Monday, June 26, 2023

Economics of platform owners' exclusive deals with third-party game makers in light of Microsoft-Activision merger reviews

The prize for the economically most nonsensical question I've ever heard an attorney ask a witness in an antitrust case goes to an institution that I hope will recover--the sooner, the better--from its current crisis: the United States Federal Trade Commission (FTC). There's an FTC v. Microsoft & Activision Blizzard preliminary injunction hearing ongoing, and at about halftime it's already clear that the FTC is losing and short of the greatest miracle in any comparable situation is not going to turn this around. On Day 2 (Friday, June 23), the presently misguided agency's Chief Deputy Trial Counsel asked Microsoft Gaming (Xbox) CEO Phil Spencer how Microsoft could afford a $70 billion acquisition if, based on what Mr. Spencer had testified before, it could not afford (from a profitability point of view) making third-party games exclusive to the Xbox the way Sony can by virtue of its dominant market position.

To explain why that comparison is not even apples to oranges but completely nuts would not take a blog post. A family may not be ale to afford a night in a presidential suite of a big-city 5-star hotel for tens of thousands of dollars even if it can afford buying a $1 million house. That's the difference between consumption and investment: the money spent on the luxury accomodation for one night is gone, while buying a house either saves rent every month (if the owners live in it) or generates passive income.

The FTC's desperation in that merger case makes its lawyers go off the deep end. It's a major embarrassment. Obviously lawyers aren't economists or business administrators, but that entire litigation department's focus is on antitrust case, and antitrust is at the intersection of economics and law. Mr. Spencer noted that the premise of the question was "incorrect" and that was a diplomatic way of putting it. Then the headline of my previous post on that case, which noted the "evidentiary and intellectual bankruptcy" of the FTC's "case" against Microsoft-Activision was also rather mild: an argument can be intellectually bankrupt, or even a naive fallacy or miscalcuation, without being completely crazy. Here, foreclosure with respect to a title like Call of Duty is not an option regardless of whether it would be compensated for by means of an exclusive agreement between independent companies or results from an acquisition.

The purpose of this post is to explain the economics of third-party exclusives, from the perspectives of platform owners and app (game) makers. And to do so in light of the Microsoft-Activision merger reviews.

I'm going to explain this in simple and general terms, unlike economist who would of course transform all of those considerations into multi-line formulae with plenty of Greek letters.

What makes this relevant in connection with that particular merger is more than the FTC's least logical question. It's also that the San Francisco hearing (which I'm attending in person) revealed that the impetus for Microsoft to acquire ZeniMax (best known for its Bethesda Softworks game label) came from a clear and present danger of that company's then-upcoming and much anticipated Starfield game otherwise having become a PlayStation-exclusive title.

In a couple of days, the FTC's economic expert witness, Harvard professor Robin Lee, is going to testify (via video deposition, apparently), and he may contradict his own papers on the effects of content exclusivity on competition between platforms, including but not limited to a 2013 paper that focused specifically on videogame consoles. Microsoft doesn't want to withdraw Call of Duty from the PlayStation anyway, but in the past Robin Lee argued that content exclusivity enabled new entrants to gain a foothold in a platform market by overcoming the chicken-and-egg problem that customers won't buy consoles without games and game makers won't make games for consoles without an installed base.

While the 2013 Lee paper correctly argued that exclusive content may enable a new entrant to compete with the incumbent(s), or smaller players to attract enough users to keep their platforms alive, it is also a fact--and a huge problem--that a dominant player can strike exclusive content deals at a lower cost, thereby increasing its market share: exacerbating the impact of increasing returns, and serving as an accelerant of network effects that could ultimately burn down competition in a given area.

Mr. Spencer explained in his testimony that "compensating [a game maker] for skipping a platform" is cheaper when the one who secures the exclusive is the dominant market leader. Let's look at the various reasons for why that is so, and while I've never personally done a deal like that, I launched an iOS-only trivia game in 2017 and experienced the problem of not being on a platform with a larger installed base (Android). So in a way I'm speaking from experience here, not just from a theoretical vantage point of a litigation watcher with an interest in a functioning competitive process.

While the discussion here is about deals between platform makers and a third party, the logic can be applied mutatis mutandis (meaning with the required adjustments) to first-party titles that are made by a game maker itself. It's just easier to understand the dynamics when the game maker is an independent economic operator as opposed to a division of one of them.

1. Direct opportunity cost of unavailability of title on other platform(s)

Let's start with the simplest model--and his oversimplifies it, but holistic analysis actually makes the problem even worse. Assuming we have a two-horse race (like Android and iOS) and one platform represents two thirds of the market and the other one third. Let's assume that purchasing power is the same on either platform (which is definitely not the case in mobile, but may be the case with consoles), and that a given game for which an exclusive deal is being negotiated is equally appealing to the user bases of either platform. In practice, the latter is rarely the case: for instance, a game may be more appealing to Asian than European customers, and platform market share distribution may vary from continent to continent. But let's keep it simple.

