# Solving Das XBox Problem

on December 19, 2005 at 7:15 am

Every year around this time there is a shortage of the hot toy (this year it's the XBox) and economists wonder why the manufacturer doesn't raise price to siphon off demand.  To set the stage remember that the problem isn't why the good is in short supply.  We can explain that with increasing production costs and peak demand (see Tim Harford for more).  The problem is why the firm doesn't raise price to eliminate the shortage.

The problem appears difficult because we see a) that the quantity demand greatly exceeds the quantity supplied and b) some units are sold at prices well above the selling price and thus we conclude c) \$500 bills must have been left on the ground.  The conclusion, however, is false.  The key is to recognize that the shortage is largest when most people are not willing to pay much above the market price.

Take a look at the figure on the right.  Note that any price below the equilibrium price will generate a larger shortage for demand curve Da than for demand curve Db.  (Ignore the left tail on Da for the moment).

But this means that a large shortage is not a sign that manufacturers could make lots more money by raising the price - in fact, it is a sign of the opposite.  Raising prices even a little would reduce the quantity demanded a lot and would generate only marginally more revenue.

Does the fact that some XBoxes are being sold for high prices on Ebay mean that the firm could sell lots of units at those prices?  Not at all.  Relative to total sales only a few are being resold and not surprisingly these go to the gamers with the very highest values.  The resale market manages to pick off some of the people on the left tail of the Da demand curve but, absent price discrimination, the firm could not sell to these buyers without greatly restricting the quantity demanded and reducing profits.  Note also that the fact that most people with an XBox won't sell it for a price above what they paid is just the endowment effect - the firm could not sell at those prices.

Once we realize that a large shortage does not imply \$500 bills on the ground explaining the shortage becomes much easier.  Small menu costs, small errors, or small values of maintaining consumer loyalty or generating "hype" (but see below) can all make it optimal or near-optimal to have a shortage.

Comments are open.  In the extension I explain why the usual explanation, a shortage generates hype, is not very convincing.

The usual explanation, a shortage generates hype, doesn’t make much sense.  First, as Tim Harford also points out hype can be generated by high prices as well as by shortages.  Very high end luxury items, for example, like Lamborghini’s are difficult to obtain but also very expensive.  Second, it’s implausible that a shortage
now could generate such greater sales later as to be worthwhile this is especially true given that Christmas is the peak selling season.  You want
hype before not during Christmas.

1 Gabriel Mihalache December 19, 2005 at 8:20 am

I usually write these things off on account of the psychological issue that people don’t like price adjustments, even if they might benefit in some way from them, because they don’t like finding in the shop a price higher than that advertised. Microsoft can’t update their price every day, for example, because people will “freak out”.
The need for prices stability is something I can’t get my head around, especially concerning what central banks are doing on this account.

Maybe they could try price discrimination? It sounded good in my 2nd Micro class so it must work in the real world, right? 🙂 Maybe deliver but ask for more than the cost of the delivery?

2 David Y. December 19, 2005 at 9:00 am

Initial shortages add to the perceived value of the product as a status item and also because of the “me to† social herding effect. This works particularly well you know that a shortage will create a lot of free media.

3 David Y. December 19, 2005 at 9:09 am

Hype due to high prices can be negative particularly when people have a social expectation as to what a “fair† price is. Further in the case of Xbox people know there is a reasonable substitute product coming from playstation in just a few months. Hype produced by too many people wanting it adds to the allure of the product which will last into the long term.

4 Peter December 19, 2005 at 9:40 am

Buyers may be unwilling to pay much above the normal price because buying an Xbox is not a one-time expenditure. You’ll need some games, and they’re not cheap. It makes little sense to spend, say, \$300 over list price if doing so means you can’t afford any games.

5 dsquared December 19, 2005 at 9:59 am

No, Alex, I can’t get behind this analysis. Two reasons:

1) It seems very dependent indeed on straight-line demand curves. Entirely possible and indeed quite likely a priori that the shortage is produced by a demand curve which is “flat” globally but quite steep locally.

2) You really can’t extrapolate a whole curve from a single point. The shortage tells us either that we are near equilibrium and the demand curve is flat, or that we are a long way from equilibrium and the demand curve is steep. There’s no reason to assume one rather than the other.

