[For as much as digital channels have changed the games industry, the biggest changes are yet to come. Gamasutra contributor Nicholas Lovell asks whether the industry is ready for the "impending tsunami."]

Games have, so far, ignored the digital tsunami that has engulfed music and is about to engulf the book world. The enormous file sizes of our boxed products together with the proprietary physical DRM systems (or, in other words, a console) has meant that filesharing has not been a major threat to the industry in the way it decimated music.

Digital innovation in our sector has happened around the edges of the core traditional games industry, such as in social, free-to-play, and mobile. It has largely been additive, although with boxed product revenues peaking in 2008, that is no longer the case.

All this is about to come to an end. While I still believe that AAA games have a future, the threat from new business models, enabled by and optimized for the internet, is growing. So what does it take to succeed?

Embrace The Internet

There are two things that that the internet does to digital content: it makes distributing it so cheap as to be almost free, and it makes it possible for companies to talk to their biggest fans and find ways to charge them lots of money in return for giving them things that they value.

It amazes me how often traditional companies focus on the fear of the former without getting excited about the prospects for a vastly more exciting business based on the latter.

It's Going Free

There is a basic rule of economics called Bertrand Competition. Broadly speaking, it says that in a competitive market, the price that consumers will be prepared to pay will fall to the marginal cost of production.

This is bad news for digital content because the marginal (i.e. per unit) cost is essentially zero.

To take one example, Tiny Tower cost meaningful money to create. It took two developers four months. They then gave it away through the App Store. Since Apple swallows the costs of the downloads of free games, it cost the developers literally nothing to distribute the content. Tiny Tower achieved 1 million downloads in the first four days. (Note this argument excludes the costs of marketing; marketing costs are important to the success of most games, but not key for an understanding of Bertrand competition).

Modern Warfare 2 cost $50 million to develop. When distributed physically, it costs a lot of money to manufacture, distribute, and retail, not to mention the royalty due to the console manufacturers. Digitally, given that it is a big file, it will cost a lot more to distribute than an iOS game like Tiny Tower, but like with so many things technological, the cost of distributing AAA games is likely to fall towards zero over time, in a Moore's-Law way.

So when the cost of distributing content is essentially free, the price people will pay for content will fall towards zero, irrespective of the initial cost of creating it. Whether it's pirates sharing content on peer-to-peer networks, games companies making high-quality promotional content like Undercroft available for free or new business models that start with the premise that you have to give the game away for free, the downwards pressure on prices will be relentless in a digital age.

It's Going Personal

The free issue blinds so many companies to the real joy of the internet. It transforms the relationship with your customers, and enables you to serve them better. Much better.

Games publishers and developers were, historically, business-to-business companies. Developers had business development executives, often the CEO, whose job was to persuade one of a handful of publishers to give them money to make a game. Publishers had account executives in shiny suits who persuaded buyers from large retail chains to place orders for thousands, tens of thousands, or even hundreds of thousands of units.

The marketing departments of publishers may have thought they were consumer-facing, but even they never actually spoke to customers, except at the occasional focus group. They bought ads in the specialist press, on TV, or on billboards, but rarely got direct feedback.

The only person in the entire games industry value chain who regularly spoke to honest-to-goodness customers was the lowly sales assistant in a retail store.

The internet turns this on its head. Companies who were historically business-to-business players are becoming business-to-consumer. Instead of persuading one retail buyer to buy a hundred thousand units, publishers or developers now have to persuade hundreds of thousands of gamers to buy one copy.

More importantly, gamers no longer pay the same amount for a game. Some people might play a game for free forever. They might check it out and decide within the space of a few minutes that it's not for them, or they might end up staying for years and become one of the game's biggest fans.

In my consulting practice, I focus on the rule of 0-1-100:

  • Make the game fun to play for free forever
  • Offer a no-brainer reason for regular players to spend their first dollar
  • Make it possible to spend $100 per month
Clearly, this is what is happening in the market. Flurry reports that for smartphone games, the average transaction value is $14. Over 50 percent of revenues come from transactions valued at over $20. Yet most companies that talk about conversion rates suggest that fewer than 5 percent of players spend money.

Why Is It So Scary?

Traditional media businesses are all about volume. Every customer pays the same amount, so the only variable that matters is how many customers you have.

In the online world, every customer is different. They can pay anything from zero to tens of thousands of dollars. The game developer's job becomes finding ways of determining what their customers want and will pay for, and then offering it to them.

It's a totally different skill to the traditional skills of game development or publishing. It is also a change that will allow the niche to flourish in a way that was impossible in the pre-digital world.

It's why so many big companies are fearful of the impending tsunami, and why I am so excited by it.