Bastiat’s Bastions

Let me start by saying that I am not very fond of the author of the article I’ll be writing about. In my opinion, Mr. Gross knows just enough economics to be dangerous.

Click here for a previous rant on an article he wrote about pick-your-own apple orchards. In that article, Mr. Gross suggests that apple consumers can’t be trusted to make wise decisions.

In his current offering in Slate and Newsweek, Mr. Gross is writing about Apple’s decision to cut the price of the iPhone. In this article, he suggests that producers can’t be trusted to make wise decisions – remarkably Apple’s consumers are quite capable decision makers.

So, apple consumers are incapable, but Apple’s consumers are not. That is an interesting distinction. However, in fairness, I should point out that it may be easier to sell articles this way. It is a lousy way to do economics, though.

What fundamentally is going in the iPhone situation is what is called price discrimination. There are many different varieties of price discrimination. In order to engage in any form of price discrimination there must be at least two things that happen. First, a firm must have market power, and second, the firm must be able to identify groups of consumers with different willingness to pay (or have the consumers identify themselves). Firms that sell unique products or are large relative to the market are often price searchers – they have market power. iPhones clearly fit the bill. As a result, Apple will have some pricing latitude.

One strategy Apple might have chosen is to charge only one price for the iPhone (and never lower this price). If Apple would have chosen this strategy, it is quite likely that they would have charged a price below $599.

A second strategy would be for Apple to engage in price discrimination. The insight is that different consumers have different willingness to pay for products. Suppose there are only three consumers:

Consumer Willingness to Pay
A $700
B $600
C $500

In a perfect world for Apple, they’d somehow get A to pay $700, B to pay $600, and C to pay $500. This is called perfect price discrimination. Practically, this is difficult to do. How could you get people to reveal this information?

One thing that comes to mind is to start out by offering a price of $700. Only consumer A would purchase the good. Then, wait a while before lowering the price to $500. At this point, both consumer B and consumer C will purchase the good. While the firm didn’t get everyone to pay as much as they were willing, they still get more revenue than by charging any single price. This is exactly what Apple is doing.

What Mr. Gross is wrong about is (at least) two things.

First, this type of pricing is not novel. (Is that a pun? Keep reading.) This type of pricing has gone on for a long time, though there is some suggestion that this is a new twist for Apple’s pricing strategies, a point I’ll touch on below. Second, the subsequent lowering of price is not an indication that something that has gone wrong, but is part of the profit-maximizing profit strategy by the firm.

How do the prices of tickets at the regular movie theatre compare to those at the second-run (dollar) movie theatre? How do the prices of the “it” fashion this year compare to prices of that same fashion on the rack next year?

So let’s watch Mr. Gross get stuff wrong:

Check out this data on the use of incentives by auto manufacturers in August. The Japanese automakers don’t offer much (Toyota’s average was just $849), while the Big Three U.S. automakers each offered incentives of more than $3,000 per car. Is it any surprise they’re having such great difficulty turning profits on their U.S. operations?

Does this tell me that US automakers are stupid? Or does it tell me that US automakers are engaging in more price discrimination than Japanese automakers. If Mr. Gross wanted to examine the wisdom of these pricing strategies, he should be comparing what profits would be at GM without price discrimination to what they would be at GM if there were price discrimination (ceteris paribus). As GM has the option to choose only one price and stick to it, and they do not, they must believe they have higher profits as a result. I assure you that they understand this at GM.

Fire sales have a way of freezing consumer decisions. Once they know that retailers are likely to slash prices, many tend to delay purchases. Why buy an SUV tomorrow if you know it will be reduced in price at the end of the season? And once you start discounting, it’s very hard to stop.

I wholeheartedly agree. The optimal timing between price decreases is a difficult one. But the waiting is precisely how the companies separate the consumers into groups. Take his example of car sales. Everyone knows that the sale is coming at the end of the season. And yet, not all people wait until the end of the season. Those who are itching to get the new phone (or car or movie) pay the high price. Those who wish to wait, pay less.

To make it up to angered iPhone customers, Apple had to offer a $100 credit to early iPhone buyers. To assuage customers angered by large discounts on a single product, in other words, Apple is effectively now discounting all its products. Think different, indeed.

Let’s not get carried away, and let’s not double count. They sold 1 million phones for an extra $200. They then offered a $100 credit to a portion of these folks that paid the extra $200. Not all of these people will redeem these rebates, and the rebate will necessarily induce consumers to do some shopping at iStores. The cost of these $100 rebates are not anywhere near $100 to Apple. To say that they are discounting all their products is double counting.

What surprises me here is that consumers are so up in arms about it. Why no complaints about cars, fashion, or movies?

The answer to this question is that there is something snobby (an economics term) going on here. Some consumers seem to be purchasing iPhones as a status symbol. The iPhone is a badge that says “I am trendy” or “I am wealthy enough to spend $600 on a phone”. The price cut bothers these people because now, everyone is wearing the badge – the club is not so exclusive. If goods have snob features, pricing is more complicated, but that is a post for another day. Consumers might feel as though they were deceived – that is where the fact that Apple doesn’t typically discount products becomes interesting. Was an implicit contract broken by the price decrease? Was it that Apple never had a product where they have so much pricing latitude? I don’t know.

One last point… If Mr. Gross is so smart, and these firms so dumb, we surely wouldn’t expect him to engage in this pricing strategy, right? Let us get back to novels. Hardcover prices exceed paperback prices. But of course, the paperback doesn’t get released until several months after the paperback. Sound familiar? (The cost difference for binding is very small.) It is price discrimination.

Mr. Gross wrote a book that was published in May of 2007. The list price of the book is $22.95, hardcover. You can buy it new now on Amazon for $15.61. If Mr. Gross believes what he is arguing, we wouldn’t expect a paperback that sells for $7.99 to be on the way now, should we?

–CT

This entry was posted on Monday, September 24th, 2007 at 9:51 am and is filed under General. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.