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. 


Jeffrey said...

I don't have any new theories, but I think Alex's theory about the extreme price sensitivity coupled with a closer examination of the products themselves (where they fit in the marketplace with relation to one another) is probably the best answer.

On the gaming board I frequent, gamers are regularly expressing concern about game prices, console prices, accessory prices etc. etc. Furthermore, the dollar amount which will make or break purchasing decisions is very small. Sometimes as little as $5.

As far as the consoles and their relative market positions, I think it's important to note that they do not all fill the same niche. The PS3 and 360 are HD consoles and the Wii is not, and in my opinion, with HD being the next big household technology to take root, the HD/Non-HD distinction must be taken into account and prices adjusted accordingly. The 360 was available at launch for as little as $299, so the Wii "should" cost less than that. If the Wii were released by itself, I'm sure it would have been much easier for Nintendo to raise the price to $300, but having a more advanced console available at that price probably, at least in part, kept them from doing so.

Beans K said...

I think it has to do with consumers' ability to buy periferals in addition to the systems themselves. Having lower prices certainly increases the availble consumer funds to purchase games, xbox live, etc all which support microsoft. The amount of money microsoft made on Halo 3 was enourmous... also doesnt that create brand loyalty?

benh57 said...

I'm surprised the printer/ink model hasn't been mentioned.. Nintendo (and the others) make money on first party games and 'points' sold for their respective consoles. Each console manufacturer wants that foothold into the living room. That's worth a lot..

Jeffrey said...
This comment has been removed by the author.
Jeffrey said...

(no edit feature so I deleted the initial post to add to it here)
I think you guys are missing the point. Of course every console maker wants to sell as many as possible, but as history has shown, these consoles are always sold out in stores for months, if not years as is the case for the Wii. If they're selling as many as they can already, why aren't they raising the initial price?

I want to add that the "Good Will" argument might not be so bad if you take some other bits into consideration. Let's take the Wii as an example. In my prior post, I stated that the Wii "should" cost less than $300 because an significantly technologically superior console was already on the market for that price. So let's say Nintendo knows that $250 is the right price for the Wii. One that allows them to make a profit on the console itself (rare) and position itself as the lowest cost option. However, given the history of massive demand at release for new consoles and the very positive hype surrounding the release of their product (remember, the Wii came out of nowhere to absolutely steal 2006 E3 from the PS3) let's say Nintendo decides to cash in and sell the initial 1,000,000 Wii's for $400. Easy $150 mil in profit.

Suppose they sell the first million Wii's in 3 months, but by then the sales cool off and Wii's are now readily available in stores. Now what? Do they lower the price to $250? Do they keep it at $450 and risk losing market share? I think if they lowered it, the "bad will" from basically burning the initial customers will be tremendous. Early adopters will feel like they got screwed. They may harbor a deep seated resentment towards Nintendo that could last generations and across product lines. "New DS coming out next year? Well I'm not buying one right away, that's for sure! "

That's a pretty big risk to take.

History might also have a role in console costs. Historically, (or at least in recent history) consoles typically cost $300. On release Microsoft made sure that they had a $300 option for sale. Nevermind that the $400 option was really the only decent option out there if you really wanted to play games with it. MS felt they had to have a product at that price point because that's what the consumer expects to pay. I'd wager that the price point was one of the initial design decisions. "We need to make a console that costs $300. Let's build the most powerful console that you can make for that price."

Sony learned the hard way how important meeting historical price points and meeting consumer price expectations is. Opening at $600 killed the PS3's release and keeping the price point above $400 even now is continuing to kill it.

pup said...

I don't recall a console SKU ever going up in price. I've seen new SKUs come out at higher prices (360 Elite, for example), but never a single SKU going up.

I think console manufacturers enter the market with prices set as low as their pain tolerance will allow, taking other market forces into consideration (competitors at a particular price point, etc). The general idea is to sell the console at a loss (or marginal profit), get as many of them on the market as possible, and eventually make up the lost money with game sales. They enter the market with the hope and expectation of creating a shortage because shortages create buzz, which create more sales in the long run. The lower they can price their console, the better chance of a shortage.

