Wednesday, September 15, 2010

Apple: Pricing Tricks or Pricing Treats

Yesterday, I came across this article on pricing by Apple via Freakonomics. Here's how it begins:
Next time you're sitting at an airport bar and hear two businesspeople debate whether Apple is a technology or design company, chime in: "Nope. What Steve Jobs sells is pricing."

Pricing? You bet.

The article goes on to cite numerous behavioral economics "tricks" to get customers to buy more and at a higher price. Although it is interesting to think about "pricing trickery," the article as deeply flawed because it does not reference the standard explanation for strategic pricing: price discrimination.

As long as Apple is insulated from competition,* it has the ability to price discriminate (video here). Apple's ability to charge different prices for seemingly the same product is where Apple's true genius in pricing shines through. Apple is a master of market segmentation, which is is a better explanation for many of the pricing examples the article brings up.

For example, the article brings up the 7-inch screen mini iPad.
The Economic Daily News of Taiwan reported in August that Apple has started to build smaller, 7-inch versions of its iPad tablet, timed to hit U.S. shelves before Christmas. If you wonder why in the world Apple would add yet another potentially cannibalizing product to its lineup of iPods, iPod Touches, iPads, laptops and computers, realize that this gadget is likely a decoy.

Decoys, in marketing, are products, services, or price points that a business doesn't really want you to take, but rather use as a reference to make another product look better.

I usually appreciate cynicism, but it is overly cynical to suggest that Apple would produce a product that it doesn't really want to sell, just to "cloud your judgment." If the company made a living by swindling its customers, people would catch on and that would be the end of Apple because no one likes to be a sucker.

Most Apple customers are enthusiastic about their iProducts rather than feeling cheated. How do we reconcile this? Instead of being a decoy, Apple's 7-inch tablet is a method to more effectively segment the market. A 7-inch iPad appeals to a different group of customers than the full-sized iPad. Upon hearing the announcement, customers who have especially high demand for the 7-inch size screen will wait for the smaller tablet. Apple knows this and they can price better with this knowledge. And at the end of the day, the 7-inch tablet customers will be enthusiastic about their product. After all, it was designed for them.

Better pricing and happier customers. Unlike trickery, that's a good long-term business strategy.

The second main example that the article brings up is charging different prices over time. The author tries to label this technique as "setting a high reference price":

Apple has played this game with itself by launching products such as the iPhone at artificially high reference prices - the iPhone cost $599 when it first hit the streets - and then rapidly lowering that price. Today, a $199 iPhone seems like a steal; Apple in essence is using its first-iteration pricing as a reference to make its current products feel affordable. You may be on the fence for a $499 iPad, but if it drops to $399 by Christmas, won't you feel better?

Just like pricing decoys, the logic of setting a high reference price requires that people wouldn't ever want to buy it at the high price. If it were trickery, no one would line up for the absurdly high priced new product until the price went down, yet Apple always sells out its new product offerings. Usually when a product sells out, an economist would tell you that the price isn't high enough. But, reference prices only work if they are too high.

This is market segmentation, not trickery. Companies start with a high price and slowly decrease the price over time because the high price is for the customers who can't wait; the low price is for customers who signal they are price sensitive by waiting it out. You may even get a higher price because the company has to put a rush on the assembly line to get the product out during a busy time (and that costs more). Either way, customers pay for impatience.

On a final note, I am disappointed by the spirit of the article. The article suggests that pricing tricks are a great business strategy, but the problem with tricks is that someone has to be tricked for it to work. That's not a sustainable business strategy. Market segmentation need not be tricky. It can be about providing a product that people want or improving an existing product. That creates value and creating value is the only great long-term business strategy.


*The article starts off by claiming that Apple faces "fierce competition." This can't be true. Although Apple isn't truly a monopoly, it isn't right to say that competition is fierce. If this were literally true, Apple wouldn't have the ability to set prices: Any competition will undercut the profitable component of a pricing strategy. For pricing to be an issue with Apple, it must be the case that Apple is insulated from competition, so let's start from that assumption.


  1. I remember when they dropped the iPhone price from $599 to $399 just a few months after the initial release. People who had already paid $599 were so outraged that they eventually gave a refund to anyone who had bought it in the month prior to the price drop (or something like that), which quieted the complaints.

    To an economist, this is a hilarious thing to be first outraged and then pacified about. If Apple has successfully pegged you as one of those people who values the iphone at x>599, then by selling, it has just given you x-599 dollars of surplus you wouldn't otherwise have. They have only been nice, and you don't really get to _expect_ an additional $200 cash handout. But more hilariously, declaring that recent buyers will retroactively get the lower price is _equivalent_ to having announced the price drop _even earlier_, which presumably would have pissed people off even more. Actually, that's not even true -- it's WORSE because if the price drop had happened earlier, even more people would have bought iPhones. The customers who bought at $599 would still have bought at $399, but in addition there would be a whole extra bunch of people who got to enjoy their iPhones a month earlier.

    But also consider that in reality the iPhones were sold out originally. Supposing that supply was too limited for the market to clear at $399, but that for some reason Apple didn't want to "screw its customers," i.e. make them pay $599...then how would it get iPhones into the hands of the people who wanted it most, without screwing them over? Well, the best way is probably to tell them the price is $599 but then retroactively decrease it to $399, which is exactly what happened, at least in part.

    Anyways, one lesson is that while trickery might damage the relationship between a company and its consumer base, many forms of price discrimination/market segmentation are equally detested. Whether people "catch on" in either case depends very much on how the action is interpreted through the popular lens. It is easy to find examples of pricing strategies that are logically equivalent but which generate very different responses from consumers.

  2. Nice comment. Price discrimination over time is surely a great example of a detested form of price discrimination. And, the Apple example is a good one to see why that's the case. For reasons discussed in the post, I don't think the high-to-low pricing is about setting a high reference price, but it is easy to see why people would be upset when the price comes down.

    Regarding the trickery motive, my point was that it isn't a good idea to build your business on tricking your customers. And, for that reason, I don't think Apple is deliberately trying to swindle its customers (even though that's a big part of the public perception).

    Finally, your example of rationing by retroactively adjusting the high price gets into an interesting question of beliefs.

    First iteration: Did Apple believe there would be outrage at the initial price reduction sufficient to force a retroactive price cut?

    Second iteration: Did customers believe that they would be able to secure a retroactive price cut when the phone first came out?

    If yes on the first and no on the second iteration, this would be a way for Apple to effectively ration the iPhone without "screwing" initial customers.

    If yes to both, it wouldn't work because anyone who values the phone at greater than $399 knows that when the price drops, they'll get the retroactive price cut. Many of them will be willing to show up for the first iPhones as long as they expect to get a retro discount.

    It is definitely a fun/hilarious/outrageous setting. That's why I enjoy it.


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