Who Gets the Surplus?

Defs:

TR = total revenue to the firm
CS = consumer surplus (Wiki)
PS = producer surplus (Wiki)

1. If the price is set at $600:

CS = A
PS = B + C + E
TR = B + C + E +G

2. If the price is set at $400:

CS = A + B + C + D
PS = E + F
TR = E + F + G + H

3. If the price is set at $600, then dropped to $400:

CS = A + D
PS = B + C + E + F
TR = B + C + E + F + G + H

4. If there is a $100 rebate to those who paid $600:

CS = A + B + D
PS = C + E + F
TR = C + E + F + G + H

Change due to two-part pricing strategy (compare 2 to 3):

ΔCS = -(B+C)
ΔPS =  +((B+C)

Change due to rebate (Compare 3 to 4):

ΔCS = +B
ΔPS = -B

The dynamic two-part pricing strategy captures B+C for producers, and the rebate gives B back to consumers. For numbers, this article says iPhone sales at the end of September are projected to be 600,000-720,000, optimistically a million, and will reach 4,500,000 by the end of the year. I can't vouch for the accuracy of the projections, but based on those numbers, and the reports that the price cuts are in anticipation of the Holiday season, Q1=500,000 and Q2=4,500,000 seems reasonable. This then gives B = $50,000,000, and B+C = $100,000,000.

The pricing strategy could have been planned from the start, but it could also be that none of this is intentional, i.e. that demand was projected to be higher and the price cut is in recognition of the faulty forecast. The Street says:

Steve Jobs got up at a press conference, unexpectedly said that he was slashing the price of the iPhone and promptly declared victory, saying that the the move was one made out of strength and that it would push sales. ...

Now, if you can name a product in the annals of commerce that was introduced to great fanfare and shortly afterward had its price slashed to ribbons where that worked out to be a good thing, well, do let me know.

Investor's Business Daily highlights the thoughts -- and I use that term lightly -- of an analyst who essentially says: This was the plan all along, to take an ax to the price by a factor of a third. Uh, dude, if it was the plan all along, they sure didn't account for the rebellion of the loyal Apple customers who waited in line for the higher-priced iPhone weeks back. Jobs had to rush out an apology and store credit to those suckers.

Clearly this analyst does not believe it was not an intentional strategy, though I'll note that the explanation above shows that an intentional price cut doesn't necessarily make the company worse off, though the $50 million dollar gain after the rebate would have to be balanced against any future costs due to unhappy customers.

[Note: the measurement of producer surplus depends upon the assumption that $400 is the competitive equilibrium price. The actual equilibrium price could be lower, e.g. there could be a three-part strategy where the price falls to $350 in a few months. It's easy to see how to extend the analysis to handle these cases and the basic message is the same, the price discrimination captures surplus for producers, and the rebate transfers some of the surplus back to consumers.]

[Update: See William Polley who predicted this might happen, and he says a bit more about the nature of the price discrimination.]

Comments

[chris]

Great post ... it's always great to see some econ in action ... but we can be sure the supply curve looks nothing like that.

[real person from the real world]

How many times do you send in for those rebates that take 3-6 months to process, and then forget about it, when you never received the check? or got one of those postcards saying you actually were not eligible because of such and such?

[bakho]

Isn't this the "Tickle me Elmo" strategy?

Is this "fad" pricing? Once the fad ends, resort to value pricing?

What effect does this have on a knock-off if a knock-off targets the "fad" price and not the "value" price?

[Paul Guinnessy]

The point is, that a iphone at $400 is going to get a lot more people into the store than a phone at $600. I popped in the Bethesda store yesterday to take a look at the iphone because of the price cut, and I seriously contemplated buying one at that price. I suspect a lot of other people might be thinking the same thing. The numbers are slightly inaccurate above, as it doesn't include the $3.50 per month per person that Apple is believed to be getting from AT&T. If they sell a million iphones, that's an additional revenue source of $42 million per year.

[William Polley]

Bruce Webb commented on my post (and I agree) that two months was just too fast for customers. But I think the real reason was to make sure that the touchscreen WiFi iPod got some traction before the Christmas shopping season. It makes no sense to have a $600 iPhone when there's a $400 WiFi iPod. Bruce thinks Apple wishes they could have introduced the iPhone in April. I agree. Then the price drop now would be less of a shock to the early adopters.

[Bruce Webb]

In all the furor over the price cut the really revolutionary part has slipped under the radar.

Forget the iPhone the real news is the touchscreen iPod with Wi-Fi. If you are a college student with access to Wi-Fi (which would be pretty much everybody) a purchase of an iPod now includes a free internet solution. No monthly fees, no minutes for data, no contract. And not a clipped down WAP version either, you get full access to almost every webpage out there (some graphic content relying on plug-ins doesn't display, at least yet). Combine that with the wide variety of free online productivity suites (e.g. Google pack) and you have a viable way to simply glide around the Telecoms and Microsoft.

Because the next step is pretty obvious. Upsize the touchscreen iPod to the size of a trade paperback and pretty much the tablet market vanishes, as well as much of the laptop market. (And good luck with that Sony Reader. Who would possibly buy into a fee based dedicated device for reading text when so much is available for free on the internet and most of the rest available from a wide range of vendors).

