Hubris. That's what it looked like.

First Microsoft revealed a new games console but mistakenly pitched it as a device for watching television instead.

Then Microsoft announced its policies around software licensing for the Xbox One. The reaction from commenters across the Internet was explosive: the software giant appeared to be plotting a draconian digital rights management system for Xbox that would put the interests of its corporate publishing and retail partners ahead of the wishes of the consumers who actually buy and play games – indeed, a system that would treat paying customers as potential criminals, and restrict rights and freedoms that they had previously taken to be inalienable.

Simultaneously, the Internet seethed with indignant fury over the US government's secret PRISM programme which has apparently been spying on the world with, allegedly, the complicity of technology companies including Microsoft. So the fact that the "Spybox One" would come with a camera that couldn't be switched off and would regularly phone home to Microsoft's servers was the icing on the cake for the console's detractors.

The killing blow came when Sony confirmed it would not follow Microsoft's lead on connectivity or used games.

Sony, sensing blood, moved in for the kill at E3 last week. At its press conference, Sony carefully emphasised that the PlayStation 4 was a gaming device first and foremost, not a media player (an executive from Sony Entertainment did stray onto the stage briefly to talk about how the media conglomerate might leverage its movie and music arms to deliver other types of content on PlayStation, but he was quickly shooed away) and demonstrated a solid line-up of games for the platform.

The killing blow, though, came when Sony confirmed it would not be following Microsoft's lead on connectivity or used games. Disc-based games for PlayStation 4 could continue to be traded the same as they are today, there would be no online check-ins, the console could be used offline, and – the ultimate coup de grâce – it would come in at a US$100 lower price point.

The fickle crowd, whipped into a frenzy, roared with ecstasy as the wizened old gladiator slayed the swaggering upstart usurper, green blood pooling on the arena floor. The winner, basking in applause, snatched back the glorious crown that it once had lost.

How did this happen?

The Xbox 360 has by most measures been a tremendous success. Xbox led the way in online gaming, reshaped the console market, and built up a large and loyal audience of dedicated fans. Being the first HD console to launch in 2006 gained it a head start, and although global sales are now neck and neck with PlayStation 3, Xbox 360 has dominated the US market throughout this generation.

But when Microsoft revealed its apparently anti-consumer stance with Xbox One, it appeared the company had committed the same sin of hubris that led Sony astray at the end of the PlayStation 2 generation.

At that time, Sony was riding high and seemed unassailable. It spent money recklessly developing an over-engineered and overly-complex architecture for the PlayStation 3 that would dog game developers throughout the next seven years, and it continually delayed the launch in order to incorporate the Blu-ray media technology that it wanted to get into everyone's living rooms – primarily to benefit Sony's movie and electronics businesses. Because of those decisions Sony was forced to launch the PlayStation 3 at an absurdly high price point that consumers balked at.

Sony was eventually able to turn its ship around and make the PlayStation 3 into a success, but the console’s shaky start cost the company dearly.

Has Microsoft made a similar mistake in arrogantly thinking that, having fought hard to win market share in the current generation, it could now dictate terms to consumers in the next?

The reality is much more complex.

The DRM problem

When you purchase a game for Xbox One, either digitally or disc-based, it will be attached to your Xbox Live account. The controversy surrounds two key policies which result from this.

Firstly, the Xbox One DRM system requires software licenses to be checked by communicating with Microsoft’s servers at least once every 24 hours. If you lose Internet for more than a day, or you want to use Xbox One in a place with no Internet, you won’t be able to play any of your games, even if you have the disc in the drive.

Secondly, Microsoft will allow games to be traded in at “participating retailers” as well as shared with friends, but with certain limitations, and with the possibility that game publishers might be able to restrict used game sales or charge fees for the privilege.

These policies have created a PR firestorm that is tarnishing the company’s image and jeopardising the launch of the Xbox One.

It is easy to dismiss these policies – as many Internet commenters have done over the past week – as simply a “money grab”. But this argument is flawed by the fact that neither of these measures will directly make any money for Microsoft. Xbox 360 games had adequate copy protections and were not heavily pirated, so the extra level of DRM is very unlikely to increase game sales on Xbox One. The used game restrictions might have been a money spinner if Microsoft had inserted itself into the middle of the transaction and taken a fee from every trade, but it has already stated clearly that it won’t be doing that. If publishers were to take a fee it might reduce second-hand sales and increase new game sales, which would earn money for Microsoft, but publishers including EA have already indicated that they’re much too afraid of the potential backlash to consider such a scheme.

On the contrary, rather than benefiting Microsoft these policies have created a PR firestorm that is tarnishing the company’s image and jeopardising the launch of the Xbox One.

