of video games for education and
entertainment), and creating entirely new industries (such as Apple with the PC). For these authors,
the ability to invent new sectors and reinvent existing ones is a prerequisite for being at the front of
the industry in the future.
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The technology Intel Viiv inaugurated new type of personal computers. The PCs based on Viiv technology are easy to
use with a remote control, and are driven by a set of Intel technologies, including a dual core processor, chipset, the
operating system Microsoft Windows Media Center Edition and features of networking with wires and wireless. The
first personal computers with this technology came to the market in the USA in 2006.
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For Christensen (2000), there are three factors linked to the success of an organization faced
with a change: its resources, its processes and its values, which form a group called the RPV
structure, which includes the organizational capabilities of the company: Resources, Processes and
Values. The resources involve people, equipment, technology, trademarks, information, money, and
relationships with suppliers, distributors and customers, and anything that can be purchased or
transferred. The processes involve the transformation of inputs into outputs and patterns of
interaction, coordination, communication and decision-making. The values are the criteria that
guide decision-making and priorities.
Management innovation reflects the process of allocating resources. Christensen (2003)
notes that the same capabilities defined by the structure RPV that make a company successful in a
particular niche may prevent success in another niche. The integration between the RPV and the
decision to structure investments that lead to effective strategy are linked to the deliberate strategy
and are emerging, although the model is continually adjusting.
2.3. Chain of Value and Strategy
The Porter (1985) Model of Competitive Forces describes the existence of a set of forces
trained by customers, suppliers, substitutes and new entrants that determines the potential for profit
in the industry. The strategy should be either to defend oneself from these forces or influence them
in one’s own favor. The competitive advantage has its origin in the activities implemented by the
company and should be evaluated within the value chain of the company. The author also discusses
the approach to the market, defining three generic strategies to achieve a competitive advantage:
Leadership in Total Costs, Differentiation and Focus.
For Porter (1985), the competitive advantage has its origin in the activities implemented by
the company and should be evaluated within the value chain of the company. To reach the concept
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of the value chain, he divided the set of activities of strategic importance into designing, producing,
marketing, delivering and supporting the product. Each activity contributes for the position of the
company's costs, as well as to their differentiation. The value system is the larger pool of activities,
and includes the various chains of values, in which the product of the business can be part of the
value chain of the buyer and is fundamental to its differentiation.
2.4. The “clockspeed”
To Fine (1998), "clockspeed," is the evolutionary speed of the industry, and its double helix
model analyzes the capabilities of the company and chain of which it is part, based on an infinite
loop between vertically integrated industries and industries horizontally disintegrated (product
integrated versus modular, and industry vertical versus horizontal). The model is dynamic; there are
always forces pushing on either side of the propeller. Competitive advantage is achieved when (1)
the company is positioned at the link in the chain where more value is added at a particular moment
in time, (2) there is only temporary competitive advantages in different links of the chain over time,
(3) the markets are continuously evolving, and (4) there is the need for constant assessment of the
strategic directions over time, examining the design of the organization "extended" with their
networks of supply, distribution and allies.
In many cases, the greatest battles are in vertical competition, between the links in the chain,
and not with traditional competitors. At the top, firms are forced to sell part of the knowledge and
control the lower echelons, and the design of power of the players in the supply chain to power is
more important, consisting of defining what work to outsource to suppliers, which suppliers to use
and how to negotiate the contracts.
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2.5. The information economy by Shapiro and Varian
Shapiro and Varian's model considers concepts and strategies for the management of
business information with a focus on wealth and introduces concepts that apply well to the case
being studied: concepts such as the lock-in cycle, positive feedback, the Cost of Technology
Substituting , the buyer's check list and the network externalities. Furthermore, Shapiro & Varian
are good points of reference for the case because they warn about the change of tendencies in the
economic world that require the adoption of a new strategy for conducting business. The basic
argument of this theory is that technology changes, but the laws of economics do not. "Information
Rules" by Shapiro and Varian (1998), is the first book that purely looks at and refines the economic
principles of information, such as its cost, competitiveness based on information or technology, and
networks in business strategies, thereby providing an important contribution to the making of
intelligent decisions about information assets.
The development of information technology is contributing to a reduction in distribution
costs, thereby reducing the cost of developing critical product information. The cost structure leads
to economies of a large scale; in other words, the more that is produced, the lower the average
production costs become. Fixed costs for producing information are dominated by sunk costs,
which are costs that are not recovered when production is interrupted. Besides the fixed costs, the
investment needed to attract the customer's attention, made up of promotional and marketing costs,
is high and has the same characteristic as sunk costs: it can not be recovered.
The variable production costs have a wealth of information structure, where the cost of
producing additional copies does not vary with the quantity produced. This is explained by the fact
that there are no restrictions on the production capacity. Generally, it is possible to produce a copy
or ten million copies with the same fixed unit cost, with an irrelevant increase in the marginal costs
of large-scale production. Economies of scale are greater in companies that sell information
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products, mainly when we compare these to the scale gains of airlines, where the incremental cost
of a seat is insignificant when compared to the investment needed for purchasing the aircraft, or to
the communication industry where the marginal cost of sending a signal across a new fiber optic
network is also insignificant.
Information markets are not markets in perfect competition. After the majority of firms have
written off the cost of creating the product, competitive pressures force the production cost of each
additional copy down to the value of the marginal cost. As an example, Shapiro & Varian (1998)
highlight the cost of general information available on the Internet, such as newspaper reports,
telephone lists, maps, quotations, etc. This information is free, and we can conclude that it is being
sold for zero value, thereby representing precisely the marginal cost for producing this information.
When the cost of exchange associated with change of a brand or technology to another is
substantial, users face a barrier to the free exchange of technology by another. The industrial age
was driven by economies of scale, while the information economy is driven by economies of
network, where the success of the initiative is directly linked to the size of the network of users who
have adopted this technology. The value of connecting to a network depends on the number of other
people already connected to it (Shapiro and Varian, 1998). Sectors are created or destroyed faster
than in the industrial economy.
