Video Games Rivalry

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All about video games industry rivalry.
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   1 RIVALRY IN VIDEO GAMES *   In May 2002, the video games industry was entering into the growth phase of a new cycle of expansion stimulated  by the launch of 128-bit video games consoles. This was fifth such cycle since the late 1970s; each of them associated with a new generation of technology. With each cycle, the industry had surpassed its previous sales  peak (see Figure 1). Industry forecasts suggested that the 5 th  generation 128-bit machines would be no exception—worldwide sales of video games consoles were expected to peak at around 45 million in 2003. However, the major part of the industry’s revenues—and virtually all of its profit—was generated by software. The production of video games software had emerged as one of the most important and profitable aspects of the entertainment industry, with retail sales increasing from about $15 billion in 2001 to $19 billion in 2003, the games software industry was comparable in revenues to the motion picture industry. For the three main players in the industry, the key issue was how revenues and profits would be split between them. Sony had taken an early lead in new generation of 128 bit consoles, its PlayStation2 was well-positioned to repeat the dominance that its srcinal PlayStation had achieved in the previous generation of 32 and 64 bit machines. However, by the summer of 2002 its continued market dominance was far from assured. Nintendo, with its powerful reputation among younger video games enthusiasts and its proven ability to create blockbuster games (Super Mario Brothers, Zelda, Gran Turismo, and Pokemon) was competing ferociously to take market share from Sony. In the meantime, newcomer Microsoft had launched the world’s most powerful games console—the Xbox with massive computing power and graphics capability and equipped with broadband connections to allow fully interactive games playing. The intensity of competition between the players was strongly influenced by the history of the industry. In every  previous generation of machines, one company had successfully dominated the world market and had scooped the major part of the industry profit pool—the only exception being the third generation 16-bit machines where Sega and Nintendo had split the world market. Escalating development costs for both hardware and software would reinforce this tendency for video games to be a “winner-take-all” industry. Already Sega had exited the hardware market, its Saturn and Dreamcast machines having failed to establish viable market shares. Yet, despite all the advantages of market leadership, the technological and creative dynamism of the industry had resulted in transitions of market leadership. Nintendo had taken over from Atari, Sony had displaced Sega and  Nintendo. The key issue for Nintendo and Microsoft was to understand how to harness the forces of change—new technology, consumers desire for novel games, and the complementarities between hardware and software—in strategies that would confer competitive advantage in the new product cycle. For Sony, the critical issue was how it could best exploit the advantages of incumbency—a vast installed base and massive library of games titles—to thwart the ambitions of the old challenger, Nintendo, and new warrior, Microsoft. ATARI AND THE 4-BIT GAMES MACHINES: 1972-1985 The home video games market emerged during the late 1970s. Its srcins lay in the video games machines designed for amusement arcades. The first of these electronic arcade video games was  Pong  , created by Nolan Bushnell in 1972. With $500, Bushnell and a friend formed Atari to market the game. This simple coin-operated table-tennis game caught on in bars and arcades, but Atari’s failure to establish effective patent and trademark  protection resulted in a flood of imitators. By 1973, Atari held 10 percent of the new video game industry, the rest of the market was shared among the followers. Meanwhile, several companies, including Magnavox, had developed home video game consoles with a few  preprogrammed games, but these dedicated machines attracted little consumer interest. Atari itself introduced a home version of its  Pong   machine in 1975. The key innovation that permitted the development of the home video market was Fairfield’s release of Channel F, the first home video game system to accept interchangeable cartridges. Interchangeable cartridges allowed games consoles to become versatile machines capable of playing a variety of games. Nolan Bushnell saw the potential of games consoles with interchangeable cartridges and two months after the release of Channel F, he sold Atari to Warner Communications for $27 million to give him the financial backing required to develop and launch a new home games machine. In 1977, Atari (now a division of Warner) released its 2600 home video games console at a retail price of $200. The release of Space Invaders  (1979) and  Pac-Man  (1981) unleashed a craze for video games. In 1982, both games were transferred from arcades to the Atari 2600: sales skyrocketed. During 1982 Atari held almost 80 percent share of the video game market. *  © 2002, Robert M. Grant.   