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Home , Electronics industry, Home video game console, Tectoy

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Abstract Number: 008-0286 Abstract Title: Value Chain and Competitive Strategy in the Home

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 – . 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 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 and disruptive , 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 to intangible goods and from the management of supply chains to the management of value chains. In this system, companies are increasingly inter- related and form 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 and , now compete for the game market, estimated at more than USD 33 billion (Cliff, 2006 and Edwards, 2006). Moreover, these companies seek to create a new market 2

not yet explored, with great potential for growth and profit (Kim and Mauborgne, 2004), and with the 1 as the center of home that could dominate the digital living room.

The is new and dynamic, existing only since the 1970s; its appearance was inter-related to the personal 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 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 and the convergence of technologies is changing the way people deal with entertainment and the industry of consumer . There were solutions for 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 integration between hardware, software and services, which is rendered possible by connectivity

1 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 , which has many other functions, or arcade machines, which are designed for businesses that buy and then charge others to play. 3

(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 4

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 arcades 2, 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 , 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 and even via mobile phones.

In this new reality, home entertainment products have greater relevance to the consumer 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 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. 5

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 Viiv 3 . 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 inherent to the network of value in which they compete; on the other hand, the emerging companies may 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 is the largest manufacturer of video games for 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.

3 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 . The first personal computers with this technology came to the market in the USA in 2006. 6

For Christensen (2000), there are three factors linked to the success of an 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 7

of the value chain, he divided the set of activities of strategic importance into designing, producing, , 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 of the organization "extended" with their networks of supply, 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 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 . 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 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 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 9

products, mainly when we compare these to the scale gains of , 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, 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 10

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 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 , '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 digital production, (2) the Director of Products and New Business of Appi, Executive Manager of 12

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 , 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. 13

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. 14

The consoles are household appliances: computers based on a 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 , among others.

Holders of the console technology developed three main activities: 1) design, marketing and manufacture of the console, 2) activities of 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. 15

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 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 Electronic Original Hardware Suppliers Services manufactoring Manufacturer/ Services (EMS) maquiladora

Distributors

Retailers

Consumers Figure 1: Value Chain of home video game consoles

Source: Results of authors’ research. 16

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, 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 , 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). 17

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 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 18

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 (), 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 19

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 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 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 " 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 Wholesaler

Development USD 10 Royalty USD 15 USD 5 Margin USD 25

Advertising USD 6 Manufacturing USD 15 Margin USD 12

Margin USD 10

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 , 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 Wholesaler Retail

Development USD 10 Royalty USD 9 Margin USD 6 Margin USD 17

Advertising USD 6

Margin USD 10

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 “”, which was developed by a 1.2 Billion USD joint venture between Sony and Toshiba (Schilling, 2003), with the 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 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 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 launched 5 almost one year after the

Microsoft’s , with only 100,000 units available on the first day 6. 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 http://www.us.PlayStation.com/News/PressReleases/335 , 12/01/2006. 6 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 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 , 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 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 Tier 2 Supplier Console Contract GPU Contract u Manufacturer Manufacturer b l RosettaNet RosettaNet Work-in-progress, i RosettaNet c advanced shipping Internet p notifications , r purchase order transmission and o c receipts, and e inventory s synchronization s BizTalk and e RosettaNet Accelerator s • B2B gateway • Document format mapping • Document routing • Message reliability

Canonical XML format P r i BizTalk Server v and Adapters a • End-to-end business t process orchestration ` e End-to-end • Business rules operations validation p framework and • Line of Business (LOB) SharePoint Portal r alerting, message system integration • End-to-end process visibility o tracking • Inventory reconciliation c (acknowledge- • Supplier scorecard e ments) s s e s

Data 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, Midia movies and Companies TV assets

Software Developers SONY First party Third Party

Royalties / advance Software Publishers First party Third Party

Royalties

Platform Provider: SONY

Manufacturer Hardware Suppliers Console: Chip Cell: Graphic Austek / IBM, Toshiba, Chip: Nvidia On Line Sony Services Distributors

Retailers

Consumers

Figure 4: Sony Playstation 3 Value Chain

Source: Compiled by the authors

33

Content Providers Midia Companies

MICROSOFT Software Developers First party Third Party

Royalties / advance Publishers de Software First party Third Party

Royalties Platform Provider : MICROSOFT

Manufacturer Hardware Suppliers Console: CPU: IBM / Graphic Chip: Flextronics / Wistrom On Line Chartered Co. ATI / others Services 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) 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 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 , 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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