This time around, Microsoft Corporation (NASDAQ:MSFT) and Sony Corporation (ADR) (NYSE:SNE) are fighting to remain competitive. Sony Corporation (ADR) (NYSE:SNE) launched its opening round with a $100 price cut that Microsoft had not anticipated. Let’s look at how this could play out.
Revisiting the past
Source: Microsoft
If you look closely at the chart, in the previous console generation, sales shot through the roof in the first year. The PlayStation 3 was priced at around $100 more than the Xbox 360 in the beginning years.
It seems that Microsoft Corporation (NASDAQ:MSFT) is pricing its console more expensively than Sony in order to capitalize on the anticipated pent-up demand for year-one sales. This is likely to lead to higher gross margins for Microsoft in the 2013 fiscal year.
Microsoft and Sony: Game theory
Let’s apply the theory of oligopolies to Microsoft Corporation (NASDAQ:MSFT) and Sony Corporation (ADR) (NYSE:SNE). Firms will have similar input costs. At Nash equilibrium – the point at which profits would be optimized – both firms sell the same or similar products at the same price and the highest price possible. Right now, if PlayStation 4 and Xbox One were both priced at $500, that would be considered the Nash equilibrium point because that’s the point at which profits would be maximized for both Sony and Microsoft.
Looking at the historical graph, first-year sales are always explosive. Sony Corporation (ADR) (NYSE:SNE) in the previous generation had a $100 price premium and still sold out. However, going into this current console generation, Sony did what Microsoft Corporation (NASDAQ:MSFT) did in 2005. It lowered prices first. In a Duopoly Payoff Matrix, one firm will intentionally lower prices in order to punish the other competitor.
There are two factors that a firm can control, which include production and price. Sony will increase production and sell at a lower price. Microsoft Corporation (NASDAQ:MSFT) will decrease production slightly, and increase its price. This will offset into what I would call dis-equilibrium. Microsoft will earn larger profits because Sony Corporation (ADR) (NYSE:SNE) would find it literally impossible to increase production at a point that could make up for the 20% decline on gross margin.
Eventually, in the theory of oligopolies, one firm will eventually have to lower its price down to what the other competitor is priced at. Chances are high that both will remain profitable. PlayStation 4 will have had a higher quantity of units sold, while the Xbox One will have more profit in the bank account (first year).
Following the holiday season, I find it extremely probable for both Xbox One and PlayStation 4 to be priced at $400 because this will be the new equilibrium point (point at which the market clears).
Microsoft Corporation (NASDAQ:MSFT) must lower prices in order to remain competitive even if it means a loss of profit. Following a price drop, neither company can raise the prices back up.
Sony breaks even
Let’s remember the sequence of events. First, both companies were able to observe each other’s products. At the E3 press conference, both companies’ decided to unveil the price.The Sony Corporation (ADR) (NYSE:SNE) spokesperson stated that the process of determining a price point takes many weeks if not months of effort (which is true). But what he doesn’t mention is that most of that time is determining the break-even point, and determining the point at which profits can be maximized.
