Internet Business Models: New Options for Game Developers

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Internet Business Models: New Options for Game Developers
By Ian MacInnes, Ph.D
Gamasutra
June 05, 2000
URL: http://www.gamasutra.com/features/20000605/macinnes_01.htm

Editor's note: This paper was originally published in the 2000 Game Developer's Conference proceedings

Since its inception the games industry has relied primarily on traditional retail models to sell its product. Developers have faced several intermediaries in getting their games to customers. The Internet is certain to transform this industry as much as or more than any other because of the fundamental characteristics of the product. Unlike most products, games can be distributed digitally to end users without using a single intermediary. There are, however, barriers to direct sales that have to be overcome before such a strategy can be successful.

One of the key issues in electronic commerce is how it transforms traditional relationships between different stages in the process of moving a product from its source inputs to its final customer. The purpose of this article is to outline how the growing use of the Internet is changing business models in the computer and video game industry.

Intermediaries Between the Game Developer and the Consumer

In general, game developers have not chosen to sell a significant volume of their output directly to consumers because it has been very difficult to attract the attention of a large number and then distribute products directly to them. Instead game developers have had to first attract interest from publishers, then negotiate contracts with them so that the publisher completes many of the value added activities that must occur. In software development, the product is largely complete before it goes to the publisher. The publisher may wish to contribute to some aspects of the product such as providing feedback on content, analyzing focus groups of consumers, and testing the product for bugs and balance. Essentially, however, the publisher's key tasks occur after the developer completes the intellectual task of providing a complete product. The publisher must then take the finished work of the developer and mass produce, package, and send it through distribution channels to retail locations where it can be sold to the consumer.

Prior to receiving the finished product, the publisher develops and implements a marketing strategy that can include advertising in appropriate media outlets. It also may negotiate special promotional activities with retailers. The retailers then decide how to place the product in their store such that the combination of all choices and special deals with publishers maximizes the overall profit level of the store. Consumers then purchase product that appeal to them, based on the exposure that they have had to them from promotional activities inside and outside of the store that they frequent. There are thus several independent entities that can handle the developer's product between its completion and its purchase by consumers. These include the publisher, the distributor, and the retailer. The key problem with this model from the developer's perspective is that it receives only a small portion of the final consumer purchase price. For example, the developer might receive only a couple of dollars for every $50 purchase of its product made by consumers.

The Traditional Retail Model

To obtain a mass market for any software product has, until recently, required the use of traditional retail channels. Developers first must find a method of getting a software title onto the shelves of a high volume retailer. This often requires the distribution skills of a successful publisher. For example, Microsoft has developed strong relationships with retailers over many years and can achieve prominent placement of its titles. Products can achieve higher sales at retail through promotional material in stores such as posters and flyers, recommendations from store employees, and box displays such as end caps between aisles. This is principally designed to encourage people to buy products on the spur of the moment or to plant the idea in the customer's head that the product is worth buying on a future trip to the store.

New Internet Revenue Models

There are several different options for Internet business models for the game industry. These models are not mutually exclusive. Combinations of two or more models can be used for a single product.

1. Shrink Wrapped Box

This is a hybrid model in which people play a game online that they have purchased in a store. Most successful multiplayer games have followed this model, at least in part. For example, games such as Ultima Online and Everquest require the purchase of a retail box prior to paying subscriptions to continue using the product. Many games, such as Age of Empires, Starcraft, and Quake, have both multiplayer and single player options. These have only been sold through the retail channel. This model will become less viable as consumers become less willing to pay more for software distributed in retail stores and become more comfortable with downloading programs. Like the traditional model, the success of this model depends on the degree of in-store promotion and placement of an attractive package on store shelves. As well, however, a certain degree of online promotion, such as through demonstration versions, can also help this model succeed.

2. Full Version Download

This represents the purchase of the product by a consumer without receiving any physical box or manual. The program exists only in an electronic form. This could be achieved through a direct sales model where the developer permits downloads off of its own server after electronic payment via credit card. In this model the developer receives substantially more revenue per customer purchase but the trade-off is that it is unlikely to be as effective in reaching consumers as it would be if a high volume Internet site promoted the download or if a traditional retail channel were used. Thus the developer would receive a bigger piece of a much smaller pie. Existing publishers are unlikely to benefit from full version download in the near term because it would undermine their relationships with bricks and mortar retailers. Currently, a key determinant of the success of mass market games is the level of promotional activities that occur at hybrid traditional/Internet retailers such as Babbages and Electronics Boutique.

3. Cross-promotion

Cross-promotion is a revenue model that holds great promise and that successful portals, such as Yahoo and MSN, have bet on. The site provides free matching services for online games. This attracts users who can then view advertisements or buy goods that are being sold on the site. Games are particularly effective in attracting traffic because they tend to captivate attention for longer periods than most web sites do. This model should have an attractive interface that will foster chat among users because this adds to the time that the user remains on the site and the friendships that can be formed provide an incentive to return. The development of user communities is essential to the promotion of games online and to the success of the cross-promotion strategy. According to a Merrill Lynch report, about 50% of user time on game sites is spent chatting with others. Related content such as tips, downloadable bug fixes, and tournaments are other important features. A key decision that developers face is whether to rely on large multi-developer games sites such as Mplayer or to build a proprietary one such as Blizzard's Battle.net. The major trade-off is between greater traffic and more directed promotion of your own products. Smaller developers require significant promotion of their games and will prefer to partner with publishers that have strong proprietary game sites.

