Tuesday, December 16, 2008

Game Console Economics

This post is related to an exam question for my Econ 265 students.

Microsoft, Nintendo, and Sony have all released new game consoles in the past three years (the Xbox 360, the Wii, and the Playstation 3, respectively, and in that chronological order). In each case, these companies apparently sold their consoles for prices below the market clearing price. Upon release, all three consoles sold out quickly, and could be found on eBay for prices significantly higher than their full retail price. Microsoft managed to address the problem fairly quickly with increased production. Sony had the problem solved for them as the high sales were not sustained. The Wii, however, continues to be difficult to reliably obtain, and still sells for a premium on eBay. Why is this? 

To elaborate, the puzzle is as follows: Nintendo could have sold just as many consoles at a higher price, giving them higher revenue with no extra cost--that is, higher profit. Why didn't they sell the Wii for $300 instead of $250? Why not sell them on eBay and get whatever price they can get? Nintendo (and the other companies) is leaving hundreds of millions of dollars on the table. Why?

Tim Harford, who is a better economist and writer than me, tried to answer this question when the Xbox 360 shortages appeared. When I ask this question, I usually get the same wrong answers that he got. Let's first dispose of some answers that cannot be correct.

Bad Arguments:
1) Good will: These companies cannot be forgoing profits to accumulate good feelings from consumers. One reason is that they have to wait in lines to get the product, which probably doesn't make them happy. Another reason is that good will is only so valuable. If Nintendo sells 2 million consoles and foregoes $50 per console, they just gave up $100 million. They've now sold over 15 million Wiis. Again, if they're giving up $50 in revenue per console, that's $750 million foregone. Good will is nice, but it's not that nice. 

2) Market share: It doesn't make sense to say that they're selling at such a low price to gain market share because they could sell just as many at a higher price
-Getting media attention: This surely cannot be an attempt to gain media attention and free promotion, because they could also get attention by selling out all their product at a higher price. Besides, what good is media attention if you don't have any product let to sell?

3) Game console companies just goofed up, picking the wrong price. This raises the question of why they don't just change the price. Sure, it would anger some consumers, but the companies could probably live with that while carrying their extra hundreds of millions of dollars to the bank. On the other hand, they've already got agreements with retailers stipulating the price, so maybe it's just too costly to change it. This still doesn't explain why every console maker repeatedly makes this mistake.

Here are the good arguments that Tim Harford and his readers came up with.

Good Arguments:
1) Microsoft underpriced in order to avoid antitrust scrutiny. By charging a high price, they might be accused of being a monopoly charging a monopoly price. On the other hand, by charging a low price they could be accused of predatory pricing, so I'm not sure this argument works.

2) Customers for each console are extremely price sensitive. At a price of $350, everyone wants the Xbox 360. They'd be willing to pay up to $375, but if the price goes up the tiniest bit above that point, everyone waits for the Playstation 3. Microsoft, which isn't exactly sure of the proper price point, charges $350 to be safe (this explanation was proposed by Alex Tabarrok). It wants to do everything possible to prevent Sony from making sales. This explanation works fine for the Xbox 360, but doesn't explain the Wii or the PS3 very well. 

3) Suppose that game developers are not sure which console manufacturers plan to stick around (because they have confidence in their product), and which ones plan to float their product and then cancel it if the launch doesn't go smoothly. This is important for game developers, as game development is very costly, and involves high fixed costs, which will be sunk and unrecoverable. Then console manufacturers that are confident in their product can signal their confidence by foregoing some revenue on the hardware. They know that they will eventually make up the lost revenue with game licensing fees, and as costs of production fall, they may even be able to make a profit on the hardware at the current price. The longer they plan to stick around, the more profit they can afford to initially forego.

Someone is likely to point out here that Nintendo actually does make a profit on the hardware right now, due to its low cost, but that's not actually the point. The point is that they could make a higher profit by charging a higher price and getting just as many sales. A console maker that is not sure if it plans to stick around for years cannot afford to forego revenue upon launch of the product. For any Econ 307 students reading this, think of the peacock signaling its genetic health with its big tail.

This argument was inspired by a paper presented by Angelina Christie at the SEA meeting this year (her paper was about signaling and IPOs, but it could also apply here). The console maker may also be signaling to consumers, indicating that it plans to support the console and release games for a long time. Consumers therefore feel safer buying the console, confident that they will have new games to buy for years to come.

4) Vinit Jagdish presented a paper at the SEA meeting inspired by this very topic, and his clever argument was also information-related. Suppose that console makers are not sure the extent to which consumers consider their products to be close substitutes. Only after the products are released, and customers buy them, will producers gain information about the demand for these products. If two products--say, the Wii and the PS3 are perceived as close substitutes, then it is hard for the companies to avoid Bertrand-style Competition. That is, a price war might occur, with both companies slashing prices, resulting in lower profits for both firms.

But suppose that Nintendo releases its console at a very low price, so that it can only be rationed by queue. Sony has less information available than if Nintendo charged a higher price. That is, Sony doesn't know if the Wiis are selling because they're a cheaper alternative to the PS3, or because they're just plain cheap. Sony is therefore reluctant to start a price war, because it cannot accurately calculate the cross-price elasticity of demand. 

One possible problem with this argument is that, of the current console generation, the PS3 and the Wii are the least likely to be close substitutes in the first place, given the large gap in prices and abilities of the two consoles. Nonetheless I think it does make sense. 

Can you come up with other explanations? I'll be looking over the exams and posting interesting solutions here.

