The price elasticity of demand for the iPhone.
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 brandlevel
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 branchlevel
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.