Closing the Xbox

Ed Felten has an interesting post (“Freeing the Xbox”) about efforts to “hack” the Xbox to open it up so that it can run the Linux operating system. And Tim Lee at the Technology Liberation Front has a series of related posts on this issue. Ed notes that given the price/power combination of the Xbox, it is an attractive target. How we should we evaluate this? Here is what Ed says:

The real action here is in Microsoft’s strategy of selling the Xbox hardware as a loss leader, and the tendency of the Xbox Linux work to frustrate this strategy. Xbox Linux creates value for its users. Should public policy be willing to destroy this value in order to enable Microsoft’s pricing strategy? My instinct is that it should not, though there is a plausible argument on the other side.

This is a reasonably balanced statement, but I don’t think that this is still the right way to frame this issue, and I do want to make clear the other side. Ed puts it as users vs. Microsoft, but this is as least as much about user vs. user and we have to understand what the Linux hack means for people playing games on the Xbox.

I think that we have a number of moving parts here: (1) monopoly v. competition in the games market; (2) selling the game platform—the Xbox—for above or below marginal cost; and (3) Microsoft’s design alternatives to the Xbox. Take these one-by-one.

If Microsoft has monopoly power in the games platform, hacking the Xbox might be a good thing. This would create, as Ed puts its, value for Linux users and would, as an economist would put it, expand output. As reduced output is the central harm of monopoly, responsive steps that expand output often improve matters. I don’t have a professional opinion about whether Microsoft has monopoly power in games, but I doubt it, especially when we focus on competition in games platforms over time. We have seen a lot of market-leader turnover in that market, which is usually a sign of meaningful competition.

If Microsoft is pricing the Xbox above the marginal cost of making it, Microsoft should be delighted to see users find new uses. If I decide that the Xbox is the world’s finest ottoman, Steve Ballmer should be happy. But if Microsoft is pricing the Xbox below marginal cost—I assume that we think that—then we have an issue, and this gets us to Ed’s central point. Ottoman users won’t buy any games, and they will inflict costs on Microsoft through their purchases.

We are now in the world of systems—or platform—competition. Multiple pieces work together. This is very much in the news right now given the French threat to regulate iTunes and the iPod, which is exactly this sort of system. The Financial Times had an editorial on June 15th ($) supporting Apple’s effort to build a closed system; I have a prior post on this here.

Pricing is a tricky issue. Adobe gives away Acrobat Reader so that it can sell the Acrobat authoring program. Gillette gives away razors—or sells them below cost—to sell blades. Selling the platform—the razor or the Xbox—for below cost can be in the collective interest of the users of the platform.

Try a concrete example. Light game players value the Xbox with one game at $200. Heavy users value the Xbox with multiple games at $300. The marginal cost of making an Xbox is $200 and the marginal cost of producing each game is zero. If Microsoft has already created the Xbox platform and the games, what would we like to happen? The marginal costs of serving both types of users are covered by their values—especially if we add epsilon to the light user’s value—so we should want both types of consumers to be served.

How do we do that? Assume that we set separate prices for the Xbox and for games and that we have six different games created. If we set a price for the Xbox that covers marginal costs, we set the price of the Xbox at $200. That means that we need to set a price of zero for the games, otherwise the light user will not buy at all. If we do that and if we have one light user and one heavy user, total revenues are $400. Of course that means we have just covered marginal costs and have received nothing to cover the fixed costs of the system.

Try a different pricing strategy. Set the price of the Xbox below marginal cost—say $150—and raise the price of games to $25. We can sell one Xbox and two games to the light user and one Xbox and six games to the heavy user. That gives us a total marginal cost of $400 and total revenues of $500. We are making progress, as now we are recovering some of the fixed costs of creating the system. With game prices necessarily about marginal cost, game purchasers contribute to the overall cost of creating the platform. The more games that you buy, the more that you contribute. Whether we can pay for those costs depends on the number of light and heavy users.

