Is the upgrade cost of the new iPhone 3GS fair? Maybe it depends on your definition of fair (and other factors) - p2.
It's been a little over a week since the 2009 edition of Apple's Annual Worldwide Developers Conference, or more accurately, a week since the 2009 WWDC keynote at which Phil Schiller et al officially introduced the new iPhone 3GS (among several other notable announcements I hope to write about on this blog). Considering that most if not all of the changes related to the device itself had been leaked prior to the event, perhaps the two biggest revelations to the iPhone itself were the release date and pricing. We now know that the iPhone 3GS will be first available to consumers this Friday, June 19, 2009. Though I haven't seen much discussion about it, I assume this will be the same backward/inefficient affair it was last year with Apple and its partner AT&T insisting on handling the lengthy, error-prone activation process in stores. This despite the fact that they demonstrated two years ago that this process runs much more smoothly when purchasing is decoupled from the activation process with the latter handled through Apple's own iTunes app.
There is a lot of discussion about upgrade pricing this year. For the most part the price structure, including upgrades, is relatively straightforward. Cost itself isn't the issue. Instead the debate revolves around a question of fairness. Simply put, is the upgrade pricing for the new iPhone 3GS fair to Apple/AT&T customers? Before I tackle that question I want to make two points.
First, as I discussed in a previous post, I believe the nature of this debate has little to do with the issue at hand. Please don't take that to mean that I don't believe the upgrade pricing is an important issue. Nothing could be further from the truth.
In fact, in my opinion these sorts of questions are critically important. As a practical necessity, companies must get fair value for the stuff they produce. We as consumers should demand nothing else. When prices are artificially low, we risk the long term viability of products and services some of which may be potentially profitable and beneficial, if not for the mistakes of a few decision makers who justify losses in the name of meeting short term goals. On the other hand, when prices are set artificially high, exceeding reasonable margins, there are all sorts of undesirable outcomes. Overpriced products unnecessarily limit the pool of potential customers. This can have long term implications for the future success of a product or service. This is especially true with something like the iPhone, the success of which is ultimately tied to an ecosystem of 3rd party products and services. Excluding customers means limiting the market for partners, and possibly excluding the potentially important contributions of future developers. Of course, no one device is for everyone. But, for numerous reasons, some not immediately apparent, producers of goods and services should strive to make them accessible to as many people as possible.
More importantly, and somewhat of an extension to the previous point, money wasted on overpriced products can't be used for other purposes. This is a huge issue and a key to understanding the failings of unrestrained capitalism. An unavoidable fact, and one with profound consequences, is that people do not always make good decisions. This is something that we cannot rationalize away, rather it's a fundamental part of the human condition. Unfair pricing complicates this problem. When we pay too much for one thing we obviously have less to spend on everything else. When it comes to the housing market for example, should sellers choose to charge whatever the market will bear or should they strive for reasonable profit? Realize that when buyers spend more than they should for housing, they have less money for other necessities (e.g. insurance, education for themselves and their children, nutritious food, medical care, transportation). Compromises in these areas can lead to long term consequences that threaten the economy, political stability, and the environment. These issues in turn impact, and to some extent define, all of our lives. Would you sell your house for an excessive profit if you knew it might threaten your job, lead to a significant increase in taxes, or impact your retirement savings? The only point I want to make related to this discussion is that I consider the issue of pricing to be an extremely important one. Hey no one is going to go broke buying a $600.00 iPhone, right? Probably not, but small businesses in an area where a lot of people buy $600.00 iPhones may see a decline in income. Some number of people will opt not to pay for health insurance in favor of the $100+ service contract, risking not only their own health but also their long term financial security.
Unfortunately, this is a bigger discussion than I have space and time for here. I believe that what's missing is the same sort of spirit of conservation that we seem to be embracing when it comes to energy use and the environment. I propose a principle of fiscal conversation (not to be confused with fiscal conservatism) which states that every payee takes only what is needed, leaving the rest for other uses, so as to create a healthy, sustainable economic environment.
The second point I want to make is that I think framing this as a question of fairness is a little misleading, in that it overly simplifies the issue. I prefer to think of the question in terms of right and wrong. In other words, the question I want to consider is this, 'Is it right for Apple and ATT to set upgrade pricing for the iPhone 3GS as they have?'.
