The Business Evolution of the Video Game Industry, Part 1: Hardware

Updated on January 10, 2024

This version has been updated with more sources and source links, more recent data, minor corrections, and more ongoing trends.

Introduction

Over the long run, business markets function like biology. Remnants from past generations exist in the present, and understanding where they came from (and why they were successful) is a good way to get a better picture of what the future might look like. The conditions that affected past business decisions are still relevant for today’s markets. This model of thinking fits video games perfectly.

The video game industry seems like a young one made for young people, but it has a long history as the convergence of toys and technology. The earliest video game consoles were sold next to billiards and bowling balls. Mattel, the maker of Barbie, and Coleco, famous for its Cabbage Patch Dolls, introduced some of the first gaming devices.

As technology improved and the industry matured, video games became more of an experience than a toy. The scale of modern games matches Hollywood blockbusters, with budgets that top $100 million and entertainment time that can easily reach thousands of hours. Game developers are entertainment giants that deserve serious attention.

This change has taken decades. It has relied on technology, but it also came from the creative influence of discovering new ways to use this technology. These innovations cover a few different themes, all of which are continuously improving:

  • Better Graphics: From lines, to pictures, to 3d models, to realistic movie-like worlds, the past few decades have seen dramatic improvements in how games look.

  • New Genres: As technology allowed better visuals, it also enabled more complex games. The first were simple arcade games, but they were eventually surpassed by more resource-intensive adventures games, shooting games, sports games, resource management games, and many others. Mobile phones now offer more casual games as well. There is something for everyone.

  • Bigger Scale: There are still “indie” developer teams that only release smaller games, or only release a large game every few years, but gaming has become a big business. The rise of video game popularity came with a rise in the number of team members required to build a new game. The original arcade games of the 70s could be produced with a very small team, while modern teams can have hundreds of developers. This dramatic increase in scale is paralleled by the number of players who can participate in the same game. The maximum was once just two players, but modern multiplayer games can be populated with millions of players.

  • Interaction between the player and the game: The first game controllers were simple and only moved in two directions. These evolved into controllers that gradually increased the number of buttons and possible movements. Now there are even more direct connections, with cameras that can track everything in the room and translate those actions to a game on a screen. There are also headsets that can that can make players feel like they are directly inside the game.

None of these ideas are relevant to a business history on their own. It’s the combination of them all that simultaneously expands the way game developers and game publishers make money. Games are becoming more digital, more mobile, and more competitive, and these features all introduce more ways to make money.

But we’re getting ahead of the story. The first thing we should know is how we got to where we are.[1]

Part 1: Hardware (Consoles)

In the beginning, every new game required an entirely new system. Designing a new game was not like writing a new computer program. The mechanisms that control each part of the game had to be designed individually, like building a new computer specifically to run a single game.

As technology improved, electronic systems became capable of running more than one game, and the design process moved from placing microchips to programming. Over time, these game systems, called consoles, became more powerful, enabling more complex games and more immersive experiences. The competition shifted from which company has the best game to which one has the best “library” of games available for its console.[2]

The introduction of each new group of consoles is divided into different generations on the basis of what technology they use and when they were introduced. Each new generation was a race to reach the best combination of price, game library, console features, and timing. Getting any of those factors wrong meant that the company would struggle, but the most important was the game library. Missing on the game library could mean failing out of the industry, but getting it right could lead to success that extends to multiple generations.

The Golden Age of Arcade Cabinets (1970s to 1980s)

The spiritual predecessor to modern video game systems is the coin-operated pinball machine. First invented in 1872 and popularized in the 1930s, pinball machines became a cultural phenomenon that grew more sophisticated and more technologically advanced, slowly switching from mechanical systems to digital in the early 1970s. This shift, from mechanical to digital, generated the birth of the modern video game arcade cabinet.

It was the invention of the integrated circuit that made it possible to create a computer small enough to fit inside a “cabinet.” This led to dedicated gaming devices called arcade cabinets that began to fill restaurants and bars. Small computers were made for games.