6 Dave Meleney December 19, 2005 at 10:13 am

Picture that every brilliant college junior in the western world, and many abroad, were to have burned in their memory bank a photo of thousands of top local students clamoring outside the GMU economics department and waiting up to 36 hours for a chance to play the games you’all play in the PhD programs there….. even if this were happening at the least ideal month it’d still be very, very good, no?

7 Windypundit December 19, 2005 at 11:05 am

Does this also explain why rock concerts sell out and people line up way ahead of time to get tickets, but opera performances don’t? Rock and roll fans are more price-sensitive?

8 123 December 19, 2005 at 12:21 pm

This is an excellent analysis. The firms surely do a great deal of pre-launch testing to figure out the price point that maximizes revenue.

The “myth” that firms seek hype, and therefore create shortages to generate publicity, has never been convincing to me. My response to the hype myth is that another theory of marketing is word-of-mouth, and that by maximizing the number of people who own my product, I am getting greater word of mouth and some network effects (particularly when it comes to systems like XBox where people benefit from friends owning them as well.) So firms should want as many out there as possible. But they’re constrained by limits on the amount they can supply in the short term.

The firms are going to only be able to supply a more limited amount than initial demand at that price will satisfy because the costs associated with creating supply need to be factored in over the life of the product. Spending a great deal in fixed costs to ramp up supply in the short term will be a bad move as the firm needs to reduce production over the next year.

9 Ben Cremeens December 19, 2005 at 12:56 pm

I think in the cases of Xboxes, the company is already committed to using the box as a loss-leader and making money off of licensing the software to developers.

I have no idea how this applies to Furbys, though.

10 Johnny D December 19, 2005 at 1:36 pm

“Relative to total sales only a few are being resold and not surprisingly these go to the gamers with the very highest values.”

Do you mean total ultimate sales? Because, by some estimates, almost 50% of the initial ship-in quantities for X360 were resold on ebay. That doesn’t seem like a trivial amount.

I think you are underestimating the marketing implications of an initially high price point and the signalling effects of subsequent price cuts.

11 Half Sigma December 19, 2005 at 1:41 pm

There is a very strong custom that you DON’T raise prices in these circumstances. Going against the custom would make people angry and perhaps lose in goodwill what you gain in extra profit.

I want to know why tickets to sporting events aren’t priced higher. I mean the sold out ones. You can’t get tickets to see the NY Giants. Doesn’t that mean the tickets are being sold for too little money? Why don’t the Giants raise prices?

12 Faryan December 19, 2005 at 2:20 pm

Microsoft can’t deal with the XBOX as a sheerly singular economic entity. Why? Because the system is attached to other products (controllers, internet devices and GAMES). The future of their enterprise is contingent upon selling as many units as possible (even perhaps at a loss) so future profits can be extracted by these linked commodities (games whose prices have been raised to \$60).

13 GamblingEconomist December 19, 2005 at 2:44 pm

How’s this for an explanation: Items like the X-Box are traditionally returnable when purchases from retailers. In fact, it seems pretty necessary to make items given as gifts returnable. The reason for the shortage is that people want to get the item to give as a gift on Christmas. After Christmas, demand will fall and there will no longer be a shortage. If retailers jacked the price up before Christmas, the rational X-Box recipient would return the gift after Christmas and buy it back at the non-Christmas price giving the retailer no benefit from the high price. Items purchased on E-Bay cannot be returned after Christmas so EBay sellers are in fact able to jack the price up while retailers are not.

14 Vasudev December 19, 2005 at 3:59 pm

Have you read Cialdini’s book Influence? There’s a pretty neat explanation for Cabbage Patch Dolls and other short-supply Christmas gift phenomena. The idea is, if product A is hot this year, a gift-giver will promise his/her gift-recipient product A for Christmas. Retailers keep A out of stock, so that gift-giver will buy some other product B for the recipient for Christmas, with an implicit (or, if the kid is really whiny, explicit) agreement to purchase the REAL present, product A, later. So retailers have essentially secured sales of lots of inferior product B during Christmas, and lots of the “hot” product A after Christmas – when they’re most hurting for shoppers.

