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.


ben

I'm commenting from the perspective of the consumer. $600 was just too much for me. the price break is really pushing me. I have to believe there are many others like me.

complaining on the internet is so overblown. it just feeds upon itself. but i think Jobs was smart in throwing them a bone. when was the last time a company did that? that bone he threw them was brilliant as well.

this premium price people keep talking about... have we somehow missed the point in that 400 is still a lot of money? especially in the free-$100 phone world. I keep using the "it's 200 less now" rationale and I have to keep reminding myself that 400 is still a lot of money. It's not like the iphone suddenly wound up in the 99 cent store.

I think a lot of teenagers are going to use this as leverage to get their parents to buy them one. People in general are going to use this as a rationale for a really nice gift... because it's $200 less that it normally is. There were a lot of people when this phone came out that said they would buy it if it weren't so much money. and that logic is going to overshadow the price point which is still high.

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James Roane

What I haven't seen asked yet is why did Apple reduce the price by $200.00 at one time. They could have reduced the price over time, say $50.00 now, $100 in November for Xmas and another $50.00 in Janaury for example. They certainly could have used the same pricing strategy for the Ipod Touch, pricing more like an Iphone than an Ipod.

Davey

This was a botch job of near-New Coke proportions. Both Coca Cola and Apple have legions of loyal customers, Coke because it is so entwined in our national identity and Apple because it is such a fantastically innovative company. Apple vs. Mac has been a debate since long before the commercials, with the Mac users remaining steadfast to their brand.

Apple has been on a roll these last few years, but they may have just screwed the same pooch that Detroit's carmakers screwed decades ago. Apple just taught their customes that if they wait long enough, Apple will come to them on price. And their customers may not even have to wait that long. Anybody out there willing to wait in line overnight for the next Apple gadget to hit the stores?

such.ire

I've got to agree with Marginal Revolution on this one. You iPhone buyers decided that your $600 wasn't worth as much to you as having an iPhone. So by buying an iPhone, you gained on the trade. As they said, "Enjoy your consumer surplus" (i.e. what you gained from the trade). If "what you were buying" was the "I can spend $600 on a phone" social status, then perhaps in the future you'll learn to spend your money on something a little less volatile than a cell phone; say, a car, an expensive suit, or a huge house.

Buck Minster

@Davey : "Apple just taught their customers that if they wait long enough, Apple will come to them on price"

so you're saying that until this week the 10s of millions of iPod owners did not know that iPods became cheaper over time? Wake Up.

As far as waiting in line - the next time Apple comes out with something as 'fantastically innovative' as the iPhone, yes, there will be people waiting in line. Price has nothing to do with it.

Wonderful comparison to Detroit's carmakers - those car companies just kept producing inspiring, innovative, revolutionary cars, yet they still struggled. I see the parallels to Apple already.

Patrick

This whole "fiasco" is so silly. This has nothing to do with the 30% drop and everything to do with the fact that it was a price drop on the iPhone, a $600 luxury product. If Apple had dropped the price of the Shuffle from $79 to $56, three months after release, I'm sure there would have been cheers all over of how great Apple was. But since this was a luxury product for the exclusive few who could afford it, the price drop suddenly lowered their "geek cred." I love all the Apple products I've bought over the years but the sheer hypocrisy of some of its fans is really shameful. The same ones who proclaim how great it would be if the entire world used Apple computers secretly hope that such a thing will never happen.

Anne

@James Roane: Maybe they aren't done and it'll be $199 in time for Christmas.

mac84

This is about supply vs. demand and an introduction with prices 6 months in advance of product availability. Apple announced the iPhone and prices in January. Once the media frenzy began, they couldn't announce a price cut too early or there wouldn't be enough product to go around.

Obviously, assumptions were made about component costs which turned out not to be true. Apple cited depressed flash NAND prices for their record profits in their June quarter and on their july 25 conference call provided investor guidance for lower profits in the September quarter partially due to expected higher flash prices. Here it is September and flash is more depressed than in June. Thus, lower product costs, lower price.

I agree with Cringely that Jobs knew the backlash was coming and pre-planned the$100 rebate bone. (I disagree with Cringely that Jobs did it as some sort of ego trip). But the timing of the announcements was planned, it did get Apple on the front page of every business section in the country -- two days in a row.

This is all about a healthy Apple and Apple is looking over its shoulder with all the talk of Google phones and Zune phones. Apple learned its lesson when it didn't cut the price of Macintoshes while Microsoft was struggling with Windows 2.0 back in 1987.

