The 8-bit video game industry is 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)). For Nintendo, a large hardware customer base increases the incentive of Nintendo’s licensees to develop games for Nintendo’s platform, which will in turn create a positive feedback loop whereby even more consumers will flock to Nintendo’s game console as it is associated with more game titles than that of Nintendo’s competitors. 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 incentivizes game developers to contract with Nintendo over other hardware developers. This also explains Nintendo’s capacity commitment with its suppler 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. There is a sense in which, as Nintendo can lock-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 increases.
Nintendo’s key actions regarding game developers can be characterized as enforcing the network effects of the industry, increasing its network size and increasing its tendency towards the industry standard. By outsourcing game development, Nintendo can charge high rents to its licensees who will have less elastic demand and a higher willingness to pay for rights to develop for Nintendo’s platform. Developers pay manufacturing costs and remain in charge of distributing their own games, while Nintendo collects a 20% royalty on games sold ($6 per game). This effectively allows Nintendo to charge licensees to extend its own network of customers. Nintendo’s stronghold over its licensees is exemplified by its power to dictate minimum orders of 10,000 units in Japan and 30,000 in the US. The firm wants 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 remains with the licensee.
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 continued value for the firm by restricting the ability of other hardware suppliers to displace Nintendo’s position as the industry standard (because no one is developing games for them), which in turn attracts more licensees and more customers. Nintendo’s vigorous objection to the development of unauthorized games by firms like Atari demonstrates 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 are also unpopular with consumers (and therefore retailers) as they take place outside the “Nintendo universe”, and cannot include popular Nintendo game characters such as Mario and Donkey Kong.
In conclusion, 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 high monopoly rents 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.