Is the game up for console makers, or can price cuts win over jaded players?

These are nerve-racking times in the video console business. Just listen to Satoru Iwata, who took over as president of Nintendo last week. One might have expected him to brim with optimism about the great games the company has in the pipeline, or the prospects of Nintendo's GameCube console muscling in on its rivals from Microsoft and Sony.

But this is what he actually said yesterday, to a group of analysts in Tokyo: "We can't be optimistic about the game market. No matter what great product you come up with, people get bored. I feel like a chef cooking for a king who's full."

That's quite an admission in a business that has long since been fuelled on macho swaggering and soaring optimism for the future. Just two weeks ago, at the Electronic Entertainment Expo in Los Angeles, Nintendo's representative Peter MacDougall was happily tussling with his rivals in the corporate wrestling ring and predicting that the current dominance of Sony's PlayStation 2 machine would prove to be short-lived. "I think they know now the battle is on", he announced to whoops and cheers from the Nintendo faithful.

The battle is indeed on, and has been ever since Nintendo and Microsoft raced into the market to try to catch up with Sony, whose PlayStation 2 had a whole year on the shelves to itself. But clearly some of the generals are beginning to worry about the casualty rates their ambitions might incur. Nintendo's new-found fatalism comes hard on the heels of a dizzying round of price slashing among the console makers, and even more dizzying plans announced by Microsoft to plunge $2bn (£1.4bn) into online video gaming – a field that has already claimed its share of corporate victims and is widely considered to be a massive gamble.

Nintendo, for one, has already worried publicly that the price war is going to eat into its future profits – it predicts a 15 per cent drop for the coming year. That's not surprising, given that all of the Big Three can now expect to lose money on every console they sell.

Sony, which enjoys an 80 per cent market share, was the first to slash its price, bringing the PlayStation 2 down from $299 to $199 in the United States just ahead of the Los Angeles Expo. Microsoft followed suit with an identical drop two days later on its Xbox, even though it had previously admitted that it could not make a profit even at the $299 price tag. Nintendo, which already had the cheapest console, dropped the price on the GameCube from $199 to $149 to stay ahead of the game.

It certainly does not help that the price war comes on top of considerable launch problems endured over the past 18 months or so by all three companies. They spent lavishly to create a marketing brouhaha, but have not seen – or not yet – the sorts of sales figures that might appear to justify it.

It's easy to conclude that the video game industry is becoming a vast commercial sinkhole, a market sector that refuses to grow at the anticipated pace and turns out to be all take and no give. But it is not quite as simple as that. Get behind the rhetoric and look at the hard numbers, and it is clear that at least some of the traditional industry swagger is entirely justified.

Video gaming is, after all, a $20bn industry, considerably bigger than the annual box-office receipts of the film industry (about $8bn) and by any measure growing fast. Taken together, the top three US game designers – Electronic Arts, Activision and THQ – showed a 45 per cent increase in sales in the first quarter of this year. Video game rentals, meanwhile, rose just under 10 per cent over the same period. The newer games are growing more complex and better-looking by the month, a fact reflected in the money being laid out to develop them: around $4m for a typical game now, compared with around $1m two years ago.

The big question remains how to take advantage of this burgeoning market. For the games designers, the answer is easy: keep creating great games and make sure they are compatible with as many machines as possible. For the console makers, the calculations are fraught with a lot more risk. Clearly, the more machines there are out there, the more money there is to be made for the industry as a whole. But is there a point at which selling at a loss becomes a self-defeating exercise?

Not everyone shares Nintendo's new-found existential gloom. PlayStation 2 has sold 30 million units in its 18 months on the market – far in excess of either the GameCube (4.5 million units) or the Xbox (3.5 million), both of which came out at the end of last year – and Sony understandably feels that a price war is a tactic well worth employing to ensure it holds on to its dominant position.

In one sense, selling consoles at a loss does limited harm to all three companies, since the real money is to be made from recouping licensing fees from the software makers, amounting to about $10 per console, per game. But it almost certainly does the least harm to Sony, which not only has the advantage of size, but either manufactures or has exclusive rights to quite a bit of the software itself. For example, the world's best-selling video game, a four-wheel drive fantasy entitled Grand Theft Auto III, is a PlayStation exclusive. Sony's strategy is clear: keep the momentum rolling in its direction, and the company can pretty much gave away its PlayStations and still make money.

The other two companies would certainly like to think that Sony's advantage is only temporary. Nintendo has worked hard to retain the audience it cultivated with its earlier-generation video games and has expressed high hopes for the release of the new game in its Super Mario series, Super Mario Sunshine, later this year.

Microsoft, meanwhile, hopes to win over consumers through the sheer classiness of its Xbox machine, which boasts 5.1 channel Dolby Digital sound and cracking video picture reproduction. But it will also have to come up with plenty of exclusive games that customers will clamour for – for the moment, it is promising a library of 200 games by the end of the year, but fewer than two dozen of them will be exclusives.

On the face of it, Microsoft is the company with the most to prove since, for all its experience of carving out monopolies in other areas of the computer market, it is the newest to the video game marketplace. Its plans to take gaming online have raised more than a few eyebrows, not least because the idea has been tried before and failed. Sega was forced to discontinue its own online experience, through the Sega.net website, when the internet bubble burst in 2000. Remarkably, Sega has got out of the console business altogether – a sobering warning of the risks involved in the sector – and now works exclusively on software development.

Microsoft's concept for Xbox Live, as the online service will be called, is to hook up clusters of video gamers at once so they can play competitively with each other without ever leaving the comfort of their own living room. The gamble is that enough people will be willing to fork out $50 or so for every online game, plus an annual subscription fee, plus the $40-$60 a month it costs to have a broadband internet hook-up.

This is an area that Nintendo, for one, wants nothing to do with. Nintendo's outgoing president, Hiroshi Yamauchi, expressed considerable scepticism this week that there is any royal road to travel in the video game business any more. "Game developers are running out of ideas," he said. "The element of surprise is critical. But delivering surprise is becoming extremely difficult."

Perhaps the most nerve-racking aspect of the business is the need to jump into the market early without entirely knowing where customer tastes are going to go in future. Microsoft's gamble might seem a dubious one for the near term, but consoles at least have a long shelf life, certainly when compared with PCs. It took Sony five years to advance from PlayStation 1 to PlayStation 2, and some industry insiders think there could be a similar time lag before the appearance of a PlayStation 3. That five-year period is, in effect, an invitation for entrepreneurs to leap into the unknown – a leap with considerable risks and uncertain rewards.

No wonder the console kings are sounding a little neurotic these days. In this business, what might seem like insanity today could just look like uncanny prescience a few years down the line. Assuming, of course, that they stay in business at all.