Second Degree Price Discrimination and iPad Mini

There are enough news media reports, may be they all came from the  same source, about the imminent iPad Mini (a smaller and cheaper version of iPad to compete against Kindle Fire and Nexus). AllThingsD is convinced Apple has ordered 8-10 million units.

First there were “confirmed rumors” about invites going out on October 10th. Now they have retreated to another “confirmed rumor” about October 23rd event.

It is possible all these sources are true and Apple will go on to release a iPad Mini. But I find it still difficult to see a scenario where the lower priced iPad Mini can deliver incremental (net new) profit.

An analyst on CNBC said,

It could be big for investors, said Sterne Agee’s Shaw Wu.

“Like other products, lower price points tend to drive sales. An iPad Mini we think would likely drive incremental iPad buyers,” Wu said in a phone interview with TheStreet. “There’s going to be some cannibalism of iPad sales, but we think it makes a lot of sense.”

I am not sure if Wu followed Apple’s pricing strategy so far. Besides he seems to miss the point that lower price points also kill profits. Apple, however, never chased market share. Shaw Wu is not alone on this, there are many stock analysts and others who seem to think “some cannibalism is not bad”.

Exactly how bad is the cannibalism? Well for starters it is not about sales volume or revenue, it is about profits. Contribution margin on iPad is 42%-50%. That is, $210 to $250.  Given that we are hearing (from analysts) either $199 or $299 price point for iPad mini and that we know from Amazon that they are selling KIndle Fire at cost, it is highly likely contribution margin from iPad mini is in the range $10-$100.

I cannot see a scenario Apple selling anything at cost.

So for each unit of $499 iPad cannibalized, Apple has to sell 2 to 25 iPad minis. If we assume average, that is 13.5 iPad Mini for every iPad sales lost. Is that doable? Let us look at recent market research numbers on customer preference for iPad in the presence of cheaper iPad mini (second degree price discrimination)

35% of iPad owners surveyed by deal aggregator TechBargains.com say they’d trade in their old model for the smaller tablet

However, only 18% of all respondents in the TechBargains survey say they want the new gadget,

These are not good numbers. Presence of lower priced iPad, packed with value, will cause more than one third of current iPad customers to trade down. This can be compensated only if the 18% of the total addressable market for iPad mini (those who will not buy $499 iPad) is greater than 35% of iPad market.

One way for Apple to reduce the magnitude of this trade down is to what railways did in the past with their third class cars. For railways there was a big market of low price travelers (and they had excess capacity). They wanted to attract these low price travelers but did not want to lose the high contribution margin from those second class (or first class) travellers trading down to cheaper third class.  So to ensure those who can afford will continue to choose the second or first class the railways removed roof from their third class cars.

Apple could do something similar and cripple their iPad mini such that only the most cost sensitive segment will self-select to this version while the higher willingness to pay segment will continue to prefer the full iPad. But that is complicated by the presence of really good alternatives at these lower price points.

Even for those who would buy an iPad mini, there are many options at the $199-$299 price points.

The $199 price point is crowded with feature rich tablets and there are two others delivering great value at $269 and $299 price point. Not to mention the $399 iPad2 which offers better value than a $299 iPad mini.  Apple cannot cripple its iPad mini and expect to win against these value packed alternatives.

The cannibalization does not end with just iPad. It also extends to iPad Touch.

At $199 and $299 price points Apple will compete with its other product line – iPod Touch. Since the 7″-8″ tablet will deliver lot more value than iPod Touch for the same price more will switch from these high contribution margin units.

Considering Apple’s practice of effective pricing (note the fact that they did not introduce a $199 new iPod Touch) and effective use of product versions at multiple different price points I do not see Apple entering this field. Even if they did, it is only 10-30% chance this new product will result in net new profits.

 

Our pricing decisions are based on … Starbucks Raising Prices

Redesigned logo used from 2011-present.

Image via Wikipedia

Two years back we saw the story of Starbucks price increase. Despite widespread criticism in the news media we saw no real ill effect on its sales or brand. You know why from here (elasticity) and here (demand curve shifts). Now they are rolling out price increases to the rest of the country. I want to point out some key points noted in the price increase story that serve to tell us how well they are executing this change.

Here is the link to Reuters story if you want to read it without my interpretations.

Starbucks Corp (SBUX.O) raised prices by an average of about 1 percent in the U.S. Northeast and Sunbelt on Tuesday, making coffee-drinkers spend more in New York, Boston, Washington, Atlanta, Dallas, Albuquerque and other cities.

Average price increase is meaningless. They want us to focus on the small number. Most likely some prices went up much higher then 1%. You won’t find that until you read the story. Most likely they also calculated the average over all their products, even those that did not see price increase, simply to bring down the average.

