Saturday, July 12, 2008

Some Economics of iPhone Pricing

With the introduction of the new iPhone, Apple has changed its revenue model quite significantly. With the first iPhone, the shared revenue model for Apple/ATT was a relatively high price for the phone and “reasonable” monthly rates for the cell service itself. Apple sold the phones themselves or to ATT, who likely marked them up quite significantly to make a margin on their sale, and Apple also got a cut of the revenues from the cell phone plans. That was an interesting revenue model, and a departure from the industry standard, which is characterized by the cell phone carriers subsidizing the purchase of handsets by consumers and no revenue sharing with the handset manufacturers. The new iPhone is being advertised as "twice as fast, and half the price," and the overall Apple/ATT pricing model is more like the industry standard, with ATT taking a loss on the sale of the phone itself, while no longer paying Apple any revenue from the monthly charges.

Why did they switch to the industry standard revenue model, with ATT now subsidizing the phones and Apple not getting any of the revenue stream from the monthly charges? To answer this, I think the best thing to do is to consider why the industry standard model makes sense for anyone. The answer to this was really given in an earlier post of mine on the economics of iTunes/iPod pricing: see here. Interestingly, the essential pricing features of the iPhone/cell service bundle are not different from that of the iPod/iTunes. Of course, one big difference is that with the iPod/iTunes bundle, Apple owns both parts, whereas with the iPhone/cell service we have Apple and ATT each controlling one part of the bundle. More on that issue at the end of this post. For now, let's think how we would price the iPhone/cell service bundle if we controlled both parts.

With the iPod example, I argued that the optimal pricing scheme would be a relatively low price on the iPod and a markup over marginal cost on the songs. The rationale is based on price discrimination across different classes of consumers. In a perfect world, you would want to set the price of songs at marginal cost to get all consumers to buy the "efficient" number of songs, generating a lot of what we call consumer surplus. Then you would make each consumer pay for the hardware, the iPod, exactly what that stream of consumer surplus is worth. This scheme would maximize profits from the bundle. Of course, we don't live in a perfect world, most notably, Apple cannot figure out what each consumer values the bundle at and make them pay exactly that. If we take the simple case where Apple can charge only one price for the hardware/iPod, then they will want to price the iPod "low" and price the songs at more than marginal cost. Such a pricing scheme manages to get even low-value consumers to buy the iPod, while getting a lot of revenue from those consumers who will purchase a lot songs.

These ideas extend naturally into the cell phone market. An integrated handset/cell service provider would want to price the handsets "low" to get the low-value, price sensitive consumer into the market (there are a lot of such folks) while extracting significant revenue through the monthly charges (which are clearly priced way above marginal cost).

There is a further reason for this "subsidized" handset cost model in the cell phone market that is not present with iTunes and songs. In the cell market, you can offer consumers a lot of different monthly plans, thereby further segmenting and discriminating across the consumer segments. Again, think that your basic objective is to get all types of consumers into the market, charging each type as close as possible what they are willing to pay for the bundle of the handset and the service. One of the key constraints you face in doing such pricing is cannibalization -- if you offer one type of consumer a low overall bundle price, your high end consumers might find that kind of scheme attractive as well, and you will lose the ability to extract maximum revenue from those high end consumers.

If you charge a high handset price, this cannibalization problem will be real tough. With a high handset price, the only way to get the price sensitive consumers into the market is to offer some monthly plan at a very low price. But such a plan might also be attractive to your high end consumers. With a subsidized handset price, you can charge relatively higher monthly prices and still get the price sensitive consumer into the market, and you can charge even higher monthly fees to the folks who are going to talk a lot and put a real high value on that service.

For other analogies, think of IBM in the old days pricing its computers, or copy machine pricing. IBM used to lease its mainframe computers at rockbottom prices, extracting revenue from consumers' use and purchase of the punch cards (Ha! Anyone out there remember those?) Copy machine pricing is similar. A lot of restaurant franchise revenue models also use this. Individual restaurant franchise owners must pay a lump sum for the franchise, but then they also pay a markup on their purchase of ingredients. You get better overall revenue extraction by keeping the franchise fee "low" and using the purchase of ingredients to essentially extract differential value based on usage. Cell phone pricing is very similar.

So the industry standard model makes sense, and Apple/ATT have moved to it. Why did they not take it on in the first place? Mistake? Maybe. Or maybe it was related to a dispute between the two companies. There is tremendous opportunity for disagreements between Apple and ATT in their joint venture. Some disagreements will just be over different beliefs about market size and growth. When two parties to a transaction differ in their beliefs about value, you will often see contingent pricing contracts: we disagree over the value, so instead of one or both of us having to take a risk, let's make the price contingent on actual value to be determined later. That is essentially what the revenue sharing did, giving Apple more revenue the more customers that would sign up. Perhaps Apple was putting its money where its mouth was, showing ATT that it was willing to take the risk of not signing up nearly so many customers as Apple believed they would.