2 However, competition in both hardware and software intensified in 1982. Mattel had entered the industry with its Intellivision system in late 1979, Coleco introduced ColecoVision, and former Atari employees set up Activision. Like the Atari 2600, all these competing consoles were 4-bit machines. During 1982, 20 new suppliers of Atari- compatible cartridges entered the market and 350 new game titles were released in that year. Atari was unable to  prevent independent software developers from marketing games for the Atari 2600, though Atari was able to collect a royalty. The market became oversupplied, forcing software manufacturers with slow-selling game titles to liquidate their inventories at closeout prices during 1983 and 1984: on some games, prices were slashed from $40 to $4. Meanwhile, consumer interest was shifting from video games to personal computers. The collapse of sales forced Atari into burying truckloads of unsold video game cartridges in the Arizona desert, forcing parent Warner Communications to report a $539 million loss on its consumer electronics business in 1983. In 1984 Warner Communications and Mattel were driven to the brink of bankruptcy by the losses of their video game subsidiaries. Warner sold its Atari division that year, and in 1985 both Mattel and Coleco announced they were exiting the video game business. Industry sales of video games collapsed from $3 billion in 1982 to $100 million in 1985. NINTENDO AND THE 8-BIT ERA: 1986-91  Nintendo was established in 1889 in Kyoto, Japan as a playing card manufacturer. In 1922, Hiroshi Yamauchi, the great grandson of Nintendo’s founder became the company’s president at the age of 22 and led Nintendo’s expansion into the toy business. In 1975, Yamauchi encouraged Nintendo’s entry into video games, initially through licensing Magnavox’s system. In 1983, Nintendo released the 8-bit Famicom home video system that used interchangeable cartridges. The ¥24,000 ($100) machine sold 500,000 units in Japan during its first two months. In 1980, Nintendo established Nintendo of America to enter the $8 billion-a-year US arcade business. After a slow start, Nintendo had a hit in 1981 with  Donkey Kong  , created by Nintendo’s legendary game developer, Sigeru Miyamota. In the fall of 1985, Nintendo test-marketed Famicom, which was renamed the Nintendo Entertainment System (NES), in New York. Despite the widespread belief that home video game systems were a fad that had seen its day, Nintendo sold over a million units in the US during its first year. By the end of 1987, three million games had been sold.  Legend of Zelda  became the first game to sell over a million copies and in 1986, Super Mario Brothers  was launched; the game would eventually sell 40 million copies worldwide. Miyamota developed both games. By 1988, Nintendo had an 80 percent market share of the $2.3 billion US video game industry. In 1989, Nintendo expanded its market with the launch of Game Boy, a portable video game system. However, Nintendo learned a valuable lesson from Atari’s failure: It was important to control the supply of the game cartridges to ensure quality and prevent fierce price competition. To this end, Nintendo required its game developers to follow strict rules regarding the creation and release of new games for its NES game players. Prior to release, Nintendo had to approve the content of a game. Every games cartridge incorporated a “security chip” that permitted it to operate on the Nintendo console. Nintendo controlled all manufacturing of cartridges and charged its independent games developers a 20% royalty and a manufacturing fee of $14 per cartridge (the subcontracted cost of manufacturer to Nintendo was $7). The minimum order was 10,000 cartridges for the Japanese market and 50,000 for the US market—paid in advance. Licensees were charged about twice the cost of manufacturing. Cartridges were delivered to licensees at the shipping dock at Kobe, Japan, and then distribution  became the licensees’ responsibility. Licensees were also limited to developing five NES games a year and could not release an NES game on a competing system for a period of two years. By 1983 only 30 percent of the NES cartridges sold were games developed by Nintendo, the rest were from licensed third party developers.  Nintendo’s stranglehold over its software developers resulted in the huge success of its NES console, but also reflected its massive marketing and distribution effort. Its advertising, which amounted to 2 percent of sales, was closely linked to new game releases. It’s monthly magazine,  Nintendo Power  , has a readership of 6 million. Its retail presence was huge—in 1989, Nintendo products amounted to 20 percent of total US spending on toys and games. Retail distribution was tightly controlled. New games were released according to a carefully designed schedule and were quickly withdrawn once interest began to wane. Nintendo typically restricted shipments of its most popular games, and discouraged its retailers from carrying competitive products. Between 1984 and 1992, Nintendo’s sales rose from $286 million to $4,417 million. By 1990, one-third of US and Japanese households owned an NES and in both countries its share of the home video console market exceeded 90 percent. Nintendo’s return on equity over the period was 23.1 percent—far above the average for large Japanese companies, while its stock market value exceeded that of both Sony and Nissan during most of 1990-91. Table 1 shows the sales of Nintendo and other manufacturing’s since 1990. [Table 1 about here]   3 SEGA AND THE 16-BIT ERA: 1992-95 Sega Enterprises, Ltd. (Sega) is a Japanese company founded by