Software Exclusivity and the Scope of Indirect Network Effects in the U.S. Home Video Game Market

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1 Sofware Exclusiviy and he Scope of Indirec Nework Effecs in he U.S. Home Video Game Marke Kenneh S. Cors Roman School of Managemen, Universiy of Torono Mara Lederman Roman School of Managemen, Universiy of Torono Firs Draf: February 2007 This Draf: Ocober 2007 Absrac This paper invesigaes he scope of indirec nework effecs in he home video game indusry. We argue ha he increasing prevalence on non-exclusive sofware gives rise o indirec nework effecs ha exis beween users of compeing and incompaible hardware plaforms. This is because sofware non-exclusiviy, like hardware compaibiliy, allows sofware providers o spread he fixed coss of game developmen over users of differen plaforms. We look for evidence ha his is rue by esimaing a model of hardware demand and sofware supply. Our sofware supply equaion allows he supply of games for a paricular plaform o depend no only on he insalled base of ha plaform, bu also on he insalled base of compeing plaforms. Our resuls indicae he presence of boh a plaform-specific nework effec and in recen years a cross-plaform (or generaionwide) nework effec. Our finding ha he scope of indirec nework effecs in his indusry has widened provides suggess one reason ha his marke, which is ofen cied as a canonical example of one wih srong indirec nework effecs, is no longer dominaed by a single plaform. We hank Avi Goldfarb and Tim Simcoe for helpful conversaions and he NET Insiue for financial suppor. Boh auhors: 150 S. George S., Torono, ON M5S 3E6. Cors: roman.uorono.ca; Lederman:

2 I. Inroducion The home video game marke has long been recognized as one in which nework effecs exis. As in many high-ech indusries, hese nework effecs are indirec. Home video games sysems consis of a console (he hardware) and games ha can be played on ha console (he sofware). Because he value of a console is derived from he games ha can be played on i, consumers prefer o buy a sysem wih a greaer variey of sofware. Because here are fixed coss o developing sofware, game publishers prefer o develop games for a console wih a large base of users. Thus, consumers value of a paricular console depends posiively hough indirecly on he number of oher users of ha console. This paper explores he scope of indirec nework effecs in he home video game indusry. While previous work has assumed ha nework effecs exis only beween users of a given console (for example, Clemens and Ohashi (2005)), we argue ha in recen years nework effecs have also come o exis beween users of compeing plaforms in he same echnological generaion. Ineresingly, his change in he scope of indirec nework effecs has occurred wihou any change in he degree of hardware compaibiliy. Home video games sysems have always been, and coninue o be, incompaible wih one anoher. As Kaz and Shapiro (1985) explain, he scope of indirec nework effecs in an indusry is ypically deermined by he degree of hardware compaibiliy. For example, if all hardware brands are incompaible nework effecs will operae a he brand level, while if all brands are compaible nework effecs will operae a he marke level. Hardware compaibiliy is he relevan consideraion in assessing he scope of indirec effecs because i deermines he se of echnologies across which he fixed coss of sofware developmen can be spread. While changes in he degree of compaibiliy beween video game sysems have no been responsible for he change in he scope of nework effecs in his indusry, we believe ha changes in he degree of sofware exclusiviy have. Over he pas 20 years, he fracion of games iles ha are released on more han one console has increased from abou 12% o almos 40%. Jus as compaible hardware allows sofware providers o spread he fixed coss of sofware developmen over muliple brands, non-exclusive sofware allows providers o spread he fixed coss of developmen over muliple 1

3 plaforms. Sofware providers considering a muli-plaform ile will compare hese fixed coss (plus he fixed coss of poring he game across plaforms) o he revenue ha can be earned by selling he game o users of all of he plaforms on which he game will be released. Thus, once non-exclusive sofware is considered, he supply of games for any paricular plaform will clearly depend no only on he number of users of ha plaform, bu also on he number of users of oher plaforms on which hose games could be released. This gives rise o indirec nework effecs beween users of incompaible video game consoles. Following exising work in his area, we will look for evidence of indirec nework effecs by esimaing wo relaionships: (1) he relaionship beween hardware demand and sofware variey; and (2) he relaionship beween sofware availabiliy and he insalled base of hardware. Our analysis uses monhly daa on U.S. hardware sales and sofware availabiliy for all maor home video game sysems from We begin by specifying a sandard discree choice model of hardware demand. One imporan benefi of his demand model is ha i allows us o accoun for boh exclusive and nonexclusive sofware in a sraighforward way. In paricular, exclusive and non-exclusive iles need no be disinguished in he uiliy funcion because consumers uiliy from having a paricular game available on a console does no depend on wheher ha game is available on oher consoles. Of course, wheher a game is exclusive will affec he relaive uiliies of differen consoles and, in urn, heir marke shares. The nesed logi model ha we use direcly accouns for his because each console s marke share will be a funcion of he characerisics of all producs in he marke. Non-exclusive game iles will simply appear as par of he sofware measure of all consoles on which hey are available. We will hen use he marke share expressions o illusrae he differenial effecs ha exclusive and non-exclusive iles have on demand. We hen esimae a reduced-form sofware supply equaion ha accouns for he possibiliy of boh console-specific and cross-console indirec nework effecs. We relae he supply of games for a paricular console o boh he insalled base of ha console and he insalled base of compeing consoles in he same echnological generaion. By including his addiional insalled base measure in he supply equaion, we allow for he possibiliy ha he insalled base of compeing (and non-compaible) hardware plaforms 2

