Apple entered the Smartphone market in June 2007 with the launch of basic 4GB and 8GB iPhone. Since then iPhone has revolutionized the Smartphone market and redefined the concept of satisfying consumer needs. Apple has been launching new versions of its successful iPhone and grabbing higher market share from its competitors. This paper looks at Apple iPhone from the microeconomic perspectives. It tracks down the demand and supply of iPhone and explains the likely rationale behind the huge and quick price cuts by Apple. The paper looks at the cost structure of iPhone and notes some of the tactics and differentiation strategies used by Apple to not only survive but thrive in the oligopolistic Smartphone market.

Introduction

Apple Inc. is an innovative designer and manufacturer of consumer electronics. The company initially manufactured personal computers and software and was called Apple Computer, Inc. In January 2007, Steve Jobs, co-founder and CEO, announced that the company name was being changed to Apple Inc. This move reflected Apple’s shift from personal computers to consumer electronics and mobile phones. The company revolutionized digital music industry through iPod portable music players and iTunes online store. Later Steve Jobs became interested in mobile electronic devices.

Steve Jobs had earlier shown interest in touch screen technology and introduction of tablet PCs and PDAs. However, he soon realized the increasing popularity and consumer demand for mobile phones for all purposes (communication, internet and music). ‘In 2002, Steve Jobs, Apple’s CEO, was beginning to realize that rather than carrying multiple devices (phones, MP3 players, Blackberry, etc.), people would prefer just one device to perform multiple functions’ (Mohr, Sengupta & Slater, 2004). Thus, Steve Jobs started developing a new mobile phone product. He wanted to develop ‘a revolutionary phone of the future’ and spent $ 150 million to develop the initial iPhone in partnership with AT&T (Mohr, Sengupta & Slater, 2004). The production and development of iPhone was concealed from the competitors and public. All the supplier partners were sworn into secrecy and even the product development team was not aware about the product they were developing.

Steve Jobs introduced the new iPhone in January 2007 at the Macworld Conference and Expo. He described the iPhone in the following words: ‘iPhone is a revolutionary and magical product that is literally five years ahead of any other mobile phone’. Regarding the innovativeness of the product, Jobs stated that ‘We are all born with the ultimate pointing device-our fingers-and iPhone uses them to create the most revolutionary user interface since the mouse’ (Apple Website, 2007).

Apple iPhone was launched on 29 June 2007 in U.S through AT&T and indeed broke new ground and is a cutting edge product, combining a mobile phone, an iPod and internet communication device with touch controls. The iPhone was an instant hit among the consumers and 525,000 iPhones were sold during the first weekend following its launch (BBC News, 2007). Steve Job was proven right as ‘some 50% of iPhone purchasers replaced another phone, 24% replaced a Motorola RAZR, 14% replaced a Windows mobile device and 20% replaced a BlackBerry or Palm’ (Mohr, Sengupta & Slater, 2004)

The iPhone was introduced in two versions, 8 GB and 4 GB model. The 8 GB model was priced $ 599 while the 4 GB iPhone was worth $ 499. The iPhone buyer also got a two-year contract with AT&T costing $59.99 per month (minimum). The 4 GB model of iPhone was discontinued while the price of the 8 GB model was cut down by $ 200 (to $ 399) in September 2007, barely two months after its initial launch. Consumers who had bought the product were dissatisfied at this price cut within such a short period of time. Steve Jobs took notice of the growing indignation and in an open letter to all customers, announced a $100 store credit to all iPhone customers not receiving any rebates etc.

On 11 June 2008, Apple launched iPhone 3G. Apple indulged in a series of price cuts. It first reduced the price of its iPhone from $399 to $199. On 19th June 2009, Apple released yet another new and speedier version of its Smartphone called iPhone 3 GS. Prices of the new iPhone 3GS were set at $199 for 16GB and $299 for 32GB. The 8 GB iPhone 3G was priced at $99.

