Video Game Wars

As of this writing, Microsoft has recently introduced its dedicated game machine, the Xbox. Should a consumer buy an Xbox? Only if he thinks that many other consumers will also buy one. The quality and quantity of games written for the Xbox will largely determine its value. Microsoft will probably write only a small percentage of Xbox software, while independent gaming companies will write the rest. These independent firms will develop Xbox games only if a lot of people own the Xbox. Thus, if most game lovers buy the Xbox, then most new games will be written for the Xbox, and most rational game lovers will buy the Xbox.

Sony’s Playstation 2 is a rival for the video game network externalities Microsoft desires. Unfortunately for Microsoft, if the Playstation 2 proves more popular than the Xbox, then it’s the Playstation 2 that will have the most games written for it, and it will be the Playstation 2 that most game lovers will desire. If a game written for the Xbox could be played on the Playstation 2, then consumers would not be playing a coordination game. Absent compatibility concerns, and it would be all right to be one of a very few people who own the Playstation 2 because you would still have many games to choose from. Because games are console specific, however, players want to buy the same machines that most other players buy. Consequently, if consumers purchase enough of any one game machine, sales of this machine will reach a tipping point and drive other firms from the market. After achieving this tipping point, the dominant firm’s position will be self-sustaining, since gamers will buy this console because it is the dominant game machine. Coordination games among consumers tend to result in winner-take-all markets for companies. When all consumers want to coordinate on a single product, the likely outcome of competition is a monopoly. This monopoly persists until the product becomes obsolete.

Microsoft, Sony, and Nintendo (the manufacturer of another new gaming machine) are in a treasure hunt. They are spending vast amounts to win the prize of being the dominant video game manufacturer. Microsoft, for example, adopted the reasonable strategy of selling each Xbox at a loss. If Microsoft becomes the dominant video game manufacturer, then network externalities will protect its position long into the future. Therefore, Microsoft should initially sell a very cheap product to get lots of buyers. If enough people have purchased the Xbox, most new video game software will be written for the Xbox. This will increase the Xbox’s value and allow Microsoft to raise its price. Of course, if the Playstation 2 becomes the dominant video game machine, then it will enjoy the benefits of network externalities, and Microsoft will never recoup the money it loses on the sale of each Xbox.