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Why has there been a shortage of Xbox?

Tim Harford writes:

...supply shortages are a fact of life. The puzzle is somewhere else: Why don't companies raise prices when supply is short and demand is frenzied? Leaving aside oxygen and a few other essentials, there is no such thing as an absolute shortage of anything: There is only a shortage if the price is too low. At the moment, Microsoft is easily selling out the half-million or so Xbox 360 units (there's no official number) for prices starting at $300 for the basic package. Why doesn't Microsoft price them at $700 instead?

Tim despairs:

Over dinner with a friendly local economics department [TC: hmm...], I challenged them to explain the puzzle of why prices stay low in the face of such shortages. They cited a number of ingenious explanations, all of them unlikely.

Surely the legal mind can do better than these economists, comments are open.

billb:
They're doing it on purpose. They released early with few low availability to build hype and marker for future units (not to mention games). MS doesn't need the money. In fact, they're probably selling below cost as a loss-leader in the anticipation of making it back on licensing and games. This is common practice in the game console industry.
12.16.2005 6:01pm
billb:
marker -> market (damn preview!)
12.16.2005 6:02pm
Senor Chumbawumba (mail):
billb is right -- selling out creates buzz, which creates anticipation, which creates sellouts, which creates envy, which sells more Xboxes after Christmas (thus smoothing the revenue stream). I personally consider this sort of market behavior a disproof of the rationality of (at least consumer) market actors. Of course, some economist is going to say "Fads are extrinsic to our model!" but that doesn't really solve the problem. The movements of the market are modifying the actual "extrinsic" preferences of the actors, so unless your model takes account of the preferences that change in response to the perceived market dynamics, it's not that useful.
12.16.2005 6:09pm
William Spieler (mail) (www):
"XBox release goes orderly" only stays in the news for a day. "Xbox release is pandemonium" lasts for a long time.
12.16.2005 6:10pm
Splunge (mail):
You need a legal mind to explain that Microsoft is in this for the long haul, and might willingly trade short-term profit for long-term? Huh?

Microsoft is a very successful business, and arguably (cf. Scott McNealy, Linus Torvalds) a business that sells a notably inferior product. That means they understand group psychology very, very well -- better than all of their competitors, and certainly better than any number of armchair theorists. They know very well how to sell over the long term. So it's an excellent bet that if Microsoft thinks the best long-term strategy is to have a shortage but not raise prices, and x economists think otherwise -- then Microsoft is right and the economists need to do some more thinking.

Why does their strategy work? I don't know (and if I did, I sure wouldn't post it for free here). But here's a line of thought: MS is new in the gaming business, which is fiercely competitive, and in which having the newest, bestest technology is a major psychological force driving the acquisition of new consoles. One thing they must avoid at all costs is the idea that they are Johnny-come-lately technobozos who know nothing about making a cool console. So, given that it is a priori impossible for them to predict exactly how many consoles they'll sell this Christmas, should they choose to err on the side of too few or too many? What will be the response of the gamer if Xbox consoles are lying around unsold, versus if they are just damn impossible to get, and selling on eBay for four times the retail price? Easy call.

Secondly, after a frustrating shortage develops, which naturally makes people irritated at MS, is MS better served by jacking the price up to reduce the shortage, or better off releasing stories about how they're doing the best they can, and of course they're not profiteering, and they'll ramp up production just as fast as possible? Which course is going to make people think well of the company, and inclined to -- while they're waiting for their new Xbox -- not mind paying for the new version of Windoze to upgrade the home PC? Again, easy call.

So why MS makes these these decisions seems easily rationalizable to me. The question of why people are the way they are, so that they reward MS's strategy instead of a different strategy, that would distribute the products more "rationally", is a separate question.
12.16.2005 6:10pm
Dilan Esper (mail) (www):
I think it's the same reason why concert promoters and sports owners usually (there are some exceptions) price their tickets below the optimal price and let the scalpers make up the difference-- consumer goodwill. They don't want to be perceived as "gouging", because many consumers don't see the price of goods as a method of allocating scarce resources but rather as a source of windfall profits for big corporations. So, if you are in this situation, shortages are better press than high prices are. If people are reselling the items at higher prices, they get cast as the villans rather than you.
12.16.2005 6:10pm
billb:
(sorry for all the errors in my previous post)

I wanted to add that MS prevents retailers from raising the price as well, so the Best Buys and GameStops of the world that bought at wholesale and would like to sell for market prices (i.e. eBay prices) are prevented by MS from doing so.
12.16.2005 6:11pm
Steve Plunk (mail):
Microsoft does not allow it's dealers to charge more than the approved price. That is the simple reason they are not higher.

Why does Microsoft keep the price low? To buy brand loyalty. Gamers are a fickle bunch and gouging them during the first few weeks of a release will earn a great deal of ill will and bad press.

The problem now is that they fouled up the production and distribution so bad they are getting bad press and making those gamers mad. Many put deposits down to reserve a place on a disrtibution list at the retailers. 50 bucks and now all they hear is that they are due to get the unit on the "next shipment" though the retailer will not show the list or say when the shipment will come or how many will be on that shipment.

