Playing video games on demand, or over a server connection instead of installing a game on your own machine, has become the hot topic of the game industry because of its potential to disrupt the business by cutting retailers out and letting gamers play any game on any kind of computer.

The competition is heating up today as Gaikai, another startup in the space, released a video showing how gamers could play any PC game on a Gaikai server without installing it on a home machine. Usually, games have to be installed on a computer because the interaction is so fast that the game can’t depend on connecting to a distant server and getting a reply in a responsive manner. With games played on servers, the home computer simply functions as a display.

David Perry, chief executive of Gaikai and a famous game developer, first talked with us about this server-based game technology in March. That was just after OnLive, a well-heeled startup headed by entrepreneur Steve Perlman, showed its technology working during the Game Developers Conference.

All of the startups have met with skepticism, since delivering excellent application performance — particularly for heavy-duty apps such as games — is extremely difficult on the Internet, which is pretty patchy in terms of service quality in the U.S. Doubts have been raised about Gaikai in particular since it isn’t as polished as rivals OnLive or Otoy, a Los Angeles-based rival. But Perry said in the video, “I just want people to see we are serious.”

“Our goals are really simple, to remove all the friction between hearing about a game and trying it out, to help reduce the cost of gaming, to grow video game audiences, to raise the revenue that publishers and developers can earn, and (most importantly) to make games accessible everywhere,” Perry said. “If the iPhone AppStore has taught us anything, when you make it easy to check things out, you get a billion downloads.”

Perry didn’t reveal Gaikai’s business model. But the advantages of playing games stored on servers and not on home computers are myriad. First, gamers can buy the games on the spot and play them almost immediately. The gamers can also play high-end games on relatively low-end hardware. Perry said that gamers could use Gaikai to play high-speed racing games such as Need For Speed on low-performance netbooks (web computers which are smaller than laptops). Since retailers aren’t involved, the games could either cost less or publishers can keep more of the money. And gamers never have to download patches or other upgrades. They just need a decent broadband connection to be able to play. That opens even hardcore games to a broader audience.

As the Internet and technology for delivering games gets better, video games on demand is in some ways inevitable. Atul Bagga, an analyst at ThinkEquity, said in a recent report that he believes that gaming will be like other industries that are moving from packaged goods or web site delivery toward a service. In that sense, he says games as a service will cross multiple platforms and have multiple channels for distribution.

Gaikai is far behind its better-known rival, OnLive, since OnLive has been working on the problem for seven years. OnLive is preparing to launch this fall and it has nine announced publishers as well as backing from Warner Bros. Interactive Entertainment, Maverick Capital and Autodesk. Perry hasn’t announced funding for Gaikai, while Otoy has an announced relationship with Advanced Micro Devices. OnLive has more than a hundred employees, while Gaikai has a handful. Perry did not show some of the most demanding games, such as Crytek’s Crysis, running on Gaikai, while OnLive has shown that.

Gaikai still has to prove that it can offer its service to a mass market. Perry said he is still seeking investors, Internet service providers to host Gaikai, and game publishers. He is also seeking gamers to join a closed beta test.

Still, the demo by itself is impressive. Perry said that he can run a game across a server that is not running a Microsoft operating system. He showed the games being displayed on a Windows Vista computer with the latest Firefox web browser and Adobe Flash installed.

Perry said that the games can run on less than a megabit a second of Internet bandwidth. Most DSL connections offer around three megabits a second, coming downstream into the home. In the demo, Perry said the server was about 800 miles away, which results in a round trip (ping rate) of 21 milliseconds. That’s a split second and not really noticeable. For a server much closer, the ping rate is about 10 milliseconds. While both OnLive and Otoy used custom servers with graphics chips, Perry said his service can run across low-end custom servers.

Perry contends the ping rate is fast enough to play most games. He showed racing games such as Mario 64 and other games such as World of Warcraft and Eve Online, all playing without downloaded software. He also showed how he could use Adobe Photoshop across the server.

In a jab at OnLive, Perry said, “We don’t claim to have 5,000 pages of patents, we didn’t take seven years, and we do not claim to have invented 1 millisecond encryption and custom chips. As you can see, we don’t need them, and so our costs will be much less.”

Perry said the service was demoed live at E3, but I didn’t get a chance to see it there. Is he credible? Well, his games such as Enter the Matrix have sold about $750 million worth to date. But he is clearly years behind his chief rival. The question is whether the market will support lots of players. Perry said he will talk about the company’s business model at upcoming game conferences: Develop and GDC Europe.

Gaikai Technology Demo (JULY 1, 2009) from David Perry on Vimeo.