Helsinki School of Economics and Business Administration ABSTRACT Department of Economics - Technology Management and Policy Master’s Thesis July 31, 2000 Jens Wilke

SOFTWARE LICENSING IN INTERACTIVE ENTERTAINMENT INDUSTRY

Research Problem and Objectives of the Study The objective of the study is to study licensing of software development tools in the interactive entertainment industry. First objective was to find a market model describing the industry. Second objective was to study how well tools like game theory used in industrial economics could be applied in this industry branch. Additional points of interest were company strategies, especially including the aspects of technology leadership and product pricing. A study was conducted in order to find out, if discriminatory pricing practices were used in the industry.

Data and Methodology The work began with an overall study of the industry in order to find out the industry characteristics. Many of the assumed facts originate from the openly published interviews of the prominent developers, and some of the information came directly from personal interviews or communication via email. One problem in the study was that pricing and licensing information wasn’t very easily available. This was due to the fact that many companies considered that as sensitive information and weren’t willing to disclose their pricing strategy. At the end of this work a case considering the Finnish company Hybrid Holding Ltd. was conducted. Interviews and studies using several Internet search engines and screenings of Internet news groups were used to study Hybrid’s position in the industry. As the industry is young and in constant change, unfortunately no larger amounts of data could be gathered in order to study the market using statistic tools or to apply models game theory.

Results of the Study A market model defining the industry was found. It became clear that due to the product characteristics, the mathematical modeling of economical dependencies between the competitors is a rather complex task. At the end of this work is the case describing the situation of the Finnish software company Hybrid. Their current market position was analyzed and several suggestions about company future strategy are made.

Keywords software licensing, price discrimination, interactive entertainment industry, game engine, graphics library Table of contents

1....Introduction...... 6 1.1 GAMING INDUSTRY ...... 6

1.2 STRUCTURE OF THIS WORK ...... 8

1.3 SUBJECT OF THIS WORK ...... 8 1.3.1 Game engines...... 9 1.3.2 Graphics libraries ...... 9

1.4 CHARACTERISTICS OF THIS WORK ...... 10

1.5 CASE HYBRID HOLDING ...... 11

2....Industry overview...... 12 2.1 INDUSTRY OVERVIEW ...... 12 2.1.1 History...... 12 2.1.2 Different platforms ...... 13 2.1.3 Scope of the industry...... 15 2.1.4 Demographics...... 15

2.2 CONTENDERS ...... 16 2.2.1 Worldwide heavyweights ...... 16 2.2.2 Finnish contenders ...... 17

2.3 PRODUCTION PROCESS ...... 18

2.4 INDUSTRY RISKS...... 19 2.4.1 Increasing risks ...... 19 2.4.2 Risk reduction with technology licensing...... 21

2.5 PRODUCT NATURE AND MARKET CHARACTERISTICS ...... 22

2.6 MARKET STRUCTURE CONSIDERATIONS ...... 24 2.6.1 Monopoly and dominant firm model ...... 25 2.6.2 Perfect competition...... 26 2.6.3 Oligopoly...... 26 2.6.4 Oligopoly conclusions...... 29 2.6.5 Monopolistic competition ...... 29 2.6.6 Monopolistic competition conclusions ...... 32

2.7 SIGNIFICANCE OF CUSTOMER INFORMATION...... 33 Table of contents 3

3....Developer strategy...... 36 3.1 TWO APPROACHES TO ENGINE LICENSING...... 37 3.1.1 Engine as a byproduct of game development ...... 37 3.1.2 Pure engines ...... 39 3.1.3 Conclusions ...... 40

3.2 R&D STRATEGY...... 41 3.2.1 Technology leaders...... 41 3.2.2 Fringe competition ...... 43

3.3 SIGNIFICANCE OF MARKET SHARE...... 44

4....Licensing...... 46 4.1 THEORY CONSIDERATIONS ...... 46 4.1.1 Evolutionary flow of innovations ...... 46 4.1.2 Asymmetric information about the product ...... 47 4.1.3 Switching costs ...... 48 4.1.4 Protection of intellectual rights...... 49

4.2 LICENSOR CONSIDERATIONS...... 50

4.3 LICENSEE CONSIDERATIONS ...... 51

4.4 INCREASING SIGNIFICANCE OF SERVICE & PARTNERSHIP...... 52

4.5 REAL WORLD LICENSING...... 52 4.5.1 Major licensors...... 52 4.5.2 Challengers ...... 53

5....Pricing schemes ...... 55 5.1 PRODUCTION COSTS ...... 55

5.2 LICENSE PRICING...... 55 5.2.1 Fixed fee...... 56 5.2.2 Fixed fee & royalties ...... 56 5.2.3 Royalties only ...... 57

5.3 DISCRIMINATORY PRICING ...... 58 5.3.1 First degree price discrimination...... 58 5.3.2 Third degree price discrimination...... 59 5.3.3 Second degree price discrimination...... 59

5.4 PRODUCT VERSIONING...... 60 5.4.1 Single two-part tariff ...... 60

Table of contents 4

5.4.2 Two two-part tariffs...... 62 5.4.3 Bundling and tie-ins ...... 63 5.4.4 Quantity discounts ...... 66 5.4.5 Quality discrimination ...... 66 5.4.6 The number of versions offered...... 69

5.5 SUMMARY OF DISCRIMINATORY PRICING ...... 70

6....Case: Hybrid holding’s Surrender 3D toolkit...... 71 6.1 COMPANY OVERVIEW ...... 71 6.1.1 Business concept...... 73 6.1.2 Licensees ...... 73

6.2 PRODUCTS’ ...... 74 6.2.1 SurRender GL ...... 74 6.2.2 SurRender Umbra ...... 75 6.2.3 SurRender SW ...... 77 6.2.4 SurRender C360...... 79

6.3 COMPETITION ...... 80

6.4 CUSTOMER SUPPORT AND TRAINING ...... 81

6.5 COMPANY IMAGE & VISIBILITY...... 82

6.6 PRICING ...... 83

6.7 STRENGTHS, WEAKNESSES, OPPORTUNITIES & THREATS ...... 85 6.7.1 Strengths...... 87 6.7.2 Weaknesses ...... 87 6.7.3 Opportunities...... 88 6.7.4 Threats ...... 89

6.8 SUGGESTIONS FOR COMPANY STRATEGY ...... 89 6.8.1 Define company strategy...... 89 6.8.2 Increase visibility ...... 90 6.8.3 Maintain core competence ...... 90 6.8.4 Offer outstanding service ...... 91 6.8.5 Price discrimination ...... 91 6.8.6 Increase market share ...... 92 6.8.7 Mobile platform...... 92 6.8.8 Refine delivery process ...... 93

Table of contents 5

7....References ...... 94 7.1 LITERARY REFERENCES...... 94

7.2 WWW-REFERENCES ...... 96

7.3 USENET REFERENCES ...... 98

7.4 OTHER REFERENCES...... 99

8....Appendices .....100 8.1 APPENDIX A GLOSSARY OF TERMS ...... 100

8.2 APPENDIX B COMPARISON CHART ...... 102

1 Introduction

This thesis takes a look at the interactive entertainment software industry. More specifically it concentrates on the gaming industry and the increasing licensing of development tools, game engines and graphics libraries. Also product positioning and licensing practices including considerations about differing pricing schemes are considered. This work is principally rather theoretical industry study, but in the last chapter the findings are applied in a case study considering the Finnish firm Hybrid Holding Ltd.

1.1 Gaming industry

In the interactive entertainment industry there is a fairly clear division on the one hand to developers and on the other hand to publishers. Normally the developers create the products and the publishers concentrate more on distribution and marketing of the final products. This work concentrates on the developer side. Developers make the software that is used to run the games and also the software tools that are used when making the games. The so-called game engines are pieces of software that are used to run and manage the games. Additional software tools could include varying editors, optimizers etc. that are used in the making of the game. Effectively, the developers are driving the technology of the gaming industry.

Formerly the games and the corresponding game engines running the games were almost completely proprietary designs produced in-house. Currently as the complexity of these software components is rising, the in-house development of these tools is Chapter 1 Introduction 7

bound to raise the risks of the project. The engine development has become an increasingly complex task, and a failure in the process can mean the cancellation of the entire game project. Considering the development costs of current games this can drive a development team into bankruptcy. By acquiring the engine and the supporting design tools from outside, game developing companies can shorten their production cycle and decrease the risks of failure. Additionally, the development time can be substantially shortened when ready-made technology is bought from outside. That is important, as a shorter development time can be an important point when looking for outside funding and the eventual profits generated by the project.

The industry is rather young and it is changing with a rapid speed. Companies are specializing and positioning themselves in the rapidly evolving market. Formerly, all engine-producing companies made also games by themselves. Now there already exist companies that have specialized purely to engine and tool production. The division to technology and content producers is emerging also in this branch of the interactive entertainment industry.

In all the major industries market analysis and varying economical tools are used when planning the company strategy. Product positioning, predatory pricing and strategic alliances are some examples of the methods used. The launch of the new console generation can serve as example. For example Microsoft has probably spent millions of dollars when analyzing features, pricing and the optimal launch time of their coming Xbox console relative to competitors like Sony’s Playstation 2. As the entertainment software industry is maturing and the stakes are getting higher, the importance of strategic analysis and tools like game theory increases also in this industry. The firms have to take the competing products more seriously into account and adapt their strategies accordingly.

Chapter 1 Introduction 8

1.2 Structure of this work

As this thesis is aimed also to people who are not so familiar with the industry, the work starts with an overview describing the characteristics and scope of the industry. In order to understand the economics of the industry, several market structure models are studied, and a model best describing the industry is chosen. The work continues with an analysis of the differing strategies that a company in the industry could follow. Considerations about technology leadership and differing company strategies are made. Thorough analysis about the licensing practices and differing pricing methods follow. At the end, a case about the Finnish software company Hybrid is analyzed, and suggestions about their future strategy are made.

1.3 Subject of this work

This work is about graphics engines and graphics libraries for multimedia production, especially videogame production. In themselves graphics engines or graphics libraries are rather vague concepts. They usually include libraries of functions and methods for things like graphics rendering, object physics modeling, collision detection, sound and input etc. Additionally tools for graphics, model animation, event-scripting etc. might be included.

Graphics engines can be used for many purposes of graphics visualization. This work concentrates on the use of real-time graphics engines in the gaming industry. Other uses for such engines are easy to find. Applications can be found for example in scientific visualization and multimedia productions. Some of these possibilities are explored at the end of this work when considering the future of Hybrid Holding Ltd.

Chapter 1 Introduction 9

1.3.1 Game engines

A game engine is a central software piece of a game and crucial for the correct functionality and performance of a game. Basically game engines are graphics engines with added functionality for game production. This might include support for game character artificial intelligence, network gaming etc. The game engines can be based on two or three-dimensional models. This work concentrates on engines and graphics libraries that are used for the creation of fully three-dimensional virtual worlds.

An engine can be made in-house or it can be licensed from outside. The motivation of licensing a ready-made product is to save development time and decrease risks of failure. In the best case the engine corresponds to the needs of the licensee, and no modifications to the licensed product are needed. In such a case the licensee can concentrate fully in content production. Unfortunately the needs of the licensor and licensee often differ, and the licensee has to do some modifications to the licensed engine.

1.3.2 Graphics libraries

Instead of buying a ready made engine one can buy or license a graphics library and rapidly develop an engine using the ready-made building blocks. In this sense graphics libraries can be seen as building blocks used to build game engines. Effectively, the advantage of buying a graphics library is their flexibility. The developer can more easily construct a system exactly matching the needs of the current project, and no reverse engineering and modifications of the licensed system are needed. On the other hand, some graphics library could be used to increase the functionality of an existing engine. In that case the products would be complements. This is effectively the case with Hybrid’s Umbra visibility optimizer module.

In practice the commercial graphics libraries come usually equipped with varied applications easing the production process. Often such a collection of tools is called a

Chapter 1 Introduction 10

development toolkit. In practice it might be hard to draw the line between a game engine and a graphics library with various add-ons. Therefore, in this thesis game engines and graphics libraries are viewed as substitutes and competing products. I don’t make a distinct separation between game engines and graphics libraries. Consequently, in this work the term game engine also encompasses advanced graphics libraries.

1.4 Characteristics of this work

The field of software licensing and especially software licensing in the interactive entertainment industry is largely unexplored in the economical literature. In addition this industry is under constant change now and in the foreseeable future. Some economical reviews have published articles analyzing the industry and a constant discussion about game development is going on in the Internet. As this work is very much based on the current industry situation I will refer to many articles published in the web. Unfortunately the reliability of the articles published in Internet isn’t usually as high as the reliability of the conventional print media. But due to the relatively general nature of the Internet references used, that shouldn’t be a significant problem. Known sites like Gamasutra or Dailyradar have been used as sources of information as well as Internet newsgroups discussing game development. Unfortunately many of these Internet references will probably disappear after some time. Consequently, I have archived those references both in printed and electronic form. If the reader is interested in an Internet reference, which can’t be reached anymore, he or she can contact me in order to receive a copy of the referenced material.

This work has been done without any obligation towards any company in the interactive entertainment. I have conducted talks with people from Hybrid Holding Ltd. and Remedy Entertainment. Additionally I have received information from Monolith Productions and Numerical Design Ltd. Some of the information is sensitive

Chapter 1 Introduction 11

in the sense of corporate strategy. I stress that such information is not published in this work nor has been submitted to any third party.

1.5 Case Hybrid holding

I made two visits to the company and discussed with one of the key software architects Jouni Mannonen who deals with the licensing of Hybrid’s products. Additionally I talked with CTO Harri Holopainen who is mainly responsible for company strategy. Hybrid produces software specializing in 3D-computer graphics visualization. They don’t produce any games, but among other things they are licensing a graphics toolkit and other tools for game developers. The developers that have used their components have had international success, but Hybrid still remains considerably unknown outside the professional world.

We take some insight to the situation and analyze Hybrid’s strategy, pricing policy and visibility compared with the overall situation of the industry. Differing strategy and pricing schemes are considered. Also a SWOT analysis considering Hybrid’s current situation and future possibilities is conducted. Eventually some suggestions about the company strategy are given.

2 Industry overview

This chapter gives an overview of the industry. The first sections introduce the field including history, economical scope, demographics and typical production process. Then some of the top selling firms of the industry are introduced, as well as product characteristics and risks facing the industry. The last sections are dedicated to the economical analysis of the field.

2.1 Industry overview

In this section we take a look at the history and characteristics of the industry. The different gaming platforms are shortly introduced, as well as the changing demographics of the target audience.

2.1.1 History

Commercial video game production has its roots in the seventies. One of the breakthroughs was the release of the Atari Video Computer System, also known as Atari 2600 game console, introduced in October 1977. Console’s lifespan was more than ten years and altogether more than 25 million units were sold. Atari became a household name making millions and millions of dollars and employing over 10,000 workers. In the era of Atari, a game could be developed by a single person in a matter of days (ClassicGaming 1999). Chapter 2 Industry overview 13

Figure 2.1 Atari 2600, the dominant console of the seventies

During the last decades the industry has grown strongly and has become increasingly international and fiercely competitive. Atari has been dead for a long while and new firms have taken its place. Nintendo and Sega were the dominant players in the second half of eighties and beginning of nineties. Playstation made a very successful entry in 1994 and Microsoft is planning its entry with the Xbox. In 2001 altogether four new generation consoles will be fighting for the market share. In addition to the consoles, IBM PC compatibles and some other personal computers have been major gaming platforms during the last decades.