The main difference between the durable goods economy and the information economy is
that in the production of durable goods, the economics of scale define the competitiveness of a
company in the information economy and the economics of scale are dominated by the strength of
the networks, where the recommendation of customers, or positive feedback, can stimulate a
competitive advantage. The strength of positive feedback lies in the perception of the customers of
the best product or technology available in the network and how this product will add value for the
customers. When the perception of the market indicates that a group of compatible products with
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good market penetration represents the best solutions for interaction with the network, the suppliers
of the products become stronger and the competitors become increasingly weaker.
So that more and more users belong to the same network, it is necessary that the information
can be read by the same software, interpreted in the same way and exchanged among all members
of the network. Shapiro and Varian (1998) give an example of this concept from observing physical
networks where the links between the strands of the network are physical connections, as we can
see in railway lines and telephone cables. In virtual networks, the links between the strands in the
network are connected invisibly, but even so, are just as critical for market dynamics and strategies
for competition as in the physical network. Nevertheless, regardless of whether they are physical or
virtual, the economic foundation of networks indicates that the value of being connected to a
network depends on how many people are already connected to it. This foundation is called the
exteriority of the network, or the network effects of economies of scale on the demand side. All
these names refer to the same point, as described by Shapiro and Varian (1998, p 175): "all other
variables being equal, it is better to be connected to a large network than to be connected to a small
network." The foundation of networks in which "bigger is better" is the type of fact that generates
positive feedback, as can be seen throughout the whole of economic history since the beginning of
commercial and transport networks.
Positive feedback can lead to the extreme situation where there is only one winner. The
evolution of a dispute involving IT (information technology) suppliers begins in a competition zone,
where the possibility of dominating competitors that have a high percentage of market penetration
exists. In this area, or battle-field, the dynamics of positive feedback emerge, encouraged by the
deep desire on the part of the users to opt for the technology that is going to remain in the market the exteriority of the network.
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3. Methods
This paper is a case study analyzing two of the largest manufacturers of consoles of today's
video games. Their different approaches explore different core competences. The goal was to
critique their approaches and to understand the factors that helped them become successful, which
resulted in likely future success.
3.1. Data Collection
We initially performed a detailed analysis of secondary data available in historical archives,
statistics and previously conducted studies (Bryman, 1989), which allowed the selection of
individuals for interviews and the preparation of roadmaps of interviews, in addition to enabling the
identification of the key links in the value chain and its general dynamic.
The companies analyzed were the two largest manufacturers of consoles of today's video
games, Sony and Microsoft. The choice of these companies is justified by their positions as market
leaders, and they represent two different approaches to the business model that operate separate
core competences. We sought to identify the critical factors of success of these two companies, and
did not focus on their mistakes or successes, nor did we attempt to criticize their approaches.
Over the course of three months, we evaluated the home PlayStation 2 consoles from Sony,
Microsoft's XBox, Nintendo's Game Cube consoles, the PlayStation Portable from Sony and
Nintendo's DS with the researchers having access to players / users, and examining their features,
similarities and differences.
The interviews were semi-structured, open and recorded, and took place between December
2006 and February 2007. We interviewed five specialists in the Brazilian video game market,
selected for relevance, knowledge of the subject and convenience: (1) the chairman of
ABRAGAMES (Brazilian Association of Electronics Games Developers) and manager of Tectoy
digital production, (2) the Director of Products and New Business of Appi, Executive Manager of
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TecGames (incubator for developers of games and digital entertainment of PUC-Rio) and CEO of
BaseOi (portal of games of the Telemar/Oi group), (3) a Ph.D. in artificial intelligence from the
University of Paris, a researcher in the area of social and Meantime Mobile Creations, (4) the
Director of the Socio-Devworks (leading development of games in Brazil), former chairman of
ABRAGAMES, (5) the General Manager of the division "mobile" of Tech Toy, focused on
developing and distributing games and related content for mobile phones, market veteran for
Brazilian games, and experience as a journalist, consultant and executive in the market for video
games.
The interviews made it possible to make inferences about the chain of value of this industry
and the relationship of its various links, the approaches of Sony and Microsoft for the next
generation of consoles, and the relevant facts associated with the success of a console. Below is a
theoretical reference to support this survey, both for the value chain and the critical success factors
in the market for household video games. After collecting information from the interviews, this
result was presented with the theory presented in this paper.
3.2. Research Development
Four criteria for the search approach defined by Yin (1994) were adopted: (1) the validity of
the construct, using interviews with professionals recognized in the market and validating
assumptions crossing secondary information from various sources to test the validity of the
evidence, (2 ) the external validity establishing the generalizability of the results, (3) the internal
validity, in order to compare the unfolding of the facts observed in light of the theory used in the
analysis, and (4) reliability, where the interviews were supported by protocols that were refined
after an interview-test validation.
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The four criteria for the search approach defined by Yin (1994) were adopted in this work.
Various practitioners of recognized competence in the market were interviewed to test the validity
of the conclusions made on the basis of the secondary data researched by the author.. To ensure
reliability, interviews followed protocols.
Yin (1994) suggests two approaches: the use of theoretical propositions and a description of
the case. This was the approach used in this study, which sought to compare the similarities and
differences of the cases discussed.
4. Results and Discussion
4.1. Value Chain of home video game consoles
Three works formed the basis for the analysis complementing the interviews: the analysis of
the industry of interactive games conducted by Kline and Dyerwithford Peuter (2003), the study of
Grantham and Kaplinsky (2005) on the evolution of the value chain of developers of the games, and
analysis of the industry (Coughlan, 2004). First of all, we characterized the components of this
chain, and then the dynamics of its relationship and the relationships of power (dominate links) are
described.
4.1.1. Characterization of the Chain
The value chain of home video game consoles is formed by the following components and
players: the home consoles, the holders of the console technology (platform providers), suppliers
and manufactures of hardware, the software or games themselves and their developers, publishers,
providers of content, the network retailers, distributors, Internet connection and access for
broadband. From this characterization a value chain of home consoles and video games was
prepared, as shown in Figure 1.
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The consoles are household appliances: computers based on a microprocessor optimized for
graphically processing information from the controls, and processed according to the information of
the software (game), sending A/V signals to a TV unit (Coughlan, 2004). The consoles have
incorporated additional functions such as playing music, photos and DVDs, among others.
Holders of the console technology developed three main activities: 1) design, marketing and
manufacture of the console, 2) activities of publishing software, and 3) management of relations
with independent publishers (Coughlan, 2004). They are responsible for approving the games and
manufacturing their physical copies, selling subsidized hardware to profit in the software (Greco
and Appleyard, 2001).