Demand for Apple iPhone

Demand for Apple iPhone has been staggeringly high. Even before the launch of the first iPhone on 29 June 2007, consumers were waiting and queuing up in front of Apple and AT&T stores to buy the new smartphone. According to M: Metrics ‘April Benchmark Survey,’ which carried out in April 2007: 19 million mobile phone users were demanding the iPhone before it actually hit the market (Please refer to Table 1). There was high awareness for iPhone as 64% of the U.S mobile users were aware of the subsequent launch of the new iPhone by Apple. 14% of the U.S. mobile users who had awareness about the new phone (its features, prices and AT&T contract) were willing to purchase it. Mark Donovan of M: Metrics stated that the 19 million U.S mobile phone users who reported strong interest and intent to purchase an iPhone formed an impressive figure, considering that the initial demand for most high-end devices rarely approaches one million. Interest and hype for iPhone was also found in UK as 30% of British mobile phone users expressed strong interest in the new smartphone.

The overall demand for smartphones kept increasing in the U.S market. According to ChangeWave research carried out during 9-15 June 2009, 37% of the respondents already owned a smartphone while 14.4% of the respondents planned to buy a smartphone in the next three months (Carton & Crumrine, 2009).

Source: ChangeWave Research, 2009

Apple iPhone benefited from the rising trend in the demand for smartphones as it carved a larger market share each quarter. According to the survey 44% of the respondents who planned to purchase a Smartphone within next three months stated that they intended to buy an Apple iPhone (Carton & Crumrine, 2009). At the time of this research, it is important to note, that the 32 GB iPhone 3GS was priced at $299, 16 GB iPhone 3 GS was priced at $ 199 while its basic model of 8 GB iPhone 3GS was available at $99. This shows that the demand for Apple iPhone was the highest in June 2008 when iPhone 3G was launched and surged with the release of a new version of iPhone or a price cut. The research finding proved to be right as the third quarter results of Apple Inc. showed that the sales of its iPhone surged by 626% as it sold 5.2 million units during the quarter. Apple had launched its new 3GS iPhone in June 2009.

Source: ChangeWave Research, 2009

An interesting finding of ChangeWave Research conducted in April 2007, was regarding the impact of a price cut on demand for the two initial iPhone versions. The survey asked those respondents who were not planning to buy an Apple iPhone to point out the price at which they would consider buying an iPhone. The result (Please refer to Table 2) showed that 9% of people not planning to buy the iPhone would consider buying it if the price of a 4GB iPhone was slashed to $ 299-$ 200 price range while 14% would get interested in buying an 8GB iPhone for the same price range (Carton & Woods, 2007).

Supply of Apple iPhone

Apple Inc. struggled to keep up with the soaring demand for iPhones since June 2007. The company accepted that it was faced with high demand but insufficient supply. Apple Inc. had serious supply issues when it launched its iPhone 3G in June 2008. One million iPhone 3G were sold during the first weekend after its launch. It was a spectacular start for the new product, yet many believed that iPhone 3G could have done much better if there were no supply constraints and distribution problems. Some skeptics believe that this is Apple’s strategy to maintain control over the market dynamics, demand and prices. The case remained the same when iPhone 3GS was introduced in the market. It took five days for Apple to fulfill an order for iPhone 3GS instead of the normal 24 hours. Demand remained unmet for a lot people in U.S and in other countries. The reason for shortage of Apple iPhone 3G was extremely high demand outside the U.S in emerging markets. Normally companies have a gap of 100,000 units per year between the actual and forecasted demand figures but for Apple Inc., this gap was being driven up to 1 million due to higher than expected international demand for the iPhone. This caused supply issues for Apple and its supply chain proved inadequate. Apple’s supply of iPhone has thus remained inconsistent and low. Had the company met all the demand, it would have achieved more sales and market share over the years.

Apple’s Pricing Strategy

Having looked at the Apple iPhone’s demand and supply situation, Apple could have increased the prices of its smartphones. Products which have high demand and short supply are sold at higher prices. However, this was not the case with Apple’s iPhone pricing strategy. Apple has been continuously decreasing the prices of the various versions of iPhones it has launched since June 2007. Had the demand for iPhones been low, we could have easily assumed that price cuts were a tactic to stimulate demand and sales. Apple iPhones demand, however, has exceeded its supply over the years. Generally, in case of new and innovative durable products, substantial price cuts are observed after the initial product launch. The timing and speed of the price cut are important managerial decisions (Mireles & Fok, 2008). The timing of the price cut in September 2007 was considered too early because Christmas was only a few months away.

