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.


David

I agree with Kent (#10) completely. It's the size of the price drop, and the fact that it happened so soon after introduction, that created the backlash.

While it may have been profit-maximizing in the short term, making your most loyal customers feel cheated and abused is not a very good long-term strategy.

Jake S.

Keep in mind that this is not a straight up rebate or refund, it is a coupon to use at Apple stores for their products, hence, it will not be as profit smashing to Apple as one might think. BTW, Apple had plenty of stock of the phone after the initial allocation, they weren't merely setting price to meet supply restrictions. Plus, unlocking is about to be unleashed...but no 3G, can't believe more people didn't wait for the downtick in price.

Anne

I think there's an element of conspicuous consumption at play here. The iPhone is, or at least was, a status symbol because of its high price. It loses its value as a status symbol when Apple drops the price. (The price drop also hurts its residual resale value, but of course this is less significant with a technology item that depreciates rapidly anyway.)

DanC

If Apple had not charged a high initial price, you would have seen a resale market for iPhones within hours of introduction. Apple priced to grab the frenzy market.

Look at concert or sports tickets, once upon a time sellers underpriced and helped create black markets. Now they charge a variety of prices to capture as much consumer surplus as possible.

The sudden dramatic drop was a mistake because of the timing. Dropping so far so quickly will teach many consumers to wait when Apple introduces a new product.

If Apple was smarter then should have offered bundled services with a more modest if any price cut. A deeper discount if you order more text messages or a free trial. Or a new iPod shuttle with purchase of iPhone. They could have made the drop in price less transparent and made more people happy.

Brian

#16, interestingly, there is a clothing store in the NY area called SYMS which does precisely that with many of their higher ticket items. The price tag on the garment has a price schedule, where the price goes down every week. So you have to weigh your desire to get the item at a lower price against the chance that there may not be any left when you go back.

John S.

@ Yoshi

You are correct, it could have been tongue and cheek, if it was then I missed that on the initial read.

In response to the article I think if anyone decides to put a large degree of trust in a 100 billion dollar plus corporation they are severely misguided. In general the cell phone market sees severe drops after release for all phones. They mostly aren't carried in the American markets though because of the tight control the telecommunication companies, so we don't see it first hand as often. Apple likely just made a calculated play based on information they have and we don't. But the way it went down it certainly is viewed as a misstep.

-John S.

BA

In addition the coupon, Apple should give AppleCare to the people who bought the iPhone at the higher price. It will not cost them that much and it will feel like a real benefit that will even out the discrepancy.

al

I think the anger on the Internets is limited to a tempest in a teapot of people who follow Apple news every day. The million people who've bought iPones so far were not all sitting at their computers hitting 'refresh' all through Steve Job's keynote and then furiously blogging about how they are upset about paying the original price.

Not to mention that Apple gained a lot of good press among the same crowd for the $100 store credit just in time to spend it on one of the new iPods.

Conor

Apple had to drop the price to compete in the cellphone market. No one has ever paid full price for a phone until the iPhone. Everyone gets some sort of break for signing a contract with the provider. So when the initial flurry of technophiles waned, they dropped the price to entice more cost sensitive buyers. They should have played the game the same way as the other phone manufacturers and left the price muddled behind contractual obligations of the provider so the real cost of the phone may be different amongst buyers but not obviously so.

Drew Thaler

I think it's likely that Apple had the coupon strategy worked out all along. Granted, Steve Jobs is a dictator and dictatorships are terribly efficient at fulfilling their leader's desires, but it really seemed to happen way too quickly. Jobs has his finger on the pulse of the tech industry -- of course he knew that a $200 price drop after two months would piss people off, and he had his response ready. Cringely's analysis is spot-on, except for the weird psychological stuff he attributes to Jobs.

Let's simplify it to three possible coupon values: $0 (no refund/screw you), $100 (half credit), $200 (full credit). The first angers customers too much, the last is suspiciously generous and would have people looking for the catch. The middle ground strikes a balance -- it gives the company some points for generosity without making anyone wonder too hard why it sold for $599 in the first place. And as any restauranteur will tell you, it costs almost nothing to give out a gift certificate because you'll tend to get back more in extra business than you give away.

Oh yeah. The other benefit of option 2 over option 3? Apple gets to keep an extra $100 million dollars.

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JDJ

I don't understand how people can be upset. They made the decision that having the iPhone was more important to them than having $600. They have no right to be upset when the price changes.

