1. Patrick Hess
Econ 416
Term Paper
The Changing Face of Video Games
Introduction
Over the past ten years, the image of video games has changed drastically. From console games,
to PC games, to games played on mobile devices, the landscape is getting ever more diverse and
ever more unpredictable. In this paper I will analyze where the video game industry has come
from and where it may be going. This will include how developers and game makers as well as
retailers have changed their tactics to appeal to consumers. I will also discuss market power,
advertising, and free to play games, among other topics.
To begin, I need to list some terms that will be used and what they will mean in the context of
this paper:
 Video game: a piece of software developed and purchased for the purpose of
entertainment
 Console: a piece of hardware with the ability to run video games (e.g. Xbox, PlayStation)
 PC: A personal computer (e.g. laptop or desktop) with the Windows operating system
able to run video games
 Mobile Game: a video game designed to be played on a mobile device (e.g. smartphone,
tablet)
 Developer: a firm that does all of the programming, designing, and testing of a video
game, can work for a publisher or independently (3rd
party developer)

2.  Publisher: a firm that owns the rights to a video game and is responsible for the
marketing and manufacturing the product
 Digital Rights Management (DRM): a systematic approach to copyright protection for
digital media. The purpose of DRM is to prevent unauthorized redistribution of digital
media and restrict the ways consumers can copy content they have purchased.
 Downloadable Content (DLC): additional content for a video game that is purchased after
the initial sale, and not included in the base game.
Growth in the US Video Game Industry
In 2012, the US video game industry employed 42,000 people among 36 states with an average
compensation of $94,797. From 2009 to 2012 the US economy had a real growth rate of 2.4
percent, while the video game industry experience a real growth rate of 9.7 percent over the same
time frame (Siwek 1). Clearly the video game industry is a big player in the United States’
economy, but how did it get to such a place?
One clear indicator is the trend of software publishing as a whole, not just limited to video
games. As Table 1 shows, software publishing has grown at a very steady pace over the past
thirteen years (Siwek 5).
Figure 1 – US Software Publishing 2005-2012

3. A second likely factor is the onset of mobile games. In
2007 Apple released the iPhone. While some games were
released in the iPhone’s infancy, mobile
gaming did not catch fire until Rovio
released the first Angry Birds (Phillpott et
all). By 2013 the top two app stores –
Apple’s App Store and Google’s Play Store
– had more than 800,000 individual apps
each. That comes to about 133,000 apps
added per year. Figure 2 illustrates the
amount of money consumers’ worldwide spent on digital content.
It is estimated that 91%, and 80% of Google Play and iPhone app purchases, respectively, were
tied to games (McDuling). Figure 2 shows how this has grown from just above 65% for both app
stores.
Figure 2 – Worldwide Digital Content
Consumer Spend, 2013
Figure 3 – Share of App Store Revenue

4. The incredible growth of these games has a lot to do with the pricing model they employ. Many
games are called “free-to-play.” The games are free to download, however players are given the
opportunity to make purchases with real world money within the game – sometimes referred to
as “microtransactions”. In February of 2014 almost all of the top 100 grossing games on Google
Play and App Store used the free-to-play pricing model (McDuling).
Because this pricing model has become so popular, it has had its fair share of criticism. Some
mobile gamers have even taken to calling these games “pay-to-win.” Their reasoning is simple
and can be shown easily with an example. A mobile game developer named King (the creators of
the extremely popular ‘Candy Crush Saga’) uses the free-to-play pricing strategy for all of their
games. If players cannot complete a given level, they are given the option to pay to make
progress and/or unlock other levels or tools to help them beat more difficult levels. It is certainly
not necessary to pay anything to complete the game, but clearly it becomes much easier when
one does. Hence leading to the alternative name of pay-to-win. Nonetheless, mobile gaming has
contributed greatly to the growth of the US video game industry.
Vertical Integration
The strategies and advantages of vertical integration in the video game industry are extremely
similar to that in other industries. Ricard Gil and Frederic Warzynski conducted a study in March
of 2011 and empirically concluded that there is a relationship between vertical integration and
video game performance and demand. They investigated three possible causes of this
relationship:
1. Publishing companies do a better job of promoting their own products after release

5. 2. Publishing companies do a better job of choosing an optimal release date, therefore
softening competition
3. Publishing companies do a better job at developing games that align with consumer
demands and limitations of platforms
Their findings are summarized here:
According to their data, the demand for a video game increases by 16% when the game becomes
developer-publisher integrated (i.e. not developed by a third party). This evidence supports the
claim that vertical integration in this industry leads to better marketing strategies, even after the
game’s initial release. A second study by Hiroshi Ohashi in 2005, found that integrated games
were released further apart than their non-integrated counterparts. In essence, publishers soften
competition for their developed games more than they do for their third party developed games,
because they wish to increase sales for their vertically integrated games. Gil and Warzynski
(2011) found that superior release strategies account for 16 extra percentage points in sales
performance. They also concluded that softening demand through a coordinated release can add
a whopping 41% in extra demand. Finally, the Gil and Warzynski (2011) data shows that, on
average, games produced internally are of a lower quality to consumers than those produced by
independent developers. However, consumers value the internally produced games $2-$7 more
than the independent games. This seems very contradictory, but it can easily be explained by the
brand name phenomenon. The brand name phenomenon essentially means consumers will have a
higher willingness to pay for a product if it is made by a company that they have heard of many
times before.

