The Economic Challenges (and opportunities) of Developing Games for the iPhone and iPad

According to a recent Game Developer Survey, increasing numbers of developers are working on games for the iPhone and iPad.

Although the App Store has certainly been a godsend to Apple (and it will continue to be for some time), for developers it has the potential to become a trap.

On the surface, the iPhone and iPad would seem to be ideal platforms to develop games for. The iPhone, for example, has:

Yet, for those same reasons, the iPhone will prove to be an economic challenge for most game developers. With 140,000 apps to compete with, even the most creative programs will have a hard time attracting the notice of potential customers.

According to Gartner research, revenue from app downloads is expected to reach $6.2 billion in 2010, rising to over $29 billion by 2013. The problem is that such predictions often assume straight line growth, both in the number of users and in the average number of applications sold. For example, for those numbers to hold, the number of smartphone users would need to increase to over 300 million by 2013, and the average user would need to consume each year the same number of apps, at the same average cost, as current users consume (Gartner expects more than 2/3 of these smartphone app consumers to be iPhone owners).

The problem with those assumptions is that they contradict basic economic models.

By far, the largest source of smartphone apps is the App Store, accounting for 99.4% of sales in 2009. Whenever an application is approved for the App Store, it diminishes the value of all the existing apps by reducing their individual utility. In a sense, it is the inverse of the network effects that accrue to a social networking site as more people become members. Online gaming communities, for example, depend on membership growth to ensure that gamers have opponents to play against at any given hour of the day.

Although these two opposing forces are easy to confuse, it is important to recognize their differences. Normally, having large numbers of programs available on a system is positive because it encourages people to buy more systems, which in turn gives a signal to publishers to fund more game development on a particular platform.

Figure 1: Aggregate Cost - Benefit Chart for the App Store

diseconomy

In the chart above, the average cost to develop an application is assumed to be the same over time. Therefore, the aggregate cost of all iPhone applications increases in a straight line as the number of applications increases. Network effects increase the benefit of each application added until point A (tangent is parallel to aggregate cost), at which point the average benefit begins to decrease. Once you reach point B, the benefit of adding new applications falls to below cost.

Consider the PlayStation 3. When it was first launched, one of the main criticisms was the lack of games (particularly exclusively titles) to justify the console's high cost relative to the Xbox 360. Over time, as more games became available for the PS3, a virtuous cycle developed that helped to increase the pace of development. So far, Xbox 360 and PS3 development has not yet reached the crossover point represented by point B in the above graph. Ideally, console makers will introduce a new platform before the crossover point is reached and before developers decide that a platform is no longer worth developing games for.

This model is very similar to the product life cycle chart that I presented in an earlier article on music simulation games (see Too Much of a Good Thing: Explaining the decline of Guitar Hero and Rock Band). For example, if you were to overlay the product life cycle chart over the total number of music games, you would notice several similarities to Figure 1 (above).

In fact, diminishing marginal utility has an important role to play in both cases. Gartner assumes that current users will continue to purchase the same number of applications each year through 2013, telling Information Week that "high-end smartphone users today are early adopters of new mobile applications and are more trustful of billing mechanisms... Therefore, they are expected to continue to pay for applications they believe will be useful."

However, diminishing marginal utility suggests that users will purchase fewer applications over time as the value of each additional application and its ability to meet the particular needs of the user decreases. A new iPhone owner who purchases a software program from the App Store will first purchase the application that most fills a perceived need. The second application will also fill a need, but most likely it will be a less important one, and so on. By the time the average iPhone user has purchased 20 applications, the value added by each new program will be marginal at best.

Although Gartner recognizes that early adopters are heavier users of technology than late adopters, they ignore the fact that iPhone's future growth will increasingly shift toward late adopters. Diffusion theory suggests that early adopters tend to be educated, have higher social status, and are wealthy. On the other end of the spectrum, late adopters tend to be less educated, have lower social status and have less income. They will be more skeptical about adding new features and applications, and will instead rely upon standard applications that come preloaded with the phone.

Apple has responded to this challenge in two ways, through market expansion and platform renewal.

By continually adding new features to the iPhone, Apple has attracted new users who value these features and are willing to enter into long term contracts to obtain them. Examples range from commonly found features like GPS navigation to more esoteric features like instrument tuning and remote invoicing.

This approach is very similar to the one taken by Nintendo with the Wii. Nintendo began by improving existing GameCube technology and adding motion control through the Wii Remote. It expanded the market again with the balance board, which attracted a new group of customers who were fundamentally concerned about fitness.

The other option is to introduce a new platform to attract more early adopters. Console makers do this every time they introduce a new generation of gaming hardware, and Apple is doing it with the introduction of the iPad.

Initial demand for the iPad could help to extend the growth stage of the App Store’s product life cycle. Ultimately, however, the iPad’s size and price will limit its market appeal relative to the iPhone. As a result, it will not provide the type of renewal that will support the growth rates projected by Gartner.

Even if Apple successfully expands the market and attracts a new group of early adopters with the iPad, developers will still need to contend with the diminishing utility problem discussed earlier. The only exceptions will be applications that

When the iPad is released, early movers who can design applications that fit all three criteria will have the best chance of success.

Quality versus Quantity

Returning to the social networking example, the network effect of adding more members would no longer be valid if the social networking site did not add additional servers, network switches, and bandwidth to compensate for the added burden. Instead, the system would begin to crash during times of peak activity and members would begin to turn to alternative sites. The value of any individual member's contribution to a social networking site does not matter to the site's overall performance. Users who fill discussion boards with gibberish impact online performance on these sites as much as users who contribute valuable content. Like the social networking user, the individual role of any given application does not matter, because it is the aggregate that determines overall performance from the point of view of the consumer.

Figure 2: Aggregate Data for the App Store

appstore

The aggregate number of applications (blue line) relative to the aggregate number of downloads (red line). Download numbers include free programs.

At the same time that iPhone owners are becoming overwhelming by the number of applications, they are also impacted by the number of lower quality applications that Apple allows to be sold through its store. In this case, it is the individual effect of each program rather than the aggregate that matters. And this is where the App Store differs most from instrument simulation games. Consumers of Guitar Hero and Rock Band know they are going to receive a polished product, whereas iPhone users are left to wade through a sea of poorly thought out applications.

Figure 3: A Typical Product Life Cycle

Standard Product Life Cycle

The iPhone and App Store are still in the growth stage of the product life cycle.

That does not necessarily mean that iPhone owners will be switching to Nokia any more than social networking users will stop using the Internet because of an inability to access a popular site, or because the site has become polluted with unmoderated nonsense. It does mean that the App Store will hold less value to iPhone owners, who will increasingly limit their purchases to popular titles from companies with large advertising budgets or apps that have been recommended by friends, TV personalities, and other influential people.