Should Apple Burn Its Economics Textbooks?

If you ask an economist how to price a new product that is just being introduced, the response you will get is that you should charge a very high price at first and then steadily reduce that price over time.

There are two reasons for doing this. First, it generally gets cheaper to produce things over time, so it makes sense to lower prices in response. Second, people vary widely in their willingness to pay for a new gadget. By starting high, you get as much money as you can from those who really want the product, then expand the market at the lower price point.

Hmm … that sounds exactly like what Apple just did with the iPhone. They brought it out at $599, sold one million iPhones, and then dropped the price to $399 after two months, in the hopes of selling nine million more this year.

So why did this strategy blow up in Apple’s face, leading them to offer a $100 coupon to the early adopters, many of whom remain irate despite the rebate?

What economists (and Apple too, I guess) ignore is that consumers hate it when companies follow practices that look like they are designed to maximize profits. You won’t find it in economic models, but consumers care about the reason a firm chooses the price it chooses. If a firm raises prices because something happens to make it more expensive to supply the good (e.g. oil prices rise, so the price of airline tickets goes up), consumers are accepting. If a firm raises prices because they cannot make enough of the product to satisfy demand (e.g. like they should have done with the Wii), consumers are likewise understanding. But when prices are raised and lowered strictly with the goal of extracting the most possible from consumers, people get upset. Apple’s price cut looks like one driven purely by a desire to maximize profit, which is why everyone is so mad.

Of course, just because people are mad, it doesn’t mean that Apple did the wrong thing (although consumer anger is usually a pretty good indicator of a mistake). Would Apple have been better off in the long run if they had introduced the iPhone at $399? Probably not. If they sold one million phones at the higher price, then starting the price high allowed them to extract an extra $200 million in profit from the early adopters. Sure, they gave them back a $100 coupon each, but it is only for Apple merchandise and many of these coupons will go unused, so the real cost of the coupon to Apple is much less than $100.

What could Apple have done differently? One very simple thing would be to have offered a $200 coupon to the early adopters. It wouldn’t have cost Apple that much more, and it would have made it much more difficult for early adopters to remain angry. Why go halfway? The company also could have waited until the new version was available and timed the price change to coincide with the introduction of the fancier version. A new, updated product makes it seem like the company is learning how to make iPhones better, so it would thus be easier for consumers to accept a price cut on the original. Seth Godin has far better and more creative ideas about what Apple should have done for early adopters, like give them special perks such as first place in line for future Apple products.

Prices are fundamental to economics, yet we don’t have good models as to why consumers respond differently to price changes depending on the reason for the change. That would be a great subject for budding young economists to tackle.


jroxz

Serves all of them right for being herded like cattle.... Moooo

Nick

No one who buys consumer electronics really expect prices to stay the same for long. Its not unusual to see the price of something decrease by 50% over a year. What I think got people so angry about the iPhone is that Apple rarely reduces the price of their products. Sure they'll give an ipod more storage and sell it for a higher price, or after a year of being out, they'll cut $50 off the price of an iPod, but nothing like the cut throat price reductions other companies need to survive. So when Apple does an about-face and slashes the price of an extremely popular item, sure people are going to be mad, it caught them by surprise.

discordian

Wondering... do restaurants work opposite this theory of start high and reduce?
Seems to me that if a restaurant starts high, perhaps in an effort to recoup startup costs quickly, they seem to generate less business and less buzz (exceptions being trendy hipster places) and often don't make it a year.
I've observed this a lot in my town (in suburban NJ).
When the restaurants start priced at or a bit below competition level and then gradually raise the prices in accordance with how busy they get, they seem to succeed more often.
I'm talking local privately owned business - not chains or franchises.
No data of course - just watching lunch places in my town come and go.

Reid

Bob Cringely has a much different viewpoint; mainly, that Steve Jobs knew what he was doing all along.

http://www.pbs.org/cringely/pulpit/2007/pulpit_20070906_002891.html

Travis A. Sinquefield

I don't think Apple would have been better off to charge only $399 in the beginning. It is an issue of supply vs. demand. They only had so much supply of the iPhone, and if they offered it at a lower price, the demand would have far outweighed the supply. People would have been writing about how mad they are at Apple for not having enough supply. Instead, they charged a higher price, had enough supply to fulfill demand, and everyone who wanted one in the beginning got it.

Zachary Pruckowski

Something not mentioned in your piece that is relevant was the simultaneous introduction of an iPod with about half of the features of the iPhone (similar OS, wireless, touchscreen, browser) at $299. A $300 markup for only a few software programs (like Mail) and interaction with AT&T is not going to sell well, especially considering how easy it is to hack the iPhone (and presumably the iPod Touch).

Chuck

While I think this post is somewhat accurate, I couldn't disagree more with the counter examples. Airline travelers have been accepting of price increases!? Please. I'm sure DEMAND is still high but satisfaction is at all time lows according to things I've read. I think the real point is that people can be mad yet accepting because of price.

Enough Wealth

It's not the price cut of an electronic product that got the early iPhone adopters upset, it's the fact that it was APPLE that did a price cut. As a previous comment noted, Apple rarely does this.

