Explaining the great Xbox shortage of 2005.

How the dismal science applies to your life.
Dec. 15 2005 6:09 PM

The Great Xbox Shortage of 2005

Why you can't buy the one present you really need.

Illustration by Mark Alan Stamaty. Click image to expand.

Gaming enthusiasts camp outside electronics stores, desperate to buy the hot new game console. Corporate flacks are deployed to fend off PR calamity: "Consumer demand for the new console has exceeded our expectations, and we are doing all we can to fulfill the wish lists of people who want a new console under their tree this holiday season."

Video-gamers are clamoring for the new Xbox 360 console, but that statement didn't come from Microsoft: It came from Sony at the beginning of last year's buying frenzy for the new slim-line PlayStation 2. In 1996, parents wrestled to get hold of a Tickle Me Elmo. 1988 saw parental panic sparked by shortages of Nintendo game cartridges. And we're now celebrating the 20th anniversary of the Cabbage Patch Kid craze: They sold $600 million of those things in 1985, and that was in the days when $600 million was worth something.

These spectacular sellouts have become as much of a holiday staple as turkey and stuffing. And, of course, they have inspired conspiracy theories. Isn't it a little odd that the same story comes round year after year? Is Microsoft really running short of consoles? Yet, for economists, the Xbox 360 crisis is more alarming than a conspiracy, because these supply shortages make no economic sense whatsoever. Despite their suspicious regularity, the shortages benefit nobody.

It isn't the scarcity of supply itself that is puzzling. That is almost inevitable for some of these seasonal toys. In any given year, many toys will be unloved and oversupplied, but a few lucky ones will be in unexpectedly high demand. We shouldn't be surprised any more than we're surprised that the champion of a knockout tennis tournament won all his matches. Somebody had to.

In Microsoft's case, the Xbox 360 can be produced only gradually, but all the demand is there at once. Plentiful supply would be possible only if Microsoft made millions of consoles in advance and stored them without releasing them, or if it built vast production lines that only ran for a few weeks—both economically unwise strategies. It makes more sense to ship the consoles as they are made—and that means gradually. The steady supply can't match peak December demand.

So, supply shortages are a fact of life. The puzzle is somewhere else: Why don't companies raise prices when supply is short and demand is frenzied? Leaving aside oxygen and a few other essentials, there is no such thing as an absolute shortage of anything: There is only a shortage if the price is too low. At the moment, Microsoft is easily selling out the half-million or so Xbox 360 units (there's no official number) for prices starting at $300 for the basic package. Why doesn't Microsoft price them at $700 instead? That's the figure that the consoles are fetching on eBay. (Back in the days of the Cabbage Patch Kids, we could only speculate how much parents would have been willing to pay for guaranteed delivery. Thanks to eBay we can now put a price on customers' frustrations.)

Perhaps the sellouts are supposed to generate free publicity. By deliberately giving Xbox consoles away too cheaply today, Microsoft gets the column inches before Christmas, and that may boost demand and sell more in the long run. If you had put that theory to me last year I might have believed it, but after all the hot air over gasoline prices this fall, no longer. It's now obvious that you can get just as much publicity by raising prices as you can by selling out at low prices. But raising prices makes money, and creating lines of frustrated customers who can't get the product doesn't.

Maybe Microsoft is worried that this would be the wrong kind of publicity, because customers would dislike a price hike. That's possible, but the publicity is already bad: Many empty-handed customers seem convinced that Microsoft has a secret hangar in Roswell stuffed full of Xboxes that they've decided not to release just yet.

In any case, strange as it may seem, even if the consoles sold out at a higher price, the average Xbox aspirant wouldn't be any worse off: The increased price should be exactly balanced by the shorter lines, reduced aggravation, and greater chance of getting a console. 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). If Microsoft is going to aggravate its customers, why doesn't it at least make a buck out of it?

So, this is all something of a headache for the dismal science. Over dinner with a friendly local economics department, I challenged them to explain the puzzle of why prices stay low in the face of such shortages. They cited a number of ingenious explanations, all of them unlikely.

The economist Kenneth McLaughlin of City University, New York, has suggested that rock concerts deliberately underprice tickets because it means that a younger audience shows up—and teenagers, while they won't buy premium-price tickets, will buy merchandise and music. It's clever, but it's a stretch even for Rolling Stones concerts. (Every extra dollar on the ticket price is pure profit, after all—and how much merchandise do they really expect to sell?) For Xbox sales, it makes no sense at all to apply McLaughlin's theory, which would only work in the bizarro-world where the people willing to pay the most for the consoles were also the ones willing to spend the least on the games.

Barry Nalebuff and Adam Brandenburger, economists at, respectively, Yale School of Management and NYU's Stern School of Business, have argued that the scarcity of Nintendo game cartridges in 1988 was a deliberate attempt by the company to create a strong bargaining position in negotiations with retailers carrying the cartridges. (Retailers requested 110 million cartridges, and Nintendo produced 33 million.) Limiting supply is an age-old tactic for creating a bargaining position, of course, but the traditional thing to do with that bargaining position is to exploit it. What is the point of limiting supply if you don't raise the price?

Microsoft could certainly have made itself popular with favored retailers. If customers value the console at $700 but it retails at $300, then a retailer such as Best Buy will certainly thank Microsoft for any extra consoles, because they will attract customers into the store. Every $300 console saves a customer the extra $400 he would have had to spend on eBay to buy it (or allows that customer to buy for $300 something he can sell for $700). This is effectively a $400 handout to a few lucky customers, but Microsoft could achieve the same effect for the same price by having its representatives stand around in Best Buy handing out a limited number of $400 checks. Either way, Best Buy enjoys the crowds that result, but what has Microsoft gained?

A final explanation is that Microsoft is creating some kind of cachet by making the console scarce. But that doesn't work either because, again, it isn't the scarcity that's puzzling, it's the low price. Microsoft could create the same cachet by selling the same limited number of units at a higher price. In any case, it's not the Hope diamond, it's just a game console. How valuable can this so-called cachet be?

That leaves us with Napoleon's explanation: Never attribute to conspiracy that which can be explained by incompetence. This view of the world is antithetical to economics, because the dismal scientists tend to be suspicious of people's motives but credit them with vast intelligence.

Perhaps readers will suggest better ideas for the Xbox 360 shortage than my economist colleagues and I have done, but something happened recently to convince me that Napoleon was right: My publisher managed to sell out its rather timid print run of my book, The Undercover Economist. There was no great scheme or publicity effort attached to my book, no cachet, no hard-talking negotiation to raise the price on Amazon. The publisher just misjudged demand, and unsurprisingly so, because life is full of uncertainty.

Microsoft has got it wrong, too, but they have missed out on a far more obvious opportunity. Why didn't they sell their initial supply of Xbox consoles, packaged as a "limited edition," using online auctions? All the while they would promise $300 consoles as soon as stocks were available. Since at an auction the price is set by the buyers, not the seller, Microsoft could have made a killing, absolutely guilt-free, and created no more annoyed, empty-handed customers than they have with their current strategy.

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