Let's simply assume that customers have either platform A (the 66% player) or B (the 33% player). In practice, there will be some users who "multihome" and then the question is whether they are equally willing to buy a game on either platform. And there may be a different type of platform, such as gaming PCs, so if Player A acquires an exclusive only with a view to consoles, Player B's customers may then have a third way of playing a game, even if not on their preferred device type for gaming.

Player A owns 66% of the market (sort of "our Sony" for the purposes of this analysis) and has to compensate a game maker for skipping, with respect to a given title, the Xbox; conversely, if we adopt Sony's and the FTC's market definition and have a two-horse race before us, Player B ("our Xbox") has to compensate the same game maker for skipping the PlayStation.

In this simplest of all models, Player A has to pay only half as much for an exclusive deal as Player B, given that it must compensate for the opportunity cost from forgoing only 33% of the market opportunity versus 66% if Player B strikes the exclusive deal.

Now, if we assume Player A capitalizes on this cost advantage not just with respect to one title, but in many cases, then after a cycle (for instance, five years), its market share may--not necessarily only, but in no small part also due to those exclusive content deals--have grown from 66% to 72%, and that of Player B may have shrunk from 33% to 27%. Then the relative cost advantage of Player A increases form a factor of 2.0 to one of 2.7. The result would be even more exclusive deals, and after a few cycles, the market would not just be dominated but plainly monopolized by Player A.

Player A has twice the revenue opportunity with a given game to generate--just from game sales, not even counting console sales and the revenues involving other content (than that particular game) those device sales entail--the income to pay for what will cost only half as much: an exclusive deal.

The solution to this competitiveness problem is not that one looks at whether Player B has other business units (in Microsoft's case, that would mean Windows, Office, or Azure) that can cross-subsidize the platform we are focusing on here. For a short period, that may be an option, but it's not sustainable and a publicly traded company sooner or later comes under pressure not to operate a bottomless pit. Even Meta, despite Mark Zuckerberg's preferential voting rights, ultimately felt forced to cut costs in some loss-making areas.

2. Partial exclusives (also including exclusive marketing rights)

The FTC and its sole ally in this context, the UK CMA, are certainly right that partial exclusives can also have anticompetitive effects. It's just a non-issue here as a 10-year total-parity promise has been offered. And if the FTC and CMA are truly concerned about that, they should be investigating Sony's dealings with game makers and clear, with or without commitments, a deal that is actually meant to result in less content exclusivity on the bottom line.

Sony negotiated certain preferential rights with Activision Blizzard. PlayStation gamers get some digital goodies that Xbox gamers do not receive. And as Xbox VP Sarah Bond explained in her testimony on Thursday, Microsoft faced various restrictions concerning its ability to reference or showcase the Xbox version of CoD in its marketing efforts--due to Sony's deal with Activision.

For partial exclusivity, the cost is much lower. Here, the product remains, in principle, available on both platforms. There isn't a simple opportunity cost calculation anymore. It's more about abstract goodwill on the part of consumers and the maker of the other platform. Some gamers may be annoyed that those using a different console get experience points (the primary criterion for progress in many games) twice a fast, but how many will dislike the game for that reason? Hard to tell. Marketing restrictions like the ones explained by Mrs. Bond mean that some free promotion (or cooperative advertising) opportunities are foregone, but that, too, is not easily quantifiable.

What is, however, ridiculous is any suggestion that--as Sony told the CMA and probably regulators around the globe--Microsoft might purposely inject bugs (program errors) into the PlayStation version of CoD or not thoroughly test and bug-fix that version of the game. In that case, it's actually easy to imagine that the damage to the reputation of not only that title but also Microsoft as a whole would far outweigh the benefits, particularly since end users who experience issues with a given game on one platform aren't likely to assume they'll get better results on the other platform. Sometimes even the opposite is the case: some people claim that Google apps for iOS are sometimes of higher quality than their Android versions, though Google makes Android.

3. Single-platforming existing titles vs. upcoming ones

For a game maker--or an acquirer of one--it is a far, far more difficult decision to single-platform an existing title, thereby alienating if not infuriating many gamers who suddenly can't play the game anymore on the platform they own. The cost in terms of customer goodwill is high.

4. Multiplayer matchmaking

In our 66%:33% scenario, there would probably be a critical mass of gamers for random matchmaking on either platform around the clock. However, if people don't just want to play against random opponents but wish to play with particular friends, then the problem of friends not having the device that is required to play the game is only half as big for a title that is exclusive to Platform A as for one that is exclusive to Platform B. This, of course, presupposes for simplicity's sake that everyone's circle of friends has, on average, the same distribution between the two platforms. With consoles that may be the case in a given geographic market, but there could also be correlations (for instance, low-income consumers having mostly low.-income friends, who may in turn share a preference for a less expensive type of device).