Now introduce a third group to the system, Linux users and the ottoman set, who buy one Xbox and no games. For now, assume that they value the Xbox at $189, $11 less than the marginal cost of serving them.

Having them buy the Xbox is a social bad, not a social good. They value it at less than the marginal cost of making it, so we don’t want them to buy. But allowing them to buy limits how we can allocate prices across the Xbox and the games. We can’t set the Xbox price at $150 anymore, as we need to boost prices of the Xbox to get rid of the ottoman types.

So set a price of $190. The Linux/ottoman users drop out of the market. What price will be set for games? At a price of $10, the light user buys the Xbox and one game, the heavy user the Xbox and six games. Total revenues are $470 against marginal costs of $400, giving rise to $70 that we can use against the fixed costs of creating the platform and the games.

But our platform creator would charge a higher price for games. Charge $190 for the Xbox and $18.33 for each game. The light user drops out of the market. The heavy users buys the Xbox and all six games for a total price of $300. Marginal cost is $200, so the contribution to fixed cost recovery is $100.

Note what has happened here. The mere presence of the ottoman users has pushed light users out of the market. Our ability to sustain the platform is the same—with $150/$25 pricing and with $190/$18.33 pricing we get $100 towards fixed cost recovery—but we have lost users. We had to raise prices of the platform to get rid of the Linux/ottoman users, but then we would have had to set low prices of games to keep light users in the market. If those users create benefits for third parties—if light users value use at $200 but they don’t capture the full value of their use, so someone else gets $5 from their use (not implausible in a world of network externalities)—we have inflicted a loss on society.

A bunch of numbers already, so I won’t do too many more. If Linux/ottoman users actually value the Xbox for more the marginal cost of creating it, getting the Xbox into their hands would be a good thing. The $150/$30 pricing structure wouldn’t be sustainable in the face of Linux users who valued the Xbox at $211. Prices would rise at least until we hit marginal cost and that would push the light users out of the market. But we would just be trading one group of users for a second and, at least in the framework of the example, I have no basis for preferring one group of users to a second.

The point of this (extended) example is to try to make clear that our focus needs to be on the consequences of opening up the Xbox for users as a whole, conditional on how Microsoft will respond to the knowledge that the system can be hacked. That means that Microsoft will take that possibility into account in its pricing decisions, and may do so for its design decisions. We may start to see a preference for services over products if freestanding products are more permanently hackable than services which require repeated interaction.

This has been pretty complicated already, but consider other issues. I suspect the Linux crowd would say that Microsoft has closed the Xbox because Microsoft was concerned about creating a cheap computer that would run something other than Windows, and if that is right, we would need to take into account cross-platform competition. And both the Xbox gaming market and Linux market are characterized by network externalities, so we have spillovers to deal with.

Finally, on innovation, two points. First, innovation isn’t an end in itself; it is just a means to whatever metric we are using to gauge social welfare (utility, jollies, happiness). Second, as I hope the example makes clear, we need to focus on all users. In the first example, the possibility of opening the Xbox could lead to the loss of one set of users, without adding any other users, and the lost users could be an important source of innovation. Who knows where the next Red vs. Blue will come from?

[Disclosure: The Law School has received grants from Microsoft in the past, and, I believe, continues to do so.]

Comments

[Ed Felten]

I'd bet that among potential Xbox customers, game players probably outnumber would-be Linux users, perhaps by a large margin. If so, then Microsoft's profit-maximizing strategy might still be to price the Xbox at (about) $150. That's the socially efficient result too, assuming the Linux users value the Xbox at more than the marginal cost of producing it.

[Xcott Craver]

We could apply the same reasoning to people who enter a retail store and only buy the one item advertised on super markdown---foiling the business model of using a loss-leader to entice customers to buy other things.

And we could similarly conclude that those people will raise sale prices and price other consumers out of the market. But does that actually happen?

In practice, I figure that people who are savvy enough and determined to exploit loss-leaders are just not that numerous.