Microsoft tried to balance the buzz and failed. Rushed to get the product out before the Playstation comes out in the spring they just wrote a "how not to do it" book for business.
12.16.2005 6:19pm
elliottg (mail):
The reasons this economist can figure are:

1. They do it to create buzz. No cheaper value for your advertising dollar than the article telling you how high the demand is. If the xbox holds to other game consoles then the profits are in the games rather than the console.

2. If they raised prices now, they would have to lower them later. The message that would be sent would be that they were having to lower the price to get rid of them which would kill the market.

3. They really can't raise the price because it's only a few price sensitive customers that would pay the higher price. Others who might pay the higher price reluctantly would then feel cheated later when the price came down. Generous return policies and price match policies mean that most customers could get the lower price anyway.

4. There really is no shortage. If you want a brand-new unopened xbox at the advertised price then all you need to do is to make a few phone calls or drive a few more miles. If that fails then you can bid on ebay where it looks like the going price is about $550. The extra profits that Microsoft can capture from this transient condition (probably measured in weeks and mainly associated with the holiday) is nowhere worth the adminstrative cost of trying to devise an appropriate price discriminatory regime.

Finally, if I did want to capture some of this profit then I would contract exclusively or create a separate subsidiary with someone like xbox360.com (I made that up). Guarantee drop shipping of any orders next day and have this non-microsoft entity (or subsidiary) charge a premium for the expedited delivery. This would signal to everyone what they were paying for and allow the list price to stay the same.
12.16.2005 6:20pm
JRL:
I am constantly lamenting prices being too low (seriously, I mean this). Everytime I have to wait at the gas station or find an empty supermarket shelf for the product I'm looking for it drives me nuts. Raise the prices.

/Can't wait until all price tags are RF and they can be changed to assure that there are never stockouts.
12.16.2005 6:21pm
Robert Cote (mail) (www):
No mystery whatsoever. The Sears store population center for more than 400,000 got an allocation of... 4. Yes, four. Nothing but a marketing ploy. MS is bad at almost everything else give them credit for perception.
12.16.2005 6:26pm
claritas:
It is my understanding that in the gaming industry, the real margin is in the games, not the consoles. Microsoft is willing to subsidize console purchase today in order to get a head start on Sony, have a built in base for games, and then more than recoup its costs from game licensing in the future.

It might be argued that they could get even more consoles out there by charging the efficient price. I tend to think that the shortage problems are overblown. The shortage will last, at most, a month. Meanwhile, Microsoft undoubtedly gets wider distribution of the consoles by basically paying people to take them.
12.16.2005 6:37pm
Fishbane (mail):
Folks have already nailed the reasons here, but I just wanted to note that selling consoles below market price is the way the console market works. "Razors, blades", and all that. Nintendo, I think (could be wrong here) was dinged for it, but they all do it. MS itself has admitted that they sell below cost.
12.16.2005 6:51pm
The Original TS (mail):
Why are there lines outside of clubs?

Creating false scarcity is an old marketing trick. To continue the analogy, in order to maintain a line, many clubs will not allow people in even when the club is not full because the line outside is such excellent advertising.

On a more sinister note, some of the scarcity may be due to quality control problems. There are very serious rumors that the XBOX 360 crashes several times an hour. If this is true, Microsoft risks a PR debacle as probably 99% of XBOX 360s sold so far won't be opened until Christmas morning -- and then promptly returned on December 26th.
12.16.2005 6:52pm
Anthony (mail):
Shortages are free advertising.
12.16.2005 6:52pm
A.S.:
OK, I agree with the marketing reasons stated above. Let me also say that there are transaction costs involved in raising prices (and lowering them too). You have printed 1,000,000 pieces of advertising stating that the price is $299. What happens is you raise the price to $399? You've got to throw all of that out and get new advertising. You've also done a whole roll-out stating the $299 price, which is worthless if you raise it all of a sudden.

All I'm saying is that it's not like the company can just snap its fingers and raise prices.
12.16.2005 6:59pm
Bruce Wilder (www):
The vast majority of prices in the consumer market are administered prices -- that is they are fixed by the manufacturer/publisher/impresario/retailer and supply of the good is managed to satisfy demand at that price (or prices, since price discrimination is the rule, rather than the exception). The kind of double-bid continuous auction that they traditionally ran at the N.Y. Stock Exchange is pretty rare, but somehow that became the iconic model of economists. Prices are not normally a short-term variable in the allocation of resources. They just aren't. A good question for a room of economists would be, when are they going to get right with reality?
12.16.2005 7:20pm
HeScreams (mail):
I believe that the question about price controls in the face of the scarcity has been answered above. At least, all the rationales make sense to me. But what about the other side of the scarcity equation: quantity? Is it really true that MS cannot produce any more XBoxes than they currently are?

Since consoles are a loss-leader for games, then it makes sense to sell as many consoles as possible. So why allow/create a scarcity? I say create because MS can surely "predict", based on the past history of console releases, what the demand will be. Surely if they wanted to meet demand, they could have spent the past few years beefing up their production lines and distribution channels.

To answer my own question with insights culled from the previous posts: MS certianly knows the cost/benefit equations for both the artificial scarcity scenario and the perfect supply scenario (where they produce enough to meet demand, thus driving up the demand for games). Surely they chose the scenario that is best, so even though we don't have the numbers in front of us, we can assume that the marketing benfits of scarcity *really* outweigh the benefits of raising cost and/or production.