4 can increase he supply of games for a console because he fixed coss of non-exclusive releases can be spread across users of muliple plaforms. Furhermore, we will allow he coefficien on he compeiors insalled base erm o vary over ime o capure he fac ha sofware publishers incenives o produce non-exclusive sofware have increased. As we explain in greaer deail in he nex secion, we believe ha a rise in he imporance of licensed conen, a rise in he size and sophisicaion of independen game publishers, and a decrease in poring coss relaive o developmen coss have increased he araciveness of non-exclusive releases. As he araciveness of muli-plaform releases increases, he srengh of indirec nework effecs beween users of compeing consoles also increase. Our sofware supply specificaion allows us o esimae and measure his effec. Our empirical resuls suppor he exisence of boh a significan plaform-level indirec nework effec and an increasingly imporan generaion-level nework effec. The resuls of he demand esimaion indicae ha he demand for a paricular console increases wih he availabiliy of sofware for ha console. Furhermore, as expeced, exclusive games have a larger impac on demand han non-exclusive games. The resuls from he sofware supply equaion indicae ha he supply of games for a console depends posiively on he insalled base on ha console and beginning in he las generaion of our sample i also depends posiively on he insalled base of compeing plaforms in he console s echnological generaion. Moreover, his coefficien is monoonically increasing over successive echnological generaions. 1 The video game marke is ofen cied as he canonical example of a ippy marke one in which indirec nework effecs lead o dominance by a single firm. The complee dominance of he indusry by Ninendo s NES sysem in he 1980s and early 1990s is ofen cied as evidence for his claim. 2 However, wih successive echnological generaions, his marke has become significanly less dominaed by any single console. Indeed, in each of he wo mos recen echnological generaions, hree compeing plaforms (hose of Ninendo, Sony, and Microsof) have reained sizable marke shares 1 This suggess ha even if here are oher facors ha will give rise o a negaive (reduced form) relaionship beween he supply of games for a console and is compeiors insalled base, hese facors are geing weaker over ime presumably because of he emergence of nework effecs across users of compeing plaforms. 2 See, for example, Brandenburger and Nalebuff (1996), pp , or Shapiro and Varian (1999), p

5 (see Figure 1). 3 While we do no esimae a dynamic model and herefore canno use our resuls o illusrae how changes in sofware exclusiviy affec he evoluion of marke shares over ime, we believe ha our empirical resuls provide a leas suggesive evidence as o why his marke has become less prone o ipping. Our resuls indicae ha non-exclusive sofware affecs a marke much in he same way ha compaibiliy does i changes he scope of indirec nework effecs. If nework effecs exis across users of differen plaforms, as our resuls indicae, hen i should be no surprise ha he endency of his marke o ip owards a single plaform has fallen. A he end of Secion V, we use our demand and supply esimaes o carry ou a simple exercise ha illusraes how he presence of generaion-wide nework effecs lowers he benefi ha a console manufacurer ges from simulaing sofware provision. This paper builds on a small bu growing lieraure ha seeks o esimae he role of indirec nework effecs in a variey of echnology indusries. I is mos closely relaed o wo recen papers ha esimae nework effecs in he home video game indusry. Clemens and Ohashi (2005) esimae he effeciveness of console price and sofware variey as alernae ways of simulaing hardware demand. Their empirical analysis implicily reas all sofware as exclusive o a plaform. Thus, hey do no disinguish beween he inroducion of exclusive and non-exclusive games in calculaing demand elasiciies nor do hey allow for he possibiliy of cross-plaform effecs in heir supply equaion. However, heir daa did end several years earlier han ours - before he rend owards non-exclusive sofware had fully manifesed iself (hey sae ha, in heir sample, 17% of iles are available on more han one plaform). Furhermore, heir focus is on he dynamics of indirec nework effecs and he evoluion and price and sofware elasiciies over a console s lifecycle. Prieger and Hu (2006) also esimae indirec nework effecs in he video game indusry. They acknowledge he presence of boh exclusive and non-exclusive sofware and, in fac, are ineresed in esing wheher indirec nework effecs are sronger for exclusive games. However, hey approach his quesion by explicily separaing 3 Figure 1 shows he long-run insalled base (IB) marke shares of he maor plaforms in each echnological generaion. We define a plaform s long-run IB marke share as is IB marke share in he monh in which he firs maor plaform of he nex generaion is launched. We believe ha he launch of he nex generaion acs as a good signal ha he previous generaion has reached a poin of mauraion. 4

6 ineres. 6 The remainder of his paper is organized as follows. In he nex secion, we exclusive and non-exclusive games in he consumer uiliy funcion (which, as described above, we do no believe is he appropriae way o approach his quesion). Perhaps no surprisingly, hey do no ge sensible resuls from his specificaion. Oher papers ha explicily esimae indirec nework effecs in echnology indusries by modeling he complemenariies beween hardware and sofware include Gandal, Kende, and Rob (2000) (in he CD marke) and Nair, Chinaguna, and Dube (2004) (in he personal digial assisan marke). 4 Our paper conribues o his lieraure by being he firs o explicily consider he role of sofware exclusiviy and is impac on he scope of indirec nework effecs. Our analysis indicaes ha he scope of indirec nework effecs depends on more han us hardware compaibiliy. Raher, he scope of hese effecs is deermined by sofware providers abiliy o share fixed coss across plaforms which will be possible if he plaforms are compaible bu will also be possible if he coss of poring sofware across incompaible plaforms are relaively low. This research draws aenion o he fac ha feaures of he sofware marke can also affec he scope of indirec nework effecs and, in urn, he likelihood ha a marke ips owards a single dominan plaform. Moreover, i raises he possibiliy ha hardware providers may have incenives eiher o sign conracs for exclusive sofware or o engineer heir hardware o increase he coss of poring sofware across plaforms. 5 Fuure research ino hese issues is clearly of provide relevan background informaion on he indusry. Secion III describes he empirical approach. Secion IV describes he daa. Our resuls are presened in Secion V. A final secion concludes. 4 There also exiss a relaed empirical lieraure on wo-sided markes (building on heoreical work by Roche and Tirole (2003) and Armsrong (2005)). For example, Rysman (2004) esimaes equaions for readership and adverising demand in he yellow pages marke, wih muliple direcories compeing for readership and adverising dollars in many ciies. Kaiser and Wrigh (2006) sudy he magazine indusry using a similar approach. 5 In some ways, his is he flip side of he lieraure ha looks a hardware providers incenives o supply converers. See Farrell and Saloner (1992) for example. 6 Manena, Sankaranarayanan and Viswanahan (2007) provide a heoreical model of compeiion beween hardware providers in a marke wih indirec neworks when exclusive conracs wih sofware providers are possible. They derive condiions under which he firms find i opimal o conrac for exclusive games. We describe heir model briefly in he nex secion using i o illusrae sofware publishers incenives o release muli-plaform games. 5