Suppliers of hardware are responsible for parts and peripherals such as graphics chips and
others, which, in general, are customized for the consoles. There is high dependence on key
components and, in extreme cases, the holders of console technology are trapped by the technology
suppliers (Shapiro and Varian, 1998; Hamel, 2000)
The manufacturers of hardware may be companies belonging to the owners of the
technology or may manufacturer services providers, that manufacture and receive the parts of the
hardware from different suppliers, and then assemble the units within the specifications of the
owner of the technology that sells under its brand. In general, such facilities are often located in
countries with a low cost of labor in Asia, Latin America and Eastern Europe. When the holder of
the technology itself is the manufacturer, the most common structure is the “maquiladoras”4, which
describes companies that import parts and components for the manufacture of products in countries
with cheap labor and tax advantages; then the finished product is exported, (Kline and Dyerwithford
Peuter, 2003).
4
A “maquiladora” or “maquila” is a factory that imports materials and equipment on a duty-free and tariff-free basis for
assembly or manufacturing and then re-exports the assembled product, usually back to the originating country. The term
"maquiladora", in Spanish, refers to the practice of millers charging a "maquila", or "miller's portion" for processing
other people's grain.
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Games rely on many aspects of technology for their development, including software for 3D
graphics, kits of development, artificial intelligence and "game engines" upon which the graphics
and gameplay are mounted. The games are at the heart of the industry as key pieces. In general,
games created for a console are not compatible with other consoles, but the game can be offered on
multiple platforms (Coughlan, 2004). The game media has varied over the years, beginning with
cartridges to the current DVDs. There are three types of developers who are responsible for the
design and creation of games: those who belong to a publisher, who belong to the owner of the
console, and the independents. Due to the high cost of the games, most belong to or are associated
with a publisher.
Content Providers
Software Developers
Royalties / advance
Software Publishers
Royalties
Platform Providers
Manufacturer
On Line
Services
Electronic
manufactoring
Services (EMS)
Original
Manufacturer/
maquiladora
Distributors
Retailers
Consumers
Figure 1: Value Chain of home video game consoles
Source: Results of authors’ research.
Hardware Suppliers
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The publishers are responsible for financing, managing and marketing the games (including
distribution and market research), as well as for negotiating the use of intellectual property. They
can be independent or linked to the manufacturers of consoles. Collaborative intellectual content is
increasingly important in this industry, and so the providers of content are keys in this chain.
Relationships with celebrities, including athletes, and with media conglomerates that publish films,
music, TV shows, books and magazines are important for the acceptance of the games. The
distributors, who buy the games from the publisher and sell to retailers often belong to the
publishers.
Network retailers sell the games and consoles by various channels such as traditional
retailers, shops, electronics, toys, etc. While the margin is small in the sale of consoles, it is 25% to
30% in the sale of games. In the U.S., most games are distributed to the traditional retailers, with
toy stores being the second most common retailer.
Internet connection and broadband access are also important, since online games are
increasingly popular, with the platforms betting that this option will expand their markets.
4.1.2. Chain Dynamics and Dominants Loops
Besides the cyclical character of each generation, this industry uses the model of the
business of razor and razor blades, selling subsidized hardware to win in the software. Unlike other
mass media, it does not generate revenue from advertising, it is generated by proprietary hardware
and no interoperability, which is a factor that is crucial to competition. The cycle of development is
similar to the movie industry and characteristics of distribution and publication are similar to
industries producing VCRs and books, Williams (2002).
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This value chain is dominated by holders of console technology, the Platform Providers. Its
power is in the accreditation of the publisher and developer, and it defines the games that may or
may not run on the console. The return is a royalty per unit of game sold and, in general, it does not
interfere in negotiations of the publisher with the distributor or the retailer.
The second strongest link in the chain are the publishers of the games, whose strength is
increasing. This chain can be divided into two parts: software and hardware. In the software part,
the link that is the dominant is the publisher, which negotiates with content provider, for content or
new intellectual property with developers and negotiates with the holder of the technology for the
approval of the game for the console. If the game is approved, the publisher pays the holder of the
console royalties for each unit of software sold (game).
The publisher provides an advance to the developer creating the game and a royalty per unit
sold (as of a certain amount), and negotiates with distributors for resale of games and marketing.
Similar to the movie industry, the publisher focuses and shapes the editorial content. The publishers
are closer to the consumer and have access to capital, with more strength in negotiations; the
developers receive less and have less autonomy regarding the content. Platform Providers and
publishers have internal development teams. But now, the publisher has increasing influence on the
console holders.
When the Atari implemented the business model of the razor and razor blade (second
generation), it developed the games and produced all the hardware. The chain was highly
verticalized and all value was with Atari, which, with the low cost of the console, maximized the
effects of a positive network (Shapiro and Varian, 1998). When new entrants started to manufacture
software (cartridges) for the Atari system, they captured a large slice of Atari’s profits, that charged
them very low Royalties (one of the main causes of Atari failure), forcing the chain to become more
horizontal (Fine , 1998), where publishers have more power. The Nintendo became the leader in the
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next generation by implementing strict rules for licensing, agreements of exclusivity, limiting the
maximum number of titles from a developer, centralizing the manufacture of cartridges and
determining which titles would be launched for its console (Gallagher and Park, 2002).
Joining the saturated market of video games in the USA in 1985, Nintendo managed to have at
Christmas in 1986, the Nintendo Entertainment System (NES) as the most desired toy on the
market. The popularity of the NES increased demand and stimulated a larger number of developers
to write games for the Nintendo system, making it more attractive. The Nintendo managed the most
difficult of technological tricks: it jumped in on the curve of positive feedback (Shapiro and Varian,
1998) and at the same time, maintained strong control over its technology. All independent game
developers paid royalties to Nintendo and could not provide their games to other platforms until two
years after the launch.
However, the rigid control of Nintendo was broken by new competitors (Sega), and with
each new generation of console, the cost of development increased. A game considered top of the
line (AAA) for the current generation could cost USD 50 million for development and marketing
(this can be 50% of the value), with the cost of exclusive intellectual property rights increasing. The
publisher has strong relationships with resellers and with developers whom increasingly depends
on the publishers. And are incorporated by them The main factor in the adoption of a console for a
publisher or developer is the return potential given the amount of consoles on the market.