Xcott

[saul levmore]

I think it is even more complicated because we do not know how many Linux users would buy Xbox (or Xbox games or XboxLive)if they could not gain from hacking hacking. More generally, it's hard to think about the welfare of those who would pay more than marginal cost when something is rented, and the cost is really the cost of capital or the gain of using a substitute. So if a squatter or other "trespasser" moves into an empty apartment, we might say this is efficient because the marginal cost to the landlord is close to zero, but in reality some trespassers would, if effectively barred from free use, join the market for renters and make some of these empty apartments full or provide a higher return to capital in the industry. Isn't the same true for Xbox. We might think of all the users as renters, but some are asked to make a fixed payment upfront.

[Tim Lee]

Wouldn't an easier way to accomplish the same goal be through bundling? i.e. require the purchase of two games with your XBox. Linux users who valued the XBox at more than $200 would buy the XBox and throw away the games. Linux users who valued the XBox at less than $200 would be deterred from purchasing it.

Also, it seems like Apple is pursuing the exact opposite strategy. They seems to be charing high prices for the razors (iPods) and low prices for the blades (iTunes).

[Doug Lay]

Why doesn't Microsoft just bundle the XBox with enough games to cross the break-even point? What class of users loses out here? I suppose the users who have enough money to buy the console but not even a couple of games. It's hard to imagine this class is very big. The console also becomes slightly less attractive to the Linux users - unless the Linux users also want to use the XBox to play games, which many of them probably do.

As usual, what irks me about your analysis is that you seem to place no value whatsoever on the freedom of users to tinker with their own property. The only personal freedom I see valued in your analysis, in fact, is the freedom to contract away your rights as simply and conveniently as possible.

...oh, I see Tim Lee beat me to the punch regarding bundling. I'm not surprised :)

[Roach]

This is all very interesting, but can someone explain to me why Ghost Recon 2 is so much worst than the original Ghost Recon. This makes no sense from any economic incentive standpoint.

[Bruce]

Fascinating post. There's another interesting wrinkle here, which is that Xbox 360 games are somewhat different from Gillette blades because Microsoft doesn't actually make or sell most of the games. See this site:

http://www.xbox.com/en-US/games/xbox360games.htm

Instead it appears to get revenue from non-Microsoft games by entering into a license with game publishers. But that raises a question in my mind: What forces publishers to buy a license? Microsoft asserts that all Xbox 360 games require a license -- see the text at the bottom of this page:

http://www.xbox.com/en-US/dev/regdev.htm

But saying that doesn't make it so. Gillette no doubt would like to license generic blades. I can't tell what Microsoft's licensing "hook" is -- what the asserted IP is that must be used by a prospective developer/publisher. I found an old version of the Xbox Publisher License Agreement here (which has been jumbled with some Nintendo language):

http://contracts.corporate.findlaw.com/agreements/bam/xbox.license.2000.11.28.html

It seems the only things being offered are an opportunity to enter a Software Development Kit license (2.3) and the ability to use Microsoft trademarks (3.1.1). Perhaps marketing a compatible game without using the Xbox logo would be too difficult, and/or perhaps the SDK is such a time-saver that most developers feel compelled to use it to keep costs down.

But if Microsoft's licensing "hook" is not an insurmountable impediment to developing Xbox games, then a game developer could make games without paying Microsoft anything -- in which case the loss leader would turn into a plain old loss.

[Patrick Dunn]

Isn’t it a bit inconsistent to cite Rooster Teeth Productions as a prime example of technological or aesthetic innovation three days after supporting a copyright licensing system for YouTube that, if applied to online content generally, might well have had the potential to stop that innovation back in Burnie’s drunkgamers.com days?

Accepting the economics above for the sake of argument, is there any reason to believe - strictly looking at the segment of artists/pirates rather than general video game playin’ utility - that the marginal increase in the number of potential content-transformers through market efficiencies will outweigh the increase in the costs of creating such transformed content through potential liability for hacking, installing new software and hardware, or generally monkeying about? What happens when innovators don’t get permission from Microsoft (or Bungie)?

