Evolution of Console Business Models

TL;DR: The console gaming industry has evolved considerably since its humble beginnings in the early 1970s. Business models originally started with one-time hardware sales, but over the decades layered on cartridge sales for incremental revenue, third-party game license fees, additional downloadable content, the razor-blade margin model, disintermediation of middlemen, and subscription services. Beyond revenue diversification, these additions brought sophistications that improved network effects, margins, predictability, and supply-chain costs. Looking forward, we expect console business models to become increasingly intricate as technology advancements unlock new revenue streams.

Evolution of the Console Business Model

From Hardware to Diversified Software

How console businesses have shifted over time

The first console (defined as a gaming-specific electronic device geared towards home use) was Ralph Baer’s 1967 prototype “Brown Box”, the first multiplayer, multiprogram video game system. Baer further developed and took the prototype to market with television manufacturer Magnavox as the Magnavox Odyssey in 1972 (National Museum of American History). Between 1972 and 1976 Magnavox sold over 800k Odyssey series consoles, kicking off the console market.

1970s: Single purchase hardware sales

After the initial success of the Magnavox Odyssey, a number of other manufacturers brought a series of competitors to market, including Atari’s Home Pong (1975), Coleco’s Telstar (1976), and Nintendo’s first console, the Color TV-Game (1977). All of these initial consoles, which made up what is widely considered the “first generation” of consoles, were sold with all of the playable games built into the system. It was a one-time purchase for end consumers and strong 40%+ profit margins were built into the pricing. There were no third-party games available for purchase.

The Fairchild Channel F, released in 1976, kicked off the second generation of consoles. Uniquely, it used a microprocessor and individual self-contained games loaded with separate cartridges. The Channel F was quickly followed by several other consoles that did the same, most notably the Atari 2600 (1977) which was a breakout success, selling 400k units in its first year and ~30m over its lifetime.

A bug becomes a feature: third-party development

The ability for these second-generation consoles to load games via cartridges meant that anyone could technically develop and sell third-party games for the consoles. At the time, there was no concept of third-party game developers, only manufacturers of consoles created games for their consoles. It was not until 1979 that a group of disgruntled Atari game designers left the company to set up the first third-party game development company, Activision. The Atari 2600, and other consoles of this generation, did not have lockout chips (specialized microcontrollers for restricting the use of unauthorized or unlicensed components, ensuring compatibility and protecting intellectual property) or other technical means of restricting third-party games. As a result, Atari began bringing a series of IP infringement lawsuits against Activision which were eventually settled outside of court with Activision agreeing to pay a portion of their game sales as a license fee to Atari.

1980s: Platform license fee (30%)

The 1983 Nintendo Famicom / Nintendo Entertainment System (NES) ushered in the third generation of consoles. The NES, which sold ~62m units in total, was the first console to introduce a dedicated lockout chip that required game cartridges to have an encrypted code used to communicate with the lockout chip to work. Nintendo used this to force third-party developers to manufacture and license cartridges directly with Nintendo for a 30% fee. This is the origin of the 30% platform fee we see across the industry for game sales today.

Razor-blade Model

This licensing fee structure also helped usher in the razor-blade business model, where consoles were sold at or near breakeven and profits were made from the licensing fees on game sales. Between the third generation (mid-1980s) and sixth generation (early 2000s), average margins for the top-selling consoles dropped from ~44.28% to ~14.58%. At the same time, game releases grew significantly.

Though thorough data is limited, the NES, the most popular third-generation console, had ~1,376 games released and 501m game sales. The most popular sixth-generation console, the PlayStation 2, had ~4,345 game releases and 1.5bn game sales. As the gaming industry grew, manufacturers were willing to sell their consoles as a platform at low margins (or even a loss) to grab market share and make their money back on the evergreen and highly profitable licenses for game sales.

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2000s: Digitization leads to Disintermediation

By the seventh generation in the mid-2000s, each of the major consoles (Nintendo Wii, Microsoft Xbox 360, Sony PlayStation 3) all enabled game downloads. This new distribution model further improved profit margins for game sales as it enabled console platforms to cut out a portion of the manufacturing cost as well as middleman retailers from the supply chain, the latter who took cuts up to 30% of sale price.

2010s: Subscriptions for Stability

The eighth generation brought the ability for players to subscribe to a content library of games from the major console manufacturers in the mid-2010s (PlayStation 4, Xbox One, and Nintendo Switch), though PlayStation was early to the game with launching their PlayStation Plus subscription on the PlayStation 3 in 2010. The subscription model is attractive for console manufacturers because it offers steady and predictable revenue and encourages players to explore a broader range of games, strengthening engagement and loyalty with the platform.

The initial launch of these subscription models was met with a number of concerns across the industry ranging from lack of game ownership by end users, added costs for consumers, and increased developer dependency on console platforms. Most importantly though, developers and console manufacturers themselves were worried that subscription offerings would cannibalize direct game sales.