7 II. Indusry Background The home video game marke is comprised of a small number of compeing, incompaible video game sysems (or plaforms ). A video game sysem consiss of hardware (a console ha is aached o a elevision se) and sofware (game iles on eiher carridge or CD). Sofware produced for a given hardware plaform canno be played on an alernae plaform; however, as described above, he same sofware ile may be produced for muliple hardware plaforms. Groups of plaforms wih similar echnological characerisics are grouped ino generaions by indusry observers. There have been seven generaions of plaforms in he modern home video game indusry, spanning 1975 o he presen. We focus our analysis on he years 1995 o 2005 inclusive. This ime period covers he launch of mos of he plaforms in generaions five and all of he plaforms in generaion six. I also includes several plaforms from generaions hree and four which were sill acively selling during his period. 7 Table 1 presens he plaforms which are included in our sample, grouped ino generaions. The able also shows heir dae of inroducion and basic echnological characerisics. Three echnical facors deermine he qualiy of a home video game sysem: (1) insrucion word lengh (in bis) of eiher he cenral processor (CPU) or graphics processor (GPU); (2) clock speed (in MHz); and (3) he amoun of RAM (in MHz). As he able indicaes, plaforms wihin a generaion are usually quie similar on hese hree characerisics. Each video game plaform is conrolled by wha we call a console manufacurer and, as is eviden from Table 1, many of he same console manufacurers appear in each successive generaion (afer he firm s iniial enry, of course). 8 In addiion o developing he hardware and operaing sysem, a console manufacurer ypically also produces some sofware ha will run on his plaform (so-call in-house or firs-pary iles). The console manufacurer will also ener ino conracs wih independen sofware publishers 7 We ignore handheld game devices and PC games. 8 Noe ha while we use he erm console manufacurer, i is conrol of he operaing sysem, raher han lieral manufacuring of he hardware, ha is relevan for our purposes. For example, Sony is he console manufacurer for he PlaySaion2. This means ha Sony owns he operaing sysem for his plaform and is responsible for he R&D ha goes ino he developmen and mainenance of PlaySaion2 plaform. Wheher Sony ousources manufacuring of some or all of he componens of he hardware is of no consequence for our purposes. 6

8 o provide games for he plaform (known as hird-pary iles). Sofware publishers finance he developmen of he game (including obaining and paying for any licensed conen he game may use) and perform he markeing and disribuion of he ile. Game developmen (he acual programming) may be carried ou by a developmen eam inernal o he publisher or may be conraced ou o an independen game developer. Conracs beween console manufacurers and sofware publishers generally sipulae ha he console manufacurer is o provide sofware developmen ools o he publisher, while he publisher agrees o proec his inellecual propery. The console manufacurer reains he righ o approve games before hey are developed and released for he console. The conrac also specifies he per-uni royalies o be paid by he publisher o he console manufacurer. Finally, he conrac will specify wheher or no he game under developmen is exclusive o he console manufacurer. As menioned in he Inroducion, over he pas 20 years, his indusry has seen a significan increase in he prevalence of non-exclusive sofware. In Tables 2A and 2B, we documen his change in sofware exclusiviy, firs a he generaion level and hen a he plaform level. Noe ha in Table 2A, he level of observaion is he ile raher han he plaform-ile. This is worh poining ou because he same number of exclusive games will accoun for a larger fracion of oal iles han of oal plaform-iles because non-exclusive releases will be couned on each plaform on which hey are available (i.e. each non-exclusive ile couns as one ile bu more han one plaform-ile). 9 Table 2A indicaes ha here has been a significan decrease in sofware exclusiviy. 88% of iles released in generaion hree were released for only a single plaform. By generaion six, only 61% were exclusive o a plaform. 10 The rend has no been monoonic, however, as a greaer fracion of generaion five games han generaion four games were exclusive. Of course, here is enry of new console manufacurers over ime, so hese changes in exclusiviy across generaions may also be capuring differences in console manufacurers propensiies for exclusiviy. For example, as Table 2B shows, he 9 For example, suppose here are hree iles wih he firs being exclusive o one plaform, he second being exclusive o he oher plaform and he hird being available on boh plaforms. Then he fracion of iles ha are exclusive is wo-hirds while he fracion of ile-plaforms ha are exclusive is one-half. 10 When we use plaform-iles as he level of observaion, we calculae ha while 81% of plaform-iles in generaion hree were exclusive, only 37% of plaform-iles in generaion six were. 7