PS: For my two cents, the Ghost Recon 2 story revolves around a growing incentive to channel production values toward online multiplayer content, where player interactions provide not only revenues for the entity providing connectivity but also better reasons for players to purchase add-ons, to create and maintain a group, to enjoy replay experience, and to put forward the game-specific capital that might justify the current pricing scheme. Also, you’ve got to think Ubisoft wanted to respond to market demand for a simplified command system, despite the accompanying degree of control loss.

[Brent Tubbs]

Bruce: A couple months ago my law school (USC) had a guest speaker, a lawyer (Barry C Seaton) who works in the video game industry, speak to us about the questions you raise.

From his comments, and my own speculation, I think there are two things compelling game developers to pay the license fee. (1) Given how few players there are in the industry, they want to stay on good terms with each other. (2) Consoles will only run code that is digitally/cryptographically signed, and if you hack that signature, you might be violating the DMCA.

[Bruce]

Thanks Brent; that's helpful. Re: point 1, that's a good point, and probably explains why no one with substantial resources (or who wants to have substantial resources) would do an end-run around MS -- as long as the royalty being charged is not too onerous, anyway. Re: point 2, I've been wondering when that's going to come up in litigation as the sequel to Sega v. Accolade and Sony v. Connectix -- pre-DMCA console/game reverse-engineering cases from the 9th Circuit. (Davidson was not that sequel.) I think in many cases the game publisher would have a good 1201(f) argument -- but it has yet to be tested. And, reverse engineering is hard.

[Xcott Craver]

Another matter that determines if companies take the license agreement: how much does it really matter to them either way?

In Sega v Accolade, Accolade bypassed the license agreement because Sega wanted certain exclusive rights over the games. IIRC, Accolade wanted to port over their existing games, a plan which was incompatible with Sega's license terms. Basically they could reverse-engineer the console or hit the road.

If MS is only asking for money, and not enough money to really stress game companies, they may never consider doing it the hard way.

[Jhn'1]

Well if your bundling were to include a single game, it would be transparent for the Xbox gamer. They have to aquire (presumably buy) at least a single game to upgrade from ottoman to a game console. It would change the advertised price from a "bare" console up to a console and basic game. I doubt that many purchasers never buy a single game, and by tour model, Microsoft doesn't want them as customers anyway.

[Steve R.]

Fascinating discussion. My feeling are along the lines of Xcott and iTunes. In a capitalistic system, if you do not effectively price your product, too bad.

To explain further; once the product is "sold", the manufacturer should have no further interest in how the product is actually used. Unfortunately, we are moving in the direction of asserting that products are no longer sold but are actually licensed to be only used under certain conditions unilaterally imposed by the manufacturer. This is wrong.

[Former Chicago student]

I think one aspect you failed to take into account is that public policy also needs to recognize probable future outcomes.

The reality is that the Xbox will be hacked. There is no way to prevent this from happening...nothing Microsoft can do will really prevent it. What Microsoft and the government can do is reduce the probability that such a 'hack' becomes widespread.

There are several famous quotes from technology executives to the extent of "People don't hack hardware", which have been proven to be dead wrong. Even for obscure products, like Transmeta's Crusoe processors, this was wrong. Clean room reverse engineering is rather easy with current tools...it's something almost any EE graduate student can do in a relatively short period of time.

A reasonable debate should be predicated on probable outcomes. I'm not sure that is really the case currently, since it appears that most law makers don't have a bloody clue.

Also, while US policy may prohibit it, foreign laws likely won't (think China). Uneven global enforcement of such laws may be functionally equivalent to no enforcement (i.e. a market for modded Xbox's imported from China will likely develop).

Ultimately, this seems like a problem that can only be partially solved by legislation. A real solution would require appropriate pricing by microsoft and legislation.

Also, there are actually two separate issues here. The big problem with folks hacking the Xbox is that they can then pirate games easily. A lesser problem is installing Linux on the xbox. One is probably an order of magnitude (or more) greater than the other.