Everyday Economics

Xbox Economics, Part 2

More reasons Microsoft isn’t charging enough for the season’s hot game console.

We have an Xbox and you don’t

Last week I wrote that the shortage of Xbox 360 consoles seemed inexplicable, at least to me and my fellow economists. I invited readers to provide better explanations, and you did.

A reminder of the puzzle: Xbox 360s are the latest in a long line of Christmas products to suffer spectacular shortages. The shortage of supply isn’t the puzzle; the low price is. Why doesn’t Microsoft raise prices temporarily from the current floor of $300 for a basic console? Why doesn’t the company auction them all on eBay, where consoles are currently reselling for $700 and up?

If I had a dollar for every e-mail I received on the subject, I’d be able to afford an Xbox myself. Most of the suggestions I received were wrong, but a few got me thinking, and they may get you thinking, too.

The stupidest explanation came up again and again: Microsoft is holding the price low in order to grab market share and make money on selling games. This is the “cheap razors and expensive razor blades” strategy. True, console manufacturers are widely thought to be losing money on the consoles and recouping the losses on the games. But only the most idiotic of my correspondents failed to see that one traditional part of grabbing market share is, um, producing enough consoles to supply the demand you’ve stoked with your low prices. If you have only 500,000 consoles, you can sell them cheaply, give them away, or even pay people to take them off your hands, but in the end there will still be only 500,000 consoles to buy games for.

Many people also claimed that the seasonal shortage creates free publicity to encourage sales later, but high prices don’t create publicity. I still don’t believe that: Exxon got plenty of publicity by raising gas prices after Hurricane Katrina. In any case, now, not later,is the Christmas season when people want to buy it.

One reader reminded me of the “hot IPO” phenomenon of underpricing to generate interest in new shares. Maybe Microsoft was trying something similar. But I counter that Google chose an IPO auction instead of an underpriced IPO and wasn’t short of publicity.

This isn’t to say that Microsoft couldn’t use the buzz: The console business is very dependent on expectations. Gamers buy consoles if they expect great games. Games-publishers invest in great games if they expect the console will be popular. Confidence in a console—or lack of it—is self-fulfilling. So, yes, buzz is important. But lines aren’t the only way to create a buzz: Microsoft could have secured plenty of publicity (and a lot more revenue) selling a “limited edition” at auction.

Why wouldn’t Microsoft raise prices to take advantage of the seasonal demand? In my original article, I claimed that Microsoft would irritate customers equally by raising prices or by creating lines, and rightly so because the typical customer is inconvenienced either way.

But more thoughtful correspondents produced good reasons why Microsoft would steer clear of raising prices.

The first is that much of Microsoft’s business is nearly monopolistic: The company has no powerful commercial rivals to its Windows software or its Office products. As a result, the company has often been targeted by regulators investigating alleged abuses of its dominant position. These businesses are huge relative to the Xbox 360. High console prices might raise government suspicions. Why take the risk of antagonizing the regulators for a relatively small financial gain?

The second reason Microsoft would avoid price hikes comes from David Friedman (whose modern classic Hidden Order will be much enjoyed by many readers). Friedman wrote to draw my attention to an essay in which he argues that there was once an evolutionary advantage for those stubborn people who insisted—contrary to what economists believe—that there is such a thing as a “just price.” Imagine a person whose response to every price hike is outrage. In the one-on-one negotiations our ancestors engaged in, it’s impossible to rip our man off, and most of the time he’ll get his way and the price will stay low. Of course, every now and then, the price hike isn’t an attempt at exploitation, but a genuine reflection of scarcity: Then the outrage means lining up in the cold for an Xbox rather than paying the price that would balance supply and demand.

A third suggestion is that Microsoft may want to raise the price, but can’t. Microsoft has to agree to a retail price in advance with sellers, who in turn incorporate that price into their advertising material. It’s too disruptive to change prices suddenly and for such a short period of time.

But the best idea of all is from my friend Alex Tabarrok, a professor at George Mason University who was one of those economists I originally stumped with the puzzle. Spurred on by this public humiliation, he has thought harder and he now claims to have the solution: Very few people really are willing to pay $700 for an Xbox. Contrary to what you might expect, long lines are perfectly consistent with customers who refuse to pay high prices. Imagine that the typical Xbox customer is willing to pay around $325 for a basic console but is extremely price sensitive. At $300, twice as many people want the console. At $350, hardly anybody wants it. Microsoft isn’t sure exactly what the average gamer will pay and can’t change the price quickly. If they priced just a little too high, all the customers would wait for Sony’s next console. A little too low, and long lines form—a better result for Microsoft, but without sacrificing hundreds of dollars per console with the low prices.

Tabarrok’s argument makes all the other arguments in this column more plausible: While Microsoft might not want to pass up an extra $400 per console for a few more game sales or some good publicity, if it’s only $25 per console, then that’s a good deal for the company.

What about those $700 consoles on eBay? If Tabarrok is right that the actual price is closer to $325, why haven’t eBay prices collapsed? The answer may be that it is gamers who are acting irrationally. Very few people resell their consoles despite the high auction prices. Having grabbed a scarce console, gamers only think about using it rather than profiting from its resale. As a result, only a few consoles are up for sale and only the most desperate buyers compete for them. If more people put their consoles up for auction, the price would drop.

I leave the last and wisest word with my much-maligned publisher, whom I teased in my first article for not printing enough copies of my book. “I can’t believe we didn’t think of this before!” he writes. “We are raising the price of The Undercover Economist to $700.”