With that, the publishers have an increasingly strong position with the platform providers,
not only because the quantity and quality of the games are important factors, but because
independent publishers help to distribute the high risk of this industry, which is similar to the movie
industry and is characterized by success or failure. Even companies with large amounts of cash,
such as Microsoft, can not cope alone with this type of risk. Publishers can dilute the costs of
intellectual property and development in versions of games for different platforms (all consoles, cell
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phones, computers and arcades), reaching a wider market and higher return. The manufacturer of
the console, which exclusively produces for its product, cannot share the risk and cost. The
escalation of costs generates a greater dependence in already famous franchises and intellectual
property as a way to minimizing risk and by that strengthening the power of content providers and
publishers.
In the chain focused on hardware, the dominant link is the platform provider, which
purchases inputs from suppliers of hardware (or manufactures parts thereof), and assembles the
console, using maquiladoras companies or services from manufacturing. Initially, the holders of the
technology of the console manufactured all hardware, but the need to keep costs low to increase the
installed base (allowance of hardware) and benefit from the network effects has led to the need to
minimize costs, leading to almost total outsourcing of manufacturing, as was the case with
Microsoft's XBox.
Suppliers of hardware have been central players in the structure of costs of consoles and
their technological differentiation because of the need for advances in the technology of parts such
as CPUs and graphic chips. This has caused companies that used to hire external suppliers to
become prisoners (lock in) due to high costs, and the need to cut costs during the console life cycle.
Thus, the owners of the console technology are increasingly making partnerships for the
development of these parts.
Retailers sell both games for the consoles and exert pressure on the holders of technology of
consoles and publishers to increase their profit margins. A network such as Wal-Mart refusing to
sell a game (ex. with violent content) may lead to its failure, but new forms of distribution, such as
the Internet, may limit its growth in the chain. Services of games on the Internet gained importance
and represent a focal point in the strategy of Microsoft. This services include the infrastructure and
20
software for playing on line, in massive multiplayer games (MMOs) and associated services as
marketplaces for downloading games, information and virtual communities.
Thus, the dominant link of the chain is held by the companies that have proprietary rights
for the consoles followed by Publishers and developers are the weakest link in the chain. The power
of suppliers of hardware is switching back to the console companies, and online services are
diminishing the power of retailers. Because the costs are increasing, there is a concentration on
fewer on publishers to produce games and on manufacturers of consoles since the increased costs of
manufacturing, marketing and distribution of a console are so high that few companies in the world
are able to invest, which limits the emergence of new entrants.
The advantages of the business model where the hardware is subsidized and the gain comes
from the software are the ability to distribute the largest amount of consoles and the encouragement
of publishers to produce for the console, earning royalties and exploiting the network effects and the
positive feedback (Shapiro and Varian, 1998). The disadvantage is the high risk of subsidizing
hardware and the piracy, but distribution over the Internet can minimize the problem.
4.2. The entry of Sony in the market for home consoles
The development team for Sony’s first console, the PlayStation, was physically located at
Sony Music, and a new company was established to take care of the console so that the influence of
the headquarters did not harm the project. Sony wanted to maximize the number and variety of
games, in part by the experience with the Betamax, when the defeat for the VHS occurred due to the
lack of titles, Coughlan (2001). Thus, the company aimed to create as friendly an environment as
possible with Publishers and developers.
A key point of the PlayStation was the use of the CD-ROM (optical disk media) in place of
ROM cartridges used by Nintendo. This revolutionized the idea that the CD-ROW data reading
21
was to slow to be adopted for games and exploited its media capabilities to the extreme, changing
the form of distribution of games (that was based in the cartridge) in Japan. Publishers often bought
large quantities of a title and distributed them to retailers. The minority of games was successful, so
the wholesaler tried to unload much of the stock quickly, but if the game was a success, wholesalers
would wait for the price rise before selling. This occurred because the cartridge ROM (a
semiconductor memory packaged in a cartridge), whose advantage was fast access to information,
was expensive to manufacture and was slow to produce, especially in bulk. Time is a critical factor
in this business -- a game can go "out of fashion" in a few months. The high cost of manufacture of
cartridges is reflected in the price (USD 30) per copy that publishers paid to Nintendo, and the final
price for the consumer of USD 98, as reported by Asakura (2000). Table 1 shows the cost structure
of Nintendo cartridges.
Table 1: Costs Structure of the Nintendo cartridges
Publisher
Nintendo
Development
USD 10 Royalty
Advertising
USD 6
Margin
USD 10
Wholesaler
USD 15 Insurance USD 5
Manufacturing USD 15 Margin
Retail
Margin
USD 25
USD 12
Source: Adapted from Asakura (2000).
Sony used the structure of Sony Music CDs for developing manufacturing cheaper and
faster and adapted the business model of the music industry, making a small initial print run of
games, increasing production if the title sold well. Thus, the PlayStation avoided the insurance of
USD 5, the wholesaler gained USD 6( in Japan at the beginning it was Sony); and the cost to the
22
retailer would be USD 17. All this totaled USD 58. Despite the lower price to the end user, as
shown in Table 2, the profit of USD 10 for the publisher would be maintained, and the publisher (
mainly the samller ones) would benefit the smaller investment for each game.
Table 2: Cost of the Sony’s CD
Publisher
Sony
Development
USD 10 Royalty
Advertising
USD 6
Margin
USD 10
Wholesaler
USD 9
Margin
USD 6
Retail
Margin
USD 17
Source: Adapted from Asakura (2000).
A key factor for success was the ability of Sony to reduce hardware costs. The hardware
lasts for the life of the console and the potential to reduce costs and be designed in a way that
facilitates mass production is essential for success. The first model of the original PlayStation had
750 parts; the model sold by the end of 1997 had 450 parts. The price dropped from USD 399 at
launch, to USD 299 after six months (Asakura, 2000), reaching USD 99 at the end of the cycle. It is
estimated that Sony lowered the costs of the console from USD 450 to USD 80 in five years
(Takahashi, 2002), leading to a price war with Sega, which resulted in Sega losing USD 450 million
and announcing its market exit in 1998 (Kent, 2001). The reduction of costs was not aimed at
increasing profits, but at reducing prices to increase the installed base, increasing positive feedback,
and allowing Sony to bring more developers to the console, with whom they sought to create a
strong relationship (Desphande, 2002).