9 increase in exclusiviy in generaion five likely reflecs he fac ha Sony (who enered he video game marke in ha generaion) had boh he larges number of games and he highes percenage of exclusive games. Since exclusive iles are ofen games ha he console manufacurer publishes iself (i.e. in-house games), one migh wonder wheher he observed decrease in he exen of exclusive sofware is simply reflecing a decrease in he prevalence of in-house games. To invesigae his, he nex row of Table 2A calculaes he fracion of iles ha are exclusive o a single plaform, looking only a iles developed by hird-pary publishers. These numbers indicae ha he fall in exclusive iles is no due o a reducion in in-house publishing. The fracion of hird-pary iles ha are exclusive o a single console is also decreasing over his period. In Table 2B, we show he fracion of each console s games ha are exclusive. This able is useful for highlighing differences in exclusiviy across consoles as well as differences in exclusiviy across successive consoles produced by he same paren (i.e.: differences across Ninendo s various sysems). For example, he able indicaes ha boh Ninendo s and Sony s generaions five consoles had a subsanially higher fracion of exclusive iles han heir generaion six consoles. The numbers in Table 2A and 2B clearly beg he quesion of why non-exclusive sofware has become more prevalen in his indusry. While no he focus of his research in he sense ha we are ineresed in esimaing he effecs of changes in exclusiviy on he scope of nework effecs (and no explaining he change in exclusiviy), i is imporan o briefly discuss wha may be causing his rend. Manena, Sankaranarayanan and Viswanahan (2007) provide a saic model of exclusive licensing in hardware/sofware markes, using video games as heir represenaive indusry. As par of heir model, hey compare a sofware publisher s incenives o develop non-exclusive versus exclusive games. We briefly summarize heir analysis here because i helps us hen explain how changes in he sofware marke may have led o changes in hese incenives over ime. Suppose ha here are wo consoles in he marke. If a sofware publisher releases a game ha is exclusive o one of hese consoles, he earns revenues from he sale of ha game o users of ha console, incurs he fixed coss of developing he game and pays royalies o he console manufacurer for each uni of he game sold. If he publisher 8

10 insead releases he game on boh consoles, he earns revenues from he sale of he game o users of boh consoles, incurs he fixed coss of he developing he game as well as he fixed coss of poring he game o he second console, and pays royalies o boh console manufacurers which may be higher han he royalies paid on he exclusive game if he console manufacurer (in he firs case) offers a lower royaly rae in exchange for exclusiviy. The publisher will prefer o develop he game for boh consoles if he addiional revenue from selling o users of he second plaform exceeds he addiional fixed coss (i.e.: he poring coss) and he addiional licensing fees. Noe ha as he fixed coss of developing a game increase and/or he fixed coss of a poring a game decrease, games may be profiable as muli-plaform releases bu no as exclusive releases. Having idenified he basic radeoff ha a publisher faces, we can now discuss he various changes ha have aken place in he sofware marke and explain how hey migh affec his radeoff. Based on our reading of he rade press and oher indusry sources, we believe ha changes in he cos srucure and echnology of game developmen, an increase in he use of licensed conen in games, and changes in he srucure of he sofware indusry all influence sofware publishers incenives o develop non-exclusive games. Figure 2 shows one indusry analys s esimae of game developmen coss over he pas 25 years. This figure is roughly consisen wih daa we have seen elsewhere ha esimaes he average cos of game developmen in generaion five was around $1 million, while he average cos of game developmen in generaion six was $5-7 million (Lofus, 2006). As illusraed by he discussion above, when he fixed coss of game developmen increase, more proecs become viable only when hey reach a very large audience larger perhaps han any one plaform can provide. In order o recoup hese massive developmen coss, publishers have an incenive o release a ile on muliple plaforms. The composiion of developmen coss has also changed in imporan ways. Wih he rise o dominance of he CD-based console in generaion five, games have become relaively more conen -inensive. CDs make i cheaper o sore vas quaniy of graphical and musical daa in a game, compared o he prior echnology ha used semiconducor chip-based carridges. As a consequence, a larger fracion of he 9

11 developmen coss has become aribuable o asks like music licensing or composiion and performance, moion-capure sudies, background ar and design (see Lofus (2006) and Reimer (2005)). Since hese coss are no specific o a plaform (for example, music is no operaing sysem-specific), he fracion of iniial developmen coss ha mus be duplicaed in order o por a game o a second plaform have shrunk. In addiion, poring coss have fallen because of he rise of sophisicaed cross-plaform developmen ools called middleware ha can dramaically reduce he coss of wriing a game for muliple plaforms compared o he radiional complee rewrie (Reimer, 2005). 11 Middleware allows specific echnical aspecs of he game for example, 3-D animaion o be developed wihin a programming ool ha can provide oupu usable by he operaing sysems of more han one plaform. In sum, he echnology of game developmen has changed so ha more of he iniial coss incurred when wriing a game for is firs plaform are avoidable in poring he game for a second. This reducion in he relaive cos of poring clearly increases he araciveness of nonexclusive releases. 12 Furhermore, as shown in Table 2A, sofware publishers are increasingly relying on licensed conen and sequels. Indusry observers aribue his o an aemp o miigae risk of failure in an environmen wih skyrockeing developmen coss (Reimer, 2005). This move o a blockbuser model mimics an ofen cied developmen in Hollywood filmmaking, which experienced a similar simulaneous run-up in producion budges and increased reliance on sequels. No only may ballooning budges make he relaive predicabiliy of a licensed game seem aracive, bu i also inroduces anoher player ino he game developmen process. If he owner of he relevan inellecual propery (e.g., he Baman franchise) is pursuing a broad, muli-produc or muli-channel sraegy for disseminaing is conen and building/exploiing is brand, and if here are spillovers across markes (e.g., video game sales simulae acion-figure sales), i may provide publishers wih incenives (perhaps wih lower licensing fees) o develop a non-exclusive game based on is conen (even if, in he narrow conex of video games sales alone, i migh be more profiable o license is conen for developmen exclusively on one plaform). 11 Also see he Poring in gaming enry in Wikipedia. 12 Manena, Sankaranarayanan and Viswanahan (2007) sae ha indusry figures indicae ha poring coss are now ypically in he range of 15% o 25% of he iniial developmen coss. 10