The other possibility is that they really couldn't raise production, but I find that hard to believe. They've been planning this release for years.
12.16.2005 7:29pm
Mr. Poon (www):
Because if they gouge then folks will wait for PS3.
12.16.2005 7:38pm
HeScreams (mail):
Oh, and about the lack of reality in economic models:

My understand of Economics I is that, while the models are sometimes described in terms of single actors making rational decisions, they don't actually *apply* to single actors making rational decisions. (Single actors are discussed in psychology. :) They apply only to the aggrigate case, the entire market. The cool part is, the models still provide *some* insight into how markets work.

Of course, as with models in Science and Engineering, you have to know when they apply and when they break down. I've always assumed that the simple supply/demand curve model (which is what I assume we're using here) is to Economics what Newton's Laws are to Physics: great to teach high-schoolers and non-specialists, but PhDs and experts know that there are much more advanced models to be used for non-layman analysis. So for Tim Harford to say that economists are discussing a real-life *marketing* campaign in a market with only 2-3 suppliers using high-school models of supply and demand... well, that's a little surprising to me. I wonder what we're missing....
12.16.2005 7:38pm
Andy Freeman (mail):
If the XBox price starts high and then drops as supply improves, some potential buyers are going to expect that the price will keep dropping as time passes. By giving up some of the potential revenue today, MS tells those potential buyers that waiting won't help. (The production cost will drop significantly, so keeping the price stable is worth a lot.)
12.16.2005 7:43pm
HeScreams (mail):
I just checked the article itself. If I had known it was in Slate, I wouldn't have spent all that time writing those posts. Lesson learned.

I retract my previous posts in favor of an open letter to Tim Harford: "Yes, you are right. All those economists are wrong, and you are right. Microsoft has passed up the chance to make millions of dollars; even though they have a huge stake in the outcome, your arm-chair analysis has proven how truly stupid they are. If only they'd hired you into their marketing department."

Or is that too sarcastic? I can never tell. :)
12.16.2005 7:57pm
Cal Lanier (mail) (www):
"It is my understanding that in the gaming industry, the real margin is in the games, not the consoles."

Bingo. They'd give the consoles away for free, if they could.

Raising the prices increases the risk that some people will settle for Playstation or some other console, which represents a huge loss over time. So they don't want to give the impression that buying XBox is a larger investment than buying Playstation.
12.16.2005 8:07pm
Avatar (mail):
One thing to keep in mind is that most consumers won't buy multiple next-generation systems. People are going to pick one and stick with it for a while. Acting in ways that are obviously profit-maximizing will put off a lot of potential consumers. After all, if you're willing to run up the price on the system itself, then doubtless you're not above doing the same on needed peripherals, "hot" games, networking subscriptions, or whatever else the gamer needs to enjoy your console.

So not only is a higher price a disincentive for the normal reasons, but it also suggests that you may be looking at higher prices later, once you're locked in, so to speak. All that suggests that you'll get less bang for your buck down the road, and since you generally only switch consoles every few years...

At the same time, the shortage is only temporary. MS will sell a good number of systems after Christmas, but they need to make the most of their first-mover advantage to get some installed base going while they can. If people are sitting on the bench because of MS's pricing policies when Sony's offering hits the market, then MS will have a harder time convincing developers to develop exclusive games for its system (a category where Sony has a good track record, and Microsoft does not.) The long-term health of the platform is definitely decided by buy-in from other game companies, so risking that for some short-term profits is probably a bad call.
12.16.2005 8:13pm
SLS 1L:
I think we shouldn't discount incompetence as an explanation. What if Microsoft priced the item based on what are now obviously bad market data and has no idea what the market-clearing price is?
12.16.2005 8:15pm
Dick King:
Microsoft would drop a billion XBOXes out of helicopters if that wwere cheap enough to make, so they could sell manymany game disks in the future.

Now they're not all that cheap to make, so they have to charge something to make sure the machines end up in the hands of those more likely to buy disks in the future. Perhaps a shortage biases purchases to those willing to wait on long lines -- who have more time to play games?

-dk
12.16.2005 8:58pm
James of England:
SLS 1L, you could put that more generously as "imperfect information", rather than "incompetence". Seriously, MS has some of the world's finest minds devoting tremendous amounts of time on this.

That said, imperfect information, which is I think what you're suggesting, probably does play a significant role, although not the only role. More important than that is the fact that consoles haven't been sold, historically, for $500. If MS did that, the headlines would be about how amazingly expensive they were. That would stop a lot of purchases.

As ElliottG says, the big difficulty with pricing these things is that you're not just pricing them for the moment of release. You're pricing them for their first year. Even beyond that, your prices cannot be cut too much without it looking like you've lost faith in the brand. This means that it is fatal to overprice (and hence imperfect information means that you have to be cautious and assume lowball figures). It also means that you cannot charge much more than Nintendo and Sony charge for their consoles. Even if it would make sense to have 'em being $500 for the next few months, the console pricing is so inflexible that it is better to have them wrongly priced for a few months now than to have them change or be wrongly priced for many months later.