These ideas on possible disagreements between Apple and ATT raise an interesting question. One of the beauties of iPods/iTunes is that Apple owns both the hardware part of the bundle and the "consumables" part of the bundle. That minimizes disagreements and distortions in the pricing and delivery of the overall bundle. (The integrated ownership by Apple of the hardware and operating system in their core computer market is another example of how well integration can work.)

So would the joint value of the iPhone and cell service be greater if they were both owned by the same company? Should Apple and ATT get together much more formally? Interestingly, the market capitalization of Apple is about $150 billion while the market cap of ATT is only $1.2 billion. And Apple has cash on hand of around $9 billion (end of March 2008).

Thursday, July 10, 2008

Ethics on the Internet/Apple App Store

A couple years ago some applicants to MBA programs got into deep trouble when they followed the advice of an internet posting on how they could access hidden pages on the ApplyYourself website. The link allowed them to see whether they had been accepted to the school or not a little earlier than the schools meant for them. One person characterized it as "sneaking a peek at your Christmas presents early" while others viewed it as a very serious breach of ethics. I fell somewhat in-between, but more on the side of it not being a huge crime. One thing is that the code for the pages being viewed was available by looking (view source code); the software developer had made an error. On the other hand, it was pretty clear that the applicants should not have been seeing the letter early, so they should have known better.

So today I have been trying to access the App Store in iTunes to see what cool things would be available for the new iPhone. I downloaded the newest version of iTunes, but I could not find the App Store anywhere on it. Then I found this story on the internet and sure enough the author was kind enough to include a link that took me to the App Store in iTunes.

Now given that the iPhone is not on sale until tomorrow, have I done something wrong?

There are some pretty cool apps that will be available.

And knowing Apple, if they had not wanted me to see the App Store, they would not have made it available, period. But why isn't it available for viewing on iTunes 7.7?

Heating Oil Price Protection Plan Shenanigans

I think there is something funny going on with some home heating oil price protection plans.

I am not generally a huge supporter of class action law suits, but if there are any enterprising lawyers out there, this one might be worthwhile. I am concerned about the impact of higher heating oil prices on lower income households in the Northeast and would be very upset if anybody was behaving in an opportunistic way to make that situation worse.

Let us be clear that I am not accusing any company of inappropriate behavior, but let me sketch what I have noticed. I will not name any companies at this point. Interestingly, I described the potential for this problem earlier this spring to my colleague at Tuck, and I said I would wait to see what happened. Sure enough, it happened.

Here is my personal situation. Last summer, I contracted to buy around 800 gallons of heating oil at a fixed price. I spread the payments across 11 months, paying a fixed and constant amount each month. The fixed price I contracted for was around $3.20 per gallon.

Now this winter, although very snowy, was not all that cold. Thus, by March and April, I had not yet used up all 800 gallons that I had contracted for.

That made me wonder what would happen if I did not use all 800 gallons.

A check that came in the mail today answered my question: the 140-odd gallons left on my contract as of May 30 were worth, at my contracted price of $3.20, about $450. My heating oil company sent me that refund check today.

Now I would have preferred to get the 140 gallons, which at current heating oil prices ($4.85 per gallon!) would be worth about $680. And, on the other side of the transaction, my delivery company clearly prefers to pay me the cash value of my contract.

I suppose that if I read the fine print, somewhere in the contract I signed last year, it would say that the company could pay in cash (using old prices of course) for any unused gallons.

It is not the settlement in cash that concerns me. It is a more subtle opportunity for opportunistic behavior.

I had noticed back in mid spring that my tank was low and that I had not received any deliveries for some time. Therein lies the possible problem. The heating oil company clearly knew that heating oil prices in the open market were way above last year's fixed prices. Therefore, every gallon they could avoid delivering would mean roughly $1.65 (4.85-$3.20=$1.65) of profit (or avoided expense, however you want to view it). In fact, at one point during this year, I had to call my company because they had not delivered for some time and I was on empty.

So what if the heating oil companies were purposely letting customers' tanks run low, thereby minimizing the amount of oil they would have to buy at open market prices and deliver at the old, lower fixed price? That would smack of opportunism, would it not? (Don't be fooled into thinking that the companies would not care, since they might have bought enough oil to cover expected deliveries early in the year at lower prices as well. They well might have locked in prices, but that doesn't mean that they still don't want to part with oil that is worth $1.65 more per gallon than they are going to get for it!)

