S. Bernstein questioned Apple about the price elasticity in regard to the iPhone. Apple replied that they were very happy with an elasticity that enabled the company to reach their goal of one million sales at the end of quarter 2008.
I want to answer a set of questions; what do we believe is the value of the price elasticity of demand for the iPhone, what factors apart from the product’s own price would effect the demand of this product and how sensitive do you think the demand would be to each of these factors?
In order to answer these questions it is vital to define the principle of price elasticity of demand (focusing on the brand level elasticity), calculate the expected value of price elasticity and analyse the effect of factors such as substitution possibilities, budget shares, time, interdependence between products, marketing, etc.
First of all, let us define price elasticity of demand. Robert H. Frank describes price elasticity in his book ‘Principles of Economics’ as the; “…percentage change in quantity demanded that results from 1 percent change in price.” This definition simply refers to the responsiveness of quantity demanded by a change of 1 percent in price. Yet, provided that the demanded change in quantity is relatively small, it is possible to calculate the price elasticity of demand as a percentage change in the demanded quantity divided by the corresponding percentage change in price;
Yet it is important to note that there is a difference between brand-level and industry-level elasticity. Due to a range of substitutes, brand-level elasticity tends to be higher then industry-level elasticity. Essentially, more competition infers the proliferation of brands; which increases elasticity.
Nevertheless, the elasticity equation depends on accurate demand figures. Unfortunately, no reliable demand figures are accessible since Apple only recently launched the iPhone. Apple’s quarterly reports only provide us with a vague idea of the demand figures for the iPhone. The iPhone was launched in the US roughly at the beginning of the second Quarter 2008, at a price of $599. In mid September Apple reduced the price for the iPhone by 33% from $599 to $434 . According to the quarterly reports, Apple sold 270 000 iPhones in the second quarter and 1,119 000 iPhones in the third quarter. If calculated according to the equation for price elasticity of demand, the iPhone would have a brand elasticity of 4.7, which means that Apple would lose almost 4.7 percent of iPhone sales for each corresponding 1 percent increase in price. Yet one must to be aware that the elasticity of 4.7 cannot be considered as a realistic value, since it ignores the fact that, just after the launch of the iPhone, Apple used market skimming strategies in order to maximize their revenue. Elasticity of demand for early adopter of the iPhone must have remained extremely low since Apple profited from an extremely strong brand, the hyped-up “it” factor of the iPhone and a highly devoted costumer base. However, early adopters prepared to pay a premium price predominantly determine the price elasticity in the short run, yet this paper analyses the long run of brand elasticity since demand tends to be more responsive and realistic to price changes in the long run.
Scott Cunningham from CoreEconomics used a different approach to calculate elasticity of demand for the iPhone. He argued that if Apple is profit maximizing it will set the retail price of the iPhone so that (Price – Unit Cost)/Price = -1/Elasticity. Based on a unit cost of $280 the implied profit margin would be 29%, which translates, according to Cunningham’s equation, into an elasticity of 3.37 for the iPhone.) In general, the iPhone cannot be considered as an essential good, but as a luxury item which purchase can be easily postponed and has several substitutes. Furthermore a brand level elasticity’s are in generally higher then industry based elasticity’s.Overall, a rather moderate brand-leveled price elasticity of approximately 4-5 percent in the long run seems plausible.
Since the numerical estimates are not fully reliable it is necessary to support our elasticity prediction of 4-5 percent by providing further evidence. The second question asked; “what factors apart from price would affect the elasticity of the iPhone and how sensitive do you think the demand would be to each of these factors?”
The iPhone itself does have direct substitutes. Generally, this implies an increasing elasticity. Nevertheless, the situation is more complex. Since the iPhone is a luxury commodity many consumers wait until increased competition forces Apple to decrease prices. Basically, the missing substitution effect is not as valuable as initially anticipated.
The iPhone’s elasticity in regard to consumer budget again supports a rather moderate 4 percent elasticity. Unlike salt or pepper brands, the iPhone consumes a relatively large portion of the average consumer budget. Aspects such as a highly devoted consumer base, product hype, etc, contributed to an inelastic demand, yet, lower prices of substitutes counterbalance these factors.
Another specific reason for the iPhone’s increase of the elasticity of demand is consumer irritation; many consumers who aspire to buy an iPhone are slightly put off by the rather unusual fact that Apple restricted the iPhone to one exclusive carrier per country (generally, mobile manufactures provide the costumer with the possibility to unlock their phones and switch between different carriers). The transaction costs of switching between different carriers and the high price of the iPhone might dissuade first time buyers from making a purchase, increase the substitution effect and result in an increase in market-elasticity.
An element that reduces the market-elasticity of the iPhone is the fact that customers of Apple’s music download platform iTunes are dependent on the iPhone if they want to buy a device that includes a mobile phone and internet with music downloading capability. Why? Because, music downloaded from iTunes can only be played on Apple devices. Yet, consumers could also have substituted their needs with a combination of an iPod and a regular mobile and wait until increased competition reduces the price of the iPhone.
Overall, all these factors contribute to the predicted moderate branch-level elasticity of 4-5 percent. I predict that elasticity, especially due to the substitution effect will increase significantly in the long-run the
According to the figures provided by Apple’s quarterly report alongside other calculations we predict an estimated elasticity of 4-5 percent. Generally speaking, a rather moderate branch-level elasticity. Several other factors support our conclusion; the iPhone is a trendy and desirable good with unique features and no direct substitute, factors usually found in inelastic products. Yet the high price of the iPhone (still one of the most expensive mobiles on the market after the price cut) and the fast response of competitors might counterbalance these factors. Furthermore, consumer irritation over Apple’s ‘one-carrier’ policy and mix of alternative products as a possible substitute increases the substitution effect and once again support our elasticity estimates. Furthermore we predict that competition due to direct substitutes will increase, resulting in a decrease of price, boosting elasticity for the iPhone.