Typical console shortages last a few months (off the top of my head), but the ongoing Wii shortage is unprecedented. Nintendo literally can't make them fast enough. I think the Wii’s perceived rarity is one reason it's still selling so astronomically well. I saw one on a shelf yesterday (the first one I've seen in over a year), and I thought seriously about buying it even though I already own one. I stood there running through acquaintances in my head, wondering if any of them had mentioned they were looking for a Wii, or what I could flip it for on Craigslist.

So if shortages are good for console manufacturers*, why doesn’t Nintendo raise the price, even a little bit, and make more money?

If Nintendo had priced the Wii at $275 or $300 at the start, I don't think it would have greatly affected their sales. But they made their bed and now they have to sleep in it. Raising the price after the fact would send too many signals, the biggest being "We want more of your money." That would be a big hit on their public image. Right now they have the best of both worlds. Their product is selling like hotcakes, and they can play the role of the innocent company working overtime trying to make the customer happy. If they bump the price, they turn into a greedy bully, stealing money from kids and hardworking parents. Just look at the ire drawn last year by a forum poster who admitting to flipping Wiis on Craigslist. Now imagine if a whole company started doing it on a large scale. Big Bad Nintendo.

* Of course, not all shortages are good. If Nintendo was having problems in the manufacturing process and couldn’t make enough to meet demand, that would be bad. However, Nintendo’s production is running overtime and the Wii’s sales numbers are destroying the Xbox 360 and PS3.

Ted Vessenes said...

One real possibility is retaliation from retailers should Nintendo decide to compete with them.

Currently Nintendo only sells consoles through retailers rather than directly (either via. an official Nintendo store or the Nintendo web site). Nintendo also relies on these retailers to sell the high markup video games and accessories that also pad Nintendo's profits, as well as the retailers. If Nintendo were to open other distribution channels separate from the retailers, the retailers might retaliate by refusing to stock any Nintendo products.

This is analogous to how labor unions try to prevent large companies from switching to cheaper but otherwise equivalent laborers. While there might represent a lot of additional profit in the long term, the retailer (or labor union) can cause a significant short term drop in profit through a retailer boycott (or strike). So the market inefficiency persists because the profit gained from the situation is a local maxima.

There's also the argument of economies of scale. Nintendo is a technology company, not a retailer. It might be that Best Buy is more efficient at selling stuff than Nintendo is. Sure you can list stuff on eBay and mail it out, but you need a different infrastructure in place to do it than Nintendo has right now. I find this argument less credible in the age of the internet, but 15 years ago it was certainly the case that Nintendo didn't even have the option of selling directly.

Another possibility to consider is that Nintendo might not have the option of selling the consoles on eBay for the same prices that resellers are. If Nintendo started selling its consoles for $500 on eBay after the first run at Best Buy sold out for $200, many people would (irrationally) feel that Nintendo was price gouging them, and perhaps not as many would sell. The fact that someone else has to resell the item for a super-high price adds mystique, which translates to utility for the purchaser.

This is just a variant of the good will argument, of course, but I think it has some weight. The question is how much brand damage (which translates into lost profit in the long term) does Nintendo incur from the short term sales on eBay? I'm not sure, but I'm confident this value is much more than $0 and much less than $500 - $200 = $300 per unit. The risk of this maneuver might be hard to judge and the company just decided to forgo the option.

Last, I think Nintendo flat out over-estimated the threat that Sony presented, and priced its Wii low enough to put serious pressure on what was probably a non-issue. If Nintendo could do it over again, I bet they'd price the Wii at $250. That's low enough to be a price bracket below the Xbox 360 but has significantly higher profit margin. The problem with setting a price too low is that it's hard to raise prices than lower them, at least for consumer products. A price increase generates far more negative press (ie. brand damage) than a price decrease.

Anonymous said...