Platform Strategy of Video Game Software: Theory and Evidence. Masayoshi Maruyama, Kobe University Kenichi Ohkita, Kyoto Gakuen University.

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1 Platform Strategy of Video Game Software: Theory and Evidence Masayoshi Maruyama, Kobe University Kenichi Ohkita, Kyoto Gakuen University bstract This paper analyzes a model of platform competition in markets of system goods composed of hardware and complementary software. When hardware products are strongly differentiated, and/or when consumers highly evaluate the marginal benefit of additional software variety, it is shown that hardware firms will engage in exclusive dealings of software platform. In contrast, when hardware products are weakly differentiated, and/or when the consumer s marginal benefit of additional software is relatively low, software firms will select single-homing of software platforms. These findings are strongly supported by our empirical results in the Japanese video game market structured by Nintendo. 1. Introduction In recent years, there has been substantial research interest in the competition of system goods (Rochet and Tirole, 2003; Evans, 2003; Illing and Peitz, 2006). System goods are composed of several complementary components combined through specified interfaces with competing providers of each component. 1) Hence competition on systems as well as on components arises from the vertical relationships among components (Farrell, Monroe and Saloner, 1998). One market that meets these conditions is the video game market. The basic structure of software platforms in the Japanese home video game industry was established by Nintendo, and is characterized by the following three points. First is the incompatibility of software. Software designed for one video game system was generally incompatible with any other system. Second is the use of software licensing. Nintendo licensed other firms to develop games for its system in return for the payment of royalties to Nintendo. Third is software development for a single platform (single-homing). In the development of game software, it was difficult for licensees to transplant the developed games for use on Famicom into the competing platforms. The first and second characteristics are well documented (see for example, randenburger, 1995; Coughlan, 2000; Evans, Hagiu and Schmalensee, 2006). However, there has been little literature on the third characteristic. The purpose of this paper is to take a detailed look at the third characteristic. This paper is the first attempt to present evidence on single-homing of software and a theoretical explanation for this. 2. The Single-Homing of Software Platforms: Evidence We conducted a survey of every game software developed for use on Famicom and its peripheral equipment, Disk System, over the period from July 28, 1984 to June 24, 1994 in the Japanese market. In this period, when Nintendo dominated the market, 1,160 titles of game software were released for Nintendo s game system by firms independent of Nintendo. We investigated whether there was software developed for use in one game system being transplanted to other game systems, and whether there were cases of software developed for multiple platforms (multi-homing). Transplants of game 148

2 software between competing platform providers can be divided here into the following three categories. (1) Game software developed for Nintendo s system being sold by software firms as games for use in rival systems. (2) Game software developed for a rival system being sold as games for Nintendo s system. (3) Software released by software firms, with the same title of the game being released for use in Nintendo s system and its rival system at the same time, i.e., the multi-homing of software. The results are as follows. First, despite the fact that there were 31 titles of games falling under category (1), there was a minimum time lag of slightly less than three months for some titles to be transplanted and sold, and in many other cases, the interval was several years. Second, there were five titles that fell into category (2). The minimum time lag for these titles to be transplanted was one week, but the titles were changed slightly prior to such software being transplanted to Famicom. Third, there were two titles that fell into category (3), which were both sold by the same software firm (Koei). One was released onto the market on the same day, while the other was released one day earlier as software for use on a rival game system. In relation to the above, we would like to offer an interesting example which illustrates the relationship between the platform provider Nintendo and software firms, i.e. Hudson and namco. s is well known, both are software firms that helped Nintendo to dominate the market. Hudson focused on software development for a rival platform, PC Engine; and namco actively supplied software for several competing platforms (PC Engine, Megadrive), despite the fact that this company sold most of its software for Nintendo. However, these firms supplied basically entirely different games for Nintendo s system and for the above competing game systems. Hudson had five games that were sold under the same title for Nintendo and its rival firms, and namco had four such titles. However, considering the fact that both firms sold numerous software titles for Nintendo s system (37 for Hudson, and 89 for namco), the sale of games with the same title for different game systems is the exception to the norm. These facts provide evidence that transplant of software in the home video game industry was extremely rare, and that cases of multi-homing were virtually nonexistent. 3. The asic Model We use the basic model of Church and Gandal (2000) to consider our problem. 2) Suppose that there are two hardware firms H and H, which are providing hardware products H and H, respectively. These hardware products are differentiated along the unit interval [0, 1], and hardware H is located at 0, and hardware H at 1. The ideal points of consumers are uniformly distributed on the unit interval with a unit density and each consumer incurs a constant proportional disutility t per unit length. There are two software firms S and S, which supply a single software product, each S and S, respectively. Consumers may be able to purchase either two software varieties or a single variety. The value of a system (hardware and software) for a consumer depends on the product characteristics of hardware and the availability of software. The utility function of a consumer located at distance t from hardware H is assumed to be U = W(N) + x + a kt, where N ( N = 1,2) is the number of software varieties consumed, W(N) is the benefit consumers receive from consuming N varieties of software, a is the stand alone benefit of hardware, x is consumption of a competitively supplied outside good (whose price is normalized to 1), and k is the extent of hardware differentiation. 3) It is assumed that the greater the variety of software, the greater the value of the system, but the marginal value of additional 149