The most famous was Pong, created by Atari in 1972. As a result of this game’s popularity, Atari quickly became the king of arcade cabinets, and followed the success of Pong with several innovative arcade games. At the same time, imitators and competitors began to appear. Every new game was followed by a similar copy, and other developers learned from Atari’s popularity. Midway, a company that published and distributed games but did not develop many of its own games, was Atari’s primary competitor.[3]

The industry accelerated in the 1980s as a series of famously popular games were released for arcade cabinets in the US, primarily from Japanese companies:

  • Space Invaders, developed by Taito in 1978 and distributed by Midway.

  • Pac-Man­, developed by Namco in 1980 and distributed by Midway.

  • Frogger, developed by Konami in 1981 and distributed by Sega.

  • Galaga, developed by Namco in 1981 and distributed by Midway.

  • Donkey Kong, developed by Nintendo in 1981, introduced the world to Mario, the world’s most well-known video game character.

  • Atari also developed a series of iconic arcade games, including Breakout (1976), Asteroids (1980), Battlezone (1980), Centipede (1980), and several others, almost all of them representing important firsts in video game development.

 While Atari maintained the dominant position in this market for many years, the competition eventually caught up with the company. In 1983, the video game industry crashed, and Atari collapsed (more on this later). Coin-operated arcade cabinets continued to be produced, but they were gradually replaced by video game consoles that could be played on a TV inside the player’s home. Video game players would no longer need to carry quarters to an arcade.

The golden age of arcade cabinets was marked by a few major acquisitions, but the one worth following is Atari. Warner Communications purchased Atari in 1976 and sold the arcade division to Namco in 1985.

The Console Wars (1970s to now) [4]

The console wars are traditionally divided into generations by time period and technology. Each generation represents a major advancement from the previous one, and every console had at least one feature or advantage that made it different from the others, but what’s important for this summary of the market is the general strategy for competing within each generation. Where those strategic thoughts are significant, I made sure to highlight them.

First Generation

The first home video game system was made by Magnavox in 1972, but it was Atari’s conversion of Pong into Home Pong in 1975 that marked the introduction of home consoles. Like the arcade cabinets of the time, Home Pong was also widely copied by many other companies entering this new industry. But these consoles were primitive. Gamers could only play the games that were hard wired into each individual console.

Second Generation

The second generation of consoles created a new market by adding microprocessors in the hardware (inside the console) and storing the games on removable cartridges. Instead of buying an entirely new system to play a new game, gamers could buy one system and then buy many games to play on one console. A console could now have a game library.

The market blew wide open: it now included serious tech companies such as Fairchild and RCA, but also toy companies such as Mattel and Coleco. This generation saw the release of 18 different consoles.

Among this chaotic competition, it was Atari, with its Atari 2600, that owned this market. The Atari 2600, which sold 30 million units, still ranks among the best-selling consoles.[5] The variety and quality of Atari games, some of which were transferred from its arcade business, were unrivaled. No other console of that generation came close. In 1981, Atari achieved a 75% market share in the console game market.

But overconfidence overcame the industry. Console makers, believing that gamers would buy any game, regardless of quality, flooded the market with a series of terrible games. The defining symbol of this excess was Atari’s E.T. game, rushed into production and released in December of 1982. It is widely regarded as the worst game of all time, and it is considered the game that killed Atari and triggered the video game crash of 1983.[6] The crash lasted for two years, devolving into price wars that wiped out most of the smaller console producers.

8-Bit Generation

In 1985, Nintendo revived the industry. It already had a successful console called the Famicom in Japan, but it struggled to extend the system’s popularity. Nintendo had approached Atari in 1983 about a partnership to bring the Famicom to America, but they could not make a deal before Atari’s collapse.