The only likely rationale behind the price cuts could be Apple’s aim to sell to additional consumers and increase its market share. With the price cuts, Apple made its iPhones more appealing for people who could not afford it. More and more people can now afford to buy the new iPhones. The price cut was also seen as a strategy to beat tough competition coming from other Smartphone manufacturers. The $199 8GB Palm Pre was being seen as a threat to the market share of iPhone. By reducing the 8GB iPhone’s price to $99, Apple Inc. made the mobile phone least expensive and more attractive for consumers in a recessionary period, in comparison to other products of rival companies such as RIM, Microsoft, Google and Palm.

In economic terms, the price strategy of Apple Inc. for its iPhones can be called inter-temporal price discrimination (Froeb & McCann, 2008). Inter-temporal price discrimination refers to setting a high price for a product initially to sell to consumers with the highest willingness to purchase and reducing the prices later to attract those with lower willingness to buy (Nair, 2006). Firms adopt price discrimination by developing various versions of a product and offer each version at a different price. In Apple’s case, ‘the versions of the product differ in the time dimension’. Apple had a premium version of iPhone which was sought after by tech-savy consumers who wanted to buy the new Smartphone as soon as it was launched while the lower-valued version was available later (after two months in September 2007). ‘High-value customers identify themselves by purchasing and, low-valued customers wait to buy’ (Froeb & McCann, 2008). Apple iPhone’s price reduction was to induce low-value customers (who were not willing to buy the product initially due to high prices) to purchase it at lower cost. Apple Inc. intended to increase sales revenue through higher sales volume rather than higher margins. When Apple reduced the price of iPhone 3G from $399 to $ 199 in 2008, its sales tripled from 4.7 million iPhones sold in the three quarters before the price cut, to 15 million iPhones (Ogg, 2009).

The sharp decrease in the prices of high-tech product or electronic items with short life cycles like video games has been termed as price landing (Mireles & Fok, 2008). This concept of price landing can be used to explain the price slash by Apple Inc for its iPhones. The drivers of Apple iPhone’s price landing could be its own sales, sales of competitors, time or product obsolescence factor. The result findings of the research done by Mireles and Fok that high-tech product companies cut prices after a certain time threshold (or product obsolescence), after enough competitors have launched rival products or after the company’s own sales reach a certain threshold. The last driver, own sales threshold was found to have limited effect of the managerial decision to cut prices. This study agreed that inter-temporal price discrimination indeed occurs for high-tech products, but time is a used as a proxy to decide when to cut prices instead of the units sold to high-value customers’ (Mireles & Fok, 2008).

Economic theory helps us understand Apple inc.’s motivation and decision to decline prices of its iPhones despite high demand and low supply situation. Apple iPhone is an example of a product that has a short life cycle and the demand for iPhone varies over its entire life. Highest demand is seen at the launch of a new iPhone as high valuation customers try to be the first to purchase the new product. High valuation customers however, exit the market after the first few months. Demand for iPhone at the time of introduction was relatively inelastic and became more elastic as time passed. This price strategy is also called price skimming whereby high price is charged to low elasticity consumers initially and then lower prices to sell to the mass market. Inter-temporal pricing or price skimming may not maximize earnings for a company, if consumers are forward-looking and anticipate a price cut in the near future. High value customers may wait to buy the product after the price cut and the pricing strategy would prove to be ineffective.

Cost of Apple iPhone

According to Andrew Rassweiler, principal analyst at iSuppli, the cost of producing a $499 iPhone was $ 245.93 and the cost of manufacturing a $599 iPhone was $280.83 (Boslet, 2007) (please refer to Table 3 for details). Thus, Apple Inc. was expected to generate a 50% gross profit margin on the sale of its initial iPhone versions. Lower production costs also gave room for aggressive future price cuts. The competition in the mobile phone industry is high and at the time of Apple iPhone launch, around 14 music-enabled mobile phones similar to Apple iPhone in terms of features were being shipped from competitors like Nokia, Motorola Inc., Samsung Electronics Co. Ltd. and LG.

In June 2008, Apple Inc. managed to further reduce manufacturing costs of iPhone 3G by $50 per unit with increased profit margin of around 55%. iPhone 3G was manufactured at a cost of $174.33 (including bill of materials and manufacturing expenses. Apple also spent $50 per unit shipped in IP royalties. The cost of manufacturing iPhone declined as economies of scale and learning effects occurred in the company.