3 software is decreasing, that is, W(2) > W(1) and W(1) > W(2) W(1). 4) The budget constraint for a consumer is given by Nq + x = y p, where q is the price of software, y is the income, p is the price of hardware. It is assumed that consumers purchase hardware before purchasing software. The decision of a consumer can be solved backwards. Given the hardware adoption decisions, the consumer selects the number of software titles to purchase in order to maximize a utility function subject to a budget constraint. If two software varieties are available for hardware i, then a software price is given by W(2) W(1) through a ertrand competition. Substituting q = W(2) W(1) into the budget constraint and solving for x, and substituting it into the utility function, we have the indirect utility in this case. When a single software variety is available, the software price is given by the monopoly price W(1). Similarly, substituting q = W(1) into the budget constraint and solving for x, and substituting it into the utility function, the indirect utility in this case is given. The consumer decides to purchase the hardware for which the indirect utility is maximized. In this way, we can derive the demand functions (market share) for hardware firm H and H. These specifications capture important aspects of the home video game market. 4. The Structure of Software Platforms We will consider the equilibrium structure of software platforms. The analysis will be carried out using a four-stage game. In stage one, hardware firms select exclusive dealings or open platforms for software development. In stage two, software firms accept the contracts if the hardware firms offer exclusive dealings, however they can select single-homing or multi-homing in the case of open platforms. In stage three, hardware prices are determined. 5) In the case of the video game market, the firms set prices for the video game consoles and charge royalties to the developers of games. However, we simply assume that there is no strategic two-sided pricing of the platform firms (see Economides and Katsamakas 2006). Two-sided pricing strategy remains for a future study. In the case of vide game market, the firms set a price for the video console and charges royalties to the developers of games. However, we simply assume that there is no strategic two-sided pricing of the platform firms. The platform strategy, following a two-sided pricing strategy remains a future study. In stage four, software prices are determined. Then there are six possible structures in principle. (1) ilateral exclusive dealing: oth hardware firms make exclusive contracts. (2) ilateral open platform and multi-homing: oth hardware firms do not make exclusive contracts, and both software firms select multi-homing of software platforms. (3) ilateral open platform and partial multi-homing: oth hardware firms do not make exclusive contracts, and only one software firm selects multi-homing of software platforms. (4) ilateral open platform and single-homing: oth hardware firms do not make exclusive contract, and both software firms select single-homing of software platforms. (5) Only one hardware firm makes an exclusive contract, and the remaining software firm selects single-homing of software platforms. (6) Only one hardware firm makes an exclusive contract, and the remaining software firm selects multi-homing of software platforms. oth structures (4) and (5) are formally equivalent to the structure (1). The structure (6) is formally equivalent to the structure (3). Thus, there are basically three different structures (1), (2) and (3). 150