2.1.2 Different platforms

There is no single machine that dominating the gaming industry. Currently four gaming platforms can be identified: PC, console, Internet and mobile platforms. When measuring revenues, PC and console formats are the dominant platforms. Currently, consoles are increasing their market share at the cost of the PC share. On the other hand, a lot is expected from the emerging mobile (or wireless) platform (Mäntylä 2000).

Chapter 2 Industry overview 14

Competition is getting fiercer as the new generation consoles are arriving. According to a questionnaire made by Forrester Research, 90 percent of the experts agreed that Sony Playstation 2 would be the number one of the console platform (Lähteenmäki 2000). Though it will be facing serious competitors. According to its current plans Microsoft is going to enter the console market and launch its X-Box console in the autumn of 2001 (Laprad 2000). Microsoft’s marketing efforts tell something about their expectations and the fierce competition of the market. Altogether the firm is going to invest approximately 500 million USD to the launch of their console (Lettice 2000 b).

Figure 2.2 Sony Playstation 2, possibly the dominant console for the beginning of the new millennium

Internet based games are still a rather small thing, but they are increasing in popularity. At the moment two thirds from the industry’s revenues come from the console platform. The trend of increasing market share of the consoles and developers concentrating on developing games only for the console platform is likely to continue (Kainulainen 2000).

Chapter 2 Industry overview 15

A fourth gaming platform can be seen emerging, as games are already being made for the mobile platform. Due to the large number of people owning mobile phones, the platform has attracted large amounts of venture capital and is developing rapidly (Mäntylä 2000). The major domestic contenders are Springtoys Oy and Riot entertainment Oy. The competition includes Digital Bridges from the UK and Infusion from France. In order to maintain some level of consistency, this paper concentrates solely in the PC and console platform.

2.1.3 Scope of the industry

In 1999 the total sales of console, computer and Internet games in US totaled more than 6 billion USD coming close behind the revenues from the movie industry. Altogether the world wide sales of these games equaled almost 20 billion USD. Though, according to Interactive Digital Software Association IDSA half of the potential revenues were lost due to software piracy (Kainulainen 2000). In 1999 the combined European market was worth 5.4 billion USD surpassing the US market, which was then valued at 5.3 USD billion (Gamasutra 2000). Hit games make the majority of revenues. Effectively 5% of the games generate more than 50% of the revenues made in the industry (Kainulainen 2000). The growth is expected to remain strong and the emphasis is on console games. The forecasted revenues alone from the US console game market in 2005 are USD 30 billion (Lähteenmäki 2000).

2.1.4 Demographics

Videogames have become a very widely spread phenomenon. Still some years ago videogames were targeted for young audiences. The former dominant console game firms Nintendo and Sega had defined their target audience to be boys between 10 and 16 years. Sony decided to pursue larger audiences. Playstation’s marketing was deliberately targeted for more mature audiences and made console gaming a “cool”

Chapter 2 Industry overview 16

and acceptable experience also for grown-ups. This far Sony has managed to sell altogether 70 million Playstations (Latvanen 2000).

Now in the United States one third of the gamers are older than 35 years and 13 % are older than 50 years. The share of female gamers has also risen to 43 % as their average age is 29 years. Altogether 60 % of US residents told that they play interactive games. Effectively, gaming has become a family social activity. One fourth of the gamers play games with their parents and 27% of gamers play games with their spouse. Online gaming is growing strongly. Market analysts at Datamonitor have estimated that 2003 there will be some five million enthusiastic online gamers and about fifty million casual gamers (Latvanen 2000).

2.2 Contenders

The field of interactive entertainment industry is highly international. The physical locations of the developers and publishers have lost their importance. Consequently, a wide variety of nationalities are present in the industry. This section introduces the big global players and three Finnish firms. The total sales of interactive entertainment products in 1999 were 19 billion USD (Latvanen 2000). The markets are still highly dispersed. There are hundreds of developers. The number of publishers is smaller, but none of the largest firms could capture more than six percent of the total sales.

2.2.1 Worldwide heavyweights

The young industry has not yet consolidated and there are numerous firms competing in the field. Some of the big players include the US based Electronic Arts and the Japan based Konami. The revenues of Electronic Arts of the fiscal year 1999 totaled more than 1,2 billion USD and the net income totaled 72,7 million USD. The company had a presence in more than 75 countries operating both on PC and console platforms. The company is still growing strongly as the revenues were up 34% and the

Chapter 2 Industry overview 17

income was up 53% (Electronic Arts 1999). Konami’s net sales for the fiscal year that ended in march 2000 were more than 1,2 billion USD, operating income was 280 million USD and sales have been increasing strongly (UK-Wire 2000). Additionally it can be told that the game division of the Sony Corporation brought in approximately 40 percent of the total income of the enterprise during the fiscal year 1999 (Sony 1999). In the recent years industry’s sales have been growing with an average rate of 15% (Kainulainen 2000)

2.2.2 Finnish contenders

Also in Finland the revenues from games are getting close to the revenues of the movie industry. In 1999 the revenues of Finnish movie industry were 270 million FIM and the game industry had revenues equaling 250 million FIM. With the more rapid growth rate of the gaming industry, it is likely that the gaming industry will surpass the movie industry during the next few years (Kainulainen 2000).

In Finland there are now three firms producing game software for the PC and console platform. Housemarque released Supreme Snowboarding also known as Boarder Zone the last autumn. The total expenses including distribution and marketing totaled some 20 million FIM and this far the game has sold some 100 000 copies (Kainulainen 2000). Remedy Entertainment is working with the much-hyped Max Payne, and the game could become the first Finnish gaming breakthrough in the worldwide games market.

The third Finnish company is Hybrid Holding Ltd. It doesn’t have any in-house game production. Instead, it produces among other things the Surrender GL toolkit, aimed especially at game development. Hybrid has already had considerable success at licensing the toolkit. Among the licensees are some prominent names like Westwood Studios, Infogrames and Electronic Arts. Despite the technological excellence and the

Chapter 2 Industry overview 18

commercial success of the licensees, Hybrid is not very well known in the gaming industry.

2.3 Production process

The two major parties in a development process are the game developer and the publisher. The developer sells usually the publishing rights to a publisher that distributes the game to the retail channel. In some cases the developer is part of the same company as the developer, but generally the developers are individual firms.

Figure 2.3 displays a simple diagram representing a typical flow of a game development process. The developer largely controls the actual development process. It is possible that the producer names somebody controlling parts of the development, but still the developing team has the major part of responsibility. The developer manages then the flow downwards through the retail channels to the end customer.

Game Game Retail End developer publisher channel customers

Technology

developer

Outsourcing

Figure 2.3 Production chain

The boxes drawn with dashed line show the optional outsourcing of resources. The game developer can outsource varying resources including artistic resources or software technology used in the production of games. In this work we analyze technology licensing by going through the case of case of Hybrid Holding that is licensing for game production.

Chapter 2 Industry overview 19

2.4 Industry risks

As the industry has matured it has expanded strongly; competition is fiercer and the financial stakes have become significantly higher. Consequently, new measures have to be used in order to deal with the increasing risks. Many of these measures have been already in use for quite a while in the traditional software industry.

2.4.1 Increasing risks

In the gaming industry both the developer and the publisher are subject to significant risks. The industry is advancing with high speed and the future of the field is hard to forecast. The success of a game title depends on many things. Especially in the last years the breakthrough of new 3D-graphics acceleration techniques from companies such as Nvidia and 3Dfx have strongly changed the game development. Those companies are constantly pushing new hardware to the market in order to stay on the leading edge of technology. The development cycle for new graphics hardware is around six months and major changes in the low-level APIs happen on a yearly basis (Hybrid 2000). As graphical quality is of high importance in the majority of gaming genres, staying behind competition in those terms is not really an option for the game developers. This constant change has become an increasing challenge especially on the PC platform. In order to stay on the edge the developers have to stay tightly in touch with the hardware and API developers defining the specifications of the future.

As the technological change is swift the developers have to make educated guesses about the technology used by the average gamer and considerable effort is needed in order to keep the development tools up to date and aligned with the customer base. The problem is aggravated, as consumers tend to adopt technologies too early in the presence of network externalities (Choi 1996). By deciding to endorse some specific technology the engine developer might take the risk of supporting technologies that

Chapter 2 Industry overview 20

don’t get widely supported leading to drastically reduced market potential. Alternatively, software might demand too much, and only the gamers with the latest hardware could play the games, effectively leaving out the majority of the gaming audience and paying customers.

The size of the projects has also grown significantly. In the beginning of the nineties a group consisting of a handful of people could make a successful video game in a relatively short time. Development of a game lasted usually less than one year and software licensing was not common as the firms were using their proprietary solutions. Things changed in 1993 as Raven Software licensed a hybrid of the Wolfenstein and Doom engines from id software for a game called ShadowCaster. After that, an increasing amount of licensing agreements have been made in the gaming industry (Jackson 2000).

Today the budgets reserved for game production start resembling the budgets reserved for the lower end of the Hollywood movies. Currently an average videogame has a budget of $1.2 to $1.5 million (Gamasutra 2000). The time span for the production of a new game varies from one year to several years. The development teams are now comprised of dozens of people, each person having his or her dedicated role in the process. The teams include concept designers, programmers, graphic designers, sound designers, project managers etc. As the investments needed to complete the project get elevated, so do the risks of the financiers. Especially the smaller developers can run into problems when trying to find funding for their projects.

Finally, the complexity of the software has also increased significantly. Research and development of a game engine can take several years for several skilled programmers (Herz 1998). A special case is the prominent Unreal engine, which took several years to develop and cost Epic 2 million USD (Rausch 1998). Usually the majority of work when doing a game goes into making the game levels art, models, animation, and game-specific code (Sweeney 1999). Because engine performance can be critical, the

Chapter 2 Industry overview 21

entire game project can fail due to problems in the development. Most probably the engine production process will become even more complicated as more features have to be supported in order to stay competitive.

2.4.2 Risk reduction with technology licensing

In order to reduce the risks of game development the companies have been forced to change the way they work. Project management has become an invaluable tool. Despite efficient managerial tools, it is hard to foresee how the design and implementation of all the parts of the game will proceed.

Some parts of the project, like the progression of audiovisual design can be estimated usually pretty well. When the development process gets drastically delayed, it is usually due to problems in software development, especially in the engine development. Development of an engine can take several years - after which it has to be maintained in order to guarantee its functionality in the ever-changing hardware and software combinations of the gaming platforms.

The decision to license has to be made according to each individual project. At the moment there exists no individual solution, which would be suitable for all game development needs. One of the most respected engine developers, Tim Sweeney from Epic Games points out (Buecheler 2000):

If a developer wants features that current engines don't provide -- especially if those features are cornerstones of the game and large-scale technical undertakings -- then it's more sensible to build your own engine than to license.

On the other hand the engines licensed are becoming ever more flexible and feature rich. In many cases licensing can take care of large amount of the developer’s

Chapter 2 Industry overview 22

problems. By using a pre-existing game engine, game developers can decrease the workload that goes into programming a game and maintenance of the technology. Instead developers can decrease the risks involved in the project and focus on the game content design. Game engine licensing will also cut down the development time, which is good for the project funding. Even big publishers have started licensing technology instead of using in-house technology (Electronic Arts b 2000).

2.5 Product nature and market characteristics

The characteristics of the software industry differ from the traditional industrial models. In the traditional models both fixed and variable costs have significant roles. Things like research, development and putting up the production made the bulk of the fixed costs. Raw materials and the labor needed made up the variable part of the production costs. In the software industry the majority of costs are fixed. The final product, software, can be then copied and downloaded with minimal costs. Software and the manuals can be copied very cheaply on cd-rom discs or alternatively the Internet can be used to transfer the products to customers. The variable costs will largely incur from the service offered to customers. If the volume of products sold gets very high, the average production costs decrease towards the marginal costs. In absence of competition, a firm with low average costs can potentially reach elevated profit margins. Effectively, Microsoft, the dominant operations system producer, has been able to reach 92 percent gross profits margins (Shapiro et al. 1999, 21).

The software bought or licensed by a customer will usually be used for an extended period. Often the firms that have licensed a particular technology will license the following generations of the same technology. This is due to the fact that the technological changes are usually gradual. It is much easier to move to the next version of the familiar set of tools than start to use a different set of tools from another licensor. In other words, the customer has switching costs.

Chapter 2 Industry overview 23

The sales of a particularly successful game can exceed one million copies. The amount of licenses sold to the actual game developers is on the contrary usually relatively small (Jackson 200). This can lead to problems when trying to apply some of the traditional market models to the industry. Those models assume large sales volumes, and don’t apply to cases where total amount of licenses might be below ten.

The making of a basic graphics engine is a considerably straightforward task. For example Karsten Isakovic maintains an engine list, which contained at the time of writing 643 engine entries (Isakovic 2000). This amount is likely to increase with time, especially when advanced books about engine development can be found from bookshops (Eberly 2000). Even source code of several engines including the Original Quake engine can be freely downloaded for study and use (FilePlanet 2000). Although the development of a basic engine is easy, creating a commercially viable solution is a completely different task. At the moment the majority of game developers are using their proprietary engines in game production, but engine development is getting increasingly difficult. This follows from the need to include increasingly advanced features to the engine. Eventually, developing the needed know-how to create a viable proprietary engine can become prohibitively difficult. The increasing complexities lead to a situation where the barriers of entry in the industry are rising, making entry for a new company harder. I stress that this is more a future vision and not yet current reality.

As often with software, network externalities are likely. As the number of licensees increases, there will be more specific tools available for the specific engine or software library. An existing example is Adobe’s Photoshop image manipulation program. Due to the many users many plug-ins have been written for the program, increasing its functionality. As a result it becomes a more attractive option for new adopters, who might make more plug-ins for the program, making it even more valuable for the customer. This phenomenon is also known by the name of positive

Chapter 2 Industry overview 24

feedbacks or network effects. As the company with the largest market share enjoys the highest positive feedbacks, it becomes tempting to increase the market share by reducing the prices. After becoming the dominant player the company can raise it’s pricing, because its customers are more reluctant to switch due to the added value of the network externalities. Because a firm with a small, initial advantage in a network market has the best possibilities to increase its advantage, competition in network industries is often especially intense – at least until a clear winner emerges (Katz et al. 1994).

According to my industry inquiries the licensing agreements can’t be normally sold forward, in the case that a development project fails. This makes discriminatory pricing possible, as the licensees with lower pricing schemes can’t resell their contract to other potential licensees with higher propensity to pay for the contract.

Below is a list of the major features that characterize the licensed software tools in the interactive entertainment industry:

• Low variable costs

• Small number of licensees

• High switching costs for the licensee

• Network externalities & positive feedbacks

• Increasing barriers of entry

• No reselling of the licenses

2.6 Market structure considerations

Economics has many models describing different market structures. These models can be used in order to understand the markets and to analyze the possible company

Chapter 2 Industry overview 25

strategies. In the following sections I’ll explain several market models and regard their applicability to the interactive entertainment industry.

2.6.1 Monopoly and dominant firm model

Monopoly is probably the most famous from all the different market models. A firm can be defined as a monopoly when it is the only supplier of a product for which there are no close substitutes. A monopoly can set its pricing without fear from rivals undercutting prices. A monopoly faces a downward sloping demand curve and price is set above marginal costs when maximizing profits. Effectively less is sold than if the market was competitive, and there exists a deadweight loss to the society (Carlton et al. 132).

In the beginning of the nineties id Software was the dominant licensor of game engines. Especially the quake engine introduced in 1996 was groundbreaking and in its time the only 3D game engine in the market (Jackson 2000). As many companies didn’t posses the needed know-how to produce such games, id Software had practically a monopoly in the market. Id could charge high licensing fees, and a substantial part of company’s profits came from licensing. The situation has changed drastically during the nineties. Now there are already several high quality engines in the market. Consequently, the market can’t be modeled anymore as a monopoly.

