The Atari 7800 really was one step forward and two steps back for Atari.
After the commercial failure of the 5200 (which was in part do to timing and in part due to some bad design decisions), Atari developed the 7800. This was the first system that was contracted out to an outside company for design (General Computer Corporation). The Atari 5200 was released in 1982 and the Atari 7800 was developed in 1983 and 1984.
The Atari 7800 had a number of advantages over the 5200. First, it was backwards compatible with the immensely popular Atari 2600 Which was still selling at the time and would continue to sell for a number of years. Second, they got rid of the analog joysticks and went back to digital. While the analog sticks of the 5200 were ahead of their time, they were poorly implemented and few games benefited from them. Finally, while the 7800 used a variation of the 6502 8-bit processor like most video game consoles and home computers of the 80s, it had a much improved graphics chip called the MARIA which allowed for a large number of sprites and colors on screen.
So why wasn’t the Atari 7800 a huge success? Well, for every good decision made in the design of the Atari 7800 there was a bad design, marketing or business decision…
For example, the sound chip in the Atari 7800 was essentially the same as the one in the Atari 2600 which was pretty antiquated. However, the design of the 7800 did allow for a POKEY chip (the sound chip used in Atari’s 8-bit computers and the 5200) to be included in the game itself. Only a couple of games took advantage of this and these seems like a pretty short-sited decision on Atari’s part in retrospect. However, Atari’s competition at the time would have been the Colecovision. Nobody had heard of the Nintendo Entertainment System yet.
Also, the controllers, while an improvement over the 5200 controller, were not exactly ergonomically friendly. However, third party controllers were far easier to come by and at least in the European market they came out with a control pad similar to what the NES or Sega Master System were using.
What really killed the 7800 though was the delay in getting it to market. It was ready to go in 1984. There had been a test release in California and units were in the warehouse ready to be shipped. Atari planned a very aggressive marketing campaign for Christmas 1984 and planned a number of high end peripherals that would have turned the 7800 into a computer. Then Jack Tramiel bought Atari’s Consumer Division.
Tramiel was the former CEO of Commodore and was largely responsible for Atari losing Amiga to Commodore, for the development of the Atari ST and perhaps for Atari being eliminated from the home video game console business. It was rumored that he felt video games were a passing fad and the computers were the future so he cancelled the release of the 7800 until the NES proved successful. However, the real issue was a contractual issue with GCC. I do not know the details but apparently GCC had not been paid what they were owed for the development of the 7800. Knowing Tramiel’s history it’s hard to believe that this was not completely his fault. The end result was that the Atari 7800 was not released on a large scale until the middle of 1986. By then Nintendo was dominating and Sega was a competitor.
To make matters worse, marketing was scaled back significantly and most peripherals were cancelled. In addition the 7800 had few games and 3rd party licensees compared to the other systems. This was due in large part to Nintendo’s anti-competitive and very restrictive licensing. But again, if the 7800 had been released in 1984 with heavy marketing as originally intended, things may have been much different.