The fact that a person can play with only a minority as opposed to majority of their friends has implications for user engagement and customer satisfaction, reducing the likelihood of in-game purchases and future purchases (new versions). It also relates to the next item, word of mouth.

5. Word of mouth and viral marketing

Multiplayer functionality is only one of the reasons for which someone who already plays a game may invite or otherwise encourage friends to play it as well. Even single-player games get word of mouth if people believe their friends may be interested in playing it and show it to them.

Word of mouth works far more effectively for a game that is exclusive to the larger platform than one that is available only on the smaller platform. Word of mouth is a degressive but exponential formula. Think of all the people who used to promote Candy Crush or Farmville to their friends via Facebook messages (at a time when that marketing method used to work). Those games were accessible over the web. If one had needed a particular device, then many recipients of those messages would not have been able to download the respective game.

From the game maker's perspective, word of mouth is extremely valuable as it brings down the average User Acquisition (UA) cost. If word of mouth is weakened by an exclusive deal with a small platform, and if the platform maker cannot compensate for that with money and/or special marketing support, that fact alone makes an exclusive deal with the larger platform maker--or not entering into any exclusive arrangements at all--more attractive.

6. Mainstream media advertising and PR

In our hypothetical 66%:33% example, there probably are websites and other media (YouTube channels etc.) for either platform. So if a game succeeds on one platform, then there will be media outlets that will take note and generate additional demand through their reporting.

But with a view to mainstream media, a game that is available only on a platform with a 33% share (let alone with a, say, 20% or 25% share) is much less likely to get press coverage than one that is available on all platforms or on the dominant platform. In one case, a mainstream media outlet knwos that 66% of its readers can play the game if they like; in the other case, only 33%.

The same problem exists with respect to the economic viability of mainstream media advertising. Imagine a TV commercial for a game: if the game is available only on a platform with a low market share, the game maker pays for 100% of the reach but only 33% of the audience will be able to buy the product at all.

7. Mind share and other long-term considerations

A game maker who enters into an exclusive arrangement with a smaller platform forgoes a larger part of the "mind share" opportunity. That is more of a long-term consideration, but one that major game makers will also take into account. Market share between platforms may shift; new platforms may emerge. That is why game makers are interested not only in revenues but also in having a large user base.

8. Merchandising and other ancillary revenue opportunities

A successful game franchise can also tap additional revenue opportunities such as merchandise or novelizations, possibly even movies based on the game. For example, Fortnite merchandise is quite popular. Those opportunities are either a linear function of the size of the user base or the likelihood of, for instance, Netflix wanting to make a movie based on a game will be drastically diminished if a game is available--even if maybe very popular--on a platform with low market share.


As the FTC's own economic expert already wrote a decade ago, if the choice is between exclusive content being generally prohibited or generally allowed, there are some ways in which smaller platforms and new entrants can benefit from the option of having exclusive content. In fact, Sony's acquisition of Psygnosis was key to the launch of the PlayStation.

The Xbox needs some exclusive titles in the current environment, but that is in no small part the case because of Sony's aggressive "IP" strategy. Given those market realities, one cannot blame Microsoft making at least some titles exclusive, including titles made by acquired companies such as Bethesda. Removing existing titles, especially very popular ones and even more so if they are multiplayer games that people may wish to play with friends, from a much larger platform is, however, clearly not a viable path. Even the UK CMA had to recognize so. The regulators in charge of 40 countries have ruled out that this would make sense for Microsoft to do with respect to CoD, leaving the FTC as a sort of flat-earth society.

The acquisition of Activision Blizzard King is primarily about mobile games, and in the console space it will actually result in less--not more--content exclusivity. Part of the reason Sony opposed the deal is because Sony, for the reasons explained herein, knows it would be in a strong position to negotiate at least partial exclusivity with respect to Call of Duty, if not even total exclusivity at some point.

If one focuses on just the PlayStation-Xbox rivalry (as Sony and the FTC propose), there is a clear and present danger of the videogame market already having reached a tipping point of increasing returns and Sony being able to engage in ever more vertical input foreclosure to the detriment of consumers. In the short term, certain "console warriors" (gamers with a passion for their platform and a desire to see their platform making its rivals disappear into oblivion) may consider this a victory, but in the long run the only thing that protects them is healthy competition between platforms.

What restrictions has Sony imposed? Has Sony precluded game makers from fully exploiting the capabilities of rival hardware? Those questions are more deserving of regulatory scrutiny than a procompetitive merger that creates opportunities for game makers large and small, and for cloud streaming providers of all sizes, too.