Americans. In 1951, two Americans in Tokyo, Raymond Lemaire and Richard Stewart, began importing jukeboxes to supply American military bases in Japan. In 1965, their company merged with Rosen Enterprises, founded by David Rosen, a former US airman who had  been stationed in Japan. Not happy with the game machines available from U.S. manufacturers, Rosen decided to make his own. The company’s first hit was a submarine warfare arcade game called Periscope. Sega was acquired  by Gulf & Western in 1969 and went public in 1974. Hayao Nakayama, a Japanese entrepreneur and former Sega distributor, was recruited to head Sega’s Japanese operation: Rosen headed the U.S. operation. Through the 1970s and early 1980s, the video game industry went through a boom period. Sega’s revenues reached $214 million in 1982. The overall game industry hit $3 billion in 1982, but collapsed three years later with sales of $100 million. With the video game slump, Gulf & Western were keen to sell, and Nakayama and Rosen bought Sega’s assets for $38 million in 1984, thus forming Sega Enterprises Ltd. The deal was backed by CSK, a large Japanese software company that in 1998 owned 20 percent of Sega. Nakayama became the chief executive, and Rosen headed the U.S. subsidiary. Sega went public in 1986. Rosen had since become a director of Sega and co-chairman of its American subsidiary. Like Nintendo, Sega had migrated from arcade games to home games, however in Japan, Sega’s 8-bit Master System lagged well behind Nintendo’s Famicom. The US story was similar. Sega launched Master System in the US in 1986, but despite better graphics than Nintendo’s NES, Sega achieved only a 15 percent market share. In Europe, where Nintendo sales had been slow to take off, Sega did better and Sega of Europe accounted for a large share of Sega’s revenues. In October 1988, Sega introduced its 16-bit  Mega Drive  home video system in Japan. Despite superior graphics and sound to the existing 8-bit systems and support from several of its arcade games, only 200,000 units were sold in the first year. In September 1989, the system, now renamed Genesis  was launched in the US priced at $190 with games selling at between $40 and $70. This was 16 months before Nintendo released its 16-bit Super NES  player. In June 1991, Sega launched its Sonic the Hedgehog   game and began bundling the game with its Genesis   player. The success of Sonic together with an advertising campaign built around the slogan “Genesis does what  Nintendon’t” established Sega’s Genesis as the cool alternative to the Nintendo NES. In addition, Sega targeted a  broader market than Nintendo, directing its appeal to adults as well as teenagers. The result was a surge of independent software developers who began writing games for Sega. By September 1991 there were 130 software titles available for the Genesis. Sega’s licensing terms were similar to those of Nintendo, but there was no exclusivity clause and Sega’s royalty charge was higher than Nintendo’s—around $20 per cartridge. Support by games developers and retailers for Sega’s Genesis  was partly a result of the unpopularity that Nintendo had generated through its allegedly monopolistic practices.  Nintendo launched its 16-bit machine, the Nintendo Super-NES, in September 1991. It modified its licensing terms with games developers to mach those of Sega: it raised its fees to $20 a cartridge and abandoned its exclusivity clause. Despite Nintendo’s huge installed base, brand awareness, and extensive distribution, the 16-bit market represented a new competitive arena where Sega was able to offer a wider variety of 16-bit games titles: by January 1993, Sega’s library of 16-bit titles totalled 320, compared with 130 for Nintendo. In the US during 1992-96, the two companies split the market almost evenly. Elsewhere, the picture varied. In Japan, Nintendo held a commanding market position over Sega with the Super NES outselling Genesis by about nine to one. Nintendo maintained its market leadership in Europe—but barely. Sega was a market leader in several European countries and was a close follower in several others. THE SONY PLAYSTATION AND THE 32/64-BIT GENERATION: 1995-1998 Established in Japan in May 1946, Sony Corporation emerged during the 1970s and 1980s as one of the world’s most successful and innovative consumer electronics companies. In 1990, Sony began developing a 32-bit games machine that utilized software stored on CD-ROMs. Sony introduced its PlayStation in the Japanese market in December 1994 and in the US in September 1995. The European launch did not occur until the spring of 1997. In the new generation of 32-bit video games using CD-ROM software, Sega was able to beat Sony to market. Sega’s Saturn was launched in Japan a month before PlayStation, and in the US it had a three-month lead over   4 PlayStation. Nevertheless, it was Sony that quickly became the market leader in the new generation of machines. Prior to its launch, Sony had built a large library of games titles. It had courted the top games developers, to the  point of contributing financially for developing games on the PlayStation, and offered a broad range of game development tools, designing its hardware to facilitate game development. Sony’s ability to gain the support of both developers and retailers was also a result of Sony’s stature and credibility. Despite Sony’s lack of history in video game hardware or software, the company was considered a formidable competitor because of its