23
The console had record profits in its first two years, more than all other business divisions of
Sony. The PlayStation increased its demographic reach in the industry to 102 million units sold, 849
developers, 7,888 titles and 961 million games sold worldwide, according to information released
by Sony, PlayStation Global (2007).
4.3. Playstation 2 and Sony hegemony consolidation
With the Playstation 2, Sony launched the approach of a “Trojan Horse” to dominate the
new digital living room, announcing it as a home entertainment center, and digital entertainment
gateway for the home, playing games, CDs, and MP3s, with backward compatibility with original
Playstation Games. It was also innovative because it was able to play DVD movies. As the game
console was subsidized, it became the cheapest DVD player available in the Japanese Market - sold
for USD 360 (a cheap DVD Player cost USD 400); the size of the Japanese DVD market doubled in
one month due to its launch (Desphande 2002).
The PlayStation 2 had a revolutionary Graphic Chip, the “Emotion Engine”, which was
developed by a 1.2 Billion USD joint venture between Sony and Toshiba (Schilling, 2003), with the
construction of a factory exclusively for its production. The difficult programming for the new chip
was not a barrier for the publishers and developers supporting the new console, due to the good
relationship established with the previous console and the fact that Playstation 2 was highly
expected by the public. It was a success, with impressive initial sales figures. Sony’s head start
made it difficult for Microsoft and Nintendo to catch up. With it’s big installed base, the developers
could reach the widest possible market with Playstation 2; furthermore, Sony was able to afford
huge advanced payments for the publishers in exchange for exclusive rights to the games because
their sales were likely to be very profitable, especially because they were associated with Sony’s
name. (Takahashi, 2006).
24
Sony made an aggressive price reduction on this console, merged its CPU and graphic chip
into one single chip, and released a much smaller version of the console, the “slim” in 2004. They
further reduced the price from USD 299 at launch to USD 149 in 2004 (Takahashi, 2002 and
Takahashi, 2006), with an actual price of USD 129. The PlayStation 2 had, by the end of 2006,
1,247 developers, 7,163 titles, 1 Billion of games sold and 103 Million consoles sold worldwide
(PlayStation Global 2007). The Playstation 2 is still on the market in 2008 and is selling relatively
well worldwide.
4.4. The current generation: The PlayStation 3
The PlayStation 3 is HDTV (High definition TV) compatible, plays CDs, DVDs, Blu-Ray
(an optical disc storage media format launched by a group of companies lead by Sony), MP3s, and
photos, can connect with the Internet, and is backward compatible with Sony’s previous consoles.
It represents an intensification of the Trojan Horse approach initiated with Playstation 2. Sony
joined Toshiba (its competitor for the Blu-ray format with the HD-DVD) and IBM to develop the
Cell Chip, the heart of Playstation 3, just after the Playstation 2 was launched, investing two billion
dollars in factories and development (Lee and Hoyot, 2006).
Despite the anticipation, the Playstation 3 was launched5 almost one year after the
Microsoft’s Xbox 360, with only 100,000 units available on the first day6. Such delay is believed to
have happened due to agreements regarding the Blu-ray technology and the development of the
graphic chip, whose project Sony abandoned due to several problems and decided to partner with
Nvidia (Takahashi, 2006).
With this console, Sony was trying to popularize the Blu-ray technology as a substitute for
the DVD and to introduce its cell chip that the company plans to use in several electronics devices.
5
6
http://www.us.PlayStation.com/News/PressReleases/335, 12/01/2006.
http://news.bbc.co.uk/2/hi/technology/6135452.stm, 02/07/2007.
25
However, this technology is complex and expensive and Sony has to heavily subsidize the
Playstation 3 (Lee and Hoyot, 2006). Due to the high cost of Cell and the Blu-Ray and the business
model that subsidizes the hardware to gain on software ( The razors and razor blade model), Sony
will lose a lot of money with The Playstation 3 hardware in order to gain market share and
consolidate Blu-ray as the substitute of the DVD. Additionally, this technology implies a big change
in the way games are developed, generating an increase in the time necessary for the developers to
fully explore the hardware potential and increasing the cost of development (OFEK, 2005).
Currently Playstation 3 has not overpowered Xbox 360 graphics and the bad sales numbers led the
publishers that used to have an exclusive approach to develop multiconsole games, which is a
situation that has worsened due to the better Xbox 360 online capabilities. The lack of good games
and high cost of the console have affected the console sales (negative feedback). Sony has lost its
place as the market leader and currently is in last place, after Nintendo (the leader) and Microsoft.
4.5. Microsoft’s entrance in the home video game console market
Microsoft already had a tradition of developing PC games and wanted to defeat Sony’s
vertical structure with a more horizontal one, with its software on a console with PC-based
hardware, obtaining large scale economics and the benefits of creating a PC game for stable
hardware. The video game was also a way to bring the PC into the living room (Takahashi, 2002).
Nevertheless, Microsoft had to learn how to manage a complex hardware supply chain and the
development of an advanced hardware system.
Due to the business model with subsidized hardware, none of the big PC manufacturers
were interested in manufacturing the console, so Microsoft hired Flextronic, an electronics
manufacturing services (EMS) company that provides electronics manufacturing facilities and
services to original equipment manufacturers (OEM). Flextronics also provided designers to help
26
with parts specifications, and the parts that were commodities, used in other OEM products and
bought in high quantities, were bought directly by Flextronics. Custom designed parts, such as the
controller, were ordered by Flextronics based on Microsoft’s agreement, however Microsoft
negotiated the contract with the vendor. Parts such as the microprocessor and graphics chip were
bought from the vendor directly by Microsoft with Intel and Nvidia (with a gradual price reducing
schedule) and were delivered to Flextronics (Lee and Hoyot, 2006)
Microsoft had problems with its supply chain, Nvidia delayed the final version of the chips
and there were problems with Intel’s motherboard; therefore, the production at Flextronics started
behind schedule and had its own problems, such as changing, in the beginning of the production, its
internal IT system, because its data base was not big enough to track all the components. It also had
to create a filter for defective parts delivered by suppliers. Microsoft delayed the launch of the
console and had to cancel the simultaneous worldwide launch (Takahashi, 2002)
Microsoft focused on obtaining the support of developers and publishers for the console in
terms believed to be more favorable than those of the competition and supplied development tools
similar to the PC, which were easier to use than those for Playstation 2, and well know by the
programmers (Greco and Appleuard, 2001). Microsoft’s first-party development team increased its
expertise by buying other game developers and seeking agreements for exclusive games for the
Xbox. By the time of the launch, Sony had 55.57% of the market, Nintendo 33.8% and Sega 10.6%.