If there exists a price setting firm in the market that faces smaller, price-taking firms, it is called a dominant firm. It typically has a large market share compared to the smaller price taking fringe firms. Generally it is not in the interest of the dominant firm to set the price so low that it would drive away all the competing fringe firms. The presence of fringe firms and the threat of entry keep the prices of the dominant firm lower than a monopoly would set. Fringe firms follow the price setting of the dominant firm. Whether the dominant firm can exercise its market power depends largely on the number of competitors that can enter the market, how their costs

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compare to those of the dominant firm, and how fast they can enter (Carlton et al. 157- 159).

The several versions of Id’s Quake engine used to be the dominant products in the industry. Nowadays several engines are seen to be very close substitutes for the Quake engine. The Unreal engine is probably the hardest competitor for the number one spot. Consequently the industry can’t be modeled with the dominant firm model either.

2.6.2 Perfect competition

Perfect competition is rarely encountered in the real world. By definition perfect competition occurs in a situation where all firms produce homogenous, perfectly divisible output and face no barriers to entry or exit. Producers and consumers have full information about products, no transaction costs exist, and the consumers are price takers (Carlton et al 87). Quite clearly the situation is different in the gaming industry. Consequently we regard the oligopoly model as the next option.

2.6.3 Oligopoly

In the oligopoly model the number of competitors is limited, fitting the scheme of game engine licensing. Oligopolies can be divided into cooperative and noncooperative models. We assume the gaming industry to be noncooperative in nature, i.e. no joint price setting between the companies is assumed. In an oligopoly there is a limited amount of companies and they know that they can affect the competitors by their pricing. Consequently oligopolists can’t ignore the actions of the competing firms (Carlton et al. 229). The number of firms in oligopoly is fixed and by definition no market entry is allowed (Carlton et al. 281).

In oligopoly the equilibrium price lies between that of competition and monopoly. Every firm maximizes its profits taking into account the actions of other firms. There is only one model depicting monopoly and competitive market, but several models

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from the noncooperative oligopoly exist. One explanation for the lack of a unified model is that market characteristics of real world oligopolies differ considerably (Carlton et al. 229-231).

The best-known oligopoly models are the Cournot, Bertrand, and Stackelberg models. In the Cournot and Stackelberg models, companies set output levels. In the Bertrand model, companies set prices. In the Cournot and Bertrand model the firms act simultaneously. In the Stackelberg model, one firm gets to decide its output level before the others. These differences in the models lead to differing equilibria in the models. All the oligopoly models can be seen as applications of game theory. (Carlton et al. 230-231).

Game theory analyzes the interactions between rational decision-makers who might not be able to fully predict the outcomes of their decisions. Certain assumptions about the oligopolistic players are made. Each market is assumed to have two or more participants. The participants are assumed to maximize their profits and each firm is aware that the decisions of the other companies can affect its profits. The equilibrium payoffs depend on the number of the firms, the rules of the game, and the length of the game. In the following sections we go through the most famous oligopoly models.

2.6.3.1 Cournot model

The French mathematician Augustin Cournot presented the first model of a noncooperative oligopoly already in 1963. Cournot assumed that each firm acts independently attempting to maximize its profits by choosing its output level. In the original model there is no entry of new firms, the competing products are assumed to be homogenous, the game is assumed to last only a single period, the demand curve is assumed to be a linear function of price, and the firms are assumed to have constant marginal costs. There are also more general models where some of the assumptions can be relaxed. Generally it is assumed that one of the companies adapts its actions according to its expectations about the strategies of the other companies. A best-

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response function is derived indicating the best action giving highest profits given its beliefs about the action taken by its rivals. The other firm derives a similar best response function in a similar manner (Carlton et al. 233-236). The Cournot duopoly price equilibrium lies between the competitive and monopolistic equilibria. When the number of competing firms increases, the price approaches the competitive prices (Carlton et al. 242).

The Cournot model isn’t really a viable model to describe the gaming industry. The model assumes that the firms set production volumes and the prices are determined in the markets. Software can be copied without any significant costs. Consequently, the artificial limiting of the amount of licenses sold doesn’t seem a reasonable idea.

2.6.3.2 Bertrand model

In Bertrand’s model, firms set prices rather than output levels. Competing firms are assumed to produce similar goods with similar costs. In the model, each firm believes its rival’s price is fixed and by cutting the price the firm is able to capture the market from its rivals. This leads to Bertrand equilibrium where marginal costs equal marginal price and no profits are made. Effectively this is the same as the social optimum in competitive equilibrium (Carlton et al. 244-246).

The Bertrand model fits this industry better than the Cournot model, because in this model the firms are price setters, which corresponds to the real world situation. The basic assumption about similar products makes the model unrealistic. Fortunately the Bertrand model can be extended allowing differentiated products, as the engines differ from each other in many ways. For example their feasibility for different purposes varies greatly as well as their pricing and the level of service offered.

2.6.3.3 Stackelberg model

In the Stackelberg model the firms set output levels and one of them acts before the others. The leader decides its output level and afterwards the other companies are

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ready to choose their optimal output levels according to their knowledge about the leader’s output. A company making an innovation and getting a natural first-mover advantage could be seen as an analogy. In two-player case the follower will use it’s Cournot best-response function to react to the output level of the leader. The leader accordingly maximizes its profits subject to the constraint that the follower firm chooses its corresponding output using its Cournot best-response function. Effectively the leader is better of than the follower (Carlton et al. 250).

The same reasons as with the Cournot model speak against using the Stackelberg model in the gaming industry. Output level setting doesn’t really fit the industry. Additionally, the leading company has to commit in a convincing manner to the output level it sets. This isn’t really possible in the software industry, where additional copies of products can be made easily available.

2.6.4 Oligopoly conclusions

All the basic oligopoly models have their limitations and none of them seems suitable enough to used as model of the engine licensing industry. The assumptions in the models are too severe making the models unrealistic in our situation. Consequently in the next sections we take a look at another model, the monopolistic competition model.

2.6.5 Monopolistic competition

In the monopolistic market model the products of the competing firms are viewed as being differentiated. The firms have some market power, which makes it possible to raise the prices of the products above the marginal cost. In contrast to oligopoly models, in this model firms have free entry to the market. Additionally, each firm has a downward sloping residual demand curve (Carlton et al. 281). Having a downward

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sloping residual demand curve means that the company can price over its marginal costs earning profits and effectively has some market power (Tirole 284).

The reason why a firm can price over marginal costs is that its product is viewed to be different from the competing products. If customers view products of the industry as imperfect substitutes, a firm may raise its price above that of the competition without losing all its customers. The game engines appear different for the licensing developers in the middle and also the end users can perceive the differences of the different underlying engines (Wojnarowicz 2000).

It's strange how every graphics engine has a completely different style. It's impossible not to tell one engine from the other. No one would confuse Half- Life for an Unreal engine game, for example. The reason is that there are features and characteristics of a graphics engine that are retained no matter who makes the game based on it.

The greater the perceived difference between the competing products, the more each firm can charge. Opposed to oligopoly, in monopolistic competition firms can freely enter and exit an industry. According to economic theory, this leads to a situation where firms enter the market until profits are driven to zero. In the monopolistic competition equilibrium firms face downward sloping demand curves and earn zero profits (Carlton et al. 315). Another interesting fact is that the lower the fixed costs of the companies, the higher the number of firms in a monopolistic competition industry. This is due to the fact that the lower the fixed costs, the higher the profits for any given number of firms in an industry (Carlton et al. 294).

The models of monopolistic competition with free entry and product differentiation can be divided into two major types. In the representative consumer model the firms compete for the same customers with differentiated products (Carlton et al. 281). In

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the spatial or location model, customers view products as having particular locations in geographical or product space (Carlton et al. 304).

2.6.5.1 Representative consumer model

In the representative consumer model all firms compete equally for all consumers who typically buy from one individual firm. Customers can be differentiated even if the content or the functionality of the products they are buying doesn’t actually differ. It is enough if the customers think that the products differ. An example can be found from the sales of different brands of Aspirin. Consumers often think that a branded Aspirin works better than a generic one, even though the products are chemically identical (Carlton et al. 282-285).

In the representative model, a firm’s demand varies as the prices of the other firms vary. A small change in the other firms pricing will result usually in a small change to the demand facing the firm. Effectively, the pricing of one brand exerts more constraint on another brand’s pricing the closer substitutes the competing products are. The primary impact of differentiation is that it makes the residual demand curve of the company steeper. In other words the company acquires some monopoly power (Carlton et al. 298).

Creating a model of monopolistic competition between firms with similar products is rather easy. A similar model with differentiated products complicates the model considerably. Each firm’s demand curve can differ from the demand curves of the competition so that a study of representative firm in the industry won’t be sufficient (Carlton et al. 298). Unfortunately creation of such a model is outside of the scope of this work.

2.6.5.2 Location models.

In the location models the customers prefer products that have certain characteristics or are sold by firms located near them. In the model the customers view certain

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products being closer substitutes than others. For example a product can have certain characteristics that the competing products lack. Similarly products sold near the customer are also close substitutes.

Maps in which consumers view each firm’s product as having a particular location in geographic or product space can be used to describe these models. In the software industry distance doesn’t matter so much in the traditional economies with tangible products. Products can be sent via Internet and service can be offered via electronic mail, telephone or with initial training sessions with licensee. Product positioning in the relative characteristic space is much more important. The closer the products are in the characteristic space, the closer substitutes they are. Effectively, it costs more to shop further away, or alternatively the customers receive less value from products that deviate from their ideal. Firms compete directly with other firms located near them in the characteristic space. The market power of a firm stems from the fact that the customers prefer to deal with nearest firm or to buy their favorite product. This gives the firms some monopoly power in the market (Carlton et al. 304). By locating their activities or targeting their product in the product space the company can alter its position relative to the competition.

2.6.6 Monopolistic competition conclusions

Of the models described in this chapter, monopolistic competition seems to describe the competitive environment of the industry in the best way Both the representative consumer model and the location model using product space analysis could be used to describe the market.

From a practical point of view, the representative consumer doesn’t seem very applicable. For example, a problem with the representative consumer model is to find appropriate demand and supply curves. The number of customers is very low and there are many dependencies, which are not taken into account in the model. The

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simple model just doesn’t seem to be appropriate in describing the industry dependencies. The model would be easier to apply to sales of products with higher volumes. An example of such markets could be the sales of the actual finished games to the consumers.

The location model is easier to apply in practice. One could use variables like product performance, level of service etc. as the dimensions of the product space. With varied location models using different variables a company could try to position its product strategically according its competition.

More elaborate dynamic noncooperative game theory models could be produced in order to study possible strategies. Game theory studies this field and offers many models describing different situations. For example Basar and Olsder discuss tree formulations and impact of information patterns on optimal strategy (Basar and Olsder 1982). Unfortunately such studies about the company strategy decision process are outside of the scope of this work.

2.7 Significance of customer information

The amount of information, that the potential licensees posses also affects their behavior. Due to lack of information two possible problems can emerge: Either the market doesn’t exist at all, or the product quality is different than in a world with perfect information. If the customers face products of good and bad quality, and are not able to observe the difference beforehand, they are not willing to pay more than the price corresponding to the inferior product. Effectively, this leads to product quality deterioration. Only products of inferior quality will be offered with the price, that the customers are willing to pay.

With imperfect price information, perfect competition will be impossible and the law of supply and demand and the law of single price won’t hold in the markets of limited

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information. This can lead to a situation where firms intentionally raise consumers’ search costs in order to obtain market power. On the other hand, if costs are high, information won’t be gathered and market inefficiencies will follow (Carlton et al. 554-555).

The situation where bad products drive out good products results usually from asymmetry of information. The seller knows more about the product than the buyer. If both buyers and sellers know the true quality of the products, prices will reflect the true value of the goods. Whether it pays for the buyer to obtain the information depends from the cost of obtaining it, as well as its benefits. When buyers can get information swiftly and economically, buyers obtain the information and markets function smoothly (Carlton et al. 562).

Seller can compensate the lack of buyer knowledge using several methods. Using guarantees or warranties the producer can try to convince the buyer about the quality of their products. By providing information these companies are capable of charging higher prices reflecting the higher quality of their goods. This will however only happen if the information conveyed is credible (Carlton et al. 562). These guarantees of quality can come in many forms. Guarantees and other liability laws are the most common ones. Reputation or expert statements about the product can also assure the potential customers. Standards and certificates can tell that the product meets some predefined standards.

In the case of licensing game engines or graphics libraries, the previous products made with the software can work as an assurance of the product quality. Additionally many companies use customer testimonials to assure potential customers about the high quality of their product. Discussions about the different qualities of competing products can be found in the newsgroups. Potential licensees can also contact existing licensees and interview them about the characteristics of some product. Generally the quality of the products can be assessed to a considerable extent before the decision to

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obtain a license. The fact that during my investigations I didn’t run into any severe complaints about licensed technologies tells about licensee’s realistic expectations of the product quality.

3 Developer strategy

Today both developing games and game engines have become vast tasks. Developing a game from a game concept to a finished product and getting it to the retail shelves takes usually several years. The development times have been prolonging lately and some of the latest games released, or soon to be released, have been in development for more than three years (Harris 2000). As the games get more complicated and include added visual finesse, the game engines also have to be more complex in order to cope with the demands. Correspondingly, the development times of the engines have become prolonged. At the moment it is broadly seen that the development of a game engine corresponding to current gaming needs takes two years or more. Due to the growing complexities many developers don't like to call their engines mere engines, and refer to them as game OS - Operating Systems (MacLellan 2000). This way they try to accentuate the flexibility and wide possibilities offered by their product.

On the other hand, the potential licensees might not be always willing to license outside technology. The licensors have problems especially when licensing technology to their direct competitors. Empirical evidence suggests that firms are often reluctant to license technology from firms that are perceived as tough competitors (Rockett 1990). Chapter 3 Developer strategy 37

3.1 Two approaches to engine licensing

When creating a successful game, a functional and capable game engine has become an indispensable necessity. Still, in the beginning of nineties a game engine was seen as a byproduct of a game development project. Id Software started the actual engine licensing. They noticed that after the completion of a game project, the corresponding engine and tools could be licensed creating additional revenues for the firm. At present a new breed of companies has emerged that solely concentrate their efforts in the engine development and don’t develop any in-house games. In the following sections we take a closer look at the two differing approaches.

3.1.1 Engine as a byproduct of game development

Formerly the practice was that the engine was a byproduct of a game. After the game had been produced the engine could be licensed in order to create extra profits. After all, the marginal cost of licensing is very small. Licensing was seen as a secondary form of income. For example id Software’s former employee denied any conscious marketing efforts made to acquire licensees (Jackson 2000).

The costs of copying the software are next to nothing. The majority of the costs to the licensor incur from customer support and the software documentation helping the licensee to adopt the new product. Development times for games have been extending during the past years. Accordingly, after the game design has been agreed upon, the efforts of a game development team can be divided into engine and actual game content development. This has both positive and negative consequences.

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Creating an engine in association with a game has its advantages, as the technology can be tested in-house and then communication is usually swift and efficient. Additionally, the game produced using the engine can serve as an assertion of the technological quality of the engine. During an interview for GameSpy, a well-known engine designer, Tim Sweeney from Epic Games, largely responsible for the design of the Unreal engine, crushes the idea of pure engine development (Buecheler 2000 a):

A team developing solely an engine is like a blind artist trying to draw a painting. No matter how good their "grand plan" is at the outset, there's no feedback guiding the brush stokes. I guess the blind artist could ask an observer (read: engine licensee), "So, how do you like my painting now?" But something important is lost in the translation.

