Video Game Economics - Lessons from Hollywood

By now, we all know that the strategy most game publishers are using is to acquire IP (ie, brands like the Matrix etc) from the film industry, and leverage it to market games more efficiently. The problem, as Costik has been pointing out for years now, is that this is also a fairly efficient innovation killer - what we might call the developer's POV. This is why Seamus Blackley and some friends tried to set up CEG - a production fund, targeted at the lack of capital for innovative developers, a year or two back (but this didn't work out).

Of course, in the long run, acquiring IP is a dominated strategy. That's because as the demand for IP increases, prices will get bid up, and as bidding wars erupt, the games industry will erode it's own margins. It's essentially supply-side price competition. In order to stave this off, publishers are consolidating in order to exert more buyer power over the film industry.

Now, to be fair, the process will take a long time - bidding wars are only starting to emerge. The average cost of IP, is, I believe, on the order of 20% of gross, with megalicenses like the Matrix costing upwards of 30% of gross. This number is slowly climbing.

All of this begs the question: why can't the games industry produce and market it's own brands as efficiently as the film industry? Understanding this is the heart of understanding the next wave of video game economics.

There are two possible reasons:

1) The film industry can attract better creative talent than the games industry.
2) The film industry realizes more marketing economies than the games industry.

Let's leave number 1 aside, and assume that talent is equally distributed (for now). I think a much more insightful answer comes from thinking about number 2.

The average marketing cost of a film is much greater than the average marketing cost of a game. For a film, it's $39 million (MPAA number - this sounds pretty high to me). The average development cost of a game is about $6 million; liberally assuming 100% marketing costs, the comparable is $6 million.

This is an order of magnitude difference. It should be intuitive to most of my readers. The interesting question, again, is why this is the movie industry can spend so much more on marketing than the games industry, especially given the fact that game industry heads trumpet the fact that the total market size for games is bigger than the market size for film box-office revenues.

The answer, and the point, is that the film industry has a more efficient supply and demand side business model than the games industry does: multiple revenue streams on the demand side, and risk-sharing agreements on the supply side.

The games industry only really has one significant revenue stream. While games sales are bigger than domestic box-office receipts, box office receipts are now the smallest component of film industry revenues. The other big components are DVD sales and library/syndication revenues.

At the same time, Hollywood has minimized the supply-side risk of movie-making by utilizing cofinancing structures, which are essentially syndication arrangements for financing across multiple publishers/studios/sources of capital.

All of this means that, on average, making a movie is relatively less risky than making a game. Films are still a risky, hit-driven industry - but because revenues are more diversified and capital is syndicated, making films is less risky than making games. Put another way, the film industry realizes greater marketing and brand economies than the games industry because it's more efficient: for the same unit of output, it earns multiple revenue streams while minimizing production and distribution risk.

What does this mean for the games industry? Well, leaving aside the isolated instances of IP flowing from games to films (Mario, Resident Evil), the business model needs significant deconstruction and reconstruction if the industry's growth is to continue - if we want innovation to heat up and innovative developers to see funding, the model needs to enable publishers to spend more (not less) on marketing.

One answer is to follow the film industry's lead: diversify revenue streams and utilize risk-sharing arrangements, in order to maximize the amount of capital flowing into and out of the industry. Think about it this way: why does the games industry still only have one significant revenue stream?

In stark contrast, the film industry is constantly experimenting with new revenue streams - here's a great example. The games industry isn't an infant anymore - if it wants to survive (rather than simply becoming a marketing medium for Hollywood, which is what's on the cards now), it's got to think a little more strategically.

Now, a Hollywood model this won't completely address the developers' complaint - risk-averse publishers stifling innovation. We only have to look to Hollywood's annual summer schlockfest for evidence of this. But what it will do, I think, is give developers a lot more freedom, because they will at least be able to develop their own brands, characters, and other IP. So it's a step in the right direction.

Of course, the most efficient (and innovation-friendly) model is a publisher-less one - something the Net's been promising for a decade but has yet to deliver. Examined in the next installment...

Post a Comment