Nintendo eventually persuaded skeptical American retailers to sell the new system as a toy (no one wanted to try selling video games). The Famicom, redesigned and renamed the Nintendo Entertainment System (NES) for the US market, filled the void that Atari left behind. It became the most popular console of the 8-bit generation, earning a 94% market share in North America by 1989, and going on to sell over 60 million units worldwide. Nintendo’s console was more advanced and its games were simply better. Super Mario Bros., a game that was packaged with most NES consoles, is still one of the best-selling games of all time. Nintendo cared about quality, and this attention to what customers wanted made it the master of the 8-bit generation.

16-Bit Generation

Nintendo followed the success of the NES with the 16-bit Super NES (SNES), released in the US in 1991. But a serious new competitor had emerged. At the end of 1991, Sega’s 16-bit Genesis console had a 55% market share in the US, while Nintendo had 45%. The SNES was better, but the Genesis had more games (a larger video game library).

Competition between the two rival companies became bitter. Both fought for the attention of game developers and raced towards the introduction of CD ROM games as PC computers began to encroach on the games market. In the end, the SNES won, selling almost 50 million units, while the Sega Genesis sold about 30 million units. The competition, however, was close, and both companies nearly exhausted their resources preparing for the next generation. 1994 became a bad year for the industry.

Fifth Generation

In the fifth generation of consoles, computer technology improved enough to allow truly 3D games. In this generation, it was Sony’s PlayStation, released in the US in 1995, that rose to the top. Originally intended to be a collaboration between Nintendo and Sony, Nintendo arrogantly overplayed its hand, believing that it could win any console war by default. Insulted by Nintendo, Sony decided to develop the PlayStation on its own.[7]

Sony’s plans were different from the traditional console competition. It focused heavily on attracting developers to its new system, and encouraged a large library of good games to be developed quickly. Sony and Sega used disks for their console systems, while Nintendo used a much more expensive cartridge. Sony’s console was also the cheapest available on the market, and the only one that targeted a demographic beyond teenagers.

By the end of this console generation, the industry’s ancillary competitors were almost entirely pushed out of the market: only Sony, Nintendo, and Sega were relevant. The PlayStation, which stayed in production for more than ten years and had a game library of almost 9,000 games, sold over 100 million units. Nintendo’s N64 system sold a respectable 30 million units (still far behind Sony), while Sega began to fade. Sony maintained a 47% worldwide market share throughout this generation, while Nintendo rose from 28% to 40%, and Sega fell from 23% to just 12%.[8]

Sixth Generation

In the sixth generation of consoles, Sony did even better. Sony followed the success of the PlayStation with the PlayStation 2 (PS2), which it released in 2000. Once again focused on its game library, Sony chose to make the PS2 “backwards compatible” with the original PlayStation game console. This meant that anyone who bought a PS2 would be able to play all of their older PlayStation games and any new games that were developed for the PS2. The backwards compatible strategy had been used by other companies before, but it was uncommon because cartridge design would change with every generation. With a CD ROM system, the CD could be made the same size for the next generation, allowing newer consoles to play older games.[9] The PS2 also included a built-in DVD player, adding to its popularity (most PS2 consoles were primarily used as DVD players in the first few months of its launch, partly because there were few PS2 games available at the time).

The PS2 sold more than 150 million units in its 13-year lifetime, and remains the best-selling console of all time.

In second place, however, was an entirely new competitor. Microsoft’s first console, the Xbox, sold 24 million units. It was an extension of Microsoft’s original vision. From “a computer in every home” to a full entertainment system, the Xbox was intended to be a powerful computer in a console box. The console’s power, and support of games intended to take advantage of that power, were heavily subsidized by Microsoft’s other businesses. Creating such a big market for a new console was an impressive achievement, but it still could not match Sony’s massive library of games.

Nintendo’s troubled Gamecube was next, with 21 million units sold. Sega had exhausted its resources, and was unable to produce a competing console. The company shifted strategy to only developing games.