4. Advertising

There are several potential methods of using advertising to gain revenue from a game. These include sponsorships, Internet banners, interstitials, and product placement in games.
Advertisers could sponsor tournaments or match-making rooms on gaming sites. Internet banners could also be used on gaming sites because substantial portions of time are spent setting up games and chatting about them. Click through rates may, however, be lower than average because games often demand closer attention than other types of web sites. Interstitials are ads that can be either static or animated that appear when a game is paused. Advertisers pay for the placement of their products in movies and television programs. They could also do so with respect to games. This might be effective with sports games, for example, since sporting events usually have billboards and other methods of conveying commercial messages. Advertising in this case would not look out of place. This could also apply to action and adventure games in modern settings.

Advertising is already a significant portion of online gaming revenues. According to Merrill Lynch, it is expected to grow from 20% of revenues in 1997 to 42% by 2002. However, there are some issues to consider with respect to advertising. For example, parents may be concerned about advertising aimed at their children. Governments may wish to regulate such advertising as a result. As well, since many games bring their players into fantasy worlds in-game advertising would detract from the atmosphere created. Another concern is whether advertisers will see games as a strong enough outlet to offer substantial contracts.

Games, however, have significant advantages. For example, users spend much longer on gaming web sites than they do on other types of sites. As well, online games are particularly strong in the young demographics that appeal to most advertisers. According to Merrill Lynch, approximately 52% of online gamers are college age or less. This proportion is expected to grow to 75% by 2002. For advertising to provide sufficient revenue, however, requires a very high volume. This is unlikely, therefore, to be a feasible model for a company that does not have a well established brand or franchise.

5. Rental

Video game cartridges are often rented in a similar way to cassettes of movies. Unlike movies, however, there is a substantial "try before you buy" advantage to consumers with games. If the game is compelling there is a relatively high probability that the customer would buy rather than rent it again. The Internet, together with technology allowing games to be locked and unlocked with codes, has fostered the rental of PC based games. For example, a company named Software-on-demand.com rents games for three day periods for $5. The software requires an Internet connection to work. The company distributes it in the physical world and through direct download at 1800software.com. Alternatively, users can purchase the game for $30. This revenue model is likely to have limited success as long as the process of rental remains as technically cumbersome as it is now. Further, users may prefer the alternative of downloading a less functional free version since this method of "try before you buy" is less expensive and can achieve the same outcome. Thus the rental model provides the benefit of some income in the try-out period but this is offset by the cost of exposing the full product to a much smaller potential market. It would seem, therefore, that this revenue model is less appropriate for a product that is intended to compete in the mass market.

There are a few variations on the rental model. Renting by the day is similar to the video store model but it is also possible to rent a game by the minute or by the hour, as hotels often choose to bill. Similarly you could charge a fee on a per game basis, as is done in an arcade. Revenue models based on charging for short periods of time are unlikely to be successful in terms of developing a mass market. Many people do not like to play under the clock, particularly when they know how addictive games sometimes are. This also is less viable on the Internet because many target gamers, such as children, do not have credit cards.

6. Pay Per Feature

One option that has been used successfully for many types of software is to give users a partially functioning product for free and then sell add-ons. The best example is the Doom phenomenon, which started as a shareware program and was compelling enough that many users paid the developers for additional levels. Similarly, some games offer add-on packages that provide new features but that can only be used if the original program was previously installed. A new type of game with a similar model is the "virtual collectible," which is modeled on trading card games such as Magic the Gathering and Pokémon. People can buy, sell, and trade cards just as they do in the physical games. Sony's Chron X is an example of this model. The disadvantage of this type of game is that it can create an unlevel playing field in multiplayer games because the player that has spent the most has a better probability of winning. As well, it is hard to imagine people seeing a virtual collectible as holding any potential long term value whereas the value of rare trading cards is a proven phenomenon.

7. Auction

An unusual potential revenue source is from percentages of a transaction paid in an auction in which users sell items that they have collected while playing an adventure game or a virtual collectible game. The most well-known examples are the sales of portions of Ultima Online and Everquest accounts on eBay. In some cases, bids have exceeded $1,000 for items that would seem to have no value in the physical world. Any successful multiplayer game that involves the collection of items that are transferable to other players could benefit from its own auction site. While it might seem logical to allow this service to be done by eBay, an electronic transactions model could be developed by the owner of an online game that would eliminate the possibility of fraud or disagreements between buyers and sellers. Thus assuming that the price was within reason, users would strongly prefer the official channel for trading over eBay. It could also improve interaction between players in a virtual community. At the moment, the volumes may not be high enough to justify the implementation of dedicated markets but this could change as new gaming models with internal economies develop and become successful.