Microsoft is not staffed by fools. It has some of the most intelligent people in the industry working for it. Don Mattrick does not sit in an underground lair beneath the volcano Mt Redmond plotting ways to screw over gamers. Microsoft wants to make money from gamers, yes, but for the most part that goal aligns with giving gamers what they want. Gamers don't seem to want this.

Why did the Xbox team not foresee the negative response these decisions would generate? And, if these policies don’t make any money for Microsoft, why did it go ahead with them?

Microsoft has failed on two levels. It has failed to perceive its policies from the perspective of gamers, and it has failed to coherently communicate to gamers the benefits of the model that it has chosen to pursue.

A matter of perspective

It was clear at E3 that Microsoft executives are confounded by the response from consumers and the media, and are struggling to understand why people are so enraged. They did not anticipate that making a console that required an Internet connection would be so controversial, or that allowing people to trade-in their games, but with a few caveats, would be so ill-received.

The problem is that people who work in the games industry and consumers who buy games approach the question of “game ownership” from very different perspectives.

When you buy a game, you aren’t really paying for a copy of the bits: what you are actually paying for is the right to play the game.

To those who create them, game discs are just vessels for transferring a copy of the bits of data required to play a game from the publisher to the consumer. Those bits are, and have always been, covered by a license agreement which permits you a restricted set of uses: you can play the game on one device, you can’t make copies of it, you can’t rent it out or sell it, you can’t modify it, and so forth for several pages of small type. When you buy a game, you aren’t really paying for a copy of the bits: what you are actually paying for is the right to play the game, under those proscribed circumstances – plus a few cents for the disc and packaging. (The same is also true for movies and music.)

This is not how most gamers view game ownership. When you buy a game, you hand over your hard earned cash and in exchange you get a disc, which is now your personal possession. Putting that disc in your console allows you to play the game. You can lend the disc to your friends so they can play, and if you get sick of the game you can trade it in for another game. This is how it has always been. Although you were always implicitly agreeing to the terms of a license agreement (even if you didn’t know it) when you played a game, without any technological solution to enforce those terms gamers were largely oblivious to them.

From a gamer’s perspective, what Microsoft intends to do is treat all their customers like criminals, requiring them to phone home once a day to verify they aren’t breaking their parole conditions. But from Microsoft’s perspective, all it is doing is enforcing licensing restrictions that were already in place. What’s the big deal?

There is a bigger picture here: the inexorable transition to digital distribution. For some years now people throughout the industry have been predicting the death of games retail as more and more games are sold as digital downloads instead of physical discs. On PC, this is already the norm, with Steam ushering in the new era nearly a decade ago.

Digital distribution on consoles in the current generation has been held back by the console makers themselves. As the idea took root, Microsoft and Sony found they were caught in a dilemma: on the one hand, digital distribution presented fantastic new opportunities for publishers to reduce costs, monetise content in new ways, change pricing models, and experiment with niche content. On the other hand, console makers and publishers have a symbiotic relationship with games retail, which they found difficult to break free from.

Console makers need retailers to sell their consoles; you can’t distribute hardware digitally. But the profit margins on consoles are slim to none. Retailers only sell console hardware because it gives them an opportunity to sell game software at the same time. Game publishers also believe they need retail, because the retail experience is a powerful way to reach consumers. Neither console makers nor game publishers want to upset retail and risk cutting themselves out of that loop.

So when Microsoft and Sony started selling full games as downloads via Xbox Games On Demand and PlayStation Store several years ago, the offerings were generally pretty disappointing. It was mostly back catalogue or delayed releases, at prices that were not competitive with retail. This was intentional: they had to protect the retail channel.

In response, console gamers kept buying discs.

But that was a poor solution, and not a sustainable model. Consumers want digital distribution, but they want digital games on day one, and want to reap the benefits of lower costs by seeing lower prices on digital games. Microsoft obviously wants to tackle this problem with the next generation, while Sony is apparently content with the status quo.

Communication failure

Microsoft’s second failing has been its inability to clearly explain why it is doing what it is doing and how it would benefit consumers.

The negatives for consumers are immediately clear: Xbox One can’t be unplugged for more than a day, and the DRM check-ins smell bad – with privacy, security, and reliability implications. The unspecified restrictions on used games could make games effectively more expensive, and the simple act of giving a game disc to a friend will now come with unnecessary strings attached.

One of the features is downright generous: you can buy a single copy of a game, and share it with up to 10 friends... at no cost.

But if we forget about discs for a moment and look at Microsoft’s policies in the context of a digital distribution system, they’re actually more than fair compared with what consumers are already happily accepting on other digital marketplaces like Steam and iTunes.

