Video Games: A report on the supply of video games in the UK

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In January 1994 we were asked to investigate the supply of video games in the UK. When the reference was made the Director General of Fair Trading drew attention to concerns about the price of games in the UK, particularly compared with prices in other markets, to the arrange-ments for licensing those wishing to publish games, and to distribu-tion arrangements for video games.

The games are played through a console, either one that has to be plugged into a television set or a portable machine with its own built-in screen. The individual game to be played is usually delivered through a cartridge inserted in the console, although compact discs (CDs) are also beginning to be used as the game medium.

Video games in their present form were developed in the mid-1980s and supply has been dominated by two Japanese companies, Nintendo Co Ltd (NCL) and Sega Enterprises Ltd (SOJ). Both operate world-wide, with their largest markets in Japan and the USA, and the video games business has been very profitable to both. Through their two wholly-owned subsidiaries Nintendo UK Entertainment Ltd (Nintendo UK) and Sega Europe Ltd (SOE) the two companies supply virtually all the video games consoles sold in the UK and about 40 per cent of the games software played on them. The rest of the software is provided by third party publishers. Since video game consoles and cartridges both embody computer programs, microchips, circuitry and other features which give rise to a range of intellectual property rights (IPRs), these publishers obtain licences from NCL or SOJ before publishing games on the Nintendo or Sega formats. In total the UK video games market at retail level in 1993 was worth about £550 million.

We noted the recent downturn in the UK market and the deterioration in the financial results of both the UK subsidiaries and their parent companies, but think that the current market weakness appears likely to be a temporary phase. We believe that Nintendo and Sega remain well placed to retain their dominant position in the market and to derive continuing profit from it.

We found two monopoly situations. SOE's UK market share (38 per cent of combined console and games software trade sales in the year ending June 1994) makes it a scale monopolist; Nintendo UK's share was just below the necessary 25 per cent. We also found a complex monopoly situation in the UK market, based on practices pursued by both parent companies, as well as Nintendo UK and SOE, most important-ly through the licensing arrangements for software publishers, but also through the pricing of software relative to hardware and through rental arrange-ments. As the following para-graphs describe, our consideration of the issues before us has led to a number of adverse findings.

In the light of the complaints we had received about UK prices, we carried out a study of retail prices of video games consoles and software in the UK, USA, France and Germany. This showed that for many video games the price differences could be accounted for by different tax levels. When allowance was made for varying levels of VAT and sales taxes, UK prices for most games systems and software covered by the survey were little different from those in the USA, Germany and France; sometimes they were lower. However, for the important 16-bit format, which accounts for about 60 per cent by value of hardware sales, prices of both the Nintendo and Sega models were substantially higher in the UK than in other countries.

Both Nintendo and Sega set prices so that margins are higher on software than on hardware. We found that this discriminatory pricing raises the total cost of games play to consumers and inhibits the entry of new systems; it therefore operates against the public interest. We linked the ability to operate such pricing policies to the licensing arrange-ments for competing software publishers, which emerged as the main focus of our inquiry.

Although SOJ appears to apply its rules a good deal more flexibly than NCL, both companies attach extensive conditions to the licences they grant to third party publishers, limiting the number of games that may be published, specifying approval before publica-tion, and controlling packaging and presentation. Most importantly, both companies control the manufacture of cartridges. NCL stipulates that it undertakes the manufac-ture of all licensed cartridges, although SOJ allows larger publishers to arrange their own cartridge manufacture.

Both companies defended the restrictions in their licence agreements as necessary, first to ensure a high quality of software for their formats and thus to protect their brands, and secondly to secure a proper reward for their innovations. We did not accept the argument that the detailed conditions in the licences are required to maintain the quality of games software. We agree that NCL and SOJ are entitled to remuneration for their IPRs. These are being taken, wholly by NCL and substantially by SOJ, through the charges they make for the cartridges they supply. Our inquiries into the cost of cartridge manufac-ture indicated that both companies earn very high margins from this source. We concluded that the remuneration taken by both companies through their supply of cartridges to third party publishers is excessive and raises the price of all software to consumers.

We also found that the conditions relating to limits on numbers of games published, prior approval of games, packaging, etc, and require-ments that NCL and SOJ arrange the manufacture of cartridges, all have the effect of raising the price of games to consumers and therefore operate against the public interest.

We also found that certain provisions in Nintendo UK's terms and conditions to retailers (which were withdrawn during the inquiry), requiring them to stock all Nintendo products and to give them as much display space as any other video games products, operated against the public interest.

Both companies restrict the rental of their games. Nintendo UK prohibits any form of rental. Although it takes no steps to enforce the prohibition, many retailers therefore do not offer Nintendo games for rental. SOE operates a rental scheme which was the subject of a number of complaints, mainly about the payments required from retailers admitted to the scheme and the way it was policed. At a late stage in the inquiry SOE indicated to us that it was contemplating major changes in its approach to rental but that it was not yet in a position to publish details. We based our appraisal on SOE's existing rental system. We found that both companies' rental policies restricted consumers' opportunities to try out games and to make informed purchases and, therefore, operated against the public interest. We also found against some of SOE's practices in operating its current rental scheme.

As we have identified the licensing arrangements as the main factor making for relatively high software prices, we consider that the appropriate remedy lies in modifying these licences. We recommend that a number of licence conditions (see paragraph 1.10) should be removed, and in particular the require-ment that the licensor arrange or control the manufacture of cartridges. If this does not prove possible some form of price control may have to be considered, in spite of the difficulties we recognize in operating such controls.

We also recommend that restrictions on rental be removed and that games soft-ware supplied by Nintendo UK or SOE be freely available for rental, if necessary on payment of an appropriate royalty.

The parties argued that for various reasons-eg extra-territori-ality and the UK's EC obligations-most of our proposed remedies could not be implemented. It is for the Secretary of State to appraise these arguments on the powers available to him. We do not believe the limitations on his freedom are as severe as has been suggested.

We have referred elsewhere in this report to other inquiries in which this Commission has considered the interaction between competition policy and IPRs, and to the provisions in UK and EC law which bear on this question. The present inquiry has provided additional evidence of the complex issues involved. We suggest to the Secretary of State that he should draw our report to the attention of other competition authorities, so that its findings can be taken into account in further consideration of those matters.

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