Feasibility of Digital Distribution

Eventually the computer and video game industry will move entirely toward digital distribution. It is unclear, however, when this will happen. Several impediments must be overcome.
First, there must be an effective way of ensuring that versions of programs downloaded from the Internet cannot be easily copied and forwarded to people who have not paid for them. Until recently, the console industry, with its proprietary cartridges, has faced a relatively limited piracy problem. Computer game publishers, however, have evolved from disk based copy protection to codes and then CD access requirements. With the advent of cheap CD burners, some have returned to disk based protection. Regardless of the method, virtually every major release of a game including many beta versions gets cracked and placed on warez sites within days of release. This has evolved into a pastime for many dedicated warez producers and consumers who will place enormous programs on the web, often in over 100 separate downloads for a single program. Only a true enthusiast would submit himself to the onerous task of downloading and reassembling the program but this could soon change as more and more households gain access to higher bandwidth. It seems unlikely that producers will gain a significant advantage over pirates in the near future but this in itself should not result in enough lost revenue to offset the potential benefits of digital distribution to a developer who can directly serve game buyers.

The size of games has grown enormously in the past decade as richer graphics and 3D engines have been incorporated. As a result, any move to digital distribution of computer and video games will require widespread access to high bandwidth Internet connections. Cable modems have experienced a surprisingly rapid adoption rate among households with access to them. According to Merrill Lynch, 40% of all households that had the opportunity to subscribe in 1998 did so. This certainly bodes well for the future of broadband Internet access because cable companies will be racing to serve this large potential market and will be in competition with phone companies and their digital subscriber line services. The demand for high bandwidth services will also be driven by the increasing usage of the Internet at slow speeds. According to IDC projections, online access in the United States will grow at an annual rate of 23% between 1998 and 2002. By then 67.6 million households will have online subscriptions, an amount that rivals the adoption of cable television. The declining price of PCs will likewise drive the demand for bandwidth.

A third major impediment to digital distribution is consumer habit. Many people find shopping in physical stores to be a sensory and social experience with intrinsic benefits that cannot be easily replicated on the Internet. They like to browse, pick up a box that attracts their attention, flip it over, read it, pay for it, and bring a tangible item home with them. They like to talk with store clerks who can give them advice and recommendations. Many buyers walk into a software section with no idea what they might buy and leave with an item chosen on the basis of having been in attractive packaging and prominently displayed, at a satisfactory price. Casual and mass market buyers of games, including those buying them as gifts for others, are often impulse purchasers who are currently much less likely to buy on the Internet instead of at their local Walmart. The phenomenon of hunting games shows the power of impulse buying and the mass market. Until web sites can find ways of attracting purchases from these buyers, there will be a significant role for traditional retail establishments in the sale of computer and video games.

Eventually the relative efficiency of Internet distribution will outweigh these impediments and developers, publishers, and consumers will conduct the bulk of their transactions on the Internet. Physical software sections of stores will recede and eventually disappear. This may not happen in the next few years but a decade from now this could be a reality.

Prospects for Disintermediation in Game Development

The computer and video game industry is special in that no physical presence, box, or physical delivery of anything is required to move the product from its original producer to its end user. The odd nature of this type of product makes traditional intermediaries particularly vulnerable to being cut out of the industry value chain. The bargaining power of bricks and mortar retailers of games will slide very quickly once digital distribution grows. The power of publishers is also challenged and this may result in significantly higher royalties for developers due to the declining need for some of the areas in which publishers have added the greatest value. Manufacturing capabilities, logistical competencies, and relationships built with large retailers will rapidly decline in importance. They will have to strengthen their abilities to market directly to consumers and, above all, will have to have a powerful web site that attracts much consumer traffic. Unless publishers can add significant new value, many developers will prefer to develop their own web presence and sell downloads of their products directly to consumers.

To understand this, it can be useful to consider some parallels with the music industry. There has been a significant shift in bargaining power away from music labels and toward artists as a result of the growing popularity of digital download of music via MP3. Artists such as David Bowie have established their own web sites and no longer feel the need to rely entirely on labels for the promotion and distribution of their music. This industry faces similar concerns related to piracy, bandwidth, and consumer habit. Nevertheless, the speed at which the music industry is being transformed would have been considered shocking only a few years ago. The traditional music industry has a very similar structure to the game industry of today. The artists create the content just as game developers do. The record labels are intermediaries helping with distribution and promotion just as game publishers do. Music retailers are similar to software retailers. In fact they often share the same store, as is the case with Media Play.

The key point is that the bargaining power has shifted upstream in the value chain toward the original producer. Many more options are available to game developers now than was the case a few years ago.

This article has outlined the changing balance of power in the business of selling computer and video games. It has pointed out shifts in bargaining power that are improving the relative position of game developers. It analyzed several revenue models for the industry. It also identified three major impediments to digital distribution: piracy, bandwidth, and consumer habit. New opportunities and threats abound for developers, publishers, and retailers. The transition period will be interesting to follow: profitable for some and painful for others.

Ian MacInnes, is an assistant professor in the School of Information Studies at Syracuse University. Reach him at imacinne@syr.edu

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