Vertical integration is the most economically visible feature of the land based slot machine industry. Players play slots at Casinos which purchase the slot machines from Manufacturers. In a simple model where both the Casino and the Manufacturer are monopolists, the Manufacturer is supposed to make all the profit. The reason is that in anticipation of the profit the Casino could earn, the Manufacturer should be able to raise its prices. The result is that the Manufacturer captures the downstream Casino’s profit. We want to learn how Casinos protect their profits from Manufacturers.
As evidence that this model has some explanatory power, we should look at IGT. They are essentially monopolists as far as their video poker machines are concerned, and ask any of their customers: they pay exorbitant prices and have to agree to contracts that no other Manufacturer in the slot industry could get. As another example, many Manufacturers even take a percentage of every bet made for big name licensed game themes, which directly scales their own profits with that of the downstream firm.
Casinos don’t only sell slot machines, they purchase a variety of goods and services which they offer to their patrons. These substitutes and complimentary goods for slot machines help the Casino create its own brand and confound the profit signal back to the Manufacturer, who at best only has access to slot floor data. Modelling this kind of information asymmetry for monopolistic Casinos and Manufacturers provides a great deal of explanatory power. In a very basic model, the Casino has no incentive to share information about its prices and profits with the Manufacturer. More generally, adding such an information friction to the model helps explain the sometimes in the dark way Manufacturers go about producing games.
The slot machines however are doing the most to protect the Casinos. Slot machines sometimes take in the hundreds of thousands to billions of plays to truly capture all their dynamics with any statistical reliability. What this means is that Players, Casinos and Manufacturers have to wait for information as they try to judge a slot's performance: Players will sometimes get the wrong impression from the machine, Casinos will be over-sensitive to “bad” performance and Manufacturers will have to sit back for 6 months to a year to find out. Most of the time a Manufacturer will not have the opportunity to mark up a game's price to the Casino.
Over time Casinos have been sharing more information, but it is often quid pro quo: an information exchange about floor data for information about the slot machines. At the same time, Manufacturers are inventing new ways to gain more information: think about how at the G2E conference Manufacturers offer floor analysis and optimization solutions. The Casino is paying for the services but handing over information that could ultimately cause the Manufacturer to raise its prices. There is clearly a war for information being waged.
Ultimately I think the Casino is facing two opposing forces. On the one hand, they don’t want to give their profits to the Manufacturer; and on the other, they don’t know ahead of time which slots will be hits and which will be lemons, hence they don’t know which machines to buy. I will write more about the latter scenario in the next post.
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