Friday, September 07, 2007

Price Discrimination, People...

For those of you that have ever taken economics, the following is merely a recap: Price discrimination occurs when the same product is sold by the same supplier to different people or groups of people at different prices. Now, economists go on to break this idea down into three categories, namely first, second and third-degree price discrimination. As a student, third-degree price discrimination is my favorite since it encompasses the idea of the student discount. With third-degree price discrimination, the idea is that when you can separate your customers into categories of "more price-sensitive" and "less price-sensitive", you (as a seller) can do better than uniform pricing by charging a higher price to the less price-sensitive group. However, this is usually framed as a lower price or a discount to the more price-sensitive group. Taken in the abstract, I doubt that people would get too much up in arms over the fairness of this type of policy.

In the United States, many forms of explicit price discrimination are illegal. However, there are ways to get around this by having the customers self-select into price points- anyone who has paid $800 for a plane ticket only to be sitting next to some guy who paid $200 6 months ago for his ticket knows what I am talking about. It seems as though Apple has taken advantage of this principle in a temporal sense, introducing its iPhone at a high price and then dropping the price by $200 two months later. As an economist, I say smart move, but apparently people are very upset (NYT). In fact, customers have made enough of a fuss that Steve Jobs has extended $100 store credits to the original iPhone owners. What irks me about the situation is that customers seem to be implying that Apple did something underhanded or shady, which is simply not the case. I have two immediate reactions to this:

1. If the iPhone were a high-fashion dress, no one would be batting an eyelash. It is commonly accepted practice in some other industries to pay a premium to get something first, when it is still new and hot rather than wait around until it is no longer new but on sale. If you were willing to pay $600 for a cool new toy, you were getting at least $600 of benefits from having the cool new toy. Get over it- you probably even got the $200 of benefits from people thinking you were cool because you had an iPhone first. Furthermore, Apple seemed to be selling plenty of iPhones at the beginning, so there probably would have been a shortage if it had been introduced at a lower price point. Someone should ask these upset consumers whether they would prefer a $600 iPhone or a waiting list.
2. I think this makes a point to those who think that behavioral economics describes phenomena that are on the fringe, as opposed to being central to "rational" decision-making. Clearly consumers' perceptions of fairness can and do have a big impact on market outcomes. (see Kahneman, Knetsch and Thaler's "Fairness as a Constraint on Profit Seeking: Entitlements in the Market") Behavioral economists would likely conjecture that customers would be less upset if they thought that Apple was reducing the price of the iPhone due to a sales slump.

Lastly, I have to point out my favorite part of the article:

"Ken Dulaney, a vice president at Gartner Research, said that in general starting high and dropping the price slowly was a smart strategy. By starting the price high, manufacturers can gauge early demand and reap greater profit from early adopters who are willing to pay any amount to be the first with a particular device. 'It’s probably a formula taught in business school,' Mr. Dulaney said."

You don't have to graduate from HBS to learn this stuff, all you need is a first-year microeconomics course! That said, I'm going to go ask my iPhone-owning MBA student friend how he views the situation.

Update: Apparently Tyler Cowen agrees with me here. Economists of the world unite!


Charles said...

I am a bit surprised that Apple would drop the price so steeply just two months after the product was released. Price drops this soon after the initial introduction especially for a technology product are a bit unusual. I think back to how hesitant Sony was in dropping the price of the PS3 even though sales were dismal after the initial release.

I do agree that the whining and active protesting by the early adopters is uncalled for, but I am not surprised by the vocal reaction. Apple's apology and attempt to appease its most loyal and vocal user base is probably a good public relations move, but I think it sets a very bad precedence. Will this encourage Apple's user base to complain every time there is a price drop or new product introduction? Would the vocal protests have occurred if Apple waited a bit longer for the price cut or dropped the price by a smaller amount? Do you really think an iPhone sales slump would have quelled the vehement reaction by the early adopters?

In this case, I get the impression that the early adopters are taking advantage of the fact that Apple goes to great lengths to protect its customer friendly image. I think back to the early adopters of high definition TVs or players. I don't see these purchasers up in arms. From my experience, early adopters of technology products usually have a good understanding that they are paying a premium to be the first users of a potentially hot trend. In this case, perhaps it can be chalked up to buyer's remorse.

I find this kind of funny in the Wiki entry. "Buyer's remorse is an emotional condition whereby a person feels remorse or regret after a purchase. It is frequently associated with the purchase of higher value items such as property, cars, computers, jewelry, Apple products, etc."

Charles said...

Perhaps mobile phones should be treated differently since many consider them to be a key component of socializing. Could this be a factor in why users were so up-in-arms about the iPhone and not other products?

Survey - 6/21/2007

Would you give up your mobile phone for a million pounds? - summary from the London School of Economics and Political Science

Official Press Release

Scott said...

Here's where I'm confused: of course the price discrimination here is a smart, rational thing for Apple to do. But normatively, is it a good thing? Is it welfare-maximizing?

If I remember my economic theory correctly, we know that third-degree price discrimination by a monopolist often decreases total surplus, but sometimes can increase total surplus if it allows a sufficient number of additional sales to be made to the more price-sensitive group that would not have been made otherwise. We know that an increase in total quantity of sales is a necessary condition for third-degree price discrimination to be welfare-maximizing, but it is not a sufficient condition. (I think it's questionable whether the average consumer is price-sensitive enough that a $200 price cut on a must-have gadget, and one that after service costs is still quite expensive, will cause that much of an increase in sales, but Apple seems to think so - else they would not have made this price cut - so I'll grant them that.)

Complicating things here are some issues of scarcity. We suspect that the first batch of iPhones sold was capacity-limited: they sold all of them they could manufacture in time, and couldn't get more off the manufacturing ramp until later. In that case I'm willing to bet that the higher initial price allowed the initial iPhones to be distributed to those who valued them most.

But suppose that there weren't any scarcity issues going on, just a price-maximizing monopolist. Do we want to allow them to charge early adopters a higher price, like Apple did here? It's not clear to me whether a third-degree price-discriminating monopolist here is better or worse for total welfare than a monopolist that is constrained to charging all consumers the same price. And that, it seems to me, is the key question, but I don't think it's answered by your post. Any thoughts or guidance on that?

Charles said...

For the record, Jodi posted three days before Steven D. Levitt did. :P

Should Apple Burn Its Economics Textbooks? - Freakonomics

My favorite part:

"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."


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