4 5. Comparison of Prices, Market Shares and Profits We can derive the equilibrium prices and profits for each of the six market structures, which constitute the subgame equilibria in stage three. In the symmetric structure each hardware firm has the same software variety. However, in the asymmetric market structure where there are two software varieties for H and a single variety for H, the high-quality firm H charges a higher price, has a higher demand and makes a higher profit than the low-quality firm H, similar to a vertical differentiation model (Mussa and Rosen, 1978; Tirole, 1988; Cremer and Thisse, 1991). Hence we can derive the following proposition for hardware firms. Proposition 1: The profitsp for hardware firms under different market structures are ordered as MM SS follows; p = p < p = p < p, where SS indicates that both software firms are single homing, MM that both software firms are multi-homing, (and ) that firm S (S) is single-homing and firm S (S) is multi-homing. Next we consider the second stage of the game. For the propositions, we define two variables ˆ 2 k º (2W (1) - W (2)) /(3( W (2) - W (1))), and D W º ( W (2) - W (1) / W (1), where the former is the degree of hardware differentiation, and the latter is the ratio of marginal benefits of the first and second software variety. In stage two, the software firms are able to choose single-homing or multi-homing. Then, we have Proposition 2: If the incremental value of software variety is small enough to satisfy the condition 0 < D W < 1/2, and the degree of product differentiation is small enough to satisfy the condition k < kˆ, then single-homing is a dominant strategy for software firms. Otherwise, the optimal response strategy of software firm is single-homing if the remaining firm selects multi-homing, and multi-homing if the remaining firm selects single-homing. 6. Equilibrium Market Structure Finally we consider the first stage of the game. In stage one, the hardware firms select exclusive dealings or open platform contracts. s the result of this selection by the two hardware firms, there are four cases: (ED, ED), (ED, OP), (OP, ED), (OP, OP). Here, for example, (ED, OP) indicates that the firm H selects exclusive dealings and the firm H selects open platform contracts. In the case of bilateral exclusive dealing (ED, ED), both software firms are obliged to be single-homing. In the asymmetric case, for example, (ED, OP), there is freedom for software firm S to select single-homing or multi-homing. From the Proposition 2, it is shown that for software firm S, single-homing is a dominant strategy if 0 < D W < 1/2 and k < kˆ, and multi-homing is a best response strategy otherwise. In the case of bilateral open platforms, both software firms are able to select single-homing or multi-homing. From Proposition 2 it is shown that the situation in which both software firms select single-homing is a dominant strategy equilibrium if 0 < D W < 1/2 and k < kˆ, and there are two subgame equilibria in which one firm selects single-homing and the other firm selects multi-homing otherwise. Thus, when 1 / 2 < DW < 1or k > kˆ, the profits of hardware firms are shown by Table

