Why “early adopters should pay more” doesn’t work

Everyone’s linking to this GamerDad column on how the Xbox 360 should have been priced higher at launch. It’s an interesting idea, though one Slate’s Tim Harford examined in much greater detail and more clear economic terms shortly after the 360 launched.

Interesting but misguided, for a different (but related) reason than why Harford was misguided. Dave Long writes:

Essentially, by making the price $400 for the Premium Pack (the “real” 360), it was priced low enough to be mass-market right out of the gate. This one simple fact causes all the problems Microsoft experienced at the holiday and even represents the first big mistake of the transition to new consoles. Microsoft cut the generation short unnecessarily because they undercharged for Xbox 360, hurting both their bottom line and everyone else’s at the same time.

But Microsoft had to make the 360 a mass-market item right out of the gate. Video game consoles, especially early in the system’s life, typically cost the company for each unit produced. They make up for this by pushing consoles into enough homes that enough software is sold to more than cancel out the loss on each system produced. If Microsoft established the 360 as a luxury tech product, it would never get the mass-market saturation it needs to succeed.

That saturation is so important because of the relative failure of the Xbox and the head start Microsoft had against the PlayStation 3. Microsoft didn’t cut its current generation short; the Xbox was already done. The system served primarily to get Microsoft into the video game arena; it was a very expensive buy-in. The company never made money off it, and pricing the 360 at $700 wouldn’t have convinced people to buy the regular Xbox. They would have just bought a DS or PSP or slim PS2 and waited for PS3 or Revolution. By cutting the current generation off and beating Sony and Nintendo by more than a year, Microsoft was positioning itself for the mass-market success it never found with Xbox — and you don’t do that by marketing your product as the Bose of video games.

To Harford, these considerations are irrelevant: Demand far outpaced supply, so Microsoft would have sold the same number of systems but made loads more money if they were priced at $700 or whatever. But Harford is thinking too much like an economist. He writes, “Customers are infuriated by the shortage itself, whether that shortage is expressed in lines (as it is today) or in high prices (as it could be if Microsoft raised them).” In the real world, though, supply and demand isn’t that simple. It matters why the supply is low and costs are high.

If supply is low because of a materials shortage, or because materials cost a lot, people understand that and are willing to pay a higher price (or at least they understand why they can’t afford it). But if supply is low or prices high because of business timing — because Microsoft launched the 360 before it had its production up to speed — then people aren’t willing to pay. So waiting in a long line for the chance to get a $400 machine is different from staying home because you aren’t willing to pay $700 for an overpriced toy. It’s one thing to say “You can’t get a 360 because we started making them so late and we can’t pump them out fast enough, but if you find one you’ll pay a fair price for it.” It’s worse, from a consumer’s point of view, for Microsoft to say “You can’t get a 360 because we jacked up the price simply because we couldn’t make them fast enough — not because components cost a lot or because of a materials shortage — and so you can’t afford it.”

Harford comes around to this in his second column, after hearing from a professor at George Mason. Microsoft didn’t charge $700, he suggests, because

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.

People are much more comfortable nowadays with buying a $300 or $400 tech toy. Thank iPods for that. But $700 or even $600 is different. And while people are willing to pay $300 for an iPod even though they know it didn’t cost that much to produce, they aren’t willing to pay $700 for a game system that maybe cost $450 to make.

Which brings me to the PlayStation 3. The Blu-ray debacle has put Sony in an incredibly tough position. If it wants the same mass-market success Microsoft is chasing, it can’t price the PS3 above $500 (My guess is it will cost $399, but I also think the $399 iPod has made a $500 game console viable). But because the Blu-ray technology is so expensive, Sony will have to take a huge loss on each console. What makes the Sony situation different is that yes, Microsoft could have experimented with pricing based on pure supply and demand. It wouldn’t have been a good idea, but it also wouldn’t have been a terrible risk because Microsoft could have lowered the price at any time. But if Sony charged $700, it would be doing so only because it had to.

In consumers’ minds, this would be as wrong as charging $700 for no reason other than artifically low supply. Consumers would know the price is high because Sony chose to force expensive technology on them even if they didn’t want it. And as with all of Sony’s recent propriety failures, consumers would say no thanks and choose another option.

— April 26, 2006

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