In another interview Sweeney justifies his opinion with the distribution of Epic’s revenue streams (Jackson 2000):

The games make several times more money than the engine does. Before the original Unreal game shipped licensing revenue was about even with other revenue sources (including revenue from older games and publishing advances toward Unreal) but once Unreal money started coming in, it quickly amounted to much more than we had earned from licensing. You can't make a viable business from engine licensing. But if you make a game that sells a million copies like Unreal has and you have great development tools and support materials then it is possible to make engine licensing a viable portion of your business

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If looking for downsides of the combined game and engine production, one disadvantage is the division of the resources of the development team. This will also delay the arrival of the engine to the licensing market and giving possibly advantage to companies only concentrating on the engine development. On the other hand, the game development team is also part of the company and will contribute possibly the major part of the revenues to the firm. Additionally, as in Epic’s case, a successful game will be extremely good publicity for a game engine.

3.1.2 Pure engines

In the last years several companies developing purely game engines and tools with no proprietary game development have emerged. These companies create engines and tools needed for game development, and license them to outside game developers. This approach divides the process of tool and content development. Co-operation is however needed in order to ensure the suitability of the tools to the customer. Some major examples of these companies are the domestic Hybrid with the SurRender toolkit and Numerical Design with the NetImmerse engine. If Tim Sweeney crushed the idea of pure tool development, John Austin from Numerical Design has a totally different point of view (Buecheler 2000 b):

By focusing specifically on the engine, we believe we can deliver to developers a better total package - features, support, and price. We don't limit ourselves to the needs of our own internal title, we address the requirements of lots of customers and this gives our feature set incredible breadth. We pour an incredible amount of effort into documentation, examples, and tutorials that make it easy to use.

Effectively, specialization purely to the engine and tool development allows better concentration of the resources. This might make better customer service possible, or it

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might be important when the developer is small and can’t afford to diversify its resources. Anyhow, in order to succeed, using this strategy the company needs partners using its technology to develop games. Obviously the company can’t make any revenues if it can’t get its product licensed. This creates barriers to entry, as it is unlikely that companies are willing to license from a newcomer without experience in the field. Secondly, the success of the licensee is crucial, as it will generate additional revenues to the licensor. The added revenues are likely to come in the form of further licensing deals and added visibility in the marketplace.

3.1.3 Conclusions

Combining game and engine development is not the only solution. There have been several more or less successful attempts to do business by concentrating in engine licensing. Some of the attempts have faded away like the Genesis 3D engine from Eclipse. On the other hand companies like Hybrid, Criterion, and Numerical Design have shown that companies concentrating purely in engine and tool development can be successful in the marketplace. However additional marketing efforts might be needed, as these companies don’t get publicity for their products. At the moment those companies have already acquired considerable number of licensees for their products. Only time will finally tell, if the strategy is viable. At least at the moment, the companies doing pure licensing to other developers seem to have considerable success.

In this work we don’t consider the strategy of combined game development and engine licensing. We assume the point of view of a company producing only software tools. Combined game production and engine licensing is not considered at all. This is largely due to the fact that Hybrid is used as a case example at the end of this work.

Chapter 3 Developer strategy 41

3.2 R&D strategy

Constant research and development race reigns in the software development in the interactive entertainment industry. Technological excellence is almost always a crucial point for the success of a product. The eventual engine rendering the gaming experience is one of the main elements in this equation. Without an adequate engine it is difficult to create a convincing gaming experience, and a commercially successful product. Features like performance measured in frames drawn per second, bump mapping and skeletal animation are some of the terms that are used to market the final products today.

The interactive entertainment is strongly advancing in the sense of the technology used, and there are always some products seen as the technology leaders in the field. Using these most advanced tools gives the developer the chance to increase their sales in the form of added visual quality and the credibility due to a known engine. Consequently, technological excellence has to be one of the core competencies for a developer producing game engines or graphics libraries.

3.2.1 Technology leaders

As in the other industry branches, also in the game engine development there are technology leaders and followers. During the nineties the dominating company in the field of game engine development was the US based id Software. Their series of games include games like Wolfenstein, released in 1991, and lastly Quake 3 Arena published in 1999. Id’s games have pushed the envelope of game engine technology with every title release. In the first half of the nineties, game engine development was a considerably straightforward task; almost all the development studios used their proprietary engines in their game production. Gradually the technology advanced, and the engine development became increasingly complex and thereby more exposed to the risk of failure. Many companies became worried about the risks of engine

Chapter 3 Developer strategy 42

development and opted for a diminished risk, and decided to license technology from companies like id Software.

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The competition is becoming increasingly intense. In 1998, a game called Unreal from EPIC games was published. Its Unreal engine offered comparable visual quality as the Quake II engine. During the last years the Quake and the Unreal engines have been dominating the licensing of game engines. Using the latest technology for game development seems to be a necessity for a blockbuster game and consequently the two major engines have been able to capitalize on this.

There can only be one or two game engines that are considered to be the technology leaders in the market. These engines are accordingly the most desired solutions for game development, and their developers have the most market power and can reap the largest revenues for their products. Consequently, it becomes desirable for a company participating in the engine development to aim for the technological lead in order to reach some of that monopoly power and added profits. However the technological quality of an engine doesn’t always decide supremacy between engines. The current best-known engines are still the Unreal and Quake III engines. In some sense the Quake III engine could be viewed as technologically superior, but the Unreal engine has profited largely due to the Unreal Tournament game, which became the most awarded game of 1999. This might be a risk for companies concentrating to producing only engines, as they can’t guarantee the quality of the games that are produced using their tools.

It seems that all developers want to give the impression of technological excellence. They strive to support the latest features offered by the new generations of Hardware and varying APIs. Effectively, the companies try to convince potential customers that it belongs to the technology leaders.

3.2.2 Fringe competition

As the games differ, so do the demands for the game engines. Some engines are better suited for specific tasks. For example the major engines are suitable for only a fraction

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of the games being developed. Generally, an engine created for rendering closed environments like scenes inside buildings are not good for rendering large open areas. This creates a need for customized solutions and gives market possibilities for smaller developers. Even though an engine is suitable for a game, it might need some enhancements. This too creates fringe markets for companies specializing for customized expert solutions. One example of such specialized products is the Surrender Umbra visibility optimizer from Hybrid. Umbra adds to the value of existing solutions without replacing them.

Often the technologically leading engines are also expensive to license. The licensing fees for Unreal and Quake engines exceed half a million USD (Jackson 2000). Meanwhile the Lithtech engine from Monolith could be licensed for 250 000 USD, or the Surrender3D toolkit from Hybrid could be licensed for 75 000 USD (in August 2000). Some of the price difference compared to the more expensive engines might be explained with the added tools of the more expensive engines. But a large part of the difference is explained by the fame and credibility of the hyped engines.

As not all game projects need the additional functionality of the tools provided with the more expensive packages, the cheaper solution could be a better choice for some licensees. The cheaper option can often offer better value, decreased production costs, and increased profits. Consequently, it might be a better strategy for a small firm to specialize into offering custom solutions instead of trying to create the number one engine in the market. This is exactly what Hybrid is trying to do with their Umbra visibility optimizer.

3.3 Significance of market share

There are some network externalities in the industry. For example a dominant SDK (Software Developer Kit) draws more supporting software tools from the third party developers strengthening the functionality of the original SDK. It is possible that some

Chapter 3 Developer strategy 45

major game development SDKs will form and take the dominant position in the market.

If dominant players emerge, it is very hard for the competitors to increase their market share. This is due to the fact that there exists very high switching costs for the licensees, who have gotten used to some particular technology. Additionally there might exist above mentioned network externalities in the form of third party applications supporting the dominant SDK.

4 Licensing

Among joint ventures and other alliances licensing is one of the few significant methods of technology transfer between firms. Due to varying industry characteristics, significant differences in the licensing terms between various industries exist. Differences exist in the degree of exclusive licensing, cross-licensing, licensing to related versus unrelated parties etc (Bhara 2000). The next sections take a look at theoretical and practical considerations of technology licensing in interactive software industry.

4.1 Theory considerations

The first sections take a look at features characterizing the innovation process and licensing in the interactive software industry.

4.1.1 Evolutionary flow of innovations

In development of software tools a flow of sequential innovations is usual. The software package gradually evolves as newer versions replace older versions. Generally, evolutionary innovations are often licensed unlike drastic innovations, which give monopoly power to the innovator. In case of drastic innovations the innovator wants to capitalize alone on its monopoly power yielding elevated profit margins (Katz et al. 1985). If a firm has a substantial technological lead, it will be reluctant to make innovations that are easily imitated. Consequently large investments to new technologies aren’t worthwhile as they can be easily imitated and the Chapter 4 Licensing 47

technological lead is lost. It is more efficient to follow the technological level of the competitors and constantly create minor innovations in order to retain differentiation and market power.

An interesting point is that constant technological and licensing can be socially beneficial. The revenues from licensing form incentives to engage in research and development activities. New advanced technology is developed in hope for future licensing revenues, but at the same time the industry is pushed forward generally increasing the consumer welfare (Katz et al. 1986).

4.1.2 Asymmetric information about the product

Opportunistic possibilities can easily rise in technology exchanges. The licensor has usually near perfect information about the value of the product being licensed. On the other hand, it is hard for the licensee to define accurately the value of the license and it will be reluctant to undertake the investment. This can lead to no licensing at all or inventing around, as the potential licensee imitates the technology offered.

Often used example of inferior product market is the market for the used cars. Used cars are individual products and no perfect a priori knowledge can be obtained. The situation is different with software, as all the licenses are basically similar. As the number of the licensees increases so does the amount of information about the quality the software license. As the products are identical this increased information guarantees the quality of the license.

A successful end product created utilizing the licensed software can work as a guarantee of the quality. Secondly, software can be usually obtained for a free test period quality assurance. Licensor can also signal the quality of the product by output- based license payment (Gallini et al. 1990). Consequently, asymmetric information hasn’t posed any major problems for licensing in the interactive entertainment industry.

Chapter 4 Licensing 48

4.1.3 Switching costs

Switching costs exist, if the previous customers have costs of switching to a competitor’s product, even when the two firms’ products are functionally identical. The switching costs give licensor firms a degree of market power over their customers, which have to license the technology repeatedly. Consequently, firms’ current market shares are important determinants of their future profits. Each of the licensor firms faces a trade-off. The licensor can invest in market share by charging price that attracts new customers who will be valuable repeat-purchasers in the future, or alternatively it can harvest profits by charging high prices. Klemperer lists six factors inducing switching costs (Klemperer 1995):

• Need for compatibility with existing equipment

• Transaction costs of switching suppliers

• Costs of learning to use new brands

• Uncertainty about the quality of untested brands

• Discount coupons and similar devices

• Psychological costs of switching, or non-economic “brand-loyalty”

Switching costs are the rule in software technology, but the costs can be reduced by the entrant. For example, Microsoft has reduced the switching costs of WordPerfect users migrating to its product. Microsoft Word has specialized help functions for former WordPerfect users and converting WordPerfect files into Word format has been made easy. Instead of drastic product switch, a more evolutionary migration path is offered. This strategy can be employed even by relatively small players (Shapiro 1999, 192).

Chapter 4 Licensing 49

4.1.4 Protection of intellectual rights

By obtaining a software license in interactive entertainment industry, the licensee will usually obtain the source code of the engine and also the source code of the included design tools and maybe source code of games made by the licensor. The source code has to be included so that the licensees have the ability to modify the licensed tools to match their own needs. After having the source code the licensee could do a complete rewrite of the engine. Subsequently the licensee could claim that the rewritten engine is a proprietary piece of software, and avoid additional licensing fees. This can be avoided by the licensor by constant research and development; keeping the technology followers behind with a mutually beneficial licensing agreement.

In more traditional industries intellectual property is sometimes protected by licensing an older version of the technology (Rockett 1990 b). For example, the firm may have a process, which it is continually improving, so older and newer versions are available. The firm can decide which version of the technology it wants to license. This is not generally possible in the interactive software industry. As high audiovisual quality is demanded from a top selling games, the leading developers are only willing to license the latest technology. The price aware budget developers might be a more interesting target group. On the other hand, the number of licensed technologies offered increases costs, as more software versions have to be supported in the same time.

The dissemination of information can be also decelerated by exclusive licensing contracts. Though, this is not usually the case in software industry. The motivation for getting an exclusive license is to deny the access of competitors to the technology, and leverage the advanced technology for elevated profits (Oster 1995). In the interactive entertainment industry, similar products are widely available and the motivation for exclusive licensing doesn’t exist. During my study of licensing in interactive entertainment industry I didn’t run into any case of exclusive licensing.

Chapter 4 Licensing 50

The technology developers can’t protect their technology by patents and they have no practical possibilities to hide the details of their technology. This leads to a situation where the developers have to continuously improve their technology so that their customers are motivated to license the products also in the future.

4.2 Licensor considerations

Licensing of the engines is very logical for the developer. After an engine has been used for a proprietary project it can be copied and licensed limitlessly without any significant costs creating additional revenues. For example, one of the most licensed engines at the moment is probably the Unreal engine from Epic games. In the beginning of March 2000 it had been licensed to more than 16 developers. To maintain constant flow of licensing revenues from the engine the company has to keep updating the product in order to keep it competitive.

In the near future the number of licensees of external software technologies is likely to be increasing, as the engine and tool software get more complicated. The development will get more intricate and the risk of failure will increase considerably (Herz 2000). By licensing tested and reliable technology these risks can be decreased. Probably a decreasing amount of companies is willing to take the risk of creating their own proprietary engines in the future. This creates positive prospects in the form of added revenues for the companies that have currently successful engines. This can be one reason for the low licensing prices that some companies offer. The companies want to increase their current market share and hope that the switching costs will keep the clients licensing their products also in the future. The higher profits are expected to come in the future.

Chapter 4 Licensing 51

4.3 Licensee considerations

Normally the primary reason for the licensee to license is to decrease the risks of the development project. Secondly, licensing can give instant access to new technology to the licensee. This can be crucial, as many game genres have heavy emphasis on the quality of the visual and aural experience. On the other hand, the use of a well-known established engine could give added credibility to the game in the eyes of the customers.

One of the drawbacks of engine licensing is the price that has to be paid for the license. Though the potential licensee is currently in a good situation. As there are currently several competing high quality products available for licensing, the licensee should be able to get a license with a very competitive price.

Another disadvantage is that the technology licensed won’t be the most advanced solution in the market, due to the fact the same technology can equally be licensed by competing developers. This is a clear disadvantage due to the fact the latest technology and audiovisual advances make the titles more successful. Fortunately the latest technology is not the only thing that counts. A good example is Half-life, which used licensed technology. It was elected by many publications to be the game of the year 1999. Brian Hook, one of the prominent industry persons, who has worked for companies like 3Dfx, id Software and Verant Interactive, agrees that creating a cutting-edge engine is not synonymous with creating a game that is fun to play (Jackson 2000 a, b):

People are recognizing that successful games are ones that are fun, not necessarily the ones that look the best. So there's a point where your technology just needs to be "good enough", and if that's the case a licensed technology may be the way to go.

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4.4 Increasing significance of service & partnership

In order to ease the adoption of their technology, the licensors have traditionally followed general design principles, developed some tools to be used with the engine and documented the code and prepared manuals to explain the use of their product. Currently, as competition between game engines is heating, the technological competence won’t be the only measure when the licensee compares the different offerings. Additional value increasing services have to be offered in order to be competitive in the current market.

Typically problems will appear in the beginning as the licensee adopts new technology from the licensor. In the best case for the licensor, the licensor and licensee enter into cooperation during the production cycle. This usually strengthens the business relation, gives consistent customer feedback, and increases the switching costs of the licensee making the entry for newcomers harder.