6. The Digital Era
The past five years or so have seen an interesting transition of video game media. Through the
‘80s, ‘90s, and early 2000s, nearly all video games were sold via physical media (i.e. a disc was
purchased). This is most certainly because until the early 2000s internet connections were not
very fast nor were they very likely to be seen in homes. In this paper I am going to look
specifically at PC games, as PC was the platform that initiated the transition. The processes that
happened for the consoles are analogous to those of the PC (“Digital Distribution”).
One of the first on the digital era scene was a company called Stardock. Stardock released a
client called Stardock Central in 2001. Stardock Central allowed consumers to access to games
on Drengin.net if they paid a yearly subscription fee. In 2004, Stardock switched to a model
where consumers would pay an initial fee which would get them tokens that could be spent on
games at a discounted price level. Starting in 2004, many more digital distribution services began
to pop up, including Amazon Digital Services, Origin, Direct2Drive, and Steam. These services
are, for the most part, the exact same. The consumer creates an online account, purchases
whichever video game their heart desires, the digital distribution software downloads the game
and installs it on the consumer’s computer, and then the consumer can play at will. Since these
services are the same (except for DRM, which we will address later) we are going to focus on
Valve Corporation’s Steam client as it easily has the largest market share (“Steam [Software]”).
For purposes of perspective, Steam was launched into beta in January of 2003 with less than 100
games available. As of February of 2015, there were over 4,500 games available and 125 million
active users on the service. With a record of 9 million users active at one time, it is no wonder
that Screen Digest estimates that 75% of all games purchased digitally for PC are downloaded

7. through Steam. Valve, the company that created and maintains Steam, is a video game publisher
as well as a developer. Because of this, up until about 2005, only Valve games were available
through the service. Around this same time, Valve declared that Steam had become profitable
because of a few insanely successful Valve games. At this point, digital distribution could in no
way match the volume that retail stores sold. But because it was digital, there was no need to
manufacture discs or cases or ship product anywhere so price margins were much bigger than in
retail (“Steam [Software]”). Unfortunately, Valve does not make publicly available any sales
numbers for Steam. But in 2011, Forbes determined that Steam sales made up 50-70% of the $4
billion industry for digitally downloaded PC games. Forbes also stated that Steam offered video
game producers margins of up to 70% versus only 30% in retail stores. One more statistic to
show Steam’s breadth: in November of 2011, the developer of The Witcher 2: Assassins of
Kings revealed that Steam was responsible for 200,000 of the 250,000 units sold online. That is a
whopping 80%, which lead to some controversy - Is Steam becoming a monopoly?
Most people you ask would surely say, “No! Of course not!!” But Valve has led Steam to take
actions that are akin to those of Microsoft. And Microsoft has been taken to court in many places
around the world due to their anti-competitive practices. One of the biggest complaints against
Steam is their Steamworks program. Steamworks is called an Application Programming
Interface, or API. It makes it possible for third-party publishers and developers to assimilate their
games with Steam. “Using Steamworks grants access to Steam's authentication services, Steam's
community features and Steam's ability to rapidly deliver patches and DLC (Smith).” It is likely
that publishers would include these features with their games, but they are already built into
Steam and are available for free. Of course when things sound too good to be true, they usually

8. are. The catch is that after a publisher or developer chooses to use Steamworks for a game,
customers must use Steam to play it. Only Steam. For competitors of Steam, Steamworks is like
a dagger to the chest. It essentially cuts off games from other distribution services and can
severely limit their content. This scenario is very similar to Microsoft and Internet Explorer,
when Microsoft made it nearly impossible to uninstall Internet Explorer or use a different
application for a default browser.
Though this is a fine example of how Steam can be anti-competitive, most people do not mind
because they all seem to be infatuated with Steam. However, just because a company is not
actively trying to make consumers worse off, does not mean that they are not a monopoly. The
same can be said about the microprocessor manufacturing company Intel. While they are/were
not attempting to be anti-competitive and were bettering the industry by improving technology,
their actions were still considered anti-competitive. And Intel has had to end some of its sales
practices just to avoid anti-competition fines. Currently, Valve does not take the accusations of
being a monopoly seriously. But if the growing trend of digital video game sales continues to
skyrocket, Valve might consider reversing their stance.
Downloadable Content
Downloadable Content (DLC) was first introduced when an internet connection began to be used
for PC gaming, then console gaming a few years later. The main goal behind DLC is to provide
more replay value to the consumer. By adding more content to a game, developers and
publishers hope to draw gamers who have strayed from a certain game back into that game, as
well as keep gamers who have not strayed away interested for a longer period of time. The most

