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