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This article is reprinted from TEQ Magazine, a publication of the Pittsburgh Technology Council.

In Part I of this article, which appeared in the last issue of TEQ, I focused on the many convergences, especially hardware and content convergences, which are at the forefront of the video gaming industry. Part II of this article focuses on the economic issues raised by those convergences and the long-term sustainability of the economic models being used today in the video gaming industry.

As discussed in Part I of this article, while many see the convergences between the business of movies and video gaming as a “natural fit,” the two industries still are quite different in many key economic respects. Hollywood is a very mature industry, which focuses primarily on profit and returns on investment and is less concerned with empowering creative talent to create great experiences for an end-user. In other words, producers gauge their level of investment in a film largely based on the expected return on investment, not on the desire to create a great viewer experience. On the other hand, the video gaming industry is much less mature in its development stage and still focuses primarily on content, creative control and the end-user experience. In other words, if you build it, they will come.

Another key difference is that Hollywood is a heavily unionized environment, dominated by the Screen Actor's Guild (SAG), the American Federation of Television and Radio Artists (AFTRA), the Writer's Guild, the Director's Guild and the American Federation of Musicians (AF of M), among others. There exist very close relationships between Hollywood production companies and these unions. In addition, the continued economic participation by talent in a property (i.e., residuals) is fairly unique to the movie industry. Conversely, the video gaming industry traditionally has not made much use of union talent because of a desire to avoid paying residuals. However, this is slowly starting to change with the increased use of well-known talent in games.

Probably the most significant difference between Hollywood's approach and that of the video gaming industry lies in the right and ability of an "end-user" to create modifications and to control content. This interactivity is viewed by game developers as critical to the "richness" of the gaming experience, but is anathema to the movie industry. Imagine the viewers of a film having the ability to decide how it should end? That is precisely what takes place in the world of interactive entertainment. I believe that as acting, voice, musical and similar talent becomes more necessary to improve the quality of games, the relationship between the unions will become much more important to game developers. Recognizing that there will need to be flexibility on both sides, AFTRA now allows a “buyout” payment, in lieu of residuals, in game sequels. At the same time, however, the unions are cracking down more stringently on the use by game developers of union talent through non-union third parties. Given the legendary workweeks, which many, if not all, developers routinely expect of their creative workforce, this could have a profound impact on the economics of the video gaming industry.

These convergences, while creating many highly complex issues, still provide a platform for jobs in the video gaming industry on a much broader scale than the traditional developer workforce, such as art directors, screenwriters, actors, musicians, in addition to the traditional roles of artists and programmers. While there are opportunities for more types of talent to participate in the creative process, the economics are still somewhat troubling for traditional game developers. For a variety of reasons, adapting business models from other entertainment industries, such as motion pictures, music and book publishing, have not always been a very good fit with video gaming.

The business model currently most widely in use (although there are exceptions) is based upon the music industry model. It involves the payment of development costs by a publisher and a back-end royalty payment once those development costs have been recouped from the royalty. Unfortunately for most developers, recoupment rarely happens. For example, assume a game cost $7,000,000 to develop (about average for a new console game) and a 20 percent royalty is to be paid to the developer. The retail price is $49 and the wholesale price is $32. The fees payable to the console manufacture, marketing and distribution average around $11. That leaves $20 to be split between the publisher and the developer. It would take a sale of 1.1 million units of the game to recoup and start paying royalties to the developer. While most developers are careful to build a profit margin into the "development costs" component, only a handful of game titles in any year will actually sell sufficiently to allow royalties to ever be paid to developers. Thus, at most, developers earn a modest profit. More often than not, however, developers are disappointed in the profitability of their game development efforts.

In the music industry, a recording artist still has other means of generating income (largely from music publishing, live performances and, increasingly important, merchandising), even if a record album's sales are not sufficient to generate artist royalties. No such alternative revenue sources exist for most developers. For that reason, the music industry model does not appear to have long-term viability in the gaming industry.

Another challenging and fundamental issue for game developers is the ability to create long-term value in their companies. Typically, a game publisher will attempt to acquire all of the intellectual property rights developed by a developer in connection with a particular game project. Even if a developer can hold onto its "development tools" (i.e., the game play or game development engine that can be reused in other games), because of the need to rapidly develop games, many developers are relying more and more on third-party middleware to provide the engine for their games and are not developing those tools themselves. Consequently, developers are often left with little, if any, reusable intellectual property. A developer's prime value, therefore, becomes its ability to manage a complex development process. Recognizing that, many publishers (such as Electronic Arts and Nintendo) have also developed significant in-house development staffs.

While creating a sustainable economic platform can be extremely difficult for a developer, there are also a host of business challenges facing game publishers. Many smaller publishers have failed to survive and the industry is increasingly dominated by a handful of companies. For example, in 2003 game publishers Electronic Arts, Nintendo and Sony accounted for more than 50 percent of all console video games sales in the U.S.

The marketplace for video games is also evolving very rapidly. While the “hardcore” gamer market may still be dominated predominantly by 15-to-29-year-old males, there is a huge and rapidly developing market for games, which appeal to 35-to-50-year-old women. This is especially profound in the area of MMOGs where many titles have more female players than male players. Another controversial area is regulation of violence and sexual conduct in games. Over the past five years, there has been a dramatic increase in litigation focused on game content, including the consequences to players of being exposed to such content. In addition, there have been legislative attempts to control violence and sexual content in games.

Currently, the video gaming industry operates under a voluntary rating system, akin to that adapted by the Motion Picture Association of America for movies. This is an area that will need to be monitored carefully, as content restrictions may have a significant impact on game developers.

In the video gaming industry one thing will remain constant: change. Change certainly will continue to occur in hardware platforms and game content. More profound, however, may be the change to the economic model utilized by the industry to sustain itself and to grow. It is indeed an exciting time to be involved in this rapidly evolving industry and to see Pittsburgh's prominent part in that evolution.