Economics of the video game industry: Why an under-researched industry merits the attention of economists?

We economists at Toulouse School of Economics have an intense romance with industrial organization. Few visiting scholars fail to mention the strong work being done here in this field. The study of industrial organization is always grounded in a deep and subtle understanding of the industry at hand, as Justin Wolfers wrote for the New York Times in an article about the work of Professor Tirole [1]. It is all the more surprising that there is no research nor teaching about one of the most interesting, dynamic, and complex sectors of the modern entertainment industry: The video game industry. In this article, I will write both about the research that has been done on this industry as well as the developments and phenomena that should put video games high up on the list of research priorities for every serious researcher in industrial organization.

The sheer size of the video game industry in business makes it astonishing how marginal it is in Research. A quick search on Google Scholar yields 153,000 results for “industrial organization of the video game industry”. Replacing “video game” with “film” or “music” yields 656,000 and 494,000 entries respectively. To put this in comparison, these industries had a turnover of 64.9 billion USD (games), 90 billion USD (films) and 20.97 billion USD (recorded music) in 2014. At the same time, according to a PwC study quoted in the same source of information, the game industry was expected to grow by 9.6% from 2013-2018. [2]

So, what makes the video game industry interesting to study from an IO perspective?

First, it is a vertical organization: video games do not just march out of video game companies straight onto your home system. Instead, we face a vertical chain that includes hardware manufacturers, development studios, publishers, distributors, and retailers.  Now, depending on the market niche, certain stages of this chain might be skipped entirely. Therefore, the video game industry allows us to study competition between different value chains aimed at the same demand. As an example, classical big-budget productions (so-called triple-A titles) have been financed by big publishers (for example Nintendo, Ubisoft), but programmed and created by development studios (for example Bioware or Related Designs) that could be either in-house or hired for a specific project. The finished game would then be distributed via classical retail and sold in appropriate electronics stores. This classical structure was challenged when platforms such as Steam started providing distribution services as well. Steam started in 2003 as a way for the game company Valve to sell and patch its games, but subsequently turned into a free online platform where everyone can upload and sell games, where players can organize their libraries, share their own content that they created for their favorite games and engage in a large number of social activities. Steam has become a very convenient and in some cases exclusive way for PC players to access certain games, and it is the easiest way for developers to access a global audience and sell digital copies of their games. The platform itself provides enormous added value for its customer base (a self-reported number of 125 million active clients in 2014), e.g. in helping players find the games they might be interested in from a catalogue of over 30,000 games. Thus, Steam is positioned as a powerful two-sided market, and not without its own menace: It uses its great power to its own advantage, keeping a tight control on resales and consumer rights such as returns.

On the question of innovation, we observe that this new distribution channel was readily accepted by so called “indie” or independent development studios. Often self-financed or crowdfunded, these studios produce games on a very tight budget, usually aiming at niche audiences that value innovative and original gameplay over state-of-the-art graphics and physics. An interesting question would be whether or not creative innovation was indeed spurned by easier access to customers. Or does the sheer size of the platform stifle creativity as original and off-the-path projects are drowned in the noise of thousands of different new releases?

Anecdotal evidence suggests that the cost surge in triple-A production has been dramatic: The bestselling video games of our time employ hundreds of programmers over years, not to speak of musical orchestras, composers, licensing costs and many more. Where a clunky game character in the 90s required weeks of work from a dedicated designer, a modern protagonist for a video is the result of months of work of a whole team of artists, designers, programmers, and plenty of even more specialized graphics experts. As the cost of keeping a programming team on the bill, the lifecycle of video games has changed accordingly: Many modern games are released with a detailed plan for additional content, scheduled over several months, to keep the interest up, the revenue flowing and the expensive production team busy with work (the publisher would have needed to keep them on the payroll to provide technical support and bug fixing). Given how much risk is involved at these financial undertakings that can nowadays run at production costs of hundreds of millions of euros, video games should by right be the new favorite example of each corporate finance professor who teaches Jean Tirole’s principal-agent model of a project with uncertain success (at the heart of [3]).

A very different source of economic knowledge comes from the act of playing done by the consumers themselves. You find it too expensive to pay 100 undergraduate students to participate in an experiment on auctions? Many online games feature auction houses in which thousands of players voluntarily spend millions of hours bidding and offering virtual goods or arbitraging prices. You find it infeasible to start a hyperinflation in your favorite real-world country to see what happens? Many games in which players “grind”, that is, obtain currency or objects from repeating repetitive tasks (like killing monsters that appear over and over), have to deal with inflation and sometimes hyperinflation. The solutions to these problems are as worthy of study as the shift in player behavior in reaction to changing economic conditions. The mathematical models that underlie most video game economies should feel disturbingly familiar to any economist (aren’t macroeconomic models more than glorified frameworks for the next grand strategy game?) and the first-hand economic knowledge accumulated at the support staff of each long-running massive multiplayer online role-playing game would make analysts at central banks faint from astonishment. If economists could tap into this wealth of data, experimental economics could be turned upside down.

This article has only touched upon a few select topics in the game industry. The interesting and dynamic economic challenges posed by it, together with the wealth of data that is created by players, should put this industry on the radar of applied economists, whether they are interested in competition, corporate finance, behavioral economics or even macroeconomics.

References:

[1] Wolfers, Justin (2014): Jean Tirole’s Nobel Prize Is Also a Win for Modern Microeconomic Theory, The New York Times. https://www.nytimes.com/2014/10/14/upshot/jean-tiroles-nobel-prize-is-also-a-win-for-modern-microeconomic-theory.html

[2] Egenfeldt-Nielsen, Simon, Jonas Heide Smith, and Susana Pajares Tosca. Understanding video games: The essential introduction. Routledge, 2016.

[3] Tirole, Jean. The theory of corporate finance. Princeton University Press, 2010.

by Philip Hanspach

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