If I were a lawyer, I would be interested in seeing if delivery policies were changed in the springtime. Maybe some low income households should get an even bigger check than they might already have received. Or at least, the delivery company could deliver the fuel that was contracted for so that low income households don't start the fall with an empty tank. That is what I have right now -- an empty tank and a check for $450 instead of a tank with 140 gallons of fuel oil worth $680. Not exactly peanuts.

Wednesday, July 09, 2008

Some Thoughts on iPhone/Blackberry

I am looking forward in the next few days to getting iPhones for my entire family. My Verizon agreement is up, so I am a free man!

There are a couple big questions in how the iPhone will do in the market, with the biggest one in my mind being how far it will penetrate the business market, which is of course currently dominated by Blackberry (something like 16 million users, mostly business, and growing rapidly).

There are a couple reasons why business penetration has been and will continue to be somewhat tough for the iPhone. Until the new 3G version, users could not link to Microsoft Exchange servers, making access to corporate information difficult if not impossible. This is not unlike the problem that Macs have had. I use a Mac at Tuck, and since Tuck is on an Exchange server, for years I had to use a Dartmouth email server instead of the Tuck server.

The new iPhone has enterprise capability so that problem technically is solved.

But the second big issue is inertia. Even now, with access by the Mac to the Tuck network wide open, my IT folks still recommend Wintel machines, and most faculty shy away from Macs thinking that there will be access problems. I suspect the iPhone will run into this as well -- until IT departments start supporting the iPhone, individual employees will have to stick with RIM or other such products.

On the other hand, there are some huge positives. It is dangerous to judge from anecdotal evidence, but I see the "pull" demand for the iPhone as being really strong. Individual faculty love the iPhone, for its applications, its ease of use, its hipness, and they are going to buy it whether Tuck IT supports it or not. Seeing that, I am already hearing that our IT group will be gearing up to support the iPhone as an approved device. If we are at all typical, this could be a tipping point for Apple and cracking the business market. The technical barriers are gone, and the transaction costs of switching over have been minimized by Apple's genius designs.

You can read all over the place about the reasons Blackberries are still better. Hmmm.....a keypad, really? And I do think that the potential for software development off the Apple platform is huge and will have a huge impact.

So, this gets us to the questions of strategy. Blackberry is huge, Apple is still tiny in the smartphone market. And Apple, at least initially, went after the consumer market, not the core business market of RIM's.

This sounds like a classic judo economics strategy. A small entrant comes in, with a strategy that credibly is going after only a small part of the incumbent's market. If the incumbent believes the entrant's strategy, its optimal response will generally be to accommodate the entry, that is, to not engage in a huge battle for the lost market. Besides the assumption that the entrant is going after only a small part of the market, accommodation being the best response also requires retaliation by the incumbent to be generalized. That is, if the incumbent can respond in a targeted fashion, such as reducing price only to those customer segments that the entrant is going after, then that would naturally be an optimal response. It is when a response must be across the board that accommodation looks attractive: the entrant is essentially saying, why would you the incumbent want to spoil the rest of your market just to fight little old me?

Note that this discussion applies most clearly to price responses, but it also applies to product innovations. I imagine that RIM is furiously looking for ways to improve its products to fight the iPhone. But to the extent that these new features will be costly, and that they will have to be implemented across the board, the above judo strategy logic applies.

A big point though is that it is not at all clear any more that Apple is working the judo strategy. When they were going after the consumer market, RIM could RIP (rest in peace). But now, Apple has cracked the enterprise barrier. Can RIM accept the loss in market share that might be forthcoming? Or should they respond aggressively -- with pricing and with new costly products and features?

I don't have the necessary pricing and cost information to do even back of the envelope calculations. My intuition, however, tells me that Apple is going to grab a reasonable portion of the business market almost no matter what RIM does. There are some segments that are just pretty indefensible against the iPhone. RIM has this huge mass of users, and they are all using pretty much the same device even though they have different tastes. The iPhone will appeal to maybe 20% of them in such a strong way that RIM might as well just kiss them goodbye -- judo works, those customers are not worth fighting for. After those low hanging fruit, however, I think the iPhone will have a tougher time, to a great extent because of inertia. RIM can slow iPhone's penetration into that thick 80% with some incremental pricing and product improvements, and that will probably be optimal over this generation of products. The iPhone will gradually move deeper and deeper into the business market, but again, much of that will be indefensible so RIM's best response is just to enjoy the cash flow from those customers while it lasts.

This is a fair amount of speculation. I will have some more ideas once I get my new phone and I see how quickly Tuck's IT department can get it up to speed.