Finally, as others have noted, there isn't too much of a problem with underpricing. So long as they can shift 'em as quickly as they can build 'em, they're achieving their primary purpose, of building marketshare and creating a market for the games.
12.16.2005 9:18pm
Pooh (www):
By charging $300 they could also be raising the long term competitve price - The first wave of vidiots (myself included) have a relative inelastic demand for the product right now. If people see all that excess demand at $300, they intuitively feel that $300 is a reasonable price, which has the effect of increasing demand.

Plus when they drop the price to $250 on Feb 1. (my guess, based on various store's return policies), it will seem like a steal.

Plus, the 'games no boxes' bit. That too.
12.16.2005 9:18pm
ken (mail) (www):
In addition to the reasons given above, I'm pretty sure that a major reason for all this is that MS is not the industry leader in gaming consoles. MS got its console out for Christmas and is generating great buzz on platform sales (although the reviews of available software by tech oriented shows have not been so generous). However, Sony's coming. If MS sold at actual short term market value there are a lot of people who would wait instead of coming back again and again to see if it's in stock, ordering it, or buying it after Christmas. Heck, if MS hadn't introduced its console before Christmas a lot of people would probably wait for Sony anyway. All of this is MS's attempt to get ahead in the market.
12.16.2005 9:26pm
RM:
Perhaps I'm restating some of what is above, but the pricing reasoning is fairly simple. MS is copying the Sony PS2 model/result from 2000. The original XBox lost a significant amount of money (well, not significant in MS terms, but for a regular company...), and there is no doubt that the loss was at least partially related to being second to market. The console makers bring in about $10/game. The consoles have always been sold below market value because that's not where the money is in this model. Sony lost money on the original PS2, and the same went for the XBox and now goes for the 360. Gotta sell games. To sell games, you gotta get the consoles in the homes. To get the consoles in the homes, you have to hit timing for your technology vs. pricing just right, and you've gotta have buzz.

So ultimately, it's a first to market with the new technology/best product sort of thing. We'll see how this works out for MS, especially when when the PS3 comes out.
12.16.2005 10:49pm
AppSocREs (mail):
I think there is a much more plausible reason than any of those given above--control of risk and uncertainty. Microsoft (and most other large corporations) have business models that allow them to project demand for product, production capacity, and other variables. They use these to determine production and pricing. The way current manufacturing processes work, this determines very precisely the input of raw materials into the production process and the distribution to retailers. Any changes in parameters after the process is started can wreak havoc with how well the model is mirroring real world operations. Manufacturers also have contractual arrangements with wholesalers and retailers regarding pricing and distribution. I'm sure there would be serious legal penalties involved with altering these duye to unexpected consumer demand. Considering how well Microsoft has done as a business (I too dislike their software.) I think it's kind of silly for people to be criticizing Gates's business acumen. Unless, of course, they too are self-made multi-billionnaires.
12.16.2005 11:11pm
David Rolfe (mail):
Why is everyone discussing the Xbox 360 as if it's not $500?

Let me point out that the the 360 is using a tiered product release to hide the true cost of the system. The Xbox 360 is $400 (the cripled "Core system" that will need to be upgraded with over $100 worth of accessories is $300). The Xbox 360 (not the cripled "Core system") at Best Buy can be found in bundle packages, all of which exceed $500 (so that you can enjoy at least one game with your new system, and variably an extra controller for 2-player, a Live subscription so you can have online play, the wireless networking adaptor costs $100, etc). If one is planning on an Xbox 360 on Christmas morning with the same level of functionality as the original Xbox you are spending at least $500 (2 games, 2 controllers, harddrive, online, headset). :-D

I think the tiered approach was engineered to give a low enough price-point to make these "360 Sold Out" stories possible (for all of the reasons mentioned in this thread, free press, after Christmas sales, and especially to increase installed base for future lock-in revenue). Every "Core system" sold is (almost) guaranteed profit from: a harddrive, as backward-compatibility and future games will require it (that's right, you can't play your old games without going for the $400 model); one or more extra controllers, so you don't have to play alone; a wireless adaptor in case you don't have ethernet near your TV; an extra PC running Windows Media Center Edition to stream movies and music; and more! If Microsoft knows anything it's that lowering the barrier to entry (OEM contracts, Xbox prices) to expand installed base (Windows, consoles) is vital to software sales (Office, their cash cow, and games/accessories/Windows MCE licenses). If they could get an Xbox 360 sold with every TV, they would. Anyway, business as usual for them.

As far as I know this is just to spite Sony and to position themselves for the post-desktop world. The Xbox business unit still isn't profitable but does give them a toe-hold in the living room.
12.16.2005 11:41pm
LINO_watcher (mail) (www):
I haven't read through all the other comments so someone else has probably said it already, but they're doing it intentionally.

They're pulling a "Cabbage Patch".

Or if you're younger than that, a "Tickle Me Elmo".

Shortages increase the mystique and buzz surrounding a product and can increase a product's perceived desirability. They also bring out the competitive and hunter/gatherer instincts in people.

