Wood has it exactly right. The idea behind consoles is that you plot the overall cost to manufacture a unit, including labor and logistics, then you project ways in which these costs will increase or decrease over time, then predict your sales over time. If you do all this correctly, you can plot a price point where you lose money initially, make money towards the end, and break even overall. In true “razors and blades” economics, you make money on the margins that you get selling accessories, games, DLC, etc.
Does the console become cheaper over time? Yes. Does it become lower quality over time? Not necessarily.
Take one minor aspect of the Xbox 360 for example. Here’s a link to an article
I wrote years ago.
As you can see, the power supply went from 203 watt to 150 watt (it’s down to 135 now) over the course of a few years. This is because the efficiency of some components improved over the years, yielding more efficient (and possibly quieter and more reliable) consoles that required less power. In turn, the power supplies became lighter because they just didn’t need to be as big. Even if you assume the cost to make these changes stayed constant, the overall weight of the console and power supply in the package went down which in turn reduced the shipping weight of the console, allowing the console to reach the stores a little more cheaply than before (ignoring global changes in the cost of freight.) We saw this with Atari consoles and home computers very early on. There was no FCC “class B” so Atari had to use a ton of metal in the shielding, yielding the original “heavy 6er” that cost a lot more than it should have, due in part that shelding - and it cost a lot more to ship. Later, when "class B" was adopted, the Ataris became lighter with no impact on quality.
It was a shock to see Nintendo choose to drop the 3DS price so much and so fast. That may really cause them to lose money over the life of the handheld. That said, they’re still going to make money overall because most of their money is coming from content for the device and the licensing fees. They may also be privy to some information that we don’t have. For example: they might know that production of a certain component is going to get much cheaper than previously thought. I remember about 4 years back there was a new plastic extrusion process introduced that integrated the glossy coating and pigment into one pass much more cheaply than the two pass process used by most manufacturers. So devices that use the “fingerprint magnet” glossy back plastic cases (think PS3 and HDTVs) suddenly became a little cheaper to produce.