What's the distinction I'm making here? Fairness literally means 'in accordance with the rules'. In the absence of blatant cheating, it can be argued that almost everything is fair. The term 'right' on the other hand, in the sense that I intend to use it here means 'morally justifiable or acceptable'. When we talk about fairness, the standard is the set of established rules related to whatever it that we're discussing. In this case is upgrade pricing for the iPhone 3GS the question, 'is it fair...?' might be restated, 'is it legal...?'. When we think about what's right, the measure is 'in relation to standards of good and bad character or conduct' (to quote the dictionary).
If this is a discussion about fairness, then it's my understanding that the answer is an unequivocal yes. Apple and AT&T are not breaking any law, and so yes, the upgrade pricing is fair. But is it the right thing to do? No, I don't believe it is. Let me explain...
First, what is the upgrade pricing? (What are we talking about?)
It's pretty straightforward. I grabbed this from a Gizmodo post titled Whiners of the World: Shut Up About the iPhone 3GS' Upgrade Price but it's essentially the same info you can find all over the web:
iPhone 3GS: Device Pricing
16GB iPhone 3GS
Standard subsidized price: $199.00
Upgrade price: $399.00
32 iPhone 3GS
Standard subsidized price: $299.00
Upgrade price: $499.00
Existing customers who are not currently eligible for a a subsidy must pay the upgrade pricing. Essentially, this is everyone who signed up for a contract and purchased a subsidized phone within the past 16 months. This includes every existing AT&T customer with an iPhone 3G. That device was made available on June 18th of last year, almost exactly 12 months ago. That's the longest anyone has had the device and well under the 16 months required for even a partial subsidy.
Note that this is exactly the situation customers who purchased the original iPhone were in last year with the release of the iPhone 3G. To my way of thinking, this fact is irrelevant. As I've already said, it's not a question of fairness but rightness. The upgrade cost may have been wrong last year, in which case it makes no sense to persist in doing the wrong thing out of some sort of misguided sense of obligation - an obligation to continue to overcharge customers is not an obligation any customer should favor. According to this sort of reasoning we would continue to accumulate an ever increasing number of mistakes without the possibility of correcting any of them without compensating everyone who had been wronged before. Whether you subscribe to this sort of reasoning or not, it is in fact not generally how things are done. For the purposes of this discussion I'm putting aside the issue of last year's upgrade cost because, as I've said, I do not consider it to be relevant.
After what has been a rather lengthy build up, I'll make three short points to support my contention that the upgrade pricing is not reasonable.
1. The prices on which the subsidy is based are artificially high.
The logic behind subsidies, and the reason my most consumers are willing to commit to a long term contract with a provider, is something like the following. Cellphones and other mobile devices are expensive. The provider is willing to pick up some of the cost in order to encourage customers to use their service, which of course requires a device. The more functional the device, the more appealing the service. So, it's not enough for providers to give away an impressive phone and expect users to be interested in the services they provide. Of course, providers can't be expected to pay for a significant portion of the device only to have customers discontinue use of the service after a short time. After all the carrier isn't in the business of giving away mobile devices. The subsidized amount can be recouped as part of the subscription but only if the customer pays for that service for an extended period of time. Assuming you're satisfied with the service provided by the carrier, it seems like a situation where everyone wins. Device makers are free to develop more capable and appealing devices, without worrying that consumers will be unable or unwilling to pay for them (after all the carrier is picking up some of the tab). Providers are able to effectively offer better service because the devices used to access those services are more capable and appealing. Consumers are able to purchase better devices at lower costs than they would without subsidies. Because the customer must pay for service with or without the subsidy, and assuming the cost of the service itself isn't increased, then the subsidy represents a cost savings. Device makers make and sell more and more innovative devices, carriers add customers, and customers save on money on the cost of mobile devices.
I'll quickly discuss how this is related to upgrade pricing. It should be pretty obvious so I won't belabor this point. When a customer opts to purchase a new device before the carrier has recouped the cost of the previous subsidy, then the provider is unwilling to partially pay for a second device. This seems reasonable given the discussion above about why subsidies work.
What's the problem?
The unsubsidized prices of these devices are unreasonably high, and those reference prices skew all of the math, spoiling the logic. I'll refer to both the iPhone 3G, released last year, and the just announced 3GS here. Remember that I've already said that the situation was the same last year when the iPhone 3G was introduced. The reason for this is two-fold. First, to the best of my knowledge no one has a detailed tear down analysis of the newer device. Second, based on the newly announced specs for, it's likely that the costs associated with the two devices are similar.
