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.