This explanation relies on a couple of assumptions wrt the XBox that I’m not sure hold, but they are:
a. that retailers, and not Microsoft, have significant control over pricing and quantity. Seeing that XBoxes are sold mostly through large chains this seems plausible, and even if Microsoft has a lot of bargaining power, I’m sure the retailers and Microsoft could effect a cash transfer since this is welfare-increasing for the both of them.
b. that a significant portion of XBox buyers are buying for others, and that those recipients hold enough sway to get their buyers to overspend based on a promise. It seems like the XBox’s target audience may be a little older than the 10-year-olds assumed in the scenario above.

Perhaps not a rigorous supply-and-demand explanation, but it does make sense.

15 fling93 December 19, 2005 at 4:09 pm

It seems to me that there is an opportunity for price-discrimination that is being passed by. Microsoft could easily charge a “reserve” fee on top of the purchase price for those who would be willing to guarantee getting a unit. But then sell the rest at the current (supposedly) profit-maximizing price.

Of course, didn’t Microsoft sell the original XBox at a loss in order to win market share? So I kinda doubt they picked the profit-maximizing price here.

16 Geoff December 19, 2005 at 4:39 pm

Alex hits on a good point here – game players are definitely price conscious, and resent the idea that they are being gouged pretty strongly. If Microsoft raised prices now, they’d face a backlash, and one that they can’t afford at launch, when the title library is fairly small and you are essentially selling a promise of future games to come. You should also think of it in terms of positioning – the PS3 will be due out next, and it is widely expected to be expensive by console standards (in the \$500ish range, sans accessories that are often all but required nowadays). If Microsoft were to increase its pricepoint, it would be forced to compete directly with the PS3, which will probably be a losing proposition from a technology and game library standpoint… unless it discounted heavily later, again irritating the gaming community.

As for those who argue that the Xbox isn’t hot because the PS2 is outselling it – it is impossible to find an Xbox available, even online, at the moment – website trackers are showing companies like Target selling out 10 minutes after posting. So the lowered sales are the result of limited supply, not limited demand. The Xbox (undeservedly, in my opinion) is definitely pretty hot.

17 David December 19, 2005 at 7:05 pm

Apologies if this has already been offered (I have not read every comment) but as I understand this market, the manufacturers generally make little money – or even lose it – on the consoles and instead make their profits in the \$50-\$75 games. Thus wouldn’t a manufacturer not care so much about wringing the last nickel of profit out of the console in order to fully penetrate the market so multiples of games can be sold?

Yeah, okay, just read freighttrainnf’s post and we’re saying the same thing.

18 Hawise December 19, 2005 at 8:58 pm

In the case of the Xbox 360, they were rushed in to appear before the Playstation3 and to get the Christmas buzz. The factories are not yet at full production but the media hype is already in full swing. The market is nowhere near saturation and the number of available games for the unit are limited. The time to really see how it fares is next Christmas when the Xbox360 and the PS3 are sharing shelf space. The current market is for families with older teenage boys, the ubergeeks who have to have the newest tech toy and older gamers. Next year will see a full frontal assault on families with younger children. It does Microsoft no good to waste their lead by pricing their product out of the market, because people will invest in the older product and wait for Sony.

19 546mpster December 19, 2005 at 11:50 pm

Here’s an out-there idea:
I would have liked to see Microsoft set up an online auction along the likes of Google’s IPO as a way to set their initial price. Obviously, they would have to then turn over the units to retailers, but if enough people participated initially, Microsoft could’ve kept the information for at least some kind of internal use. It would have made an interesting promotion, too (“Price the Xbox!”), though the distaste to Microsoft of adopting any practice of Google’s might preclude the idea . . .