4.5 Real world licensing

There were some difficulties gathering information on licensing in interactive entertainment industry. Especially the dominant players are reluctant to publish their licensing conditions. The challengers on the other hand even published their licensing conditions publicly on their corporate web sites. This follows quite clearly from the fact that they are competing with lower prices against the more established licensors.

4.5.1 Major licensors

At the moment the Quake and Unreal engines are the most known, and most expensive licensing options. The Quake 3 engine is still probably the most expensive engine (Jackson 2000):

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The flat fee for the license ranged from 400,000 to 1 million dollars with the royalty fees varying based on the amount of the flat fee. At the 400,000 dollar mark approximately 10% or more of the profits from the game went to id software while at the 1 million dollar mark a very small royalty percentage would be awarded to id. With these figures in mind, Quake II engine licensing would have amounted to between 5 and 10 million dollars if not more.

Neither John Carmack nor Todd Hollenshead replied to several email requests for an interview. I wrote Mark Rein from Epic Games Inc., inquiring about the licensing conditions of the other prominent product, the Unreal engine. He wasn’t willing to answer any of the pricing questions. Again some information was to be found in the Internet. Industry analysts have estimated the value of the Unreal license to be worth approximately 500,000 USD (Rausch 1998).

4.5.2 Challengers

Understandably challengers like Monolith, Numerical Design and Hybrid have to settle for lower licensing fees. Monolith’s Lithtech is the most expensive option with the licensing price of 250000 USD. Hybrid is willing to license its SurRender GL package for 75000 USD and Numerical Design’s NetImmerse has prices comparable to Hybrid. Lithtech’s higher price is explained by several facts. It is the most famous one from the three. Its games Blood, Blood II and Shogo have been commercially successful. The source code for Blood II and Shogo is included in Lithtech’s licensing deal. SurRender and NetImmerse aren’t really associated with any hit games, neither do they include source code for any commercially successful game.

The pricing seems rather rational in the sense that the products that have been used in the most successful games carry the highest price tags. Both Quake and Unreal engines are advanced in terms of graphical quality and come equipped with extensive

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developer tools. Part of the higher price surely comes from the added visibility and hype. The smaller players have to compete with price in order to gain market share and credibility so that they can lift their prices later.

Personally I feel that the prices seem rather low especially at the lower end. All these products are very advanced, and have taken several years of research and development. In another segment of software development I would expect to see price tags that would be multiples of these prices. Firstly, the competing licensors push the prices down. Secondly, the potential licensees often go for an in-house solution, as it will surely satisfy their needs. This leaves little possibilities for higher pricing. Maybe in the future as the software technology production times get even longer and barriers of entry get higher, the surviving technology developers reach higher profit levels.

5 Pricing schemes

5.1 Production costs

The production cycle to create a new engine lasts several years. After this, new revisions are usually created that support the added features. The maintenance and updating take less effort than the creation of a new engine. Due to constant technological changes, some updating has to be done continuously. The original structure can usually be maintained for several years before a full redesign and rewrite of the code is needed. Typically the lifespan of an engine before a rewrite is some two years. Some updating of the technology is needed during that time. As the software and the accompanying manuals can be copied easily, the cost structure consists of high fixed costs and minor marginal costs.

5.2 License pricing

The nature of licensing contract depends on several factors: how drastic the innovation is, the asymmetric information between the parties and the capability of the licensee to imitate the technology being offered (Gallini et al. 1990). The optimal licensing contract consists, in general, of a mix of a fixed fee and royalties (Bousquet et al. 1996)

In the interactive entertainment industry two major pricing models are currently used: a fixed fee model and fixed fee plus royalties model. The pure royalty model is practically non-existent in the industry. In the next sections we take a look at the reasons behind those conventions. Chapter 5 Pricing schemes 56

5.2.1 Fixed fee

Fixed fee pricing seems to be the most commonly used pricing scheme in the gaming industry. This is largely credited to the ease of the lump-sum payment according to Hybrid’s Harri Holopainen. It is difficult to trace the cumulated sales of the products and at the end of the product life cycle games are often sold with a considerable discount. This might lead to some complications with royalty based pricing. The use of fixed fee pricing makes it easier for the licensee to set the pricing and doesn’t force to exact sales monitoring. Another reason for the use of the lump-sum payment has been said to be the instant nature of the payment. The developer gets the payment immediately and can use it to manage the current projects without approximating and discounting a flow of unsure payments.

5.2.2 Fixed fee & royalties

The second licensing option for game development tools is the combination of a fixed fee and royalties. Unfortunately I didn’t get exact information about the division of licensing agreements into fixed fee and to fixed fee and royalty agreements. My general feeling is that the fixed fee only agreements seem more popular.

One problem of royalties is the monitoring of sales numbers. This scheme becomes also difficult in the sense that the price of end products declines often quite rapidly. The games can be sold with a reduced price already after some months after of their launch. A more serious reason for fixed fee only pricing is the fact that the developing licensors have been often low on reserves and have preferred early cash flows. This follows from the fact that game development has been an insecure and not always lucrative business. Consequently, it hasn’t attracted venture capital, and many developers are often short on cash.

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Secondly, relatively many of the game development projects are cancelled. In those cases the licensor would also loose the income from royalties. In that light the engine licensors are probably more likely to make agreements including royalties with firms that have some game developing experience and success, as those firms are more likely to finish their projects.

5.2.3 Royalties only

Licensors can signal high product quality with output-based (or royalty) license pricing (Gallini et al. 1990). However, pricing models that are based purely on royalties are almost unknown in the industry. This is due to the fact that there is a considerably high probability that the product won’t ever be finished. As a known recruiter in the interactive entertainment industry, Mary Margaret, wrote (Margaret 2000):

Very few technology providers will be willing to let you use the engine without paying a significant portion of the licensing fee up front. They do this for a good reason - it costs them money to support their developers and they want to eliminate anyone who isn't funded well enough to go the distance.

The fixed fee or fixed fee plus royalty might be generally better solutions. But they might attract high-risk customers with a high probability of defaulting, and leaving the licensor with only the initial payments.

Secondly, in purely royalty based licensing cash flows would start after the product is in the sales channel. As many of the smaller developers don’t have very deep pockets, early payments are preferred over the delayed ones.

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5.3 Discriminatory pricing

As the different licensors have varying products and reputations they have some market power. In order to maximize profits firms may use nonuniform pricing by charging customers different prices for the same product or charging a single customer a price that varies depending on how may units the customer buys. Some common examples of discriminatory pricing are student discounts and product rebates. Price discrimination is profitable because consumers who value the good the most pay more than if prices were uniform. Effectively the purpose of all methods of price discrimination is to capture as much consumer surplus as possible and redistribute the consumer surplus to the producer (Carlton et al. 1994, 431-438). On the other hand, in some special cases the price competition by imperfectly competitive firms may intensify competition leading to lower prices for all customers. The possible escalation of competition may make firms worse off, and as result firms may wish to avoid the discriminatory outcome (Corts 1998).

5.3.1 First degree price discrimination

First degree price discrimination happens in a situation where a firm can assess the maximum amount that each of their customers is willing to pay. Ideally, firm can charge each of its customers the maximum that they are willing to pay and absorb all the consumer surplus (Shapiro et al. 1999, 40-42). In practice, no firm has perfect information about how much its customers are willing to pay, and won’t be able to pursue perfect first-degree price discrimination. Firm may still have enough information to imperfectly price discriminate.

Airline companies offer an example of first-degree price discrimination. The fare may depend on when you book, what restrictions you are willing accept, and what your travel history has been. A more relevant example is the pricing used by the online database provider Lexis-Nexis. It sells to virtually every user with a different price.

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The price paid may depend on what kind of enterprise you are, the size of the organization, time of accessing the databases, cumulated usage of the database, and what kind of information is accessed (Shapiro et al. 1999, 41).

5.3.2 Third degree price discrimination

More likely than to assess what each customer is willing to pay the company can determine whether a customer belongs to some larger customer group. Each of these groups has a different demand and the groups can be charged different prices. If resale of the goods can be prevented, it can be profitable to set different prices for the different groups. This pricing scheme is called third-degree price discrimination (Carlton et al. 443). One example of third-degree price discrimination are different customer prices for products sold in different geographical locations. Another division might be a division into price conscious and to not so price conscious customers.

Price discrimination can begin by estimating the demand elasticities of the current and potential customers. Varying methods can be used, but they are out of scope of this work. As the characteristics of the current and especially potential customers are estimated, varying pricing schemes can be established.

5.3.3 Second degree price discrimination

Second degree price discrimination has been also called versioning. Users are offered a product line and choose the version of the product most appropriate for them. Shapiro names two basic principles for designing a product line of information goods (Shapiro 1999, 39):

• Versions tailored to the needs of different customers. A full line of products maximizes the total value of the offering.

• Versions should serve the needs of different groups of customers. Emphasizing customer differences allows to extract more of the value created, as each customer selects the version that best meets his or her needs.

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The applicability of the above mentioned principles depends from the products sold and the nature of the market. There are numerous ways to differentiate and version products, and next section takes a closer look at the possible versioning strategies in software industry.

5.4 Product versioning

This section takes a more thorough look at the possible versioning strategies. The product offerings can be differentiated. Same product can be sold with varying price according to sales volumes, complementing products can be bundled, quality and corresponding price of the offering can be varied etc. The fundamental idea is value based pricing. Product variations are sold at different prices to different customers according to their willingness to pay.

5.4.1 Single two-part tariff

In a two-part tariff scheme a firm charges a customer a fee for the right to buy as many units of the product as the customer wants at a specified price. For example customers of telephone operators have usually monthly fixed fees and charge extra for each call that is made. The idea behind two-part tariffs is to distinguish between clients that value the products differently and accordingly have different demands as presented in figure 5.1.

If the firm has perfect information about its clients and it can prevent resale of its goods and achieve perfect price discrimination. The firm achieves perfect price discrimination by charging each of its customers a price equal its marginal cost and additionally extracting the customer surplus by charging a fixed fee equal to the customer surplus (Carlton et al. 1994, 465).

In many cases the firm lacks specific knowledge of each individual customer’s demand. Even though the firm knows the general distribution of demand, it might be

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unable to determine the group to which a particular customer belongs. In figure 5.1 two demand curves present the demands for two types of customers. The first customer can be charged a lump-sum T1 and the second firm can be charged a lump- sum T2 in order to extract the entire consumer surplus. It the firm charges a low price, it sells more of its product and can charge a higher lump-sum fee. The sum can’t be higher than T1, if the company doesn’t want exclude the type 1 customer. The optimal two-part tariff normally generates more profits than a single price. This is due to the fact that a single price model is a special type of two-part tariff: a two-part tariff with a zero lump-sum (Carlton et al. 1994, 462-464).

Customer surplus with zero $ $ lump-sum fee

T1 T2 Price Price

Demand curve, customer 1 Demand curve, customer 2 (Marginal customer)

Quantity, Q Quantity, Q

Figure 5.1 Demand curves depicting two customers having different demands.

The model can be also viewed as depicting two charges for two different products. One example could be a photocopy machine. The firm charges first a lump sum fee for the machine and then an additional service and material fee for each copy made. Carlton et al. show that the optimal usage-sensitive price tends to exceed its marginal cost, but the fixed charge may be below the actual cost of the item. Generally, the fixed charge increases as the difference between the average quantity bought and the quantity bought by the marginal customer increases (Carlton et al. 1994, 464).

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One way to apply two part tariffs to software licensing would be to charge a lump-sum for the right to use the software and then additionally charge a predefined sum for each product that is made by the licensor. A fixed fee for the basic package including the software and documentation would be paid, added services like support could be then charged on the basis of use. The problem with this approach is the difficulty of the monitoring of the use of the added services. This would call for an automated system to track the sales of the added services.

Another form of two-part tariffs would be to define the software package as the primary product and the service required in the use the product could be then considered as the secondary product. By varying the amount and length of service offered varying packages could be created offering the possibility to price discriminate.

5.4.2 Two two-part tariffs

In the two two-part tariff model the company can charge the clients two different combinations of lump-sums and usage fees. Again the firm is aware that there are two types of customers in the market, but it isn’t able to recognize them. Consequently the firm can let its clients choose their pricing scheme. It offers two packages: one with low lump-sum payment and high usage fees and another package with high lump-sum payment and low usage fees.

The customers then select by themselves, which of the models suits them better. Common examples of such pricing are the packages offered by the mobile telephone operators. People making less phone calls are offered a contract with a low fixed fee and high usage fees, and people making many calls can take a contract with a high fixed fee and low usage fees, which is visualized in the figure 5.2. When buying small quantities the customers are better off using the schedule 1. When the amount bought is bigger than q* it becomes more economical to use the schedule 2.

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Schedule 1: Low fixed & high usage Expenditure Schedule 2: High fixed & low usage

Price after self selection

q* Quantity, q

Fig 5.2 Expenditures with two two-part tariffs.

Naturally the seller or licensor chooses its two two-part tariff schedule to maximize its profits. The firm provides a choice of two two-part tariffs in order to separate the customers into two different groups. Thus it can lower the price for the one group with lower demand without having to pass the lower pricing to the other group. If the firm knew which customers belonged to each group and could prevent the resale of its products, it would be optimal to design a two-part tariff for each of the groups in order to achieve perfect price discrimination (Carlton et al. 1994, 465). Finnish telephone operator Sonera offers an example of this type pricing with their five different pricing schemes for their customers (Sonera 2000).

5.4.3 Bundling and tie-ins

In tie-in sales a combination of products is offered with one price. Bundling differs from tie-ins in the sense that the products are sold also individually. In some cases bundling or tie-ins are considered illegal. For example in Finland the combined sales of mobile phones and contracts with the service provider are prohibited. On the other hand such deals are allowed in many countries. In some cases tie-in sales are considered legal. For example a car can be considered to be made of several different

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products, which have been assembled together and sold as a tie-in. An example of software bundling is the combination of Microsoft Office that bundles together a word processor, a spreadsheet, a database, and a presentation tool. The bundle has been phenomenally successful, capturing over 90 percent of the market for office suites (Shapiro 1999, 74).

Tie-in sales can be used as a way to price discriminate. A monopoly can increase its profits over and above what it would earn if the two goods were sold with two constant prices. As with all price discrimination models, this is based on the fact that the customers valuing the good the most are willing to pay more for the product. On the other hand there are other motivations for tie-in sales than price discrimination. Examples of these uses include increased efficiency, avoiding price regulations, price discounts, and quality assurance (Carlton et al. 1994, 467).

An example can illustrate the utility of bundling. Suppose “Moritz” values application A at 100 USD and application B at 150 USD. On the other hand the other customer “Max” values application A at 150 USD and application B at 100 USD. If the firm producing the applications sets the price of both applications to be 100 USD, four applications are bought and the firm gains 400 USD revenues. If the price of both applications is set at 150 USD, two applications are bought and the firm gains 300 USD revenues. If the products are bundled together and the bundle is sold at a price of 250 USD, both Max and Moritz buy the bundle and firm gains 500 USD in revenues.

Another example could be the sales of some particular car, which is sold with a pre- installed air conditioning. The consumers use these products in fixed proportions, or else they have to dispose of part of the product they bought. Another common type of price discrimination is requirement tie-in sales. In such deals customers who bought one product from a firm are required to make all their purchases from that same firm. Polaroid instant cameras are an example. As Polaroid is the only firm that can sell the film, the owners of the cameras are forced to buy their film from Polaroid. These two

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types of nonlinear pricing increase a monopoly’s profit by enabling it to charge each customer group different price (Carlton et al. 1994, 470).