Seventh Generation

In the seventh generation, the console market continued to consolidate, and it emphasized online multiplayer more than any generation before it. Microsoft and Sony competed directly for the hardcore gamer market, focusing on high-end visually stunning games. The Xbox 360 (released in 2005) and PlayStation 3 (2006) each sold about 80 million units (although these final numbers are misleading, because the Xbox 360 outsold the PlayStation 3 for seven years).

But it was Nintendo, focusing on the casual gamer, emphasizing family-friendly games, that won the market. The Nintendo Wii (2006), with a unique easy-to-use motion controller, sold over 100 million units. Nintendo avoided the competition and went for a larger market, similar to the strategy that Sony employed for the PlayStation in the fifth generation.

Eighth Generation

The eighth generation console market is still fading into the ninth. This generation was marked by an increasing reliance on digitally-downloaded games. Rather than storing games on a disk that gamers buy at the store, almost all games can be downloaded.

In this generation, Sony sold more than 100 million PlayStation 4 consoles (it was released in 2013), while Microsoft’s Xbox One (also released in 2013) only sold about half that number. A major reason for the difference is that Microsoft’s first announcement for the Xbox One included limitations on sharing games with friends. Gamers revolted, and Microsoft reluctantly reversed the decision, but the damage was done. Sony also went back to its roots and made a big push for encouraging independent developers.

Nintendo’s initial entry for this generation, the Wii U, did not sell very well (poor branding made gamers perceive it as an add-on to the Wii). It was quickly discontinued and replaced with the Nintendo Switch, which came close to becoming the best-selling console of all time. The Switch, however, is a hybrid design. It can be used as a console or carried around and used as a handheld gaming device. It is not as powerful as other consoles, and not as much of a direct competitor.[10]

The Ninth Generation[11]

The ninth generation of consoles began right in the heart of the COVID-19 pandemic, with Sony’s Playstation 5 (PS5) and Microsoft’s Xbox Series X both released in 2020. The Nintendo Switch is sometimes included in this generation, but it doesn’t quite fit.[12] The main feature for this generation is an emphasis on extraordinary computing power, loading speed, and visual realism. Console gaming has also become almost fully digital.

The PS5 and Xbox Series X are both backwards compatible with older consoles and focused heavily on cloud gaming. And without much difference between the two, Sony’s advantage has been carried from the previous generation. At the time of this writing, the PS5 is outselling the Xbox Series X (and its other version, the S), by twice as many units.[13]

Handhelds (1990s to now)

The “handheld console” story is not as dramatic. It has been dominated by Nintendo since the very beginning.

The first successful handheld console was the Nintendo Game Boy, released in 1989. Several other handhelds, or consoles that could be carried and played without a TV, were attempted in the 70s and 80s, but the technology was not ready. These early devices were functionally interesting, but did not have enough portability to make them attractive (they didn’t have enough battery life). The Game Boy was not as advanced as the other handhelds available at the time, but it was much cheaper and had a much longer battery life, two of the most important features for handheld popularity. By 1990, the Game Boy had a US market share of 93%, making Nintendo the undisputed leader in both consoles and handheld consoles.

Since then, Nintendo has never been seriously challenged in the handheld console market. Nintendo continued producing more advanced variations of the Game Boy handheld system for 20 years, and the combination of the Game Boy and the Game Boy Advance sold a total of over 200 million units during their lifetimes. A major reason for this extended success (and the common theme among consoles) was the robust library of games: many old NES games were “ported” to Game Boy, and the launch of the Pokémon franchise (a franchise with a fan base that could rival Star Wars) kept the console fresh in the late 90s.

The Game Boy family of handhelds was gradually replaced by the Nintendo DS after 2004, a handheld that sold over 150 million units. These were phased out after the release of the Nintendo 3DS in 2011, a handheld that sold about 75 million units. The 3DS itself was also discontinued in 2020, but the spiritual successor is the Nintendo Switch, which can be used as a TV console or a handheld console.