In short, its a marketing technique or gimmick. In the right situations it can be a particularly good one.
12.17.2005 12:24am
David Friedman (mail) (www):
I propose one answer to the puzzle of predictable lines, and the more general version associated with belief in just prices, in a recent book chapter. A draft is webbed at Economics and Evolutionary Psychology
12.17.2005 1:39am
James of England:
David Rolfe has a good point. Even if the full system costs $500, the headline figure is $300. Pushing down that figure and pushing the excessive demand headlines raises the bar for Sony and co. I've no idea if Sony will find the challenge easy to meet, but if they don't, Microsoft looks great in comparison. If they do, Microsoft avoids looking lame incomparison. At the very worst, Microsoft avoids looking radically less appealing.
12.17.2005 1:43am
Tim DeRoche (mail) (www):
Read INFLUENCE: THE PSYCHOLOGY OF PERSUASION by Robert Cialdini of Arizona State. When human beings perceive a resource to be "scarce," our desire for that resource goes through the roof.

This fits in nicely with evolutionary models of human psychology.

And also explains why the selling out of the XBox creates the "buzz" mentioned by many readers above: People have a huge craving for information about the possible scarcity of a resource.
12.17.2005 2:35am
Shelby (mail):
HeScreams:
Or is that too sarcastic? I can never tell. :)

You're talking about Slate. There's no such thing as "too sarcastic."
12.17.2005 2:58am
Eric:
I don't think this is an artificial shortage. I think there is just a limited supply for other reasons. The reason they don't raise the price to demand is because xboxes are not commodity items. Microsoft wants the price of xboxes to remain constant because it would reduce sales if people didn't know how much they were going to have to pay.
12.17.2005 2:59am
ThomH (mail):
My two cents: it's a classic tying arrangement. It's the same concept that causes computer companies to sell printers below cost, and then make up their losses on the ink and accessories.

Consider that when MS sells an Xbox console to customer Smith, the expected value of that sale is much much more than the mere wholesale price of that console. Rather, the expected value also includes the future profits of all the Xbox videogames that Smith is going to buy over the life of that videogame console. This is probably YEARS of future videogame sales, all of which have to be licensed through MS.

On the other hand, suppose Smith had chosen a Playstation console over an Xbox console. Well now MS has lost not only the money that Smith would have paid for an Xbox. The loss is MUCH bigger than that. Consider that over the next several years, Smith will be now be buying Playstation games and not MS games. So MS has not lost merely one console sale, but rather YEARS worth of videogame sales.

Thus, the incentive for a company like MS here is to sell as many consoles as humanly possible, even if it means losing money on them. Then make up the loss later by selling the games. (Notice that MS or Sony or Nintendo, etc is going to have quasi-monopoly power on the market for its own videogames. Once you've bought their console, you're pretty much stuck buying their games for the next few years, unless they screw up so badly that you're willing to accept the console purchase price as a deadweight loss and buy one from another company).

In sum, MS has no special market power over the videogame console market (people can always just choose to buy Playstation or whatever), but TREMENDOUS market power over the Xbox game market (since an Xbox user is STUCK buying Xbox games). So we'd except the console market -- the tying product -- to be extremely competitive (since so much is at stake), and the actual game market -- the tied product -- to be much less competitive. Happens in all tying arrangements.

As a side note, I happen think a lot of good can come from tying arrangements. It's almost like a form of financing -- people can buy the main product upfront for pretty cheap, and then basically pay for it overtime through the purchase of accessories.

But I'm also no expert on tying and I'd be interested in hearing other competing arguments, both for and against tying.
12.17.2005 8:02am
anony (mail):
What is striking is how many of the explanations proferred here (such as hype-building) WERE mentioned by Tim in his article. [Does no one read the link before commenting?] Whether Tim's dismissal of them was accurate or not, it seems the legal minds here can only come up with minor variants of the arguments that economists have already put forward.
12.17.2005 8:45am
Jam (mail):
Prices of XBOX are for a Starter's system. A few people already alluded to this. Future profits through the sale of accessories and games.

I wonder if inventory taxes/cost play a part of letting the inventory to deplete? Expected econonmy downturn?
12.17.2005 9:56am
SKlein:
Those who say msft "would give them away if the could" misundertand. They wouldn't give them away, because they want the xbox owner to have a sufficient investment in the box to commit the buyer to xbox games (and serve as a barrier to switching to or adding a competitor's gaming system, which wold presumably also be free). If I've spent $300 on an xbox, I can either pony up hundreds of dollars more for games and gizmos, or effectively throw away my $300. I'm sure there are some interesting academic models on how toprice in these srots of markets, but it is alot more complicated and interesting than simple supply and demand curves.
12.17.2005 10:23am
Tim Howland (mail) (www):
It's important to recognize the importance of the price point in comparison to the other consoles as a key part of the brand's positioning.

The initial XBox was released at the same price point as the Sony PS2 in part to build the confidence of the people purchasing the console that they were buying a valuable system. The Nintendo game cube has always been priced significantly below either the Xbox or the PS2. The Nintendo is intended for a younger audience (5 - 10 year olds), and even though it has roughly similar capabilities, it has a much lower perceived value due to it's supporting cast of games.

Strikingly, whenever Sony drops the PS2 price, Microsoft and Nintendo have been compelled to do the same in order to maintain their parity; it's very similar to airline discounts, where airlines will almost always follow the leader when routes are repriced.