Microsoft launched the Xbox at the same price of the Playstation 2, USD 299, which was less than
its production costs (Takahashi, 2002; Schilling 2003).
Similar to the Playstation 2, the Xbox was able to play DVDs, CDs and MP3. But there
were a few differences such as the hard drive that could store content, which could improve the
online experience. The Xbox live, the online multiplayer gaming and digital contents delivery
service from Microsoft, was launched at the end of 2002 and Microsoft committed to invest USD 2
27
Billion in five years on the service, believing that it would be profitable in the future (Takahashi,
2006), allowing the exploration of new business models with alternatives to distribute contents
(such as music and videos), games and services
In May 2002, Sony reduced its price to USD 199 and Microsoft matched, even though the
loss per unit sold was going to be higher; reducing the cost of the console was difficult because it
used PC standard parts that were already cost reduced, and suppliers of major components such as
Nvidia and Intel were not willing to reduce the price to the level Microsoft needed. Another issue
was the HD, one of the most costly items, which did not allow a major price reduction and did not
bring an advantage that the clients were willing to pay for. As Sony was the market leader, game
developers focused on the Playstation 2 (without the HD) and converted them for the Xbox, not
taking advantage of the HD. However, the games were what really made the difference. Since Sony
launched its console much earlier, it gained the support of the majority of the developers and a
bigger game library, as mentioned previously in this article. (Takahashi, 2006).
By the end of 2005, Microsoft had sold 22 million Xbox units, Nintendo 20 Million Game
Cubes and Sony more than 90 Million Playstation 2 units. The market estimated that Microsoft had
lost almost USD 4 Billion by June 2005 (Guth, 2005).
4.6. The new Microsoft attack, the XBox 360
The main objective was to retire the Xbox sooner in order to limit losses and launch the new
generation before Sony, creating a huge installed base and conditions to reduce console costs before
the rival (Takahashi, 2006).
Microsoft did not want to be locked in again by its suppliers, however, it wanted to
continue to use the manufacturing capabilities of third parties; therefore, it selected IBM as a
partner for the CPU, and ATI for the graphic chip (GPU). ATI was going to receive a fee for
28
designing the chip and Microsoft would own the design allowing Microsoft to select any chip
producer it needed. IBM agreed to license its technology for the Chartered Semiconductor Co, a
second alternative for Microsoft to build the chip. Nevertheless, to allow backward compatibility, it
had to pay royalties to Nvidia for the new consoles sold.
To manage GPU chip manufacturing, Microsoft implemented an enterprise resource
planning (ERP) solution based on Microsoft Dynamics™ AX, as per figure 2. The real-time data
provided insight into the cost structure of the design and manufacturing processes enabling the
discovery of places in these processes where efficiency could be improved. After six months, it
achieved a 10 percent reduction in component inventories and a 126 percent return in development
savings on the investment of $950,000 U.S. (Microsoft TechNet, 2006)
Figure 2: Microsoft Solution for the GPU manufacture
Source: Microsoft TechNet (2006)
29
Microsoft focused on the aspects with more ad value to the console design and performance,
and created a system to better manage its supply chain. To manufacture the Xbox, Microsoft
interacted daily with its contractors through an EDI-based system with batch transmissions, lacking
real-time visibility into the supply chain, and requiring expensive and time-consuming development
to bring each contractor into the solution. For the Xbox 360, Microsoft developed an internal
Business Integration and Intelligence solution, to create standardized data exchange between its
ERP and contract manufacturers and subcontractor suppliers systems (Microsoft TechNet, 2005),
as per figure 3.
P
u
b
l
i
c
p
r
o
c
e
s
s
e
s
Tier 2 Supplier
Work-in-progress,
advanced
shipping
notifications ,
purchase order
transmission and
receipts, and
inventory
synchronization
RosettaNet
Console Contr act
Manufactur er
GPU Contr act
Manufacturer
RosettaNet
RosettaNet
In tern et
BizTalk Server and
RosettaNet Acceler ator
•
•
•
•
B2B gateway
Document format mapping
Document routing
Message reliability
Canonical XML format
P
r
i
v
a
t
e
p
r
o
c
e
s
s
e
s
BizTalk Server
and Adapters
• End-to-end business
process orchestration
• Business rules
End-to-end
validation
operations
• Line of Business (LOB)
framework and
alerting , message system integration
tracking
(acknowledgements)
Data War ehouse
`
SharePoint Portal
• End-to-end process visibility
• Inventory reconciliation
• Supplier scorecard
Axapta
SAP
Figure 3: Microsoft Xbox supply-chain architecture
Source: Microsoft TechNet (2005)
30
With the real-time visibility into the supply chain, Microsoft gained a one-day increase in
responsiveness, and increased on-time deliveries by about 20%, reduced stock cost by 10% and
reduce by 50% in the costs for development from the previous system based on the traditional EDI
(Microsoft TechNet, 2005).
With the Xbox 360, Microsoft wanted to provide the consumer an integrated experience
end-to-end, integrating hardware, software and services (the digital convergence). Gaming would
remain its main function , however it was going to be a digital amplifier of the equipment that the
clients already had at their homes, and therefore, they sought to integrate other Microsoft initiatives
to ensure this objective (Takahashi, 2006). The strategy of simplifying game development and
seeking developer’s support (as well as buying them) continued. The use of third parties had gone
beyond the hardware; Microsoft hired developers from China and India to develop part of the
games (similar to car design, for example) and developed tools to coordinate the efforts.
Microsoft’s major bet was the Xbox live. It improved the services and download
possibilities for games and contents, and tried to create a feeling of community to attract a higher
number of users, using also casual games (simpler and faster games, generally without a storyline,
like a puzzle for example) with low development cost and downloadable directly by the users. This
resulted in millions of units sold at a small price via internet and diminished the risk of development
and piracy. In the near future, Microsoft is going to explore the microtransactions at Xbox live, such
as the transactions of content made by the users (for example, clothes or a Tattoo for a character or
music) being a critical additional revenue generator for the razors and razor blade model.
