Namco, the maker of snapping yellow video game icon Pacman, has agreed to join forces with Bandai, the toy firm behind the Power Ranger action dolls.
The merger will create Japan's second biggest maker of toys and video games after Sega Sammy Holdings.
Bandai put forward an agreed offer of 175.3 bn yen ($1.7bn; £874m) in cash and shares to create a new joint venture, Namco Bandai Holdings.
Rising development costs are driving consolidation among games makers.
Shares in Namco soared 8.9% in Tokyo on Monday, while Bandai's stock price slipped 2.5%.
Survival strategy
"Amid severe market conditions we decided a merger was the best way to focus our resources in an effort to boost corporate value, expand our businesss and come out on top of the competition," the two firms said.
The cost of making video games is rising as higher quality graphics demand an ever-more detailed and complex cast of characters, which tend to take longer to design and perfect.
The new venture will be 57% owned by Bandai and 43% by Namco.
Games analysts took a broadly positive view of the merger, which comes in the wake of Sega's 2004 tie-up with Sammy.
"It's positive because they can complement each other's weakness," said Ryoji Nagaoka, an analyst at SMBC Friend Securities Co.
"Bandai has abundant characters but is behind in terms of technology. Namco has graphic technology to develop games for game centres, but has no outstanding characters apart from Pacman."
Bandai became famous for Tamagotchi, an egg-shaped virtual friend that spawned a craze in the 1990s and has recently been relaunched.
It is now best-known for its Power Ranger action dolls, the Gundam sci-fi fighters, and Digimon. Its gentler characters include boy hero Astro Boy, and the Strawberry Shortcake scented dolls brand.
The two toymakers have combined sales of 442bn yen which they are hoping to increase to 550bn yen within three years, Reuters news agency reported.
Japan's falling birth rate has analysts worried about the medium-to-long term size of the home market.
More immediate pressures include competition from foreign games designers such as Electronic Arts which makes games for Nintendo, Sony's Playstation 2 and Microsoft's Xbox.
By: N. Peter Kramer