A whole lot of business plans just had a huge hole blown in them, particularly for the Telecoms. For the price of a lot of peoples monthly cell phone bills you can have a 8GB music/video player with unlimited internet access. I don't think the iPod has built in texting, but certainly there have to be web based clients. For millions of people the cellphone service monopoly essentially imploded. Buy your voice minutes at the 7/11, get a phone that is a phone and use your iPod for almost everything else. Why pay Verizon $80 a month?

(Of course you might not be able to have full freedom to have the most annoying ring tone possible. For which much of humanity will be grateful).

[Bruce Wilder]

MT: ". . . the measurement of producer surplus depends upon the assumption that $400 is the competitive equilibrium price. The actual equilibrium price could be lower . . . "

Oh my.

Why "assume" an equilibrium price?

Commenter Chris notes "the supply curve looks nothing like that". No kidding. I think we all presume that there are substantial sunk cost investments in design and in the organization of production, not to mention marketing, and that marginal cost is small (relative to price), and falling with both increasing scale of production and increased production experience.

I cannot put a drawing in comments, but, trust me on this, there cannot be a competitive equilibrium price, where marginal cost is falling.

The price of the iPhone is an administered price, obviously, and considerable market power is necessary to recover the very large sunk cost investments in design and marketing. Hence, Apple's shared monopoly with AT&T.

In some ways, Apple's problem is like that of Coase's monopolist selling a durable good: Apple anticipates competing with the stock of previously sold iPhones, as well as its own new-and-improved products. One might expect the rate of price decline to be a function of the durability of the product's market value. (Hint: an economic analyst might reasonably posit an equilibrium competitive "price" for used iPhones, even though not much of a market really exists, even though no equilibrium can exist for new phones sold by the manufacturer.)

I expect, though, that considerations surrounding the preservation of the market-power-enhancing intangible assets, not the prospect of capturing consumer surplus, drove Apple's decision. The prospect of journalists picking up a story about Apple iPhones being a market failure at $600 probably scared Steve Jobs something silly. A reputation, which provides considerable market power, is something worth preserving.

It should be worth noticing that the retail price, whether it is $600 or $400, is not a market price, but an administered price, and it is not the market providing information, but market research. Apple made a bunch of administrative decisions about when and where and how to introduce the phone, and guessed at a price. The price they chose was, at best, only tangentially related to marginal costs of production, which marginal costs were small (relative to price) and declining, and the price they chose was fixed and arbitrary.

Consumers know the game, here, and expect price cuts at intervals. And, Apple knows consumers know the game, and acts to preserve their goodwill and trust -- which are intangible assets related to effective market power, essential to recovering sunk cost investments. It might be interesting to know why it is at intervals and not continuous. But, these are not market prices a Hayek could recognize and love.

[bruce webb]

Let me repeat the point William made and I tried to.

This isn't about the iPhone, which for most practical purposes been marginalized. If you need a phone that will allow really cool management of your voicemail and give really slick ways of tracking your stocks or need driving directions from Google, well the iPhone is an elegant solution, if you want free Internet and the coolest music/video player out there for a one time price of $299 or $399 you need a WiFi iPod.

The current Telecom business model builds in the assumption that they can tie down anyone for two years at a time and meter and charge for every unit of content. A WiFi safari enabled iPod allows anyone to send a big FU to telecom companies (and that has nothing to do with 6 month time frames).

[ken melvin]

Someone, either here or AB, figured the cost @ around $67.00.

[Bruce Wilder]

Apropos of what Bruce Webb has written, I think a consensus has built that VoIP will wipe out POTS sooner rather than later, and that the prime vehicle for doing that is the cellphone with WiFi capability.

I really don't know what an iPod with WiFi adds to this picture. It would seem to me that a cellphone that can handle the transition from cell service to VoIP/WiFi seamlessly will carry the day.

AT&T and Verizon will use bundling of DSL with cellphone service to cannibalize their own POTS, which also provides a means of reaching the one-third of the market, which has resisted both cellphones and PCs/DSL. What's most challenging here is not the tech-hip college student living in a free WiFi paradise -- it is the tech-phobe at home, who has never wanted DSL or a computer, or maybe even a cellphone. If you can get him into the 21st century, can you sell him something?

[Laurent GUERBY]

I wonder what impact do these price games have on the measured CPI now that they take new product into account sooner.

Any idea?

[Bruce Webb]

Let me take a crack at B. Wilder's question; "I really don't know what an iPod with WiFi adds to this picture"

It establishes a transitional position that opens up the chokehold the Telecoms have on the current market. They sell deliberately crippled phones with features limited to those they control and price with ridiculously strict and expensive contracts. If all you really need a cellphone for is voice then buying your minutes retail is a nice option. Substituting a voice only phone and an WiFi iPod that has only a one time intial cost and the average urban dweller can probably save hundreds or in some cases a thousand or more in a typical year. And all coming right off the bottom line of Verizon and the other TelCos.

And Comcast shouldn't be sleeping easy. Given the proliferation of streaming video and the bandwidth of next generation WiFi, a tablet sized iPod could cause millions of people to take a hard look at that cable package.

WiFi iPods don't quite equate to a breaking of the monopoly powers of the major carriers but it certainly provides a viable workaround for the majority of most peoples daily needs. I love my iPhone. On the other hand come July 2009 I will be taking a hard look at how much value that $59.99 a month cell service from AT&T really adds. By not renewing I would essentially be converting my iPhone into a fully functioing WiFi iPod. And since the overwhelming majority of my usage is Internet why not?