The Market Structure and Competition in the Smartphone Industry

The Smartphone market is an oligopoly because there are few firms that account for more than half the industry supply. The main players in the market are Research in Motion, with its Blackberry phones; Apple with its iPhone; Nokia; Microsoft with its Windows mobile; Google with the Android phone, Palm with Pre Palm. These firms are interdependent and actions taken by one company affects the competition in the market and changes the competitor’s behavior. ‘Each firm knows that any changes in its product’s quality, price, output, or advertising policy may prompt a reaction from its rivals (McEachern, 2009). Also the Smartphone market can be specifically termed as a differentiated oligopoly in which each producer offer a unique and different product. Smartphone manufacturers differentiate their products by offering them with different physical qualities, at different sales locations, with unique peripheral and supporting services (e.g. App store) and branding that creates a unique image in the consumers’ mind. In the oligopolistic Smartphone market each competitor tries to crowd out its competitor by offering new versions of a phone in quick succession. Firms try to put up high barriers of entry like economies of scale, cost leadership, high investment and product differentiation to deter possible new entrants in the market.

When Apple entered the Smartphone market in 2007, it made sure that its product was innovative and better than all the other smartphones present in the market. The feature that stood out the most in Apple iPhone was its screen which was the largest screen (8.9 cm diagonal, 320×480) as compared to other normal sized phones. There was no keypad and the phone incorporated touch screen technology to dial phone numbers, sms and carry out other input functions. Apple also used the success of its bestselling product iPod to take control of the distribution channel. It created a partnership with Cingular (later called AT&T), the largest U.S carrier with 26.6% market share (West & Mace, 2007). Apple has established itself as the market leader by providing unique supporting services from App Store and iTunes from where iPhone users can browse and download applications. Some applications can be downloaded for free and this has increased its appeal to consumers. iPhone 3G was launched in the market with iPhone OS 2.0 with App Store support. Apple iPhone’s marketing and branding was done in such a way that it became a much-awaited and sough after product. Apple also geared up to face competition by adopting economies of scale and continuously cutting down costs of manufacturing iPhones and attaining cost leadership. Cost Leadership refers to providing the same or better value to customers at a lower cost than competitors. This involves considerable time and money spent on research and development. Before launching the most recent version of iPhone, Apple spent time, effort and resources in researching the cost of developing and manufacturing it and at what price the customers would be willing to buy it (Mowen, Hansen & Heitger, 2009). This differentiation strategy of cost leadership has helped Apple iPhone to thrive in the oligopolistic market.

Apple has been able to increase its market share in the Smartphone market successfully since June 2007. Nokia, the global market leader lost its market share to RIM and Apple as its share decreased from 51.4% in Q3 2007 to 38.9% in Q3 2008. Apple iPhone’s market share increased from just under 4% in Q3 2007 to 17.3% in Q3 2008. By Q3 2009, it market share increased to 18% (please refer to Table 4 for details).

Conclusion

Apple iPhone has been surrounded by controversies regarding its pricing policy and stiff competition from rival Smartphone manufacturer. Despite all this, Apple iPhone has not only been able to survive in the industry but actually carve a larger market share each year. The success factors are it high-tech product quality and features that has satisfied the needs of the tech-savy and entertainment aspiring costumers. The demand of the iPhone has soared each year with new versions and price cuts. In this paper, we established that the demand for iPhone far exceeds its supply. The reasons for supply shortage are unclear. Yet it is safe to presume that the supply constraint is caused by supply chain limitations and delays. International demand for iPhone plummeted as the products popularity sky-rocketed and made the existing Apple iPhone manufacturing capacities, competencies, component availability and quality control under pressure. Normally, in a free market price is determined by demand and supply interaction and this way, the price of iPhone should have increased, but in the Smartphone market this phenomenon does not occur. The prices of high-tech products are cut down after the initial product introduction. The paper discusses the rationale for iPhone’s continuous price cut. Ethical issues have been raised regarding the price discrimination by Apple in September 2007, but this is the normal trend in the industry. Even Motorola cut prices of it RAZR a year after its launch. The timing and speed with which the price was cut can be deemed controversial but not completely irrational. Apple seems to have achieved economies of scale through valuable and strategic supplier-vendor relationships, volume/ bulk purchase of components and large-scale production of iPhone. This enabled the company to reduce price without damaging its gross margins. Apple is expected to do well in the shrinking Smartphone industry in the future as it is all set to release the new iPhone 4G in June or July of 2010.