12 One final change ha migh have faciliaed he rise in nonexclusive games is he growh and mauraion of he sofware publishing indusry. The final row of Table 2A shows ha he average number of iles released by an independen publisher has grown more han hree-fold over his period. As game developmen has increasingly become financed by publishers raher han by developers, and as developmen coss have soared, publishers have grown larger and beer capialized, wih a number of he larges becoming publicly raded. This should correc some capial marke imperfecions likely presen in he indusry s earlier days and make in-house publishing less necessary as a means of simulaing sofware developmen due o lack of financing. Of course, here may be oher reasons ha plaform providers wish o be involved in in-house publishing, bu he relaive increase in he independen provision of games may be in par due o his developmen. And, since in-house games are almos always exclusive (apparenly because plaform providers are relucan o share heir IP and developmen ools wih rival plaforms, in addiion o he fac ha i may in heir ineres o simulae plaformspecific demand), a rise in independen publishing may increase he prevalence of nonexclusive games. III. Empirical Approach Indirec nework effecs can be esimaed in wo ways. One can rea hem as direc nework effecs and esimae a direc relaionship beween he demand for a given hardware plaform and is insalled base (see Ohashi (2003) for an example). Or, one can explicily accoun for he feedback beween hardware and sofware by esimaing boh a hardware demand equaion (in which hardware demand depends on sofware availabiliy) and a sofware supply equaion (in which sofware supply depends on he insalled base of hardware). Finding of a posiive effec of sofware availabiliy on hardware demand and a posiive effec of hardware insalled base on sofware supply esablishes he (indirec) posiive relaionship beween he demand for a hardware plaform and he exising number of users of ha hardware. This is he basic approach followed in he exising lieraure cied above, and we employ i as well. However, as we describe in he nex wo subsecions, we modify i o accoun for he changing scope of indirec nework effecs in his indusry. 11

13 III.A. Hardware demand We model a consumer s choice of which (if any) hardware plaform o buy in a given monh as a discree choice problem in which he consumer evaluaes he uiliy ha he would receive from each poenial plaform and chooses he one plaform ha maximizes his uiliy. We include an explici ouside good so ha consumers also have he opion of buying none of he plaforms. Following Berry (1994), consumer i s uiliy from purchasing console, in monh is wrien as, (1) u = x β + αp + γsw + ξ + v i where x is a vecor of observed characerisics for console in monh, of console in monh, i p is he price SW is a measure of sofware availabiliy for console in monh, ξ is a vecor of unobserved (o he economerician) characerisics for console in monh (such as markeing or brand image), and consumer is assumed o choose he produc ha maximizes his uiliy. v i is an idiosyncraic error erm. Each The coefficien γ measures he relaionship beween hardware demand and sofware availabiliy. We expec γ > 0, meaning ha greaer sofware availabiliy on plaform increases a consumer s uiliy from console. Because of daa limiaions, in mos of our specificaions we have o assume ha consumers care only abou he number of iles available for he console and no abou he qualiy of hose iles. Bu, because we know ha here is, in fac, quie a bi of heerogeneiy in he qualiy of games (and, indeed, only a small number of iles acually become his ), we also aemp some qualiy-adused sofware measures. Coninuing o follow Berry (1994), we le δ = x β + αp + γsw + ξ denoe he mean valuaion of console across all consumers, meaning we can inerpre v i as he difference beween consumer i s valuaion of console in monh and he mean valuaion. The disribuion assumed for v i deermines he choice probabiliies and subsiuion paerns. We adop a nesed logi framework and group all inside goods (i.e.: all consoles) ino one nes and he ouside good ino anoher. This allows for correlaion 12

14 in v i across he inside goods, allowing hem o be closer subsiues wih each oher han hey are wih he ouside good. As Berry (1994) shows, wih hese assumpions on v i and by seing he mean uiliy of he ouside good o zero, he following linear esimaing equaion for one-level nesed logi can be derived, (2) ln( s ) β / + ξ ln( s0 ) = x αp + γsw + σ ln( s g ) where, s / is console s wihin-group share (his is console s share of all consumers g who purchase any console in monh ) and ξ is he economeric error erm. In our empirical specificaions, we divide ξ ino a ime invarian componen which we will esimae as a plaform fixed effec and a ime-varying componen. 13 We also include dummy variables o conrol for he monh of he year. These capure he fac ha he perceived qualiy of all consoles may be higher in some monhs such as November and December when parens are purchasing gifs for children. Furhermore, we conrol for he age of he console (wih eiher polynomials or dummy variables) o capure how perceived and acual qualiy changes wih a console age. 14 Finally, in some specificaions we replace he separae plaform and age effecs wih plaform-age fixed effecs. This is our mos flexible specificaion in he sense ha hese fixed effecs conrol for he unobserved qualiy of each plaform in each year of is life. I is worhwhile o highligh he way in which non-exclusive sofware (i.e.: game iles available on muliple compeing plaforms) affecs he demand analysis. Exclusive and nonexclusive sofware iles do no need o be disinguished from one anoher in he daa or in equaion (2). This is because he righ-hand side of equaion (2) is lierally he mean uiliy ha a consumer receives from purchasing produc. As is eviden from he uiliy funcion in (1), wheher or no a paricular game is exclusive o console has no impac on he uiliy ha a consumer derives from console. Tha is, when evaluaing his uiliy from a given console, a consumer will consider he games ha can be played on 13 Because we include plaform fixed effecs, he marginal uiliy of plaforms characerisics which do no change over ime (for example, wheher he plaform is carridge or CD based) will no be separaely idenified. 14 For example, consumers may use console age as a signal for how longer hey expec sofware wriers o produce sofware for ha console. Alernaively, oher ypes of complemenary producs may emerge for a console (such as, gaming websies or magazines ha offer ips ) as i ages. The age variables will pick up boh of hese hings. 13