Indeed, one of the features is downright generous: you can buy a single copy of a game, and share it with up to 10 friends. Any one of those friends can play the game on their Xbox One at the same time as you’re playing on yours, at no cost. Instead of highlighting this feature, however, Microsoft made it sound confusing and restrictive by talking about sharing with “family”; it has since clarified that you will be able to add anyone to your Xbox Live “family”, regardless of their relationship to you.

Microsoft has made a key design choice: the elimination of discs as runtime media. If the consumer buys a disc at all, it will only be used for installation, after which it is no longer needed to play the game. The data is copied to the hard drive using some clever streaming technology which allows the game to start playing once a minimal amount of data has been copied; the rest continues in the background. The same technology can work for downloads, too, so downloading a 10GB game won’t mean a day’s wait to start playing.

The move to a cloud based game library enables other features familiar to Steam users, like being able to access your whole library from any Xbox One simply by logging in, without reinstalling everything from discs. Xbox One goes a step further, too, by allowing all games installed on a console to be accessed by all users logging into that console, regardless of which account the game is attached to.

Microsoft has made a key design choice: the elimination of discs as runtime media.

The elimination of discs obviously makes booting up a game easier, but it also allows for entirely new modes of play. During Microsoft’s E3 press conference it demonstrated a feature where a player could initiate a search for a multiplayer match in one game, then switch to another game to kill some time while the match search continued in the background. Once a match was found, the player could seamlessly switch back to the first game.

In order to support an ecosystem where discs are no longer required to play games, Microsoft had no choice but to come up with another way to check whether the player was entitled to play each of the games installed on their console. Hence, the online license checks every 24 hours. This is not significantly different from Steam, which requires a log-in and license check before every play of any installed game (though Steam does have an offline mode).

Once Microsoft got to that point, it then had to consider another problem: used games. If it was to implement an account-based licensing system, then it would have to think about how trade-ins and second-hand sales would work. If they were to be permitted at all, it would have to create a system for transferring licenses from one account to another.

The GameStop problem

Game publishers have long had a love-hate relationship with GameStop. The US mega-retailer, which has over 6,200 stores worldwide and turned over nearly US$9 billion in 2012, sells a lot of new games, but it makes the lion’s share of its profits from selling used games. GameStop and other retailers which have replicated the model are incentivised to do so because the profit margin on used games is much larger than on new games. When a customer trades in a recent release they’ve just finished, GameStop pays them about half what the game sells for in store, then slaps it on the shelf next to the brand new copies at a discount of around $5.

Consumers win – or think they win – from this, as they get half their money back on each trade-in, and they get slightly cheaper games. And retailers clearly win from it. But publishers and developers have long bemoaned the practice because they only get paid when consumers buy new games, and used game sales come to the detriment of new game sales.

GameStop has argued in response that the secondary market for used games is beneficial to publishers because the cash consumers get from trading in is generally spent on buying more games. If used game sales were removed from the picture, new game sales would not increase by the same amount. This is no doubt true, but the overall effect is to reduce the value of games while siphoning off a big chunk of money into GameStop’s pockets.

If that hole could be plugged, or some of the money from used game sales could be redirected back to publishers, then it’s possible that game prices could be reduced. Currently, publishers have to keep game prices high to compensate for the revenue lost to used game sales.

With its account-based licensing system, Microsoft had the opportunity to either block used games on Xbox One entirely, or to insert itself into the middle of each license transfer transaction. But Microsoft’s official position is that disc-based games can be resold, and it will not charge any fees.

If it had left it at that, then any threat to used games probably could have been crossed off the list of consumer concerns. However, its policy announcement included an ominous suggestion that, while Microsoft wouldn’t do so itself, it might allow publishers to charge transfer fees or restrict used game sales.

That begs the question: why did it do that? If Microsoft wants to see restrictions on used games in order to bring the price of new games down, it might have been better to say so. If it was something publishers had been clamouring for, then those publishers have rather rudely left Microsoft out to dry with their public statements during E3 distancing themselves from the idea.

Insert disc one

Microsoft could have avoided most if not all of the negative response the Xbox One has received if it had made one simple change: when the disc is in the drive, treat that as authorisation to play, just as it has always been treated in the past.

This would enable offline play without license checks, and it would allow discs to be traded and shared the same way they are today without the threat of fees or restrictions (though an optional license transfer could still be offered to enable disc-less play for the new owner).

By making that change, gamers who want the advantages of a disc-less library would be able to enjoy Xbox One just as Microsoft envisaged, while those who prefer to stick with the disc-based status quo would also be free to do so.

One thing’s certain: the mob is no longer on Microsoft’s side, and if this bloodied and battered warrior is to get up from the dirt of the arena and win back the hearts of gamers, it needs to do something to change the tone of the conversation.