By the end of 2005, the Xbox was launched in the USA. Despite problems with the GPU
that generated a console shortage that took months to be solved, problems with the Japanese launch,
31
and constant complaints from customers regarding problems with the hardware, by the end of 2006,
Microsoft had sold 10.4 million Xbox 360 units - a good advantage before the release of Nintendo
and Sony’s new generation consoles. In December, competing directly with the Xbox 360, they
obtained a market share of 16% with an increase in demand of 267%, selling 4.9 games per console
at USD 52 each by the end of 2006. (CitiGroup Research, 2006b)
4.7. Microsoft and Sony case study analysis
Strong network effects characterize this market, and both companies tried to maximize it by
gaining the support of publishers and developers from the start. Nevertheless, Sony was more
successful in gaining this support the first time the two companies competed directly against each
other. The main factors for this success were: the success of its first console that leveraged the
Playstation 2; the power of the hardware; Sony’s control of the value chain allowing it to reduce
costs and gain marketshare. However, Microsoft had an impressive increase in its ability to manage
the value chain with the current generation of its console and was able to invert the situation. Sony’s
value chain with the Playstation 3 is represented in figure 4, and Microsofts’s Xbox 360 value chain
is in figure 5.
32
Content Providers
Sony music,
movies and
TV assets
Midia
Companies
Software Developers
First party
SONY
Third Party
Royalties / advance
Software Publishers
First party
Third Party
Royalties
Platform Provider: SONY
Manufacturer
Console:
On Line
Services
Austek / Foxconn
Distributors
Retailers
Consumers
Figure 4: Sony Playstation 3 Value Chain
Source: Compiled by the authors
Hardware Suppliers
Chip Cell:
IBM, Toshiba,
Sony
Graphic
Chip: Nvidia
33
Content Providers
Midia Companies
Software Developers
First party
MICROSOFT
Third Party
Royalties / advance
Publishers de Software
First party
Third Party
Royalties
Platform Provider :
MICROSOFT
Manufacturer
On Line
Services
Console:
Flextronics / Wistrom
Hardware Suppliers
Graphic Chip:
CPU: IBM /
Chartered Co. ATI / others
Distributors
Retailers
Consumers
Figure 5: Microsoft XBox 360 value chain
Source: Compiled by the authors
Sony and Microsoft tried to verticalize part of the value chain, buying and creating internal
publishing and development teams, but, despite this effort, the power in the value chain was moving
towards the publishers. Sony had a strong bargain power and sales potential due to its big installed
base, allowing Sony to obtain several exclusive games. But with the small Playstation 3 penetration
(mainly due to the high cost of the console) and its programming difficulty, this advantage quickly
eroded.
Sony’s value chain is more vertical, since the company can generate intellectual property
from its music, film and television companies, and make them exclusive for the console, and Sony
34
uses its experience as a hardware manufacturer to manufacture key parts of the console, such as the
chip cell, the console heart, developed in a joint venture with IBM and Toshiba ( Sony’s competitor
against the Blu-ray with its HD DVD format). In this generation, the approaches of the two
companies converge, as Sony used EMS to manufacturer the console (like Microsoft), using Austek
and Foxconn for the task, and Microsoft used ATI to develop the graphic chip, but retained the
intellectual property rights. Additionally, Microsoft could manufacture it with any supplier but
negotiated with IBM, the developer and manufacturer of the CPU and used a second manufacturer,
the Chartered Semiconductor Co, in order to reduce its dependency on the suppliers. It is interesting
to note that Sony’s approach became more similar to Microsoft’s approach when it horizontalized
parts of the hardware manufacturing in the value chain, and Microsoft becomes similar to Sony
when its verticalized the intellectual property of key parts of its hardware
The two companies offer online services, however, Microsoft’s approach is more centralized
and offers an integrated and richer experience to the final user. It has also had more success than
Sony, despite the fact that this centralized approach did not please several of the publishers. Sony
will probably try a service model similar to Microsoft’s due to the pressure of users and the market,
and will announce some changes by the second semester of 2008. Sony uses its core competences
as a hardware manufacturer and explores the power of its hardware, and Mircosoft uses its
experience as a software company to offer a new integrated experience for the users with a new
business model. The greatest risk of Sony’s strategy is the high cost of its hardware and the fact that
it may be offering more technology then the clients need or are willing to pay for. Microsoft is
betting on the integration of software, hardware and services with the single and integrated
experience concept, however, its main competitive advantage, the Xbox live, is easier to copy.
(Sony is advancing in this way), rather than improving the hardware that is “locked” until the next
generation of the console.
35
5. Conclusions
The following were identified as critical success factors in the home console video game
industry: (1) building the biggest possible installed base and game options; (2) hardware cost
leadership and value chain management.
In this study, a value chain map and an analysis of the power relation between the links of the
chain were made for the video game home console industry. Based on the interviews made, relevant
information was obtained and combined with the theoretical background and bibliography
references to create a map of the agents in this industry, their value chains and the relationship
between the links, as well as the vertical and horizontal movements to links in the value chain with
more revenue potential. This analysis allowed an understanding of how the companies operate in
this market and their strategies, mainly for this new generation of consoles. Nevertheless, due to the
fact that this generation of consoles recently started (the majority of the players released their
consoles one year ago), it was almost a unanimous opinion between the specialists interviewed in
this research and the authors, that it is still too soon to analyze which strategy will be the winner.
Entertainment has more importance in modern society than ever and it continues to grow. In
this market, the video game industry is gaining importance, rivaling and complementing other
traditional media and influencing industries such electronics and software. In this industry, the
home video game console has a prominent position, not only for its economic relevance, but for its
presence in the daily activities of the individual, increasing its presence in the living room of
millions of homes around the globe, reaching a broader audience than boys and teenagers, with
whom its image was initially associated, as people from all ages and independent of the gender
become involved.
36
The five-year cycle characteristic and the dynamic of home video game consoles enables a
detailed study of how it works and what strategies were winners and losers during its short history
of less than 30 years. In every 5 to 6 year cycle, this industry leads to winners such as Nintendo and
eliminates losers such as Atari and Sega, and makes possible the transition from one generation to
the other based on the razors and razor blade model, subsidizing hardware to generate profits with
the software.