The PS3 has been announced as coming in at a significantly higher price point than the Xbox360, although that may be gamesmanship on Sony's part. When it's released, it will almost certainly be at or slightly above whatever price the Xbox360 is at- and the next generation nintendo product will be priced 30 - 50% less.

In addition, game systems benefit enormously by network effects; multiplayer games and a rich selection of products for a gaming platform are crucial to sophisticated purchasers. If it looks like the platform will be unpopular - for any reason- gamers will refuse to get onboard, sending the platform into a spiral.

So, ultimately, Microsoft is probably losing some short term profits (on unprofitable equipment), in order to maintain brand positioning and build the perception that network effects will be working in purchaser's favor down the road. This is probably a wise strategy, as gamers are an especially fickle group, and if Microsoft appears to be gaming the system to maximize short-term profits, or appears to be failing to win new converts to the system, the gamers will sit on their wallets and wait till he PS3 comes out.
12.17.2005 11:10am
Justin (mail):
The link does not cover the concept that MS is not interested in making a profit bc the real profit is on games argument at all, FWIW. Whether that by itself makes that argument plausible is another story.
12.17.2005 11:11am
Dick King:
SKlein, the commitment comes not from the cost of the box you now have but the cost of switching over, which includes the cost of the box you would have to replace it with and [unless you plan to have multiple gaming consoles, logistically difficult in a game room where the TV is about as big as fits with a few accessories and with your fingers used to the nuances of one controller] the cost of the games you already bought for the machine you now have.

Next time you go to the drug store, take a look at those blood sugar meters that diabetics buy. Diabetics need to test their blood sugar several times per day. First they buy a meter that comes in about five brands and two or three models in each brand, that lasts essentially forever. The meters cost a few tens of dollars for the basic version and over a hundred dollars for the advanced version that gives you some electronic memory for readings. For each test they need a test strip, which costs about $0.70 each in quantities of a hundred or so. The meters are reasonably sophisticated devices that, like cellular phones, are almost certainly being sold well below cost of manufacture and distribution.

There's no need to use price to find the people most likely to buy test strips in the future. Everybody either has been diagnosed diabetic or you're not. Yeah, yeah, we have the medically uninsured in this country yada yada, but I imagine the elasticity of demand for the meters to be 0.1 or less. I do imagine that some patients test less often than they ideally should, possibly because of the cost of the strips. Therefore, the machines can be dirt cheap and the companies still do well.

Disclaimer: I am not a diabetic and I may have something wrong. For example, there may be more differences between machines' abilities than I think.

-dk
12.17.2005 11:27am
Alex Kroman (www):
The XBox shortage is part of a market campaign to drive up demand.

Gizmodo reports that in Norway, the launch marketing campaign aims to build hype around the console by trumpeting its "SOLD OUT!" status to would-be buyers. In addition to limiting the per-store stock of consoles and having the retailers prepare to prominently note the unit's "sold out" status, Microsoft has allegedly asked Norwegian retailers to sign an agreement that they'll sell out of the consoles on the launch date.
12.17.2005 1:03pm
Kevin Murphy:
I'm surpised that no one seems to think that the shortage might be based on some technical or production hitch. Most companies have delays in announced new products for these reasons -- some component doesn't work right, or something is late. Microsoft, however, was under great pressure to GET IT OUT NOW, so could not delay. But they may have limited quantities as something ramps up late.
12.17.2005 2:18pm
econ novice (mail):
I wonder if MS is auctioning off xboxes at all on ebay? if they sold 10,000 on ebay between launch and christmas, for an average premium of $250, that's $2.5m profit. nothing to sniff at, even fore MS.

ebay does illustrate that the price at least is wrong, at least in a supply/demand sense. Thousands of people are paying a lot more to get one. But it's also pretty cool how much ebay, et al., facilitate greater market efficiency today vs. 10 years ago (before e-commerce)
12.17.2005 5:11pm
Bruce:
Most of the above sounds plausible. I would just add a trademark spin: MS may want to associate the XBox 360 with a particular price. I know from the Calvin Klein-Walmart dispute that designer jeans manufacturers have *minimum prices* beyond which retailers are not allowed to go, not because they wouldn't still make money, but because it would destroy the brand if you could get them too cheaply. MS may not want the XBox 360 to be associated, even briefly, with a $1,000 price tag.

As for the idea that consoles are loss leaders, does Microsoft make money on the games? My understanding was that others can design and sell games for consoles, just like PC games. Is there a licensing fee involved?
12.17.2005 5:46pm
Humble Law Student:
Bruce,

You are correct. Most platforms are sold at a lost. The companies recoup their losses and usually make a tidy proft through game sales.
12.17.2005 7:21pm
triticale (mail) (www):
Reportedly, the groovieness of the XBox360 only manifests on an HD display. There is a nontrivial risk of disappointment if consumers who remain with NTSC (I have some friends in their 20s with a 32" CRT used only for gaming) buy one. Too much of that before the dangerous PSP3 comes out will produce a negative buzz which will hurt their relative position. They need to build a positive reputation between now and then.