Keeping prices high is part of the mystique that has driven apple devotees to overpay for good product for years. I'm sure that many of the 1 million early adopters are more aggrieved that 9 million other folk will be able to buy an iPhone, not the price cut per se. It's the loss of "wow factor" and exclusivity that usually grates with apple consumers.

Regards
http://enoughwealth.com

ps. I'm still chuckling over the way all the mac magazines suddenly stopped using their favourite put-down expression of "Wintel" PCs as soon as apple started producing "Mactels" ;)

Craig Stacey

My guess is that Apple wanted to unveil a new fancier version at this same event, but it wasn't ready yet. People have been grousing about the radio in these phones and how spending a lot on a phone that's not 3G is silly.

Apple wanted these price cuts in time for the Christmas selling season, and the 16GB 3G version of the iPhone wasn't ready to go along with it.

(Expect the 16GB to go for $599, natch.)

Kent

I think the major issue was how quickly and steeply the price dropped. It dropped 33% in less than 3 months.

If they had lowered it by 10%, consumers would have probably been ok.

Or if they had waited a 9 months before dropping it by 33%, consumers would have been ok.

It's definitely entertaining that a price drop would cause outrage instead of glee. I'm not sure why he dropped the price unless sales had slowed down a lot more than the public knew about.

Nick Bond

Also, to add to what Levitt said about the apple rebate, one of the writers on i believe it was Gizmodo brought up the point that with the rebates, they have to spend it at the apple store, online or in person, and anyone that has ever bought anything from apple (myself included, i'm on my fourth apple machine and 3rd iPod) knows that you can't really buy ANYTHING from apple that is less than 100 dollars, so they may even increase profits even more because it adds incentive for a person that was already looking to get something like a MacBook or iPod Hi-fi or something like that

Eric

I live by the rule: "Never buy the first generation of ANYTHING"

John

As an early adopter, count me among those who were upset by the combination of the size and speed of the price decrease. Of course, no one expects Apple (or any other company) not to offer discounts to move more product at some point after the initial launch, but so fast and so soon? As you point out, it felt (to me, at least), like Apple had -- intentionally or not -- gouged the early adopters.

To those who say, "tough, you early adopters knew what you were getting into, serves you right, etc.", I say you are missing the point: Apple benefited greatly from the positive buzz created by the long lines and the high reported satisfaction of the early adopters. By alienating them, Apple has ensured those future lines will be shorter and the buzz a little less enthusiastic.

Luis Jerez

The buzz on the iPhone probably made a lot of people angry when the prices went down in less time than the new update saw coming. No one wants to feel ripped off. No one wants to hear a friend say, See if you should have waited a little..., like me! But I believe this is another case of just having the gadget for keeps not just for functionality and history repeats itself again.

Lee

Apple could have followed the marketing strategy of Scholastic Books for Harry Potter books. Knowing there is a big demand, they could have taken pre-orders or pre-payment for the iPhone. Those who want it so badly would have obliged and they could have a better indicator of the demand. I was tempted to buy the iPhone when it was introduced but came to my senses that the premium was too much. I seldom buy products with rebates because it shows that the seller is still padding their margins. Now we know how much bragging rights to owning an iPhone is worth - $200.

Rocky

Perhaps companies should publish their future rate schedules at the introduction of a new product. For example:

Week 1, $599
Week 2, $549
Week 3, $509
Week 4, $479 etc. . .

Knowing in advance, the consumer then has to make a decision on the opportunity cost of having the new item vs. the cost of waiting one more week. There most certainly will still be people buying the item at the highest price. Perhaps it isn't the company's motivation in price changes that angers consumers so much, as most consumers realize companies are designed to make money. Perhaps the issue is the lack of communication. I, for one, would be quite frustrated if I had bought the very last iPhone to sell for $599.

John S.

"They brought it out at $599, sold one million iPhones, and then dropped the price to $399 after two months, in the hopes of selling nine million more this year."

It has been widely reported that their target is 10 million phones by the end of 2008. I didn't finish reading your article because it has such a glaring factual error.

-John S.

jeffg

People are irate because of who they are. Anyone who feels the need to jump on a bandwaggon and purchase the iPhone in its first two months is probably missing a few bricks short of all full load to begin with. So we have less than rational people showing less rationality by being upset at a price decrease. this is a surprise? It has nothing to do with the reason why, it is simply an emotional reaction by people who have already proved that they are guided by their emotions.

yoshi

@John S.

Ah no - I think that comment was tongue firmly in cheek so why don't you try again?

I bought the 8gig iPhone the first day. I fully expected prices to go down because that is what happens in technology and especially in the mobile device market. But ignoring that those that bought the phone the first day had the money to buy the phone and wanted it badly enough to pay the high cost of owning the phone. So I am not sympathetic in the least to those crying foul over the price cut.

Cry me a river. And I take issue with this "blowing up in Apple's face". It looks like they will come out far ahead with this move.

Cliff

I bet that Cingular has more to do with the price cut than Apple does. Think about it. For every phone Apple sells, Cingular gets 24 x 60 or $1,440 in revenue. When the iPhone came out, it came unsubsidized and a lot of people have been sitting on the sidelines, because of the high price.

I think Cingular may have said, Hey, we'll give you money for each phone if you lower the price. It's only natural. Cingular wants that revenue.