5 Table 1: Payoff Matrix of Hardware Firms ED OP ED OP SS SS ( p, p ) ( p, p ) ( p, p ) ( p, p ) or ( p, p ) From Proposition 1 it can be easily seen that (ED, ED) is a unique Nash equilibrium for hardware firms. Hence we can derive our major proposition. Proposition 3: If the incremental value of software variety is large enough to satisfy the condition 1/2 < D W < 1, or the degree of product differentiation is large enough to satisfy the condition k > kˆ, then (ED, ED) is a unique Nash equilibrium for hardware firms. This result provides a theoretical explanation for the characteristic of the Japanese video game industry during In this period, Nintendo s Famicom was strongly differentiated from competing game consoles. Numerous game titles were developed and issued rapidly, and they were enthusiastically welcomed. Thus, the incremental value of software was relatively large for consumers. In addition, Nintendo dominated the market and had a power to commit to exclusive dealings with software firms. These facts entirely coincide with the condition of Proposition 3. Furthermore, single-homing of software platforms still remained in the video game industry, even when the incremental value of software variety decreased and the hardware was less differentiated in the maturity period just before the introduction of Sony PlayStation (as shown in Proposition 2). 7. Conclusion We made a survey of every game software developed for use on Famicom and its peripheral equipment during 1984 to 1994, and provided evidence that multi-homing of software platforms was virtually nonexistent in Japan. We formulated a four-stage game to analyze platform strategies, and showed that single-homing is a perfect equilibrium of the game. In our theory, we predicted that hardware firms will engage in exclusive dealings of software, when hardware products are strongly differentiated, and/or when the consumers marginal benefit of additional software is relatively large. Otherwise, software firms will engage in single homing. These results match the actual conditions in those years. Empirical studies of these hypotheses in the markets of other countries and/or in other periods are important issues that need to be studied in future research. Footnotes 1) For example, recent computer based systems such as the hardware and the software of personal computers and home video games, the digital content and network services of digital music (ipod-itunes), mobile-phone services with i-mode, and even more generally, products themselves and the distribution services provided by retailers. 2) e must note that the analysis in this paper differs from Church and Gandal (2000) in two significant aspects. First, in their model the software is assumed to be initially available in formats compatible with both hardware technologies. However, in this paper we assume the incompatibility of software, that is, game software designed for one video game system cannot be played on any other game system. Hence, if a software firm wants to supply its software to both hardware technologies, then 152

6 the firm must provide different versions of its software (i.e., multi-homing of software). Second, they have shown the possibility of a hardware firm merging with a software firm and the integrated firm making its software incompatible with a rival technology or system. Whereas in the home video game industry, it can be seen that almost all game software is provided by outside or third-party publishers. While there is an intimate relationship through a licensing contract between a platform provider and the software publishers, vertical 3) In this paper, we present the variety of consumer preferences by their different ideal points in the product space. Following previous literature since Hotelling (1929), we assume the parameter k is common to every consumer. 4) Here it is assumed that individual software products are differentiated but are treated symmetrically in the consumers utility function. For a more general formulation of software differentiation, see Lee et al. (2006). 5) In reality, at the outset of launching a new model of video game console Nintendo set its price in advance, then several software firms provided software and set those prices. 153

7 References randenburger,. M., Power play (): Nintendo in 8-bit video games. Harvard usiness School Case # randenburger,. M., Nalebuff,. J., Co-opetition, Currency Doubleday. Church, J., Gandal, N., Systems competition, vertical merger and foreclosure. Journal of Economics and Management Strategy 9(1), Coughlan, P.J., Note on home video game technology and industry structure. Harvard usiness School Case # Cremer, H., Thisse, J. F., Location models of horizontal differentiation: a special case of vertical differentiation models. Journal of Industrial Economics 39(4), Economides, N., Katsamakas, E., Two-sided competition of proprietary vs. open source technology platforms and the implications for the software industry. Management Science 52(7), pp Evans, D., Some empirical aspects of multi-sided platform industries. Review of Network Economics 2(3), Evans, D.S., Hagiu,., Schmalensee, R., Software platforms. In: Illing, G. and Peitz, M. (eds.), Industrial Organization and the Digital Economy. MIT Press, Farrell, J., Monroe, H.K., Saloner, G., The vertical organization of industry: systems competition versus component competition. Journal of Economics & Management Strategy 7(2), Hotelling, H., Stability in competition, Economic Journal 34, Lee, S.T., Fu, W.W., Software-platform integration, incompatibility, and system-user switching, Journal of Media Economics 19(3), Mussa, M., Rosen, S., Monopoly and product quality. Journal of Economic Theory 18, Rochet, J. C., Tirole, J., Platform competition in two-sided markets. Journal of the European Economic ssociation 1(4), Tirole, J., The Theory of Industrial Organization, MIT Press. 154

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