15 ha console bu no wheher or no hose same iles are also available on oher consoles. However, wheher or no sofware is exclusive o a console will affec he relaive uiliies of he differen alernaives and herefore which console a consumer ulimaely chooses. Games ha are available on muliple plaforms will increase he uiliy he consumer ges from each of hose plaforms and will, in urn, have lile effec on he probabiliy ha he consumer chooses one of hose plaforms over anoher. On he oher hand, an exclusive ile will increase he likelihood ha a consumer chooses a paricular plaform. Given his, one way o illusrae he differen effecs ha exclusive and nonexclusive sofware have is o calculae separae derivaives of demand wih respec o exclusive and non-exclusive sofware. 15 When calculaing he change in demand in response o a change in exclusive sofware, he change in sofware will only affec he aribues and uiliy of plaform. In conras, when calculaing he change in demand wih respec o non-exclusive sofware, he change in sofware will affec boh he aribues of plaform as well as he aribues of all oher plaform on which his game is available. In a logi model, he demand for any produc depends on he characerisics of all producs in he marke; herefore, an increase in exclusive sofware will clearly have a larger effec on demand han an increase in non-exclusive sofware. III.B. Sofware supply Our supply equaion generally follows he previous lieraure, wih modificaions ha allow us o esimae wheher he scope of indirec nework effecs in his indusry has changed. In paricular, we modify he sofware supply equaion so ha we can explicily esimae wheher, in successive generaions, compeing plaforms insalled base generae a posiive spillover in he producion of sofware for plaform. This would provide evidence ha he rise of non-exclusive sofware resuling from changes in he sofware producion process acs like an increase in compaibiliy in ha i changes he scope of indirec nework effecs from being plaform-specific o being generaion-specific. 15 Prieger and Hu (2006) ry o esimae wheher indirec nework effecs in he video game indusry are sronger for exclusive han non-exclusive games. They explicily disinguish he wo ypes of sofware in he consumer uiliy funcion find no difference (if anyhing, hey find ha non-unique games have a larger effec). However, given he discussion here, i is clear ha here is no reason o expec he uiliy of he wo ypes of games o differ. Raher, i is heir effecs on demand ha should differ. 14

16 We esimae a reduced-form relaionship beween he variey of sofware available on a plaform and ha plaform s insalled base of hardware. 16 Specifically, we esimae he following equaion, (3) ln( SW ) = + Z β + γ 1IB + γ 2IB where, α is a plaform fixed effec, α + η Z is a vecor of characerisics of console in monh ha may affec firms incenive o supply sofware for ha console (such as he age of he console), IB is he insalled base of console in monh, IB is he insalled base of all oher consoles in he same echnological generaion as plaform, and η is an error erm. Because we believe ha over our sample period - here have been a series of imporan echnological changes in he sofware side of his indusry, we conrol for ime effecs wih eiher year or monh dummies. 17 The inclusion of plaform and year (or monh) dummies prevens us from also including plaform age dummies (his is he common cohor/age/year problem) so we insead include higher order polynomials of plaform age. 18 γ 1 capures he relaionship beween he supply of sofware for plaform and is insalled base while γ 2 capures he relaionship beween he supply of sofware for plaform and is compeiors (combined) insalled base. We expec γ > 1 0, meaning ha increases in a plaform s insalled base simulae he provision of sofware for ha plaform. If i were echnologically impossible (or prohibiively cosly) for sofware providers o release he same game on more han one plaform, hen we would expec γ 2 o be less han or equal o zero. 19 However, as he coss of poring a game from one plaform o anoher fall, he possibiliy (and profiabiliy) of non-exclusive releases 16 This is basically he same reduced form model employed by Clemens and Ohashi (2005) and Prieger and Hu (2006) in esimaing he supply of sofware. The primary difference is ha we allow dependence of one plaform s sofware supply on all plaforms insalled base of hardware. 17 These are acual monh dummies as opposed o he calendar monh dummies we include in he demand equaion. Obviously, hese monh dummies subsume he calendar monh dummies; however, we do include he calendar monh dummies when we include only year effecs. 18 See Hall, Mairesse and Turner (2005) for example. 19 Compeiors insalled base should have no direc effec on he supply of sofware o plaform ; however, here may be indirec effecs ha would lead o γ < 2 0 in a reduced form model. For example, when deciding wheher o produce games for plaform, sofware publishers may use he insalled base of plaform k as a signal of he expeced fuure growh of plaform. 15

