The Economics of Gaming Consoles (SNE, MSFT)

The video game console wars are closely followed by gamers worldwide. Though the financial aspect is often lost in the noise surrounding it, profitability is the most important metric that a company looks for in the end.

The previous generation of consoles (known as the seventh generation) had three main contenders: Sony Corp. (SNE) PS3, Microsoft Inc. (MSFT) Xbox 360 and Nintendo Wii. The Nintendo Wii was designed more for recreational gaming than for hardcore gaming, but in past years it has at times outsold the other consoles. The current generation of gaming consoles is the eighth generation of consoles. The seventh generation consoles played out their life cycle and have been in the market long enough to analyze their strategies and business models. Sony’s competence lies in its hardware capabilities, given its long history of expertise in the storage industry, whereas Microsoft’s competence lies in software, given its dominance in computer operating software.

The eighth generation of consoles began in 2012 and includes Sony’s PS4, Microsoft’s XBox1 and the Nintendo WiiU. ThePS3 and Xbox 360 have sold more than 80 million units worldwide since they were released in 2006 and 2005 respectively; the Wii has sold more than 100 million units. These consoles generally have a life cycle of around six to eight years, which helps them cover the costs for research and development, production, etc. In 2006, at the time of PS3’s launch, each console was sold at a loss of around US $240 per console, while the Xbox 360 lost around US $125 per console when it launched in 2005. The biggest costs in the PS3 were for the graphics card, a Blu-ray drive and a cell CPU, all of which were ahead for their time. While the Xbox 360 earned a profit per console a year later, it took the PS3 quite some time before it began to break even.  

One reason why companies sell the consoles at a loss initially is to lure customers into buying them and then try to make up for the losses through each game sold, as well as online subscriptions. Also, as more and more units are manufactured, the costs eventually decrease due to economies of scale.

The major players involved in the industry are the developers, publishers, console manufacturers and distributors. The developers do the nuts and bolts work of designing and coding the games while the publishers are responsible for the manufacturing, marketing, etc. Sony and Microsoft also act as publishers for some of their games. Because the cost for developing a game for the PS3 and Xbox 360 is above USD 10 million and because only a fraction of games are profitable, the publisher generally finances the development of the video game while developers are limited to their role and earn very little of the value chain. The majority of the value is captured by sales and distribution.

If we look at the economics of video-game publishers, marketing makes up the largest component, followed by development costs, distribution costs, and licensing fees. Development costs consist of the cost of hiring designers, programmers and other staff required for developing the game. Publishers also pay a certain fee to Sony and Microsoft for using their consoles. Third-party publishers pay some percentage to Sony as licensing fees, but it is in-house games such as the very popular God of War series that allow Sony to keep a much larger share of the revenue to itself. (See also How the Video Game Industry Works.)

In hindsight, Sony got its initial strategy of offering high-end technology at premium pricing wrong compared to its less technologically advanced Xbox 360. As the Xbox added more features to its hardware to compete with the PS3 and Sony brought out a cheaper version of the PS3, the PS3 finally started to perform well.

Then there's the Nintendo Wii, the console that surprised everyone with its performance, managing to outsell both the PS3 and Xbox 360 despite having much lower technical capabilities in terms of graphics and processing power. The Wii was marketed to casual and social gamers as opposed to the traditional gaming crowd that the PS3 and the Xbox targeted. In stark contrast to its competitors, it also managed to make a profit on its hardware unit from the very beginning. It also keeps a much larger share of all Wii games sold, since it publishes the majority of the games as compared to the Xbox and PS3.

Though the Wii started on a very high note, Sony and Microsoft quickly adapted to the challenge by modifying their consoles. Sony launched the PlayStation Eye, and Microsoft launched Kinect, both of which incorporated the features of Wii’s motion controller. 

With the eighth generation gaming consoles, which began with Nintendo’s Wii U launch in December 2012 followed by Sony’s PS4 and Microsoft’s Xbox One a year later, Sony has managed to drastically reduce its loss per console while Microsoft is posting higher losses per console. Even the Wii U is now selling at a loss.

This generation is also likely to see fierce competition from smartphones and tablets running Android and iOS. Console revenues have already fallen behind Android and iOS gaming revenues. Many analysts predict that this may be the last generation of home gaming consoles. Also, PC graphics are expected to surpass console graphics. Going by current sales figures, Sony’s PS4 seems to have gotten it right in terms of pricing and features and leads the other two consoles by a wide margin. (See also Console Wars Heating Up.) As of 2017, data from Statista shows the PlayStation 4 with the greatest market share at 19.64%.

Sony was dominating the gaming console market with its PS2 but stumbled with the PS3, giving Nintendo and Microsoft a greater foothold in the market. It seems to have gotten some of the market share back with the PS4, but only time will tell how newer technology and changing consumer habits will affect the console-gaming industry.