By the way, there was a sophisticated operation scamming demo XBox360s away from retailers just after the release, with an investment made in XBOX embroidered shirts and neckties.
12.17.2005 10:04pm
Dave:
How does all of this interact with the fact that Microsoft dramatically OVERestimated demand in Japan? I think Harford is right that it's just incompetence.

link
12.17.2005 10:26pm
Chris C.:
If you're releasing a platform system you can't price skim if you're going to capture the long tail market. The pricing side of this doesn't seem like incompetence at all.
12.18.2005 1:52am
Bruce:
Humble Law Student,

My question though is how does Microsoft recoup its losses on games it doesn't sell? For example, look at Call of Duty 2, made by Infinity Ward and published by Activision; is Activision paying a royalty to Microsoft for each unit sold?
12.18.2005 2:14am
MS Paper Clip (mail):
Yes Bruce, developers must pay royalties to use the developer's kit for XBOX 360 at around 10 dollars per game sold.

That price can be renegotiated later for "best hits" type games too.

But every single penny of profit for the XBOX 360 and Playstation 3 will come from licensing (and online service) unless manufacturing become much much cheaper during the product cycle. And that's unlikely to happen due to the shorter lifecycle fo systems.

Playstation 2's are no longer loss leaders, but the original XBOX is STILL a loss leader and has had a very very short lifecycle.

Everything about this launch is meant to play unupsmanship with Sony. Developers are confident the PS3 will be radically more successful, but Microsoft is getting a foothold and valuable brandimage in the living room. Eventually, we won't be using desktops for internet and home office, we will be using something like a Mega Xbox, and having a solid known brand for that future household appliance is extremely valuable, particularly with Microsoft's monthly subscription service for XBOX. This sub scription idea has been MS's plan for all software for over a decade.

Sony has no such online service, but they also plan for future playstations to be living room everything systems and microsoft correctly sees them as their most serious real future competitor.
12.18.2005 3:18am
Avatar (mail):
If I recall correctly, the actual royalty paid per game is a bit less than that... but my information on the topic is a bit out of date, so it could well have increased to there.

Sony, currently, has no problems with getting other game companies to produce games for its system. It took the lead away from Nintendo with the original Playstation, significantly by going to the cheaper CD-based media (cartridges are expensive!) and by charging an inexpensive licensing fee (while Nintendo's fee was quite expensive). They don't have a whole lot to worry about - assuming they don't totally drop the ball on producing the new system, their past success should ensure them a strong launch and buy-in from other game companies.

MS can't count on that. The Xbox did well compared to Nintendo's offering, but isn't anywhere near as popular as the Playstation 2. There were relatively few "hits" and many of those were released by Microsoft-owned studios. In other words, they have a vested interest in the strongest launch possible, because their track record with their last system vis a vis attracting third-party game companies to release software for that system is pretty lackluster. But if they can get a strong installed base out there, especially if Sony's launch is delayed, then they can turn that advantage into a lure for additional games... which in turn drives subsequent platform sales, and you get a positive feedback loop. Conversely, if demand for their system is soft at the time of the PS3 launch, Sony can take a commanding lead once again.

Also, MS has traditionally done very poorly in the Japanese market (they're not selling out in Japan, heh), so they're behind in attracting Japanese developers to begin with - important because a significant proportion of games and an even higher proportion of hits come out of that market. If the Xbox 2 doesn't gain an immediate foothold in the US, Sony's Japanese dominance means they can compete favorably over here as well.
12.18.2005 12:20pm
AWH:
I'm guessing the reason they don't raise their prices is because they suspect that a bunch of legal minds, duly elected to the Senate will think of ways to tax them for excessive profits if they charge too much when supply dips significantly below demand ;) hehe
12.18.2005 2:48pm
Kevin L. Connors (mail) (www):
Why is there a shortage of Ferraris? One might think, with their "entry level" car, the F430, at $180,000, you could just go out to your local Ferrari dealer and buy one. But you will have to wait months, and likely pay a hefty dealer premium.
12.18.2005 2:51pm
crane (mail):
Harford writes,

Perhaps the sellouts are supposed to generate free publicity. By deliberately giving Xbox consoles away too cheaply today, Microsoft gets the column inches before Christmas, and that may boost demand and sell more in the long run. If you had put that theory to me last year I might have believed it, but after all the hot air over gasoline prices this fall, no longer. It's now obvious that you can get just as much publicity by raising prices as you can by selling out at low prices. But raising prices makes money, and creating lines of frustrated customers who can't get the product doesn't.


Frankly, I'm appalled that someone could take this argument seriously. Does the man not understand the concept of bad PR?

I once read about an experiment that was done to see if chimpanzees could determine the intent of others. The chimps were offered juice, and given a choice of two humans to bring it to them. One human would always manage to trip or otherwise spill it by accident, while the other would dump it out deliberately. Soon, the chimps were always choosing the former, presumably hoping that he might someday succeed at delivering the treat.

I suppose Harford would be confused by this experiment, too.
12.18.2005 3:57pm
Jeroen Wenting (mail):
"I think it's the same reason why concert promoters and sports owners usually (there are some exceptions) price their tickets below the optimal price and let the scalpers make up the difference-- consumer goodwill. They don't want to be perceived as "gouging", because many consumers don't see the price of goods as a method of allocating scarce resources but rather as a source of windfall profits for big corporations. So, if you are in this situation, shortages are better press than high prices are. If people are reselling the items at higher prices, they get cast as the villans rather than you."