This industry is dominated by the companies that retain the console technology, who sought to
increase the partnership and joint ventures for the development of the consoles, adopting a strategy
that is more horizontal and modular, focusing on the tasks with more added value. Although Sony’s
approach is more vertical than Microsoft’s, both seek to control the value chain with strategic
partnership and at the same time, avoid being locked into a given technology. In addition, there is
the continuous increase in the publisher’s influence, as suppliers of essential complementary goods
to the consoles - the games - that are gaining power in relation to Sony and Microsoft, as they
verticalized power that used to be from the developers and the platform providers.
In this industry, there are strong network effects and positive feedback to attract developers,
publishers and new users who are very sensitive to the console price and games available.
Disruptive technologies are implemented with each console generation as the companies seek
differentiation and cost reduction. The winner of this battle will be the company that better exploits
the points explained in this article, reaching the biggest installed base of consoles and availability of
games, under the strong network effects of this industry via leadership in costs as they manage the
value chain network and avoid being locked in.
The current console generation brings two main factors that can be vital to success if used with
the correct strategy: the digital convergence and the technological convergence. Sony bets on its
hardware, exploring its core competences as an electronic leader and media conglomerate, trying to
37
reach a greater integration between its products that can be achieved via the console such as the
Trojan Horse to conquer the living room. Microsoft wants to use the same Trojan horse to bring the
PC to the living room, integrating the “Digital Home” via its software, using its core competences
as the biggest software company in the world.
Sony invested strongly in the technological convergence concept, offering hardware capable of
becoming a complete home digital entertainment center, centralized on the cell chip, which will be
used in other Sony products and may cause a revolution in the company’s electronic products,
facilitating the communication between them and investing in a new media, the Blu-ray, to replace
today’s DVDs. Nevertheless, the console’s high price due to this technology, keep it away from
many costumers, and few customers push away developers, creating a vicious cycle that hurt the
console’s acceptance.
This effect was worsened by the difficulty in programming this new
hardware and its bigger learning curve, causing a shortage of games with only average graphics,
costing Sony the first place in the market. However, the risk strategy is starting to pay off and
promises to flourish in 2008, as the Blu-ray player in the Playstation was vital ( among other
factors) to guarantee the victory of the standard (Toshiba decided in February 2008 to discontinue
its rival standard the HD DVD) since the Playstation 3 sold almost 10 Million units worldwide until
February and the HD DVD players sold a little more than 1 million units around the world.
This will speed up the console sales, as the subsidized hardware makes it one of the cheapest
Blu-ray players available, and the Blu-ray players sells as well. It will increase the velocity of the
cost reduction of the technology and thus of the console. In addition, in the second semester of
2008, the first games that start to really explore the hardware potential with graphics better than the
competition will be released. Those factors can increase the positive feedback and boost sales,
increasing the console’s installed base.
38
Microsoft opted for modest hardware (in comparison to Sony), but with the potential to be a
home entertainment center, with the main objective of connecting different digital entertainment
equipment in the home using the midia PC as a hub.
The experience obtained with the Xbox line, not only in terms of hardware, but also with the
integrated experience and digital convergence with the Xbox live, was the first step for Microsoft in
developing its MP3 player, the Zune, released in 2006. The Zune represents the beginning of a
more aggressive movement in this direction, taking Microsoft to frontiers and markets beyond the
reach of a “software company”.
The Xbox live is one of the key factors for the success of the Xbox 360, and Microsoft wants to
expand its reach to computers and other devices and explore the possibilities generated as the
revenue from the micro transactions.
Although Sony is not as well developed as the Xbox live and has explored the micro
transactions in a limited way, the Xbox live is, before everything else, a great idea, and can be
copied. Its user network of an estimated 10 million people is still small for a market where the
leader can sell 100 million consoles and may not be sufficient to stop Sony’s progress in this field in
2008. Sony is planning to launch a community very similar to the popular Second Life universe and
provides more autonomy for the users to create, distribute and sell contents. In addition, Sony has
strong film, music and TV assets being one of the major media conglomerates in the world, an
important source of intellectual property and synergy that puts Sony in a unique position to explore
digital convergence. This fact, in addition to the facts exposed above, makes Sony a serious
contender that can surpass Microsoft in the end of 2008 and rival the leader Nintendo.
This research contributes to the literature as it analysis a new industry that has a high clock
speed where new companies and incremental and disruptive technology innovations appear with
each new generation of consoles, allowing the study of the common factors for the winners in each
39
cycle. At the same time, it analyzes the increasing competition of companies in distinct industries,
powered in this industry by the digital convergence, with the integration of software, hardware and
services and technological convergence, and with the home video game console value chain having
direct effect in several other industries, mainly the ones related to electronics and entertainment.
Future research in this field could address the following issues: (1) An economic analysis of the
markets that are emerging in virtual worlds such as MMOs like Second Life and World of Warcraft;
(2) Alternative ways to distribute and sell content over the Internet and its impact on the industry
business model; (3) How the convergence of technologies and medias in these consoles affect the
entertainment and electronics industry value chains; (4) Alternative sources of income such as
advertising on games and advergames, games that are meant to be an advertisement or have a
central role in the promotion of a brand or product; (5) Analysis of the Brazilian home video game
console market with the official entrance of the Nintendo and Microsoft consoles at the end of
2006, and the impact of piracy on this market, against the successful experience in Mexico, where
industry growth was due to a reduction of the fiscal burden and better piracy controls ; (6)
Discussion of the availability of the current home video game industry model, centralized in
proprietary hardware as the only interface for the games, with the current trend of the games
migrating to the internet environment ; (7) Analysis of the potential for creating new markets due to
the integration of software hardware and services that is happening in several fields such as in
music (Ipod) and videogames.
In the battle for the living room, the new video game consoles have a central role, and may
decide the future of the electronics and entertainment industries. However, if this proposal does not
materialize, Microsoft and Sony will suffer huge costs that will not be forgiven by the market and
its shareholders, which will be worse for Sony, who relies on the home video game market as one of
40
its major sources of revenue and a central point in its overall strategy, and for whom 2008 will be
the console’s real test.
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