20 andrew December 20, 2005 at 2:57 am

microsoft has plenty of x-box 360s to meet christmas demand, the only problem is they are region locked (most game consoles are region locked to discourage importing etc.). MS could easily take the excess japanese 360s and sell them on the u.s. market if it weren’t due to the region locking on the consoles (the japanese console won’t play most U.S. games although some of the launch games surprisingly don’t have a region lock). What they’ve created a is bigger incentive for the people to break the region locking with mod-chips (they usually hit w/n a few months of the system’s release).

peace,
A

21 dsquared December 20, 2005 at 3:46 am

Perhaps a more succinct way of describing my points above would be that it is not inconsistent for each individual consumer to have a steeply-sloping demand curve for X-Boxes but for the aggregate market demand curve to be flat, and the fact that conventional Marshallian analysis says it is inconsistent is a problem for Marshallian analysis, not consumers.

22 UberIcarus December 20, 2005 at 6:55 am

An addendum: Something I forgot to mention. If keeping prices the same allows the firm to keep prices higher over longer periods there’s a good illustration as to why a firm might do this, even if raising prices might lead to higher near term profits. Particularly in the case of providing content, it takes time to develop for instance additional games or additional applications, and thus keeping cashflow higher and steadier over a longer time horizon would be preferable to a less steady cash-flow with one significant peak.

23 Mr. Econotarian December 20, 2005 at 10:39 am

Data point: On Ebay, there are currently 1498 items found for “Microsoft Xbox 360 Core System”. The current ending bid prices are around \$465-\$485.

24 Captaink59 December 20, 2005 at 12:40 pm

Is there a way to track the auction prices of Xbox @ Ebay ? Is demand still as strong now as it was 3 weeks ago ? If the auction prices is still high, would this confirm that High end users are still unable to find an Xbox at retail \$ or do many just buy @ Ebay, to avoid the Brick & mortar traffic ?

25 fling93 December 20, 2005 at 7:24 pm

UberIcarus: “Technically Microsoft allready offers a two tiered system. The basic package costs \$300…”

Yes, but why not another pricing tier to guarantee getting a unit? At least some of the people willing to stand in line would put a dollar value on that time.

I think the game theory stuff makes the most sense, especially since it also explains why they sold the first XBox at a loss (and it’s also a similar strategy they used with IE).

26 Leon December 21, 2005 at 1:28 pm

Equilibrium is not consistent with shortage. Maybe we should return to the drawing board. Demand to the left of the crossing point on the graph IS satisfied.

I suggest the supply curve as a POINT, as MS do not allow its selling price to rise. Then shortage is to the right, but still rise with the flatness of demand curve. Above the point, but on the demand curve is the ebay price.

I would agree with previous point, that MS throwing money at the market to gain market share.

27 DK December 21, 2005 at 3:05 pm

Auros, you are right, but youar point is a lot less impressive when you post it after Tyler linked Tim Hartford’s new Slate article making exactly the same point.

I was one of the “idiots” [Tim Hartford’s word] making the market share argument, although I had other arguments (the retailers have more power and like the shortages) that still hold.

What I think makes the market share argument work is the network/word-of-mouth effects. If you can get some units in teenage homes before Christmas, then all the teenage xbox owners’ friends will get to try them out and will want to buy them when they become available. If older/richer customers don’t influence word of mouth as much as teenagers, then you’d rather put the early units in the hands of lower-paying teenagers.

Example: free movie screenings are often held before the movie comes out, to create buzz, and get insiders/influential people/cheap young people talking about them.

28 mrad December 21, 2005 at 6:51 pm

Dsquared has it right. The whole reason for xbox360 pricing is to create the appearance of success. We have direct evidence from the mouth to MS execs themselves, in the form of Balmer’s mantra, “Developers, developers, developers.” As if the history of the Windows platform didn’t make it obvious enough. It’s not quite the same as hype, but it is a perceptual effect, specifically among 3rd party software houses.

In other words, MS leaves \$500 on the floor as an insurance premium against the failure of the platform.

That seems to make this a slightly different phenomenon from the Furbys & Cabbage Patches though.

29 levan September 5, 2006 at 7:55 am

30 æ°´æ— ç—• July 6, 2007 at 4:37 am
31 wslmwps July 12, 2007 at 2:28 am
32 asdd July 12, 2007 at 3:50 am
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34 wslmwps July 21, 2007 at 3:50 am
35 xdrs July 25, 2007 at 1:33 am
36 Missliang August 16, 2007 at 2:41 am
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