Dillan is quite correct.
I work in the software industry (with some contacts in the entertainment software industry) and there's a constant battle with a small but extremely vocal group of people who consider any price too high. They scream "unfair" pricing on products and demand to be given access to the books of private corporations in order to determine the "true" price of the product (so the price they consider "fair").
This is getting worse all the time, as people (and especially the younger generation) has less and less knowledge of the way the world works, seeing only the handouts they get from their parents or the government.

Increasing prices to reduce a (possibly artificial) shortage in such an environment is detrimental, your antagonists will only scream the louder and they're the ones who get heard by the press (who in general are no more economically educated than the screamers).

Keeping the price low while working to supply the market until saturation is the best policy.
In the end you sell more units without having to increase production capacity for a shortterm burst output leading to idle factories at a later stage.
12.19.2005 3:27am
Kevin L. Connors (mail) (www):
12.19.2005 4:48am
Jaybird (mail):
One other reason to keep demand high?

There are only ~20 games available for purchase. Half of those are sports titles. Backwards compatibility only affects about half of the titles already out there for the Xbox.

If you buy a 360 and you don't care about football or basketball, you won't have much to play.

This happened with the PS2 as well. I remember being thrilled that I *FINALLY* got my hands on one... then I went to look for a game to play on it... and I had my pick between Fantavision and Eternal Ring.

Final Fantasy X wasn't due to come out for another 6 months or so. I was playing my old playstation games on my PS2. I felt soooooo dumb trying to explain to my wife how cool I thought it was that I was playing Final Fantasy IX on my $300 system and leaving the $99 system to collect dust.

Anyway, a false shortage can get people thinking "Those people told me that I couldn't buy an XBox 360!!! WHO IN THE HELL ARE THEY TO TELL ME THAT I CAN'T BUY AN XBOX 360?!?!?" which is a lot better for eventual sales than having them tell their friends "yeah, I got one, got it home, set it up, realized that I needed a game, went to the store... and they didn't really have anything. When does Halo 3 come out?"
12.19.2005 11:54am
SeaDrive (mail):
I think that most of the responders are thinking too hard. My guess is that Microsoft guessed at the market-clearing price, and missed (of course). They can't raise the price without public cries of price gouging. (One way or another, a lot of retaillers will raise the price, likely by bundling. I've had at least one order for an electronic product go unfilled since I didn't buy the expensive extras that justified the low-ball price.)

It used to be said by IBM that every successful product exceeded sales projections by some huge amount. Market forecasting is not easy.
12.19.2005 1:21pm
Bruce:
"Yes Bruce, developers must pay royalties to use the developer's kit for XBOX 360 at around 10 dollars per game sold." Thanks Clippy and Avatar for the info; that's what I suspected, but wanted it confirmed from someone more in the loop.
12.19.2005 1:39pm
Cheburashka (mail):
Its none of those things. Its a combination of two contractual arrangements.

First, contracts with the developers. Console vendors make their money by selling licenses to developers; the consoles are sold below cost. For the developers to be induced to pay those fees -- more than a year before the product is released, before the shortage is predictable -- the console vendor commits contractually not to sell above a fixed price. That way, the developer knows the console vendor won't double-dip and that the installed base (over time) will be high enough to merit the investment of licensing fees and development resources.

Second, retail distribution agreements (contracts between wholesellers and retailers) are put together months ahead of time. That explains why MS doesnt hike the price. The contracts also limit the prices the retailers can charge, to prevent marketing value from being converted to retailer profit.

Since both sets of contracts are put together long in advance of Christmas, when the shortage is highly unlikely (there's only one hit toy a year) the parties do not spend the transaction costs required to negotiate clauses to handle the hit-toy contingency.
12.19.2005 1:54pm
Ken Hellewell (mail) (www):
I have followed this "shortage" controversy for some time. I have come to the conclusion that it is a combination of the intentional and unintentional. I believe that Microsoft intended a shortage but not as large a shortage as occured. The reported technical problems (crashing and overheating) appear to be genuine and point to a production run that was forced.

I am a perrenial Microsoft supporter but I do belive Microsoft is terrified. I think they have cause to be.

The battle with Sony is not about game consoles. It is about the end of the desktop computer. Sony has every intention of turning the Playstation into the family entertainment center, game console, web browser and personal computer.

This fits in with where the world of computing is headed. In the future we will not need Microsoft Windows, or Word or even Photoshop. If we need to edit a photo or write a story, we will simply log onto the internet and head to www.word.com or say www.photoshop.com etc. Adobe is already offering pay per use for Adobe Acrobat. Google and other companies are edging this direction and I do believe it is the future. No longer will every computer need a copy of every program the user might need. FOr a fee or for the simple pain of looking at an ad, we will be able to choose and use any program that we desire.

With all of this at stake, Microsoft's NEED to crush Sony has forced them to market with an inferior product. It is a life and death battle and Gates is losing.

Mark my words... you heard it here first (maybe) ;)
12.31.2005 12:15am