It is what Jobs said it is, Apple is looking for an early knockdown punch, just like it has done with the iPod. And if the early adopters feel alienated, so be it.

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Caleb Powers

In reference to the comment about the SYMS department store giving a list of when prices would be marked down, that practice was always historically associated with the old Filene's Basement, where Filene's department store in Boston put a tag on each item with a list of prices at different dates; the price would drop each week until the item sold, and on the last date, it would be given to charity.

Presumably each week that you wait is a week in which someone else will buy the item and you won't get it. That's not true with iPhones. Anyone can get one, and if they gave a list of price drops, few people would see the utility in paying a higher price now when they could continue to use their own cell phone for another month and then switch at a lower price.

What made the Filene's Basement system work was that last entry: Give to charity; if you wait too long, it's gone. Something tells me that won't happen with iPhones.

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John Faughnan

I suspect Apple will do fine with all this. They sure kept their name in the news, didn't they?

I didn't buy an iPhone because it doesn't meet my minimal requirements list (unlike, say, the much missed Samsung i500). The minute it does I'll buy it, hang the price.

I wonder though, what happens if Apple introduces the 3G phone in February/March of 2008 with the features I want. EDGE to 3G is a huge jump, and buyers of the 1.0 phone will again be very unhappy. Unless the 3G phone debuts again at $599. Then the 1.0 owners won't feel quite so bad.

For me, if they deliver the phone I want I'll pay the $600, and I won't moan if the price drops 15 days later. Hear that Steve? Just give me the Samsung i500 features and take my money. Please.

hardmanb

Apple always planned most of their "10 Million sales" goal from foreign sales. Why is it so strange that now that Apple is contracting with European carriers and preparing to introduce the product to (more sophisticated) European consumers...that they give the product a major boost with a giant price change?

The sudden price drop, just before Christmas will not only drive sales, but delivers a kick to the kneecaps of the competition's "iphone killers". Will Nokia reduce the $750 price of their N95, now that it costs twice as much as an iPhone?

Also, it drives momentum for Australia, Canada and all of Asia to line up for this product that will encourage many more consumers to change carriers than at $599...increasing attractiveness to carriers.

Apple's introduction to the US market is already on track and exceeding targets...their eyes are now on markets in Europe and Asia.

Bertil

> You won't find it in economic models,

That's *neo-classical* models; many models consider it, and there are an increasing number of published estimation of similar effects, including in the AER or by Nobel-laureate: no need to label them as non-economic fringe anymore. It's not surprising from Chicago economists, but you seem to generally ignore non-classical explanations—too bad for you, as you miss a great source of inspiration and critic.

Regarding restaurants, like technology and cultural goods (see the comment on Harry Potter), they are *experience good*: you can't tell their value unless you tried. This can be because everyone had different preferences, or because the service is new, or the market is lacking trustable institutions. There are many coping mechanisms: critics, guarantees, coupons, sampling, serial, etc. Status through a high price tag can only work if most user can't estimate the value and the high price is well known; an impulsive, socially conscious artifact like a cell-phone matches that scenario quite well—especially in a country where most people have generally tried and owned a couple other phones: undue hype is less likely in a more developed country like Japan.

The quality of the food at local restaurants is easily valued (be there once, having ate other meals before), once the patrons are used to enjoy a meal there, their visits won't probably be less frequent if the prices go up—but they have to try.

With different settings, things can be completely opposite: I live in a very touristy area, where people come for the food. Most restaurants are terrible, with amazingly high prices: whatever they think about the food won't really impact the length of their stay, and fellow travelers will just continue coming (themselves included), thinking *they* can find the good restaurants.

A Market for Lemons, by Akerloff is the best introduction to such issues.

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Davey

Bucky, Bucky, Bucky, Bucky, Bucky...

Apple just demonstrated, as did Coke and the Detroit Three (no longer the Big Three), that if you take your customers for granted, you pay for it. In this case, $100 million worth of coupons (likely less, since they either won't be used or they will be used to buy an iPod cover. Either way, it still shows up as a liability in their financials.) It also cost them an unknown amount of goodwill. If they repeat this mistake again, they will pay for it. They did before, you know, and it took them about 20 years to recover from it.

And I'm still trying to think of the last "inspiring, innovative, revolutionary car" to come out of Detroit, something on a par with the Mac or the iPod. Uh, the Ford 500?