According to Carlton, requirement tie-ins have been perhaps the most common type of tie-ins. Requirement tie-ins can’t be really used in engine licensing. This is due to the fact that there are not really secondary products that could be tied-in with the engine. Additionally, licensees get the source code of the licensed software and can modify it to their needs effectively freeing them from the software architecture of the licensor.

Bundling can be further divided into different schemes: tie-in with both products monopolized, tie-in with one product monopolized and tie-ins with products having interrelated demands. An example of interrelated demands could be a company using two compounds to produce a product. If variable proportions of the raw material can be used for production, the demands are interrelated. An example could be a company, which can use different combinations of screws and bolts in its production. In practice I can’t see game engines being bundled in such a way that interrelated demands could be achieved. This leaves the above-mentioned forms of bundling out of the question in the game engine licensing market.

In the game development business games are often developed for several platforms at the same time. Consequently there are different versions of the engine for different platforms. When doing the initial licensing, the licensee can be rather indifferent between different solutions. But after the initial engine solution, it is not indifferent about the engine, which it will use for the other platforms. For example, it is much easier to port a game from one platform to another if both platforms use the same engine. In that sense the developer is inclined to use the same engine for production on all platforms. Consequently when licensing a multi-platform engine to a client, who is developing for two platforms, a tie-in with one product monopolized can be made. Generally, if the products are not interrelated, tie-ins are not profitable (Carlton et al. 1994, 473-474).

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On the other hand, the licensee has the source code of the engine and can thus port the customized engine to another platform in-house. This can be rather complicated depending on the code. Anyhow this takes away a large part of the monopoly power of the licensor.

5.4.4 Quantity discounts

Quantity discounts decrease the average price of the product as the number of units bought increases. In interactive entertainment industry an example could be a long- term customer developing several games using the licensed technology. As game production is a long-term project, the developers usually release less than one title a year. As the volumes are low, the quantity discounts won’t be very significant in the game development industry. Additionally, because of the switching costs the licensors are unlikely to switch their development tools – providing that they are content with the tools. Consequently the quantity discounts would probably only decrease the income of the licensor.

5.4.5 Quality discrimination

In quality discrimination a firm offers consumers a choice of product with varying levels of quality at the same price or at prices that do not fully reflect the quality differential. Goods of different qualities are related because consumers view them as substitutes. If the qualities of the goods are prespecified, the situation is similar to the requirement tie-ins with interrelated demands. If the firm can decide the qualities of the goods, it takes the demand interrelationships into account when it decides how it prices the different products (Carlton et al. 1994, 479).

The producer with monopoly power can produce products that are substitutes, but not too close substitutes. The reason is that the firm can charge for the high quality product and not worry about customers substituting to the low quality product,

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because it is not so good a substitute. This way the company with monopoly power can extract some of the consumer surplus by manipulating the qualities of goods produced (Carlton et al. 1994, 480).

One way of quality discrimination in game engine licensing would be to offer products with differing levels of service. A cheaper package might include only manuals, comments in source code, and maybe consulting via email. Another package might include training sessions on site and consulting via email and telephone when needed. The problem is that the lower service level package could deteriorate the image of the licensor. For example, the licensee of a cheaper package without proper consulting could be running against a steep learning curve, and complain that the product is overly difficult to use. This problem could be partially avoided by meticulous documentation of the product.

Another possibility would be to categorize the products according to their performance. For example a stripped down version of the engine with diminished features could be sold for the licensees that are more price sensitive. Matlab Mathworks is an example of such quality discrimination. A cheaper version with crippled functionality of the program is offered to students with reduced price. Unfortunately the game engines have to have certain functionality and it is very difficult to decrease the functionality of a product without making it useless.

A third possibility would be to license older versions of the engine with a discount and charge the early adopters a premium. The problem with this approach is the interoperability of the various parts. Usually the team developing the engine works only with the latest product, and having multiple versions of the same product would demand a toolkit that could be used to maintain the different products functional and updated relative to the hardware. The programmers often do the major part of the support by answering the questions of the licensees. Having several versions of the same product would practically demand some support personnel who would be devoted to a specific product generation. Having various versions could complicate

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the work. Effort would be distracted from the development of the newest version and maintaining the technological lead.

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5.4.6 The number of versions offered

If several versions of the product are offered, the customer might have problems deciding which one to choose. Often firms offer two versions: one for the “standard” user and one for the “professional” user. It might be better to offer a wider product mix: “standard”, “professional”, and “gold” versions. The rationale behind the suggestion is a psychological phenomenon known as extremeness aversion. People normally try to avoid extreme choices. It’s perceived to be risky to go for the top or the bottom of the product line, and much safer to choose something in the middle. Positioning a product so that it represents a compromise should lead to additional revenues. The effect has been studied especially in the market for consumer goods. An example describes the sales of microwave ovens: A bargain product was offered for 109.99 USD and a midrange product was offered for 179.99 USD, the customer chose the midrange choice in 45 percent of the cases. When a premium product at 199.99 USD was added to the mix, the customer chose the midrange product in 60 percent of the cases (Simonson et al. 1992).

Adding a premium product to the line might not necessarily result in overwhelming sales of the premium product itself. However, it enhances buyers’ perception of lower priced products in the product line and influences low-end buyers to trade up to higher-priced models (Smith et al. 1995). The idea is diluted somewhat by the fact that the customers are software professionals knowing pretty well what they are after. However, in some cases the psychological effect might take over leading to additional revenues.

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5.5 Summary of discriminatory pricing

No general industry guidelines can be defined. The optimal policy has to be decided on a case-by-case basis. Two-part tariffs could be applied in some cases. For example they could be applied for customers demanding varying levels of service. Alternatively the two-part tariffs could be used to distinguish between licensees buying single or several licenses for different projects. If the licensor has several interrelated products, tie-ins are possible. Quality discounts could also be used in order to divide the target market into finer segments.

According to questionnaires sent to the companies, discriminatory pricing methods weren’t largely used. Except Criterion software none of the companies used quality discrimination or tie-ins. On the other two-part tariffs were offered, or could be negotiated on a case-by-case basis.

6 Case: Hybrid holding’s Surrender 3D toolkit

I paid a visit to the Finnish firm Hybrid and discussed the company’s policy with Jouni Mannonen who is responsible for licensing and CTO Harri Holopainen. Hybrid develops and licenses software tools for game production and has currently 23 workers in its office in Helsinki.

6.1 Company overview

Hybrid was started in 1995 and has already licensed products to some of the most prominent game developers. Company strategy has been to specialize in a narrow segment and to be technologically on the leading edge. The company has been growing slowly so that new people can be efficiently integrated to the working community.

The revenues for 2000 are estimated to be around five million FIM and slight losses are expected. The emphasis has been on the PC platform, but more lucrative platforms are approached. The console platform, especially Sony’s Playstation 2, has been targeted. Additionally, a lot is expected from the upcoming product licensing for mobile gaming.

Marketing has been minimal during the company’s history. Consequently the company is not very well known among the end customers buying the games. In the developer circles the situation seems to be somewhat different. Hybrid is widely Chapter 6 Case: Hybrid holding’s Surrender 3D toolkit 72

respected around the world as an expert on the field of graphics technology. For example, Hybrid has its representatives in the Graphics Advisory Board of Microsoft, and has participated in Intel’s Pentium III and Pentium 4 development programs.

Company’s customers have been attained through reputation in the developer circles; public marketing efforts have been negligible. The efforts have been concentrated into the development of the product and not to pricing or market analysis. So far the products have managed to sell themselves successfully and added efforts have been found unnecessary. More refined pricing could increase the profits and secure the future of the company.

The number of the customers is also relatively low. This is probably due to low visibility and the fact that cooperation with the customers has been intense. The nature of the product is such that a lot of interaction between the licensor and licensee is needed. At the moment the programmers of tools at Hybrid’s side and the programmers from the licensor companies communicate directly using e-mail and telephone. If the number of licensees were higher this would increase the workload of the people developing the products and core competence of Hybrid. The amount of service needed to help licensors is the bottleneck when considering new licensees. More efficient product delivery process and recognition of delivery bottlenecks should be considered for efficient product delivery.

As the licensors adapt to Hybrids technology it creates significant switching costs for the licensees. Adopting new development tools is a time consuming process. Additionally the co-operation between the licensor and licensee is usually intense and established personal relations make interaction fluent, thereby saving time. This leads to a situation where there is no initiative for price reductions for established customers.

Chapter 6 Case: Hybrid holding’s Surrender 3D toolkit 73

6.1.1 Business concept

The majority of Hybrid’s income comes from the licensing of its proprietary 3D graphics visualization software. The cash flows from the licensing agreements are very irregular in nature and it is hard to forecast the future developments in the industry. Fortunately Hybrid has some other activities that balance the irregular cash flows. In the future Hybrid is aiming for the growing mobile platform in close cooperation with Springtoys Oy. The wireless markets are not yet so saturated as in the PC or console market, and it is probably easier to reach strong business position and profitable operations.

Additionally, Hybrid has produced computer-animated commercials for marketing agencies. The combination of various activities diversifies the risks and evens out the cash flows. Clear synergies can be seen in the activities. For example, 3D modelers are needed for the demos of the Surrender GL kit, but they can also work in the computer animation projects.

6.1.2 Licensees

Hybrid has licensed software to several well-known game developers including Westwood Studios, Electronic Arts and Housemarque. The finished games have been financially successful on the PC-platform, and some of the games have been also ported to the console platforms. Traditionally, Hybrid has operated more on the PC- platform. In the near future many of the central components should be ported also to the console platform including the Surrender GL and Surrender Umbra. This is important, as the gaming market is biasing strongly towards the console platform (Samuel 2000 b).

The number of licensees is relatively low. At the moment Hybrid has less than ten paying licensees. Altogether more than twenty licensees have been granted, so some of

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the licensees have been granted a license without payment. An example of these licensees is katastro.fi, a non-profit organization working with digital art. These agreements don’t bring any immediate revenues, but I do think they could in some cases increase the visibility of Hybrid.

The small number of licensees comes largely from the niche player role that Hybrid has assumed. According to CTO Harri Holopainen high market share growth is not pursued – emphasis is on special solutions that give Hybrid an edge over the competitors.

6.2 Products’

Hybrid is licensing four different software packages. They are all aimed at 3D visualization. Some of them can be used alone and some are software modules that are aimed to increase the functionality of existing software. An overview of the products follows in the next sections. Due to the nature of this of this work the emphasis is on the SurRender GL graphics toolkit.

6.2.1 SurRender GL

SurRender GL is Hybrid’s primary product. It is a C++ toolkit for real-time 3D rendering. It is a graphics library and a collection of software tools, which are aimed for 3D real-time visualization. SurRender GL offers an application independent interface to 3D rendering taking care of all 3D rendering and offering functionality, such as a complete math library, texture manipulation and input/output facilities.

In it itself SurRender GL is not exactly a game engine. Like game engines, it has a scene-graph interface for world modeling and tools for importing external 3D models into the system. Surrender GL can be used to create considerably quickly a tailored high quality game engine. Consequently, the system is competing more or less in the same market as the more complete game engines like the Unreal engine.

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The toolkit was originally done for the PC-platform. Other platforms will be also supported as Hybrid is participating in Sony Middleware and Sega Dreamcast development programs. SurRender GL will be soon ported to SEGA’s Dreamcast and SONY Playstation 2. This is a very important move as the majority of the current best- selling entertainment titles are made for the consoles and not for the PC-platform (Samuel 2000 b).

Surrender GL is a considerably complex product. Thus thorough documentation and efficient customer support are necessities. Hybrid has no specific customer support department. Effectively Hybrid’s programmers answer the questions of the licensees. Communication happens via email and telephone. As the number of paying licensees is low, this kind of arrangement seems reasonable.

Hybrid’s licensing agreement of the toolkit is rather straightforward. License is paid with a lump-sum payment of 75000 USD without any royalty claims. The license includes free technical support for 18 months, updates to the library and access to complete source code. The license allows the licensee to produce one product with the license. The licensing price is clearly below the license prices for complete engine and toolkits offered by the competition. This is partly due to the fact that SurRender GL isn’t a complete engine and it doesn’t offer so many development tools as the competing packages. The majority of the competing products include also source code source code to complete games released by the licensor. Another reason for the lower price tag is that SurRender GL is not so widely recognized as the other development packages.

6.2.2 SurRender Umbra

SurRender Umbra is a visibility optimizer speeding the rendering process as it cuts down some unneeded processes during rendering. During the rendering process the graphics hardware renders a two dimensional image of the three dimensional virtual

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environment. The environment consists typically from a large number of triangles. As the number of these triangles is high enough, complex scenes can be modeled giving an impression of smoothly curving surfaces. The problem follows from the fact that many of these triangles are rendered even though they are not visible in the final picture. An example could be a closed cube. From whatever angle the cube is viewed some of its sides are not visible. If the graphics hardware renders these surfaces valuable time is lost as these surfaces won’t be visible in the final image.

Surrender Umbra can work together with other graphics libraries in order to reduce the amount of wasted graphics processing time. It effectively decides which of the triangles present in the model are invisible. Consequently, those triangles don’t have to be rendered and significant processing time reductions can be achieved. These savings result into higher frame rates and smoother gameplay.

The technology used is very sophisticated and Umbra is a unique software product on the market to offer this kind of functionality. Umbra can be integrated with the above- mentioned GL toolkit or other engines. License is paid with a 50000 USD lump-sum payment and includes free technical support for 12 months and free library updates for 12 months (August 2000).

The problem with Umbra is that it can be replaced by the new generation of graphics accelerating hardware technology. For example the latest graphics card from the Canadian based company ATi technologies Inc. offers similar functionality as the Surrender Umbra with its Radeon graphics card. ATi’s ‘HyperZ’ technology uses a hardware accelerated hierarchical process to eliminate the invisible pixels from the rendering process (Pabst 2000). The competition in the graphics acceleration hardware market is very hard as companies are trying to reach dominant position introducing new products every six months (Yu 2000). Consequently it is more than probable that Radeon’s features will be imitated in the forthcoming graphics cards from the other manufacturers.

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The current hardware accelerated occlusion culling solutions aren’t mutually compatible. For example one implementation doesn’t function in Ati’s and Nvidia’s cards. If the feature is implemented, the games have to be individually optimized. On the other hand Hybrid’s solution functions on a higher level. Consequently, it could be possible to combine the benefits of these technologies. Hybrid won’t have the power to push the technology alone. Consequently, Hybrid should now push actively the technology in order to try to establish its technology on the software side of the rendering process. Umbra could be for example licensed to be part of Microsoft’s DirectX application programming interface.

Umbra has also additional market potential on the console platform. The consoles have a fixed hardware setup during their lifetime, which can extend to considerable length. Playstation 2 was introduced in March 2000 and sold almost two million units in Japan during the first two months (Courier-Journal 2000). It will probably be a similar long lasting success as the first Playstation. Playstation 2 or the other new generation consoles don’t have any kind of visibility optimization comparable to the new generation PC graphics hardware. Consequently the Umbra technology should be targeted for the more lucrative console game development.

6.2.3 SurRender SW

SurRender SW is a software rasterizer. Rasterizer is the component that forms a two- dimensional image for the display from the three dimensional virtual world. The current three-dimensional games rely mainly on accelerated hardware rasterization where dedicated graphics hardware handles the process with high speed. In the games hardware acceleration has become a de facto standard and the majority of the new computer games with three-dimensional graphics require dedicated hardware in order to function.

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Even though the graphics hardware acceleration has become a fact in three- dimensional games, it is not available to all users. Still many of the computers lack the special 3D graphics cards, especially the elderly machines. Consequently a software- based rasterizer might have to be offered for the users that don’t have the special hardware, or whose equipment has become outdated.