The only company to offer a real alternative is Sony. Sony released the PlayStation Portable (PSP) in 2004 as a competitor to the Nintendo DS. It was the most powerful handheld console of its time, and was designed to work with the PlayStation 2 and PlayStation 3. It sold 80 million units in its lifetime—impressive, but nowhere near Nintendo. Nothing could dislodge Nintendo from its ownership of this market.

But the handheld market is changing. Now there is a serious new threat—mobile phones. Mobile phones are functionally similar to handheld consoles, and they can do almost all of the same things. They also have continuously growing game libraries supported by millions of small game developers. There will always be demand for high quality handheld consoles (meaning there will always be demand for Nintendo products), but casual gamers have accepted mobile phones as an adequate replacement.

End of Part 1

The rule behind the market for consoles is what economists call a two-sided market. On one side is the content (the number and quality of games available for the console), and on the other side is the consumers (the people choosing which games to play)—and the console with the best content is usually the most successful. What matters for investment timing is the industry cycle, which resets with every new console generation. There is always a big boom in business at the start of a generation, when consumers upgrade their systems.

From a really long-term view, the technology for consoles has followed the same pattern as the rest of the computer industry: devices continue to become smaller, more powerful, and more interactive. The only difference is that consoles are used primarily for games.

The market for consoles has also followed a familiar pattern—it opened with many small competitors, exploded, and re-formed into a small number of major companies. To compete in this market today requires a massive investment in technology and (more importantly) another massive investment in a large video game library, something that the established players have taken decades to build. There will be no small startups here.

The market for the actual games, however, is an entirely different story.

Andrew Wagner
Chief Investment Officer
Wagner Road Capital Management


[1] The earliest years of the industry are wonderfully cataloged in The Ultimate History of Video Games by Steven L. Kent. The book ends abruptly in 2001, but I have been following the industry closely since then.

[2] The most simplified way to understand the idea of a game library is to think of it as a movie store (or today’s version, a movie streaming service). The store that has the largest variety of good movies (the best movie “library”) will be the most popular.

[3] To understand the role of a publisher, think about the book writing industry. The game developer in this comparison would be writer, while the game publisher would be the same as the book publisher. It is common for game developers to be their own publishers or be owned by a publisher.

[4] There are many articles about the console wars. HowStuffWorks has good technical descriptions of the console generations, while Gamicus and history.com have detailed play-by-play explanations, and Smithsonian has a good look at early video game history. The best resource for sales details on each generation can be found in Video Game Sales Wiki.

[5] It continues to be popular today among collectors of old computer hardware.

[6] It is more accurate to say that poor management killed Atari. Warner Communications, by this time the parent company for Atari, destroyed the video game company’s culture and replaced it with bureaucracy.  The vision from the company’s original team was stifled by demands from the parent company. Key employees were easily poached by more successful competitors. From 1983 to 1985, Atari’s different divisions were torn apart and sold away. Atari produced consoles into the mid-90s, but they continually declined in popularity until the company left the market.

[7] Nintendo must have forgotten the lesson from Atari’s downfall a decade earlier.

[8] Sony’s dominance in the late 90s was catalogued at the end of the decade.

[9] There are technical differences that determine which CDs a system can read, but it’s much easier to overcome these differences because CDs are all the same size.

[10] Each of the eighth generation of consoles have all made it on Statistica’s list of the best-selling consoles. A nice summary of this generation is available on History-Computer.

[11] In the original version of this blog post, Google’s Stadia was mentioned as a potential new entry for the ninth generation of consoles. My assessment at the time was negative, and the Stadia project has since been shut down. The biggest frustration for gamers was that Stadia’s game library was too small.

[12] The Switch 2 is expected to come out in the second half of 2024.

[13] Sony has sold close to 500 million Playstation consoles of all types, making it the best-selling console brand of all time (when adding PS5 sales totals to the confirmed 450 million units sold at the end of 2019).


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