17 increases. Sofware providers incenives o provide games for plaform may hen be posiively influenced by he insalled base of oher plaforms since he fixed coss of sofware developmen for plaform can also be spread across hese consumers. Thus, over ime we expec γ 2 o become posiive. We es his hypohesis by allowing he coefficien γ 2 o vary by generaion so ha we esimae how he relaionship beween compeiors insalled base and he supply of games for plaform changes over our sample period. We can hen combine he parameers of he demand and supply equaions o esablish he exisence and scope of indirec nework effecs in his indusry. In paricular, a finding of λ > 0 in he demand equaion and γ 0 in he supply equaion esablishes he presence of a plaform-level indirec nework effec. A finding of λ > 0 in he demand equaion and γ 0 in he supply equaion esablishes he presence of a 2 > generaion-level indirec nework effec. Moreover, a finding ha γ 2 increases over successive generaions in our sample would indirec ha he scope of indirec nework effecs has changes from users of he same plaform o users of differen plaforms in he same generaion. Noe ha his change in he scope of indirec nework effecs can ake place even in he absence of physical compaibiliy beween he producs. 1 > III.C. Endogeneiy i. Hardware Demand Price, Wihin Group Share and # of Tiles are all poenially endogenous in he demand equaion. Wih he inclusion of plaform fixed effecs, he error erm in he demand equaion can be inerpreed as he deviaion of he unobserved qualiy of plaform in monh from is average unobserved qualiy. This error erm may capure several sources of variaion in unobserved qualiy. Firs, i may capure changes in perceived qualiy ha resul from adverising campaigns (since hese would occur a differen poins in a plaform s life cycle, hey would no be conrolled for by he plaform fixed effecs). Second, i may capure changes in qualiy ha resul from he release of new informaion abou he plaform - for example hrough posiive or negaive produc reviews. Finally, i may capure changes in qualiy ha resuls from he 16

18 emergence of complemenary producs (oher han sofware) ha enhance he value of he plaform for example, a websie ha provides ips on how o solve games. Because hese ypes of changes in unobserved qualiy will be considered by firms when seing prices and by consumers when making choices, hey will likely be correlaed wih boh Price and Wihin Group Share. In addiion, if changes in unobserved qualiy are persisen over ime (i.e.: if here is serial correlaion in he error erm in he demand equaion), hen # of Tiles may be endogenous as well. This logic is perhaps bes illusraed wih an example. Suppose ha in monh, plaform has a high level of unobserved qualiy because he plaform received posiive reviews from gaming websies. This increase in qualiy will lead o higher demand from plaform ha monh. This, in urn, will increase he insalled base of plaform in monh +1 and, hrough he sofware supply relaionship, increase he supply of games for plaform in monh +1. If he increase in he unobserved qualiy of plaform persiss (i.e.: he posiive reviews in monh increase he qualiy of plaform in monh +1 as well), hen here will be correlaions beween # of Tiles in monh +1 and he error erm in he demand equaion in monh +1. Because we expec ha a leas some of he ime-varying componens of unobserved qualiy may persis for more han one monh, we rea # of Tiles as endogenous. Following Berry, Levinsohn and Pakes (1995), we consruc insrumens ha measure he exen of compeiion faced by a plaform as well as he exen o which ha compeiion comes from oher plaforms owned by he same paren. Specifically, our insrumens include he sum of each hardware characerisic (processor speed, memory, and processor word lengh in bis) over he compeing producs in he marke, he oal number of compeing plaforms in he marke, he number of compeing plaforms from he same generaion, and he number of compeing plaforms from he same manufacurer (i.e.: he number of oher Ninendo consoles acively selling in he marke). We expec ha hese variables will be correlaed wih plaform s price (because hey affec plaform s abiliy o raise prices), plaform s wihin group share (because hey affec he relaive uiliies of he differen opions), and plaform s sofware (because, as we show in our modified supply equaion, hey affec sofware providers incenives o supply games o plaform ). However, hese insrumens should be uncorrelaed wih he 17

19 error in he demand equaion because ha error erm is lierally he unobserved uiliy of plaform in a given monh which is independen of he characerisics of oher offerings. Noe ha all of hese insrumens vary over ime for a given plaform (and are herefore no subsumed in he plaform fixed effecs) because he mix of plaforms in he marke changes wih enry and exi. Noe as well ha he endogeneiy concerns discussed here are likely o be considerably less severe in specificaions ha include plaform-age fixed effecs since hese allow he unobserved qualiy of a plaform o change in each year of is life. ii. Sofware Supply The insalled base variables may be endogenous in he sofware supply equaion. As above, his endogeneiy problem will resul if here is serial correlaion in he error erm. Specifically, a high value of η will simulae addiional games for plaform in monh. This will increase he uiliy and sales of plaform ha monh which will +1 increase he insalled base of plaform in monh +1. If η is correlaed wih η, hen Plaform IB will be endogenous. Because he sofware available on plaform also affecs he demand for compeing plaforms (and hence heir insalled base), he Generaion IB erms can be endogenous as well. To insrumen for a plaform s insalled base, we consruc a measure of ha plaform s price hisory by aking he average of is price in each monh since is launch. To insrumen for he insalled base of oher plaforms in a generaion, we use he average price hisory of all compeing plaforms in he generaion. In boh cases, we expec ha he price hisories will be correlaed wih he insalled base variables because hey influenced sales in prior periods. However, hey should be unrelaed o he error erm in he sofware supply equaion since sofware providers care only abou curren and fuure insalled base (and hus he only avenue by which pas prices should affec curren sofware availabiliy is hrough heir affec on pas sales). IV. Daa IV. A. Sources of Daa 18