Interestingly though, a recent research paper on the rise of the subscription model in the video game console industry by University of Erasmus professors Michiel Van Crombrugge and Stefan Stremersch found evidence that the subscription models for Xbox Game Pass and PlayStation Plus:

1. Enhanced console revenue (expected): PlayStation experienced strong initial console revenue growth, which slowly tapered off, while the impact for Xbox was more moderate but sustained.
2. Had limited impact on game sales revenue (contrary to the cannibalization concern): PlayStation saw an initial negative impact on game sales revenue, primarily driven by a decline in first-party game revenue, which reversed positively over time. Third-party revenue was impacted much less and recovered quickly. Xbox only saw a slightly positive impact on video game revenue overall.

General trend: Sophistication and diversification over time

Through each successive generation, the console market not only grew in real terms, but the business models employed by manufacturers evolved to more sophisticated and strategic models that helped cement market dominance, diversify revenue streams, improve margins, and reduce supply-chain costs:

• First Generation: had one-time hardware sales
• Second Generation: introduced cartridges for incremental sales
• Third Generation: created the third-party publisher model and 30% platform fee
• Fourth-Sixth Generations: increasingly adopted the razor-blade model (low upfront hardware margins, followed by high software margins)
• Seventh generation: disintermediated middleman retailers
• Eighth generation: steady and predictable revenue through subscriptions

The Strategies of the Big 3

Console manufacturers jostled for market share in the early decades of the console wars. Over the past twenty years, the dust has largely settled around a triopoly of Nintendo, PlayStation, and Xbox. While all these console manufacturers have adopted similar business models, they each maintain certain unique strategies in the market.

Nintendo is incredibly first-party dominant in the games sold on their platform. Between 2018 and 2023, revenue from first-party games represents 81% of overall software revenues (third-party titles made up the remaining 19%). The cost of production for the Switch was estimated to be ~$257 at launch and sold at a $300 price point, indicating a ~14% margin. While still embracing the razor-blade model, this is a higher margin than other consoles. Nintendo is the only major console manufacturer whose company is dedicated solely to video games.

PlayStation leverages third-party titles more heavily than Nintendo, in 2023, ~14% of PlayStation's total game sales were first-party. While PlayStation sits within the larger Sony organization, it is the largest piece of the business. Game & Network Services (which is the PlayStation business) accounted for $32bn of Sony’s overall $97.7bn revenue in FY23 (~33%) (Sony). PlayStation also has unique advantages by being part of the broader Sony organization. They are integrated with Sony’s entertainment ecosystem, which enables strong content synergies for transmedia projects (such as The Last of Us). PlayStation leverages Sony's economies of scale for manufacturing, production, and distribution.

Xbox does not release data on first-party versus third-party sales, but it is likely that historically this has been fairly third-party dominant, similar to PlayStation. However, in terms of revenue, that has shifted considerably after the purchase of Activision Blizzard, which generated $7.53bn revenue in FY22 (the last full year before acquisition). Xbox, while a major console manufacturer, is a relatively small portion of Microsoft’s overall business. For FY23, gaming accounted for ~$15.5bn of Microsoft’s $211.9bn revenue (~7%) (Microsoft). Despite being a small portion of Microsoft’s revenue, Xbox leverages the company's cloud computing expertise (Azure), which is central to its growing cloud gaming offering. Xbox also gains distribution advantages through Microsoft’s consumer PC reach.

The Console Business Models of the Future?

We do not have a crystal ball, but given the trends over time and how technology is currently shifting, we do have a few predictions of how the future business models of consoles will be modified:

1) Growth in cloud gaming subscriptions

While Xbox is leading the charge in terms of cloud gaming offerings, each of the ninth generation consoles (Switch, Xbox Series X|S, PlayStation 5) all offer some form of cloud gaming offering. Moving forward we expect these hybrid cloud gaming offerings to garner further adoption. As the cloud offerings are part of the console premium subscription, we expect the subscription business lines to grow.

2) Physical consoles will stay

Cloud gaming reduces hardware requirements, enabling access via any internet-connected device with a supported controller. However, console manufacturers benefit from high switching costs of their hardware. A unilateral move away from physical consoles could trigger industry-wide adoption, likely eroding these switching cost advantages. For this reason, we expect console manufacturers to maintain physical hardware while deploying hybrid models of reaching new customers with cloud gaming and preserving added benefits for console buyers.

3) Proliferation of portability

The Nintendo Switch has led the way in a contemporary (non-mobile) handheld gaming renaissance, but the Steam Deck and PlayStation Portal have also brought unique offerings for PC-centric players and PlayStation 5 owners respectively. We expect manufacturers to continue to lean into portability and the ability to have a console you can take everywhere. One feature that most portable consoles today lack is SIM slots or integrated mobile data connections; as wireless networking communications continue to improve, this seems like an obvious addition, which also contributes to subscription revenue.

Takeaway: The console gaming industry has evolved considerably since its humble beginnings in the early 1970s. Business models originally started with one-time hardware sales, but over the decades layered on cartridge sales for incremental revenue, third-party game license fees, additional downloadable content, the razor-blade margin model, disintermediation of middlemen, and subscription services. Beyond revenue diversification, these additions brought sophistications that improved network effects, overall margins, predictability, and supply-chain costs. Looking forward, we expect console business models to become increasingly intricate as technology advancements unlock new revenue streams.