In the 8-bit video game industry, Nintendo was very successful at capturing value created by its complementors. The industry was characterized by network effects, whereby a large customer base leads to an increased supply of complementary products or services, which in turn leads to increased consumer utility. This can be thought of an isolating mechanism which can result in a sustainable competitive advantage for a competing firm, protecting it from imitation by rivals (Rumelt (1984)). There is a Nash equilibrium: licensees want to develop games for Nintendo’s hardware platform because it has a large installed user base, and consumers want to purchase Nintendo’s hardware because it has many available games.
It is therefore no surprise that Nintendo priced its Famicom at or below cost when it was launched in 1983: by capturing more hardware users early, the firm incentivized game developers to contract with Nintendo over other hardware developers. This also explains Nintendo’s capacity commitment with its supplier of chips for 3 million units, and its development of the Nintendo Power magazine, which served to increase the positive network effects among its installed base of customers. As Nintendo locked-in its consumers to purchase only Nintendo games (e.g. the cost of buying competing hardware having already purchased Nintendo’s, the fan community that Nintendo created, the wide availability of games), its stronghold over developers in turn increased.
Nintendo’s key actions regarding game developers can be characterized as enforcing the network effects of the industry, increasing its network size and its tendency towards the industry standard, while capturing value created by game developers. By outsourcing game development, Nintendo could charge high rents to its licensees who had less elastic demand and a higher willingness to pay for rights to develop for Nintendo’s platform. Developers paid manufacturing costs and remained in charge of distributing their own games, while Nintendo collected a 20% royalty on games sold ($6 per game). This effectively allowed Nintendo to charge licensees to extend its own network of customers, capturing part of the value developers alone created. This is exemplified by the firm’s power to dictate minimum orders of 10,000 units in Japan and 30,000 in the US. The firm wanted as wide a distribution of games for its hardware as possible to extend and reinforce the strength of its customer network, and the risk of a game’s success or failure ultimately remained with the licensee. Nintendo also retained a portion of game development in-house, posing a credible threat to developers that the firm could launch its own games at any point. This further increased its bargaining power vis-a-vis outside developers.
The firm’s exclusivity clause in the US prevented licensees from releasing their NES games for other game platforms for a two-year period. This captured more value for the firm by restricting the ability of other hardware suppliers to displace Nintendo’s position as the industry standard (because no one was developing games for them), which in turn attracted more licensees and more customers. Nintendo’s vigorous objection to the development of unauthorized games which outsmarted its security chip demonstrated the firm’s determination to increase its own market power vis-a-vis game developers by leaving them with no profitable competing options and increasing Nintendo’s ability to collect rents from them. Unlicensed games were also unpopular with consumers (and therefore retailers) as they took place outside the “Nintendo universe”, and could not include popular Nintendo game characters such as Mario and Donkey Kong.
Nintendo’s emergence as the industry standard for gaming hardware gave the firm a sustainable competitive advantage which allowed it to reduce the value of competing products to both game developers and customers, and extract value from its licensees safe in the knowledge that they would continue to want to develop games for Nintendo’s platform as their most profitable option.