My thanks to Vinit and Angelina for their interesting presentations at the meeting. 

Sunday, December 07, 2008

Magnum P.I., Evolutionary Philologist?

Or should that be linguist? Etymologist? I'm not sure of the proper term here.

While writing exams I've had episodes of Magnum P.I. playing on Netflix in the background. For those of you who have never seen it (I'm looking at my students, here), it's a good but goofy 1980s detective show, set in Hawaii, starring Tom Selleck. If you can put up with bad 1980s action music, it's worth watching. 

In this particular episode Thomas Magnum is pursuing a cat burglar while working as a hotel detective. He gives the following monologue, which I recall enjoying when I last saw this episode years ago (I forgot all about the story and such, but I remember this bit):
I didn't think the cat-man's taunting note was the height of subtlety, either. And I guess neither is that old adage about killing two birds with one stone. But the reason clichés are clichés is because ultimately, they're either true, or they work. That's why you never hear sayings you've never heard before. Those are the ones that didn't work. Which is all to say why I was hoping this one would.
This is some fun evolutionary reasoning. On the other hand, what are we to make of contradictory clichés, such as "many hands make light work" and "too many cooks spoil the stew"? Presumably we are to balance the two, finding the point where Marginal Revenue Product equals Marginal Factor Cost. I suppose MRP=MFC isn't very pithy.

Thursday, December 04, 2008

It Is Not Your Duty to Spend

My colleague Art Carden wrote  a great editorial on Christmas and consumption. On NPR a couple weeks ago I heard a discussion of consumer spending, and one of the panelists (I wish I could remember a name or the name of the show) suggested that it makes about as much sense to "spend to save the economy" as it does to say that we should all eat cholesterol-rich diets to make sure that cardiologists stay employed. 

Over Thanksgiving a family member asked if we should be spending in order to stimulate the economy. It's frustrating to me that so many people seem to be pushing the view that consumption for consumption's sake is patriotic. There was an editorial in the Tennessean recently exhorting people to spend. I suppose one could argue that there is a sort of prisoner's dilemma in Aggregate Demand falling (if we both spend we could avoid recession, but if you don't spend and I do, then we enter recession and now I'm even poorer than I would have been if I had just saved), but trying to persuade people individually to carry on as usual seems about as productive as telling people to reduce their individual greenhouse gas emissions. 

My advice: Be thrifty. Don't buy for the sake of buying. Do not buy because someone tells you it is your duty. Buy when you see a really good deal on something you need and you can afford it. Frivolous spending on things you don't really want is a waste of resources. This may sound obvious, but the fact that some people exhort us to spend, and some of us listen, suggests that my advice isn't completely trivial. 

Wednesday, December 03, 2008

Used Game Sales Again

I have posted previously about used video game sales. Game publishers and developers continue to take the position that used game sales are harmful to the industry. 

I still cannot understand this logic. Suppose I would be willing to pay $35 to play a particular game. Its retail price is $50. I will not buy it. If, however, I could resell it when I'm done for $20, then my total willingness to pay is now $35+$20=$55. I choose to buy the game, with a net gain to me (a "consumer surplus") of $5.  Every dollar I lose from inability to resell is a $1 reduction in my willingness to pay for the product in the first place. 

It is true that the existence of used games means that some people who would have paid $50 end up paying $20, and that the producer of the game does not get any of this $20. This is not unique to video games, however. This is, in fact, true of all goods and services that can be resold. If you buy a painting for $1,000, and later resell it for $1,200, the painter does not get any of the $1200. Suppose there were a law prohibiting resale of the painting. Then the original buyer would be less willing to buy it in the first place. The painter would make money on resales, but he would make less money on the original sale. 

The same holds true for video games. If I know that I cannot resell my game after buying it, I am less willing to buy--my willingness to pay is lower. Do video game publishers and developers really think they will make a great deal more money selling all games for, say, $30, and prohibiting resale? I don't see how. 

So, then, what is the reason why publishers and developers take this position? Are they simply mistaken? They should know what is in their interest better than I do, but companies do sometimes ignore good opportunities and use flawed reasoning. Is there some other reasoning I missing? Maybe the companies pushing this position feel that reducing used game sales would somehow give them a competitive advantage against other companies, rather than helping all game companies. 


Popes and Private Roads

When I was in D.C. for the Southern Economic Association meeting a couple weeks ago I rode the metro. There was an old notice posted on the train warning that some streets would be closed as a result of the Pope's visit. 

It occurred to me that this is a strange example of the Theory of the Second Best. Suppose the government took a laissez-faire approach, keeping the roads open. If the Pope wants to get people off the roads, he has to pay them to stop driving. Obviously this encourages people to drive in order to be paid to stop to wait for his procession to pass. He could also simply refrain from visiting, but assuming the benefits from society of his visit are greater than the costs, this might be inefficient. 

Given the inability of the market to solve this problem, the second-best (and very un-laissez-faire) solution is to simply ban driving in certain areas at certain times. The first-best solution might be to privatize the roads, if this were somehow possible. 

The two crucial and questionable assumptions in this story are 1) there is no market solution available to the Pope and 2) privatizing the roads is possible and first-best.  Maybe the Pope can, at low cost, take a helicopter everywhere he wants to go, making 1) false. 2) might also be false, if privatizing the roads leads to other market failures. I don't think this is necessarily the case, though. Shopping malls have private "roads" for pedestrians, and they work just fine. Some neighborhoods and businesses maintain their roads privately, although they not enforce traffic laws there. The real trick is how to get there from here.