global distribution capability, brand awareness, and the content potential of the movie libraries of Columbia Pictures and Tri-Star Entertainment (both Sony subsidiaries). Sony made few mistakes in launching its PlayStation: it came to market with a wider range of quality games, well-planned distribution, and a massive advertising budget. By contrast, Sega, despite its solid reputation among video game consumers and its well-known brand, suffered from the ill-coordinated product launch of its Saturn system. Only a handful of game titles were available at the launch, the supply of machines was limited by lack of manufacturing capacity, and distribution was haphazard. Sony’s machine attracted such a huge early following that Sega could not recover. Sega’s US sales were sluggish throughout 1996 and 1997. At the end of 1997, Saturn had an estimated total installed base of fewer than 2 million units. Almost no third-party licensees published titles exclusively on the Saturn, and very few planned to publish any new titles for the Saturn system. Saturn’s market failure was attributed to its comparatively high launch price, its lack of blockbuster exclusive titles, and a development system that many developers felt was inferior to that of the PlayStation. To try to bolster the declining market share of its Saturn player, Sega instituted rebate and incentive programs. Sega stopped marketing the Saturn in the United States in the spring of 1997. Meanwhile, Nintendo attempted to recapture market leadership by leapfrogging Sony in technology. The N-64 system launched in Japan in May 1996, in the US in September 1996, and in Europe in the spring of 1997 used a 64-bit processor. One of its launch games—  SuperMario 64  —was acclaimed as one of the best games ever developed, while the James Bond game, Goldeneye , was a major draw that attracted customers to the N64. Unlike Sony, Nintendo stuck with cartridges instead of CD-ROMs. Although this permitted cheaper hardware, it resulted in lower margins for developers and made distribution more cumbersome. Nintendo games were priced $15 to $20 above those of PlayStation games. There was little doubt about the winner of this competitive battle. Sony achieved market share leadership in Japan, the United States, and Europe. In early 1998, Sony’s game division had sold more than 33 million PlayStation game players worldwide, along with 236 million games CDs. PlayStation was one of Sony’s greatest product successes in its history. From a consumer standpoint, Sony PlayStation’s most attractive features (compared to those of Nintendo’s N-64) were its lower software costs and greater library of titles. The average PlayStation title retailed for fewer than $45, whereas N-64 titles averaged close to $60. Hardware prices were comparable at $150, with some industry  participants expecting a possible PlayStation price cut to below $100 sometime in 1998. From a software developer’s point of view, the PlayStation system had both advantages and disadvantages. On the  positive side, the manufacturing cost of PlayStation CD-ROMs was far lower than that of N-64 cartridges, and CD-ROMs containing a PlayStation video game could be pressed and shipped to retailers in much less time than  Nintendo cartridges (which were made in Japan). Furthermore, N-64 cartridges had to be paid for at the time of order placement. The longer lead times for getting N-64 cartridges on retailer shelves also meant greater inventory and sales risks for Nintendo game developers. It was difficult to judge how quickly a title would sell, particularly in the case of newly introduced games. To keep from losing out on sales and from disgruntling both retailers and consumers, publishers of Nintendo games were motivated to order larger quantities in order to avoid retailer stock-outs of what might prove to be a popular-selling title. In contrast, retailers could normally be resupplied with additional copies of hot-selling PlayStation titles within a matter of days (the packaging and booklets take longer to complete than pressing). If a PlayStation’s title didn’t sell well, no additional discs had to be pressed, and the costs associated with slow-selling inventories were minimized. Table 2 shows cost comparisons between PlayStation and the N-64 for both software and hardware. [Table 2 about here] Most software publishers liked developing PlayStation games because of their lower prices and short production lead times, features which gave them a lower break-even point for recovering development costs  —  the estimated  break-even point for the N-64 was 190,000 units, versus 172,000 units for the PlayStation. In terms of gaining the support of third-party developers, the competitive disadvantages Nintendo faced from higher cartridge costs and longer lead times to supply retailers had to be balanced against the advantages afforded  by Nintendo’s strategy of restricting the number of its game titles. Sony’s PlayStation had over 300 titles vying for shelf space. It was estimated that the average N64 title sold over 400,000 units in 1997 whereas the average PlayStation game had sales of just over 69,000 copies. Hence, software developers had the potential to make more  profit from a successful N-64 game than from a successful PlayStation game. Sony’s ability to offer a vast library of titles for the PlayStation was assisted by its high ratio of games sold per console (called the tie ratio ) was
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