SurRender SW is Hybrid’s software rasterizer that can be used instead of the 3D hardware rendering of the graphics card. Surrender stands out of the crowd because of its high speed and flexibility. Hybrid has been working with software rasterizing technology since 1995. The current performance of the rasterizer beats the competing OpenGL and Microsoft’s Direct3D software rasterizers by a factor of two to five. Graphical quality of the rasterizer should also match the quality of the competing products.

Gradually software rasterizing is being excluded in the gaming scene, as the majority of the computers used for gaming already have 3D graphics acceleration hardware for hardware rasterization. This also a fact in the game console market, where the machines come equipped with hardware rasterization. Consequently the product has to be targeted for other markets. One possibility are the 3D visualizations, that are not gaming oriented. Another future possibility might be the hand held PDAs. Currently they use only 2D visualization, but it is likely that 3D visualization will also be used in the hand held machines. Consequently, Hybrid should leverage its cooperation with Springtoys Oy, which is concentrating on the mobile platform.

License is paid with a 40000 USD lump-sum without any royalty claims. The agreement includes free technical support for 12 months and free library updates for 12 months. No larger revenues can be expected from the 3D gaming industry as the majority of the new 3D games require hardware graphics acceleration and won’t even include a software rasterizer.

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6.2.4 SurRender C360

SurRender C360 is a plug-in for the popular 3D modeling software 3D Studio MAX. C360 is aimed for creating realistic walkthroughs of 3D scenes using modeling and rendering software. Realistic visualizations of complex models can be made. An example of such visualization could be a computer animation made to demonstrate an architectural plan. The problem with such a solution is that very large or complex models still can’t be rendered in real-time. The only option for visualizing these models is to render the animations beforehand off-line, and then view the resulting two-dimensional movie with minimal interaction.

SurRender C360 uses also off-line rendering, but it offers some extra freedom to the viewer, increasing the feeling of interaction. In order to maintain realistic lighting, textures etc. SurRender C360 uses 3D Studio MAX to precalculate lighting, materials and geometry of a 3D world. Afterwards the model can viewed using a viewer program, which is supplied with SurRender C360 package. The added functionality compared to a pre-rendered animation is that the user may freely move along the camera track, zoom and look in any direction.

SurRender C360 is priced at 3200 USD. The product is not really aimed for the interactive entertainment industry and doesn’t really supplement the other Hybrid products. Consequently further considerations about SurRender C360 are left out of this work.

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6.3 Competition

At the moment the number of technology licensors in the interactive entertainment industry is rather low. Epic and id Software are the prominent names in the industry. Two visible challengers are Monolith and Numerical Design. The above-mentioned developers produce both games and engines. On the other hand, Hybrid and Criterion produce only dedicated middleware for game production and have no plans for game production. In terms of visibility and number of licensees Hybrid and Criterion are clear challengers, as their name doesn’t often surface with the game projects. Table 6.1 gives an overview of the situation. The table is not meant to be comprehensive in the sense of firms mentioned. It is meant to give a picture of the different types of approaches used by different firms.

Table 6.1 Firms licensing

Graphics toolkits Combined game and engine production

Dominant players Contenders

Hybrid Holding Id Software LithTech

Criterion Software Epic Games Numerical Design

Currently only minority of developers uses technology licensed from outside. The majority of developers still use in-house made engines for their projects. Many of these engines are very impressive demonstrations of excellent software engineering. Altogether there are many firms, which have produced in-house engines with advanced tools for game development.

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It would be considerably easy for those non-licensing firms to start licensing their products and competing with the current licensors. Barriers of entry are still low. Currently, the revenues from engine licensing are low. If the potential licensors don’t have the most advanced technology available, they have to settle for lower licensing fees. Probably low expected income from licensing keeps these firms out of the licensing business. At the moment there are several low cost options available for licensees including SurRender GL for $75000, Lithtech for $250000. NetImmerse and Criterion also have very competitive pricing. If the expected revenues would be higher, there would be probably many more licensors in the market. In that sense it is unlikely that the engine licensors will get high profits in the near future.

6.4 Customer support and training

As the product being licensed is getting increasingly complex, the importance of good support and training programs becomes important. Accordingly all the licensors emphasize the quality of their service. Support is generally offered via email and phone, and in some cases personal training sessions lasting several days are offered.

Accordingly Hybrid also emphasizes their good customer support. At the moment Hybrid has no dedicated customer service personnel. Due to the small number of licensees Hybrid has been able to offer very good service to its licensees, which can be noted from the positive customer feedback. Support happens usually by phone or e- mail between individual programmers. If the number of licensees would be higher, service tasks would probably take a significant part of their time. This would probably slow down the pace of software evolution endangering Hybrid’s future.

If the company plans to grow by acquiring more licensees, it is important that the current level of service is maintained and possibly some of the employees are trained especially for support and training. This personnel could also be used to give initial training sessions for new licensees in order to give the licensees a flying start.

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6.5 Company image & visibility

Hybrid’s products are technologically advanced and they have been already licensed by several premium developers. Despite of that, Hybrid has had considerable little media visibility. 9.8.2000 I conducted a short study using the Internet search engine AltaVista checking for the visibility of graphics engines and libraries. As expected the most known engines gave results way above the smaller players. Search term “quake engine” scored 5060 results and correspondingly search term “unreal engine” scored 7670 results. The results for the companies having no internal game development gave much more modest results. The challengers had their share of visibility too. Search term “Lithtech engine” gave 1940 results; Numerical Design’s “NetImmerse engine” gave 119 results. Naturally many of the possible references are not counted due to the search term used. For example pages with text “NetImmerse 3D game engine” aren’t registered with the search “NetImmerse engine”. However this probably discriminates all the engines more or less equally.

Search term “SurRender3d” gave 74 responses, “SurRender GL” gave 8 results, and “SurRender engine” gave 22 results (even though Hybrid doesn’t classify SurRender GL as an engine). These results clearly tell that SurRender’s visibility is rather low in the World Wide Web. Numerical Design’s situation resembles Hybrid’s situation as they got also a very low amount of hits. It seems clear that these lower numbers are explained by the fact, that neither of these companies has own game production and none of them has been used to make a blockbuster game.

Even though SurRender toolkit has been used for game development of stunning games it hasn’t received much publicity. For example the gaming site Firingsquad had large coverage from the Electronic Entertainment Expo 2000 held in Los Angeles. One of the games that attracted a lot of attention was the forthcoming Renegade from Westwood Studios. Journalists were impressed by the game’s graphics engine. Firingsquad’s article (Colayco et al. 2000) explains some of the outstanding qualities

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of the engine and mentions that it has been made in-house at Westwood Studios. There was no mentioning of Hybrid or Surrender GL although that is the backbone of the game’s graphics engine.

In my opinion it is clear that Hybrid should raise its visibility in the market. This would probably lead to an increased amount of licenses and would allow Hybrid to check its pricing up a notch. Naturally this demands some work from the company. For example many of the competitors take part in interviews and special events happening in gaming community. This is also an opportunity for Hybrid. One example of such a happening is the Enginweek held at the Gamespy site in March 2000. Four engine developers took part in the happening and gained added visibility and free advertisement for their product (Buecheler 2000 a). Engines are also discussed in the Usenet newsgroups, and company workers have discussed the features of theirs product in the newsgroups increasing the product awareness of the target group (Grueber 2000 & Preston 1999).

6.6 Pricing

At the moment the products are sold separately with a fixed licensing fee and no royalties. No product tie-ins are offered. Jouni Mannonen who is responsible for the licensing of the 3D visualization products told that the pricing scheme hadn’t been largely considered. According to Jouni Mannonen the total production costs were roughly estimated using common sense and a margin was added in order to cover the costs. Clearly, the pricing was not deemed as important task as the technological excellence.

Naturally, pricing has to be compared with the pricing of the competing products. The most notorious competing products like the Unreal and Quake III engines cost more than a half a million USD to license when using a lump-sum payment (Jackson 2000 a). LithTech and NetImmerse are also capable solutions, but not quite as potent as the

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dominant players. Consequently the prices of the challengers lie considerably below the dominant players (Honeywell 2000 & Kaiser 2000).

With its price of 75000 USD for SurRender GL Hybrid is competing more against the lower end, especially Numerical Design. Comparing the functionality of the products, the licensing prices of the SurRender tools seem very low. According to the CTO Harri Holopainen this is largely due to the lower visibility of the Surrender products. Anyhow, price competition wouldn’t be wise. In consumer goods market, firms signal new high-quality products with prices that are above full-information profit- maximizing price. As information about the product diffuses, the price distortion lessens or vanishes entirely (Bagwell 1991). Effectively, Hybrid should avoid price competition with their high-quality products as price drops could be interpreted as signals of inferior quality,

Hybrid could increase the visibility of their products and create a more visible brand for the SurRender technologies. The SurRender or Hybrid label could be associated with high quality products in the minds of the end consumers buying games. For example now the Unreal and Quake brands can benefit from their visibility in the market and consequently the licensing prices for these engines are the highest. Westwood is now developing a sequel to their hit game Command & Conquer. The sequel, Renegade will be visually very advanced using Hybrid’s technology. If Hybrid gets its name associated with the game, it could raise its price and even increase the number of its licenses at the same time.

Currently, all Hybrid’s products are sold and licensed separately and the pricing scheme is based on lump-sum payments. I do think that more elaborate pricing schemes using discriminatory pricing should be applied. Two-part tariffs could be applied to distinguish between developers making one or multiple releases. For example developers doing a single release would pay a standard fee, and developers doing multiple releases concurrently could pay high fixed fee and low variable fees.

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Additionally the software priced for different platforms has similar prices. Due to the fact that different platforms have different expectations about revenues for a typical release, also the prices for the software toolkit should vary accordingly. Expectedly more lucrative PS 2 developer market should pay more for the license than developers for not so lucrative markets – provided that the software toolkit being licensed can’t be ported easily to another platform.

Pricing for simultaneous licenses for different platforms should be considered. Again the market demand should be the guiding principle. For example one could assume a PC-license. Additional licenses could be available for smaller Mac or Linux markets. It is reasonable to charge less for those licenses because the expected income from those markets is decisively lower than from the PC-platform. On the other hand the situation would be totally different with a potentially very valuable PS2 license. It would make little sense to price it at the same level as the PC license, or offer it as an economical add-on to an existing license.

Quality discrimination might be also considered. This would divide licensees to ones paying less for the license and relying mainly on the online and web documentation. The other group would be licensees paying more for the license and receiving more personal service and possibly training sessions in order to get the development process quickly running. Also the length of the service period could vary. Then for example larger game developers like Westwood Studios could opt for better service, in order to speed up the development – smaller developers might opt for less service in order to lower their costs.

6.7 Strengths, Weaknesses, Opportunities & Threats

Before the final conclusions it’s good to take a look at Hybrid’s overall strengths, weaknesses, opportunities and threats. This has been a classic way to simplify the relations of the internal and external factors affecting a company.

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6.7.1 Strengths

Technological excellence has been Hybrid’s backbone during its existence. Also the current version of SurRender GL is a very advanced product with very high performance, supporting all the latest features. The other products offer similar technological excellence and partially complementing SurRender GL.

During its existence Hybrid has had some good partners and licensees including the US based Westwood Studios and the Finnish Housemarque. Westwood has had worldwide success with its products. Housemarque is a technologically advanced company located physically and ideologically near Hybrid, helping to contribute to the development of Hybrid’s products.

Hybrid’s customers have praised the support it offers, as the company has been able to supply tailored software solutions and offer excellent service. As the significance of good support is becoming a more important factor when competing for customers, Hybrid should strive to keep up the quality of service.

6.7.2 Weaknesses

The main weakness that I noticed during this short study was the poor visibility of the company. Even though some excellent products have been made the company is rather hard to come by when compared to the competition.

Hybrid has been doing tools mainly for the PC-platform. On the other hand, at the moment the majority of revenues in the industry come from the console platform. Fortunately Hybrid is currently readying its software ports of the SurRender GL toolkit for the Sega Dreamcast and Sony Playstation 2 platforms.

Company’s marketing efforts have been minimal. The majority of the customer base has been achieved with technological excellence and industry connections. This far, it

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has been a sufficient strategy. As the competitors are more active in marketing, Hybrid might have to revise its nonexistent marketing strategy.

6.7.3 Opportunities

So far Hybrid has been licensing its products for the PC-platform. According to the NPD Group, a research and industry-tracking company, console games outsell their PC counterparts more than two to one in dollar figures (Derowitsch 2000). The sales for the existing and future game consoles make the bulk of the revenues in the gaming industry. This trend will probably continue in the future. Hybrid should also try to move aggressively to this direction in order to get into this more lucrative market.

PCs and consoles have been the traditional games and graphics platforms. On the other hand a mobile revolution is going on. Already now mobile phones and PDAs incorporate games and graphics. The games are rather limited by the low processor performance of the handheld machines and by the monochrome displays used. So far the games have been 2D only. 3D games will probably start appearing on the mobile platform in the near future. Hybrid might be able to capitalize on its know-how of 3D graphics and low-level programming. The situation is intriguing, especially as Hybrid has the mobile developer Springtoys as its partner.

Other uses for the 3D know-how might also be found. For example, at the moment almost all mainstream multimedia production software tools are based on 2D graphics. Macromedia’s Director is probably the most known of these tools. A transition to 3D also in that field will take place. I do believe that for example SurRender GL could be used as a sound and efficient basis for such applications. Consequently Hybrid could to try actively market the GL toolkit for potential developers of such systems.

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6.7.4 Threats

The industry is very heavily competed. At the moment there are more than half a dozen mean and lean companies competing for market share. Many of those firms gain the majority of their revenue from games they develop, and consider engine licensing only as a secondary source of revenue. This keeps the prices and profits relatively low especially at the lower end of the market.

The number of potential entrants is very high. At the moment the majority of developers is using in-house game engines in their game production and doesn’t license them to other firms. If licensing would become a more lucrative business, it would be likely that there would be a number of new entries. Gaining extraordinary profits doesn’t seem to be an option in the near future.

As the console platform was seen as an opportunity, sticking to the PC-platform could be seen as a threat. If Hybrid doesn’t move decidedly to console markets, it will be out of the most lucrative part of the interactive entertainment industry.

Hybrid’s customer base is rather limited. If for some reason the competing firms could convince Hybrid’s clients to switch, it would put Hybrid into a very difficult position. Fortunately Hybrid has some other business activities that help to balance the cash flows.

6.8 Suggestions for company strategy

6.8.1 Define company strategy

During my visit at Hybrid’s office I got the impression that the company’s strategy wasn’t quite clearly defined. Some goals have been clearly set and ambitiously pursued. On the other hand some aspects like product positioning and the company role in the market place seemed to be somewhat unclear. Setting a clear company

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strategy and taking a more defined role in the market could help the company find its place in the market.

6.8.2 Increase visibility

In order to increase the demand for its products Hybrid could increase its visibility in the minds of the end customers buying the games. As the gamers would associate Hybrid’s name with quality products this could increase the demand for the games using Hybrid’s technology. This in turn would make it possible to increase the prices of Hybrid’s products (Colayco et al. 2000).

Increasing visibility doesn’t necessarily mean buying advertising space at magazines, having banners in Internet or hiring booth space at expositions. As discussed in section 6.5, visibility can for example be achieved by actively taking part in Internet forums. Taking part in discussions and special events would also aid in keeping updated about the competition.

Additionally, Hybrid’s hasn’t been associated with the products that use its technology. Hybrid is not mentioned in the product reviews or in the packages containing the end products. Hybrid could well demand that its trademark has to be visibly included with the product that uses its technology and try to associate itself with successful products using its technology.