9. common forms of DLC include, but are not limited to: new maps, characters, missions, weapons,
vehicles, and even character clothing. However unlike expansion packs for certain PC games,
DLC is strictly distributed through the internet utilizing services like Xbox Live, PlayStation
Network, and Steam. Prices for DLC can vary greatly, ranging anywhere from free to upwards of
thirty US Dollars. More recently, game developers have started bundling DLC into what has
come to be called a “Season Pass.” The season pass allows the consumer access to all DLC, past
and future, usually at a discounted price compared to all the DLC purchased separately.
There is quite a big partisanship regarding DLC. Some believe it is a waste of time and money
while others believe it is a fantastic addition to games. Those who are not supportive of
developers making DLC believe that developers should not waste resources on such packs. But,
rather, they should use that time and money before the game is released to make a better and
more complete game. While those who support the offering of DLC claim that it adds so much to
a game that they are willing to wait and pay extra for it on top of the original game. Either way,
DLC clearly leads to an increase in revenue for game developers and publishers (“Downloadable
Content”).
Digital Rights Management
To see how the video game industry handles digital
rights management, we must first look at how
revenue is split for an average $60 video
game. As Figure 4 illustrates, the revenue
from a video game goes to a few different
places. The retailer takes about fifteen of the
Figure 4 – Revenue Distribution

10. sixty dollars initially. The next forty-five dollars go to the publisher who must pay other costs.
These include a platform royalty, which means they must pay Microsoft, or Sony for the rights to
create a game for the Xbox or PlayStation, respectively. The publishers obviously have a cost of
distribution including advertising and marketing. In the case that there are unsold games, the firm
must pay a price to have all of that software returned. And this leaves publishers with a revenue
of about twenty-seven dollars per disc sold (Pham). Some may think that sixty dollars is a very
steep price to pay for a single game and many would agree with that. This is partially why video
game piracy has become so prominent in the last five years. Video game piracy is also a large
factor in more strict digital rights management or DRM. In 2007, the Business Software Alliance
released a report stating that 26 countries in the world had piracy rates that led to over $250
million in lost revenue for developers and publishers. The United States was at the front of the
pack with over $8 billion in losses. The Business Software Alliance (BSA) also discovered that
one in five software programs installed in the United States is pirated. Where does DRM come
into play? DRM helps prevent piracy by
requiring different ways of proving you have
paid for a certain piece of software.
One of the most common forms of DRM
is a CD Key. A CD Key comes within
the case of the game when you purchase
it, and when you are installing, the
installation client asks for and verifies
that your CD Key is authentic. However,
Figure 5 – Software Losses Due to Piracy

11. it is very simple for a user to just Google, ‘cd key crack’ for a game and find a workaround if
they have lost or do not want to purchase a Key. Another form of DRM is Limited Install
Activations. This method allows the developer of a software to program their software to
communicate to the developer’s servers and verify that the user has not installed the software
more than they are allowed (usually 3 or 5 times). The obvious problem with this method is that
if a user has more devices than they have number of licenses, then they are just out of luck. A
secondary drawback is that this method requires an internet connection but today, an internet
connection is quite easy to come by. The newest up and coming form of DRM is Persistent
Online Authentication. The name is somewhat self-explanatory, a gamer must be constantly
connected to the internet in order to play a game with this kind of DRM. Persistent online
authentication is the DRM that is utilized in clients like Steam and Origin.
Many claim that DRM has little effect on piracy, though there are yet to be any empirical studies
on this claim. Sometimes DRM may even make piracy worse for certain games. In 2008, the
game Spore by Electronic Arts was targeted by video game pirates for having intrusive DRM
which lead to Spore being one of the fastest and most pirated games of all time. Some retailers
within the industry have even spoken out against DRM. GOG.com (formerly Good Old Games)
is a website that sells video games (albeit mostly 5+ years old games) without any form of DRM.
The marketing director of GOG made a statement saying, “DRM drives people to pirate games
rather than prevent them from doing that. Would you rather spend $50 on a game that requires
installing malware on your system, or to stay online all the time and crashes every time the
connection goes down, or would you rather download a cracked version without all that hassle”

12. (“Digital Rights Management”). Executives for other companies have also claimed that DRM
punishes genuine consumers and is seldom effective.
Where to Next?
It is very hard to say which direction the video game industry will head next. A lot of people are
speculating that the mobile gaming sector is going to be the highest grossing sector in 2015. All
this amid a growing PC gaming population. Then there are those who think free-to-play games
are going to take over the industry in the coming years. This is certainly possible, given their
strong recent push in numbers. Wherever this market is headed one thing is certain, video games
are not going away anytime soon.

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