20 Our empirical analysis combines several sources of daa. Our daa on hardware prices and quaniies were obained from he NPD Group, a marke research firm. The NPD Group collecs daa from approximaely wo dozen of he larges game reailers in he Unied Saes. These reailers accoun for abou 65% of he U.S. marke. From his daa, NPD formulaes esimaes of figures for he enire U.S. marke. The NPD daa provides monhly uni and dollar sales of each console wih posiive sales. Dollar sales are divided by uni sales o obain an average monhly price for each console. Our hardware daa covers he period , inclusive. We supplemen hese daa wih informaion on he echnological characerisics and release daes of each console, which we colleced from a variey of sources including analys repors, company websies, and rade publicaions. Technological characerisics include processor speed, processor word lengh (8-bi, 16-bi, ec he basis of mos groupings of video game sysems), console memory capaciy, and wheher he sysem was CD-ROM based. While hese characerisics are no acually separaely idenified from he plaform fixed effecs ha we include in our specificaions, hey are imporan because we use hem as insrumens for price. Our main source of daa on sofware is is a websie ha seeks o caalog all relevan informaion abou elecronic games (compuer, console, and arcade) on a game-by-game basis. 20 MobyGames provides a daabase of sofware iles ha includes he release dae of each ile, for each plaform on which i appears and for each counry in which i is released. The daa also conain he name of he publisher, he genre of he game, and an indicaion of wheher i uses conen licensed from anoher pary (like a movie sudio). This daabase in principle goes back indefiniely in ime, and is inended o capure all releases from he beginning of each plaform s life. 21 IV. B. Variables 22 i. Marke Shares and Insalled Base Measures 20 See hp:// The informaion conained in MobyGames daabase is provided by he websie s creaors as well as from volunary conribuions. All informaion submied o MobyGames is checked by he websie s creaors. 21 Is earlies enries are in 1972, for which here are six releases for he Odyssey game sysem. 22 Variable names and definiions appear in Table 3a. Table 3b presens summary saisics. 19

21 Esimaion of he hardware demand equaion requires ha we consruc measures of each plaform s share of he oal poenial marke for video game consoles as well as is share of he share of he marke capured by all of he inside goods combined. Following Clemens and Ohashi (2005), we define he poenial marke for video games consoles in any monh o be he number of households wih a elevision (aken from he U.S. Census websie) less he combined insalled base of all acive plaforms (i.e.: we wan o subrac a measure of he number of consumer who are no in he marke because hey already own plaforms). The simples such measure would be he sum of each console s pas sales. We sar by consrucing a plaform-level insalled base measure (Plaform IB). Since six of he en plaforms ha we sudy launch wihin he period of our daa, we can consruc heir pas sales simply using he sales figures from our daa. 23 For he oher four plaforms, we obained daa on heir year-end 1994 insalled base from oher sources. The year-end insalled base figures for he plaforms in generaions hree and four come from Shankar and Bayus (2003) while he figure for 3DO comes from an analys repor. For hese four plaforms, we consruc Plaform IB by combining hese figures wih he NPD sales daa. Noe ha for each plaform, we runcae he ime series in he monh ha is sales firs fall under 1000, defining his as a plaform s exi from he marke. While we could use his Plaform IB measure in our consrucion of he oal poenial marke, i presens a problem. In paricular, his approach does no allow users of an old plaform o gradually re-ener he marke; raher, when an old plaform exis he marke by having is sales fall below 1000 in a monh, i yields a discree (and poenially huge) influx of new cusomers ino he poenial marke. We solve his problem by modifying he insalled base variable based on a depreciaion rae. Specifically, we calculae each monh s insalled base as a fracion of he previous monh s insalled base plus he previous monh s hardware sales, where he depreciaion rae varies wih he age of he plaform. 24 We call his variable Depreciaed IB. We focus on his paricular formulaion of he depreciaion rae because, pracically speaking, 23 While Table 2 gives a launch dae for Jaguar ha predaes our sample, is naional launch was no unil he end of 1994, so we ignore sales prior o our daa, which begins in January The monhly depreciaion rae (or rae of reenry ino he poenial marke) is imes he age of he plaform in years. This yields abou a 1% re-enry over he course of he firs year and abou a 7.5% reenry rae over he course of a plaform s enh year. 20

22 i yields declines in insalled base ha roughly coincides for mos plaforms wih heir exi from he marke defined by curren sales. We also run robusness checks using alernae ways of measuring insalled base. Having calculaed each plaform s depreciaed insalled base, we hen calculae he oal poenial marke for video game sysems in a monh as he number of U.S. households wih a elevision minus he sum of Depreciaed IB over all acive plaforms. We consruc a plaform s marke share in a monh as is hardware sales divided by he oal poenial marke and call his Marke Share. We consruc a plaform s wihingroup share (Wihin Group Share) as is hardware sales ha monh divided by he oal hardware sales of all acive plaforms ha monh. The share of he ouside good (which is needed o consruc he dependen variable for he demand equaion) is calculaed as one minus he combined marke shares of all of he acive consoles in a monh. Our sofware supply equaion includes measures of boh a plaform s own insalled base and he insalled base of he oher plaforms in is generaion. We use Plaform IB in he sofware supply equaion and calculae Generaion IB as he sum of Plaform IB over he compeing plaform s in a generaion. ii. Console Characerisics Because our hardware demand equaion includes console fixed effecs, non-ime varying console characerisics (such as echnical specificaions) are no separaely idenified. The hree ime-varying characerisics ha we include in he demand model are price, age and, of course, sofware availabiliy. We consruc he average price of each console in each monh (Price) by dividing he console s dollar sales by is uni sales. We measure he age of a plaform as he number of monhs ha have pas since he plaform s U.S. launch monh. We call his variable Plaform Age. In some specificaions, we measure a plaform s age in years since is U.S. launch. While he age of a console may no direcly affec consumers uiliy, we expec ha i maers indirecly. For example, consumers may use console age o predic how many more new games may be released for ha console or hey may use i o predic when he nex generaion of machines may be launched. Age may also capure he availabiliy of complemenary producs oher han sofware, such gaming magazines and/or websies. 21

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