Vertical integration and two -sided market pricing: Evidence from the video game industry

The focus of this dissertation is twofold. The first objective is to construct an empirical demand model for video game consoles which captures the complementary nature between hardware and software while accounting for software heterogeneity and competition. The second objective is to determine the effects of vertical integration on video game console price competition as well as consumer welfare and firm profits.;These objectives are answered with data from the 128 bit video game industry which consists of Nintendo Gamecube, Sony Playstation 2 and Microsoft Xbox. A new methodology is formed to estimate the demand for video game consoles. In order to understand how vertical integration impacts console price competition, my analysis extends the empirical industrial organization literature by constructing a new methodology which allows consumer demand for video game consoles to depend upon the set of available video games rather than only the number of games. The estimation technique differs from prior research by incorporating video game heterogeneity and software competition into the indirect network effect.;With the implementation of a model which is more flexible than prior models, I determine vertical integration in the video game industry increases price competition as well as consumer welfare and console manufacturer profits. There are two important trade-offs to vertical integration. The first is a demand effect which further differentiates consoles and forces prices higher. The second, a market structure effect, drives prices lower. Since price competition increases, the demand effect is thus dominated by the market structure effect which results in higher consumer welfare. Moreover, the increase in price competition also benefits console manufacturers. Lower prices generate greater demand for consoles which leads to a rise in the number of video games sold, where the "real" profits are made. I find that console makers are thus willing to set lower console prices in order to increase sales of their own developed video games. Under a more restrictive model, however, prices rise leading to the conclusion which is counter to what an industry insider would suspect. I determine that it is important to properly model the console manufacturers' profit functions and model the demand for video games well since console demand is derived from video game demand. Without doing so, incorrect policy conclusions are made.