Console Price and Software Availability in the Home Video Game Industry
Gretz, Richard T., Atlantic Economic Journal
Network effects are characterized by a positive feedback loop where consumers receive greater benefit as more consumers purchase the same product or service. These effects are direct when consumers obtain greater benefit solely through the addition of more consumers to the network. A telephone network, for example, becomes more valuable to the user when she is able to call more people. These effects are indirect when additional consumers prompt an increase in the amount of complementary products available for the network. For example, a video game console is more attractive to consumers when it has a greater selection of compatible games, while game developers find it more attractive to make games available for consoles with a larger installed base of consumers. In either instance, consumers experience increasing returns; value increases, either directly or indirectly, as more consumers join the network.
The present paper empirically estimates the pricing implications of increasing returns in video game console industry. Controlling for endogeneity, hedonic results from a unique data set which covers most of the life of the industry (1976-2003) show that increased software availability has a negative and significant effect on the price of a console. This is in contrast to many empirical pricing studies in the network effects literature: greater software provision makes hardware more valuable and this should be reflected by increased hardware price.
Several empirical papers have focused on the pricing implications of increasing returns. For example, Gandal (1994) shows a price premium exists for spreadsheets that have wider consumer adoption and greater amounts of compatible software. Also, Gandal (1995) finds that same result for the Data Management Software industry. Gandal et al. (2000) find that a 10% increase in the variety of compact disks (CDs) could cause a 5% increase in the price of CD players. Finally, Park (2004) finds evidence of increasing price premiums for VHS format video cassette recorders (VCR) as the market share of VHS grew.
Though the studies mentioned above are not exhaustive, the clear implication is that firms exploit network effects in their pricing strategies. It should be noted that a key feature of the industries examined above is that hardware producers (CD players, VCRs, etc.) obtain a majority of their revenue from hardware sales. Growth in the recent two-sided market literature has shed light on different methods firms use to capture (at least part of) the value of increasing returns when the revenue stream goes beyond hardware sales.
A market is two-sided when buyers and sellers interact through a platform and the structure of platform pricing on both sides affects the volume of transactions (Rochet and Tirole 2006). The video game console industry is a classic example of a two-sided market as hardware firms charge consumers for consoles and charge royalty fees to software developers. In fact, royalty fees are a main component of a console producer's revenue stream. There is a tradeoff between console price and software provision. A console producer may be willing to forego profit (or, indeed, take a loss) on console sales if they are able to earn greater profit on royalties.
This is a common theme in the theoretical literature on two-sided markets (see Economides and Katsamakas 2006; Rochet and Tirole 2006 for recent treatments). Rochet and Tirole (2006, p. 648) note
managers devote considerable time and resources to figure out which side should bear the pricing burden, and commonly end up making little money on one side (or even using this side as a loss-leader) and recouping their costs on the other side.
However, the theory has relied mostly on qualitative examples for hypothesis testing and guidance. Empirical examinations of pricing in two-sided markets have been limited. This paper begins to address this gap in the literature. …