Starbucks expects high costs for things like coffee, milk and fuel to cut into profits this year. Like other restaurant operators ranging from Chipotle Mexican Grill (CMG.N) to McDonald’s Corp (MCD.N), it is raising prices to help offset some of that cost pressure.

They are giving reason for the price increase. As William Poundstone, author of Priceless wrote in a guest post for this blog, customers are more likely to find the price increase acceptable if associated with a fair reason. Starbucks is going a step further in using examples, “hey others already did it and we are following them”. You should give them credit for both points and extra credit for giving future cost increase as the reason.

the price for 12-ounce “tall” brewed coffees and latte drinks went up 10 cents. Prices on about half a dozen other beverages also were set to increase

This further attests to first point, not all prices are going up. Most likely they are increasing prices of their most popular drinks, those whose demand is relatively inelastic or those with lower contribution margin such that they are okay with lost sales from price increases. For the last point see my past post on how lower contribution margin means okay to lose sales from price increases.

Starbucks’ Olson said the price for a 16-ounce “grande” brewed coffee, the company’s most popular beverage, remained the same across the United States and has not changed since January 2011. The price for grande lattes was unchanged in most markets, he added.

To state the obvious, Starbucks has three sizes, tall, grande and venti. They are increasing prices on their tall while leaving the grande untouched. This is classic case of second degree price discrimination. After the price increase on tall, some customers may find they get more value with grande (higher consumer surplus) than they get from higher priced tall and will instead choose grande. Since the marginal cost of additional coffee in grande is almost negligible this is still an upside for Starbucks. They are able to capture higher consumer surplus without alienating their customers. Because they have done their versioning right.

Lastly this one is the most measured statement of all (I bold texted the key phrases)

The Seattle-based chain said its pricing decisions are based on multiple factors, not just the price of coffee, which has eased lately.

Those considerations include “competitive dynamics” in individual markets as well as costs related to distribution, store operations and commodities, including fuel and ingredients for food and beverages, Olson said.

As you read this multiple times you will find all kinds of reasons except, “We cater to a somewhat higher-income customer and we price our products based on customer willingness to pay. Besides we don’t expect any push back from these high income segment”.

A key attribute of those practicing value based pricing is never explicitly saying that they are practicing value based pricing. There are always other reasons and you never say pricing at customer willingness to pay. A key part of practicing effective pricing is effective pricing communication and managing customer perception. Failing that you will face backlash as some brands recently did.

Overall, great pricing strategy, execution and communication by Starbucks.

Observations on iMac Pricing – A case of well executed versioning?

Take a look at the pricing of the two lowest priced iMacs.

The cheapest one not only has the lowest configuration but also allows no customizations to the CPU and Disk capacity. It cannot be that it is technically infeasible to support customization on this version. Moreover, it is not farfetched to think that, among the customers who prefer the lowest priced version, there must exist two sub-segments who would prefer to

  1. upgrade just the CPU to the next level
  2. upgrade just the disk to 1Tbyte level from 500GByte level

(Note: The segment that prefers both will choose the next higher version since it offers them better price. I am clearly ignoring the graphics card is not a factor.)

Apple charges $188 for upgrading CPU to next level and $141 for the Disk upgrade. So why doesn’t the Apple offer these customizations for the lowest priced version? Are they leaving money on the table by not meeting the demand by not asking “Do you want to supersize it for just $141 or $188?”?

One possible answer is they want to nudge those who can and willing to pay higher price ($1499) for a faster CPU or bigger disk to self-select themselves to the next higher version  instead of choosing the lowest priced version and paying just for that upgrade. While there may be some customers in the $1199 segment who are willing to upgrade just one of the features, there may be others in the $1499 segment who may be tempted to do just that as well. That is there must exist sub-segments in the $1499 category who would prefer to

  1. Downgrade to $1199 version and upgrade just the CPU to next level
  2. Downgrade to $1199 version and upgrade just the disk to next level

I believe their customer demand modeling must indicate that the revenue gain from those willing to upgrade from the $1199 version is less than the revenue loss from those who are willing to downgrade

$188 * (number of customers willing to upgrade CPU) + $141 *( number of customers willing to upgrade disk)

<

$112 *( number of customers willing to  downgrade to $1199 version with CPU upgrade)  +  $159 *( number of customers willing to downgrade to $1199 version with Disk upgrade)

There is nothing new  or Apple magic here. This is a case of second degree price discrimination (versioning) executed very well.

The other possible reason is, this isn’t by deliberate versioning design at all but a random scheme chosen by one of the product managers.  But I am 70% confident it is the former.

How do you set your version prices?