Michelle

I bought the iPhone a few days after it came out and I wasn't upset at all by the recent price reduction. The iPhone was worth the money to me when it came out, so I have no regrets. I didn't buy it because I thought the materials used to make it were worth that much. I bought it because it's delightful to use and no phone has ever been like that for me before. I knew I was buying their design innovation, and that's not based on the supplies market.

It feels like I just got a free $100 worth of music and video content for nothing. Yay! A sunk cost is a sunk cost, right?

Btw, I don't own a nice car, trendy clothes, or any designer merchandise. The iPhone isn't a status symbol for everyone.

Ken Cheng

Funny, I sent a question about the iPhone pricing, and more about the ethics of iPhone buyers using their 90 day purchase protection warranty from the credit card companies.

Anyhow, I think that if Apple had priced the phone at $399 at intro, they would have had a Wii issue. There would have been too many buyers for the limited supply, and like the Wii, angry shoppers who were not able to find an iPhone. In fact, the price and supply were priced to perfection. Many of the stores just sold out over the first weekend, and supply was restored on a daily basis. Ebay prices were barely at a premium.

As for bringing out a new higher priced iPhone, to replace the older one, Apple didn't because it was iPod product release day, not iPhone product release day. Jobs didn't want to sully the message by releasing both iPods and iPhones; however, he couldn't leave that huge $300 price gap between a 8gig iPhone and an 8gig iPod touch. It would have killed iPhone sales. You just wait, and Apple will release a 16gig iPhone before Thanksgiving for $499, and a 3G version for $599 as well. It's their modus operandi for iPods. Keep the same price points, but add features to the newest top-of-the-line.

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Niels

I think the problem is that consumers expect that Apple transfers it's laptop price model to the iPhone. Laptops usually have one price-tag during their whole lifetime in the applestore. When introduced they are cheap, but the lost profit are gained back in the last sale periods.

Miguel

The price drop is a very visible artifact but tells little about the underlying earthquake the telco industry is experiencing *because* of the iPhone. Apple has introduced paradigm changes (yes, more than one) in this highly business conservative sector.

The first paradigm change is that a device manufacturer squeezes a share of the ARPU (average revenue per user) out of the operators (10% seems to be the number). This is not only unprecedented, it shakes badly the existing provider-enabler relationship. Nokia, Samsung and others are surely pushing hard to follow the new model, at the cost of even loosing image. In fact, Nokia just raised the "me too" flag by announcing a touch phone that seems to resemble closely the iPhone.

The second paradigm change was meant to be an advantage but I would argue it hurts Apple in the short term. The iPhone is the first phone that is *designed* to become smarter by software. In fact lots of the "power" of the iPhone come from its applications and operating system. And those are upgradeable at the push of a button. This keeps consumers loyal, who can profit (buy) the latest features. It also generates a biosphere market around the device boosting the customer base. Apple has had a good experience with this model in the PC market, but, is that shiftable to the mobile market? Many people contend that. Nokia for one has refused in the past to go on that path, even though they probably could have done it, alas not as elegantly as Apple can do it now.

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Moe

So Apple reduced $200 from the price of the iphone since it was first introduced for the public. I'm a big fan of hi tecs, and this is the first time i witness such a thing. It was not the right move, but it also wasn't wrong.
Iphone owners are mad? huh!! why would they be? did they expect the price to hold @ 600/500$ for long? I take a guess they probably expected a drop on the price sooner or later. So I think they're a little mad because the drop was a little too early, and not because it was a 200$ drop.
Finally, For such a respected company, one that struggled in the past, fans should be supporting Apple, supporting thier economic plans.

AC

Nice post. This has been an observation in the marketing research realm for many years. To the specific question of a price drop: the rebate makes sense if apple's product sales to mass market buyers depends heavily on the hype generated by initial adopters (Which I suspect that it does). The price drop probably would have been fine if it were more gradual, but Apple wanted potential new consumers to take note of an aggressive price drop in advance of the holidays.

On another note: the major reason for sluggish sales seems to be due to the Cingular-lock in.

NL

What might have happened if Apple had auctioned the first one on Ebay, then continued selling individual items for the next couple of months, until finally releasing it to stores? Perhaps consumers would have found that pricing scheme more acceptable? I suspect that Apple might also obtained some interesting empirical data as to what the average price should be set at for the average consumer.