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Price Discrimination, People…

September 7th, 2007 · 8 Comments
Econ 101

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!

Tags: Econ 101

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