6.8.3 Maintain core competence

The 3D graphics programming know-how is the core competence of Hybrid. Because of the advanced products, the company has been able to operate successfully in the market place with minimal marketing efforts. In order to stay competitive in the fiercely competed industry, the company has to retain its technological excellence.

Maintaining technological quality in Hybrid’s case means researching and developing new software. Additionally, Hybrid has to follow the competition as the level of

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technological excellence is measured relative to it. The followers are usually left in the shadow as the technology leader gets the majority of attention. This leads to a situation where the most advanced technology reaps premium profits, as the followers have to do with significantly lower licensing revenues.

6.8.4 Offer outstanding service

The products like game engines and graphics libraries are rather feature rich and complicated. It takes some time to understand the functionality and possibilities of such a product. Consequently the licensor should make it easy for the licensee to start using the product and all its features. This calls for good documentation and efficient support from the licensor’s side. As the competition is getting increasingly fierce, the importance of support is becoming even more important. This far Hybrid’s customers have been pleased with the support. This level of service has to be guaranteed also in the future. Consequently, regular surveys could be made about the quality of the documentation and person-to-person support.

If Hybrid were to grow rapidly in the near future, an increased number of customers would increase also the demand for service. That in turn would decrease the time of the developers to work with the actual product. Consequently Hybrid could train a special support team that could handle the most common problems faced by the licensees. Thus the people developing the actual products wouldn’t have to use more time supporting the customers.

6.8.5 Price discrimination

At the moment all Hybrid’s products are sold on a lump-sum basis. This isn’t probably the optimal pricing scheme. More refined pricing for different platforms should be considered. As the expected revenues on different platforms vary, so does the willingness of the developers to pay for the software toolkit used to build the end product.

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In addition to more elaborate lump-sum payments discriminatory pricing could be used. Two-part tariffs could be used to divide licensees into different categories and possibly different levels of support quality could be offered in order to target different customer groups.

6.8.6 Increase market share

Relative to product quality the number of Hybrid’s clients seems very low. The low product prices and low customer count doesn’t seem a viable business concept. A more stable and trustworthy business model could be achieved by increasing the amount of licensees. As the market is fiercely competed raising the customer count isn’t easy. Fortunately, Hybrid could get some very positive attention with the launch of Westwood’s Renegade. Additionally, increased presence and visibility in the market place would surely attract some more licensees.

An increased amount of licensees would naturally put some stress on the support functions. If Hybrid truly wants to grow and acquire more licensees, it has to be prepared to offer the same level of service to the new licensees as the existing ones. This might call for several persons mainly specializing in support and possible training sessions at licensee’s location.

6.8.7 Mobile platform

Mobile platform is certainly going to be an important gaming platform in the future. Hybrid has good opportunities to be on the forefront of the development of the mobile platform. Firstly, the Finnish mobile telephone operators are rapidly implementing new technologies, and Hybrid can test the mobile technology on its home ground. Secondly and more importantly, Hybrid is cooperating with Springtoys, which is dedicated to the mobile platform. Due to the high expectations and good connections Hybrid has great possibilities to leverage the mobile platform.

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6.8.8 Refine delivery process

If Hybrid wants to increase the number of its licensees, it should refine its delivery process. By this I mean that the process of getting the product delivered to the client should be efficient and clearly defined. By refining its delivery process Hybrid could decrease delivery costs and minimize the number of working hours in order to get its product into customer’s efficient use. This would decrease the delivery costs, leave more time for core activities, and allow more concurrent paying customers.

7 References

7.1 Literary references

Bagwell, Kyle and Riordan, H. Michael 1991. High and Declining Prices Signal Product Quality. The American Economic Review. 81:1. 224-239.

Basar, Tamer and Olsder, Geert Jan 1982. Dynamic Noncooperative Game Theory. Academic Press, London.

Bhara, Anand N. and Khanna Tarun 2000. The structure of licensing contracts. The Journal of Industrial Economics. 48:1. 103-135.

Carlton Dennis W. & Perloff Jeffrey M. 1994. Modern Industrial Organization. Harper Collins College Publishers, New York.

Choi, Jay Pil and Thum, Marcel 1998. Market structure and the timing of technology adoption with network externalities. European Economic Review. 42. 225-244.

Corts, Kenneth S. 1998. Third-degree price discrimination in oligopoly: all-out competition and strategic commitment. Rand Journal of Economics. 29:2. 306- 323.

Eberly, David H. 2000. 3D Game Engine Design : A Practical Approach to Real-Time Computer Graphics. Morgan Kaufmann Publishers, San Fransisco.

Electronic Arts 2000a. Annual Report. 1999.

Gallini, T. Nancy & Wright, Brian D. 1990. Technology transfer under asymmetric information. Rand Journal of Economics. 21:1. 147-159.

Herz, J. C. 1999. For Game Maker, There's Gold in the Code. New York Times. December 2, 1999.

Kainulainen, Teemu 2000. Pelisofta vyöryttää viihteen. Talouselämä. 2000:23. 32- 34. Chapter 7 References 95

Katz, Michael L. and Shapiro, Carl 1994. Systems Competition and Network Effects. Journal of Economic Perspectives. 8:2. 93-115.

Katz, Michael L. and Shapiro, Carl 1986. How to license intangible property. Quarterly Journal of Economics. 101:3. 567-589.

Katz, Michael L. & Shapiro, Carl 1985. On the licensing of innovations. Rand Journal of economics. 16:4. 504-520.

Klemperer, Paul 1995. Competition when Consumers have Switching costs: An Overview with Applications to Industrial Organization, Macroeconomics, and International Trade. Review of Economic Studies. 62. 515-539.

Latvanen, Kari 2000. Restart – pelitoimialan kulmakivet järkkyvät. Bisnes.fi. November 2000. 43-45.

Lähteenmäki, Pekka 2000. Pelihelvetti olohuoneessa. Bisnes.fi. November 2000. 40-43.

Mäntylä, Juha-Matti 2000. Se ei pelkää, joka pelkää. Bisnes.fi. November 2000. 34- 39.

Oster, Sharon M. 1995. Exclusive Licensing in a Sequence of Innovations. International Journal of the Economics of Business. 2:2. 185-200.

Rockett, Katharine E.1990 a. Choosing the competition and patent licensing. Rand Journal of Economics. 21:1. 161-171.

Rockett, Katharine 1990. The Quality of Licensed Technology. International Journal of Industrial Organization. 8. 559-574.

Shapiro, Carl and Varian, Hal R. 1999. Information Rules – a strategic guide to the network economy. Harvard Business Scholl Press. Boston, Massachusets.

Simonson, Itamar and Tversky, Amos 1992. Choice in Context: Tradeoff Contrast and Extremeness Aversion. Journal of Marketing Research. 29. 281-295.

Smith, Gerald E. and Thomas T. Nagle 1995. Frames of Reference and Buyers’ Perception of Price and Value. California Management Review. 38:1. 98-116.

Chapter 7 References 96

Tirole Jean 1988. Industrial organization. The MIT Press, Cambridge Massachusetts.

7.2 WWW-references

Activision 2000. Activision Licenses Classic id Shooter, Wolfenstein 3- D http://biz.yahoo.com/prnews/000131/ca_activis_1.html, 26.5.2000.

Buecheler, Cristopher 2000a. Tim Sweeney discusses the Unreal Engine. http://www.gamespy.com/articles/engineweek2_a.shtm, 7.6.2000.

Buecheler, Cristopher 2000b. John Austin sounds off on the versatile NetImmerse engine http://www.gamespy.com/articles/ engineweek5_a.shtm, 9.7.2000.

ClassicGaming 1999. Museum Atari 2600. http://www.classicgaming.com/ museum/2600.shtml, 11.8.2000.

Colayco, Bob and Bell, Brandon 2000. E3 2000 Part 5 http://firingsquad.gamers.com/features/2000e3part5/, 18.6.2000.

Derowitsch, Rachel 2000. PC vs. Console - Understanding What Types Of Games Sell & Why. http://www.smartcomputing.com/editorial/ article.asp?article=articles%2Farchive%2Fg0810%2F005g10%2F05g10%2Eas p, 7.12.2000.

Electronic Arts 2000b. Electronic Arts licensing Quake 3 Arena engine. http://www.easports.com.au/main/news/left.html, 26.5.2000.

FilePlanet 2000. Download Quake 1 source code. http://www.fileplanet.com/index.asp?file=35264, 6.12.2000.

Gamasutra 2000. Leisure software sales. http://www.gamasutra.com/ newswire/eurospeak/ 20000113/index.htm, 26.5.2000.

Harris, Tricia 2000. Where The Hell Is...Max Payne? http://www.gamers.com/framelink/243708, 6.12.2000.

Hybrid Holding Ltd. 2000. SurRender GL. http://www.hybrid.fi/surrender/ products/sr3d.html, 8.8.2000.

Chapter 7 References 97

Isakovic, Karsten 2000. 3D Engines List. http://cg.cs.tu-berlin.de/~ki/ engines.html, 23.6.2000.

Jackson, Glenn 2000 a. In the Business of Making Games Engines. http://www.r- pov.com/features/engine.html, 3.8.2000.

Jackson, Glenn 2000 b. Interview with Brian Hook. http://www.r-pov.com/ interviews/bhook.html, 1.8.2000.

Laprad, David 2000. Xbox Production Update. http://www.avault.com/news/displaynews.asp?story=7282000-135611, 28.6.2000.

Lettice, John 2000 a. MS plans subsidised X-Box street price, $500m promo blitz. http://www.theregister.co.uk/content/1/12235.html, 28.07.2000.

MacLellan, Jon 2000. Jon 'Jeh' MacLellan Chats with Tim Sweeney. http://www.unrealkingdom.com/interviews/tim_sweeney_021600.html, 16.6.2000.

Margaret, Mary 2000. Ask Mary-Margaret #5: "Licensing issues" http://www.gamasutra.com/features/20000629/askmm_01.htm, 10.8.2000.

Mullich, David 1997. Milestones and Glass Houses: Protecting Your Development Schedule From Shattering. http://www.gamasutra.com/ features/production/061997/milestones1.htm, 18.6.2000.

Pabst, Tom 2000. http://www.tomshardware.com/graphic/00q3/000717/ radeon256-10.html, 10.8.2000.

Rausch, Allen 1998. The 3D Engine Title Match. http://www.gamecenter.com/ Features/Exclusives/3dengine/ss02.html, 16.6.2000.

Ryan, Tim 1999. The Anatomy of a Design Document, Part 1: Documentation Guidelines for the Game Concept and Proposal. http://www.gamasutra.com/features/19991019/ryan_01.htm, 26.5.2000.

Chapter 7 References 98

Samuel, Jason 2000. The Mule Speaks!: Is Diablo II Killing the PC Games Industry? http://www.dailyradar.com/columns/game_column_181.html, 10.8.2000.

Sonera, 2000. GSM ja GSM Duo hinnasto. http://www.sonera.fi/gsm/hinnasto/, 14.8.2000

Sony, 1999. SONY CONSOLIDATED RESULTS FOR THE YEAR. http://www.world.sony.com/IR/Financial/FR/1999-4-28/1-1.html, 26.5.2000.

Sony Marketing Asia Pacific Pte Ltd., 1999. http://www.sony- asia.com.sg/press/corpnews/mar99cnews11.html, 6.12.2000.

Sweeney, Tim 1999. Licensing: How Does It Work? http://www.3dactionplanet. com/features/articles/licensing/, 4.8.2000.

UK-Wire 2000. Final results Part 3 Konami Co Ltd, 16 May 2000. http://www.uk-wire.com/cgi-bin/articles/200005171824327515K.html, 6.12.2000.

Wojnarowicz, Jakub 2000. Kiss Psycho Circus Review. http://firingsquad.gamers.com/games/kiss/page3.asp, 4.8.2000.

Young, Jason 1998. Have You Heard? http://www.haas.berkeley.edu/ ~haasweek/98spring/980413/headlines/hyh.html Haasweek, 4.8.2000.

Yu, James 2000. http://firingsquad.gamers.com/hardware/nv15preview/ default.asp, 10.8.2000.

7.3 Usenet references

Gruber, Diana 2000. Thread: Licensing a 3D Engine... Forum:comp.games.development.industry. 20.6.2000 email: [email protected]

Preston, Timothy 1999. Thread: Prince of Persia 3D - but not for Mac.. Forum: comp.sys.mac.games.action 3.10.1999 email: [email protected]

Chapter 7 References 99

7.4 Other references

Honeywell, Phil (Licensing and Marketing Manager Lithtech, Inc.) 2000. Email response to an inquiry about licensing practices. Received 27.6.2000.

Kaiser, Herman (Manager, Worldwide Sales, Numerical Design Ltd.) 2000. Email response to an inquiry about licensing practices. Received 27.6.2000.

Rein, Mark (Epic Games Inc.) 2000. Email response to an inquiry about licensing practices. Received 27.6.2000.

Wilke, Jens 2000. Interview with Hybrid’s Jouni Mannonen and CTO Harri Holopainen

8 Appendices

8.1 Appendix A Glossary of terms 2D Two dimensional 3D Three dimensional AI Artificial Intelligence used to create behavior having intelligent features API Application Programming Interface – An API provides an interface between a high level language and lower level utilities and services which were written without consideration for the calling conventions supported by compiled languages. CPU Central Processing Unit Direct3D Microsoft’s 3D graphics API DirectX Microsoft’s general multimedia API EULA End-User License Agreement FPS Frames Per Second Glide 3Dfx’s graphics API GPU Graphics Processing Unit Graphics Library Software Library for graphics programming LAN Local Area Network (e.g. computer network used in offices & homes) Middleware Programming and development tools for software makers to make applications. Software to make software.

MOD Modified version of a game (done usually by fans of some particular game) OGRE Open Source Gaming Project Chapter 8 Appendices 101

Network Games Games played in a LAN or Internet OpenGL Open graphics API developed by SGI Open Source Publishing of the source code for the public. PDA Personal Digital Assistant – hand held computer, usually aimed for time management etc. Platform System used to run applications or play games (e.g. PC, PS2 & Sega Dreamcast) Plug-in Usually a small program written to increase the functionality of some other program. Porting To modify (software) for use on a different machine or platform. PS2 Sony Playstation 2 Rendering Generation of a graphical image from a mathematical model of a three-dimensional object or scene. Scripting Prearranged flow of the story in a game SDK Software Developers Kit Site A computer or network of computers associated with a unique identifying number on the Internet and electronically accessible, as through a browser. Software Library A collection of standard programs, routines, or subroutines, often related to a specific application, that are available for general use. Source Code The original form in which a computer program is written by the programmer. Usenet A distributed electronic bulletin board system where people post and read articles.

Chapter 8 Appendices 102

8.2 Appendix B comparison chart

Engines, graphics libraries & their properties

Surrender GL LithTech NetImmerse Quake 3 Unreal from from Hybrid from from from id Epic games Monolith Numerical Software Design Type Library Engine Engine Engine Engine In-house No Shogo, Blood No Quake Unreal series games etc. Fixed fee $75,000 $250,000 >$500,000 >$500,000

Valid for Single Single According to According to NA deal deal Royalties No No NA

Support 18 months Email Email Email Email Email Phone phone Phone Phone phone (in person) Updates 18 months Until ships 2/year Yes

Engine Yes Yes Yes Yes Yes source Game source No Yes No Yes Yes

Tools No Yes Yes Yes Yes

Manuals Online Printed Online

PC Yes Yes Yes Yes Yes

OpenGL Yes No No Yes No

DirectX Yes Yes Yes No Yes

PS2 3Q2000 Coming Probably No Yes

X-Box Yes No Yes No Yes

Dreamcast 2Q2000 NA NA No NA