Alan

Reading this post makes me wonder if the esteemed Mr. Levitt is at all familiar with actual research being done on pricing and technology adoption.

First, any introductory marketing textbook will tell you about two dominant ways of pricing new tech products, "skim pricing" which is what our theoretical economist proposes above, and "penetration pricing." There's something headscratching about Levitt's theoretical economist not contemplating a trade off between Q and P.

Second, a relatively dominant name in technology adoption these days is Bass, whose basic theory says that adoption follows information diffusion, not pricing patience and willingness to pay. Economists who subscribe to this theory would argue that opposite pricing strategy. (There remains a meaningful debate over whether WTP or information is really driving adoption.)

And if you don't think firms can price in future learning curve economies to their initial price, you're severely underestimating them.

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Travis Stoliker

"So why did this strategy blow up in Apple's face, " Who said it did? I don't agree w/ your premise.

Joel

I think you're missing something here. It's something of a standard Apple policy to offer such refunds. When there was a price cut for the Mac Mini just after I bought one, I was able to get a credit for the difference by calling customer service.

Sure they don't ADVERTISE this policy but they will do it :)

Hoyt L Kesterson II

I have purchased three V1.0 products. Two were the original Tivo and the recent HD Tivo. The third was the IPhone on the first day (but no standing in line; it's too hot in Phoenix). For each of them, I paid the premium price. And each of them became available for a cheaper price. I'm not angry and I don't regret acquiring them. They made me happy.

I used to work for a mainframe company. If we were first in the marketplace we set initial margins high to quickly recoup R&D. Then we lowered prices to meet competition. If we were good, we set the new lower price before the competition could.

I think Apple did just that. When the knockoffs come they won't be able to set their price comfortably under $600. They will have to find margin at under $400. Sony never understood that for their betamax.

I suspect Apple may have been pleasantly surprised at how fast the iPhone was embraced. I'm sure they wanted it but it was their first foray into the phone market. Such adoption at high margin must have offset R&D cost significantly and allowed them to reduce price in time for the holiday season and well before a competitor released a less expensive alternative.

The only thing I think Apple did wrong was announcing the price cut at the coming-out party for the new iPods. I would have let them have a few weeks on the stage by themselves before announcing such a significant price cut but I must admit I don't know the lead times necessary for getting products set for the holiday sale.

The only reason I was bothered by the price cut because of the nonsense one will take from some people - if you were so smart to get one of them, why weren't you smart enough to wait? The rebate takes a little of the sting out. It's going to cover a significant part of the cost of Leopard in October. I had already planned to buy it; in fact, I need to cancel my order with Amazon.

I am still happy to say iPhone I own (with apologies to Dr. Seuss)

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Terry

Apple sent a clear message that the iPhone was not competing on price vs. performance. They had the best selling handset at $599 because of amazing design and integration of hardware, interface, and software(iTunes).
As for the rebate, when I ordered my 4gig iPhone for $299 I felt $200 smarter than the early adopters. Now because I feel only $100 smarter, does Apple owe me $100?

Browning

Remember the wizards at Polaroid: A high-priced new model for every Christmas, with lots of slick features, followed by a March model slightly less fancy, slightly lower price, and so on through the year until next year's Christmas trick was introduced.

Sam

By offering the $100 rebate, Apple is inviting the iPhone adapters to use the $100 towards another post-100 dollar product. Other than the Shuffle, the cheapest iPod is $150. By offering customers a $200 rebate, Apple could essentially have given away 1 million iPod Nanos, or significantly reduced the profit margins on the iPod classics and albeit not much of an issue with iPhone users, the iPod Touch as well.

Jorge Pareja

Then, Where it is core the neoclassical economics Theory that You teach daily? So,
Let us begin to look for new alternative realistic assumptions baseline for microeconomics theory.

regards,

Kathleen

So, even though every other cell phone company does this routinely (Motorola Razr listed at $500 originally, dropped by $200 two or three months later, and I got mine for $50 less than a year after they came out), Apple takes the blame? In fact, almost all electronics work this way. Yes, the timeframe is offensive, but even that is not a first.

If you're an early adopter, you're going to pay more. This isn't back to school shopping - there's no discount for being early. You're paying to be the hippest, coolest kid. If you pay the money, then get mad, that's just childish - you can't stand that your precious is now available to the plebian masses.