It was widely reported that the cost to build the iPhone 3G was estimated to be $174.33. That price is $56 less than the $227 estimate for the cost of the original iPhone. That's not surprising. With each generation of the device the complex processes involved in building these devices become more efficient, even as the devices themselves become more capable, and manufacturers are better able to estimate demand which allows them to take advantage of quantity discounts on materials and components.
We need to be careful to keep in mind that this figure represents only component costs and does not include other expenses (e.g. packaging, shipping, software development). That having been said, we should not over estimate these additional costs, particularly software development. Though it is certainly not a trivial matter to develop the software for the iPhone it is a relatively small scale affair in terms of the number of people involved. There are no material costs and relatively few salaries to consider. Furthermore, software is typically evolved rather than rewritten from scratch. The OS for the original iPhone is based on Mac OS X. Mac OS X in turn is based on operating systems that preceded it, which were themselves the collection of many other software projects. Each new version of the iPhone OS builds on the version that preceded it. All of this reuse not only helps to ensure predictability, stability, and performance, it also helps to minimize software development costs. Furthermore, keep in mind that software development costs are distributed over the total number of products sold. In other words, the software costs are the same whether Apple sells 1 iPhone or 100,000,000. That having been said, Apple has sold a lot of iPhones, exceeding even their own estimates, which means that per device, software development costs are lower than anticipated for nearly two years now. iPhone OS 3.0 will bring with it important new features, but no doubt carries lower development costs than any of the two previous versions of the device. At the same WWDC keynote where Apple introduced the iPhone 3GS they announced that 40,000,000 iPhone OS devices have been sold to date. Based on that figure, in order for software costs to add even $10 to the price of each device, Apple would have had to spend $400,000,000 dollars on software development. That's enough to pay 400 engineers a $1,000,000 salary each or 4,000 engineers $100,000. Apple does not have 4,000 engineers working on the iPhone platform, and just as certainly, they are not paying developers a million dollars. In other words, Apple is not spending 400 million on software development costs, and so software costs most likely amount to less than $10 per device. For software costs to contribute just $50 to the cost of each device, the total investment in software development for the iPhone platform would have to be a whopping two billion dollars ($2,000,000,000), which is of course ludicrous. What's the point? It's perfectly fair to limit the discussion to build costs. Just keep in mind that they will be a little off. OK?
Let's get to it then. We'll assume the build price of the iPhone 3GS is the same as it was for the iPhone 3G at $174.33, and based on the now recently released specifications there is no reason to assume they would be significantly higher. The price without contract for the 16GB and 32GB versions of the iPhone 3GS are Apple and AT are $599.00 and $699.00 respectively. These prices represent a markup of 71% for the 16GB model and 75% for the 32GB iPhone 3GS, which is absurd. Keep in mind that these devices are sold directly by Apple and AT&T. There are no middlemen here. It is true margins for Apple's products typically far exceed its competitors in the PC industry. I found this article from marketwatch.com titled "Apple could see margins at risk with price cuts" from June _ 2009, stating that Apple has reported gross margins of about 34% for its last two fiscal years while Dell's margins for the same period are closer to 18% - 19%. Still margins higher than 40% are excessive (even for Apple). The no-contract prices for the iPhone then are well beyond excessive. These are the numbers against which all of the other costs are measured.
We are willing to commit to a two year contract, because $299.00 and $199.00 seem like a value when compared to the what we're told we could be paying. Even the the upgrade pricing might seem like a bargain. The problem is that all of this arithmetic, and the conversation about it, are based on an artificially high reference price. This mistake is based on a well known cognitive bias called anchoring, and it distorts our decision making. From the wikipedia entry for anchoring:
During normal decision making, individuals anchor, or overly rely, on specific information or a specific value and then adjust to that value to account for other elements of the circumstance. Usually once the anchor is set, there is a bias toward that value.
So my first point is that it isn't right for Apple and AT&T to charge upgrade pricing because the pricing is based on ridiculously a high estimation of the value of the device.
I'm not suggesting that the subsidy isn't real. Again, I'm arguing that the upgrading pricing isn't reasonable, not that it isn't fair. I'm not accusing Apple and AT&T of cheating customers. I am saying that the subsidy shouldn't be necessary.
Why would AT&T agree to pay more for the device than it's worth? Why would they agree to pay for a subsidy rather than negotiate for better pricing? An obvious answer is the guaranteed revenue tied to the two year contract. The high price of the device serves as justification for demanding that customers agree to a such a lengthy commitment. The contract guarantees that AT&T will recoup any money spent on the subsidy (so there is no risk of losing money) and what's more important of course, is that over the life of the contract the carrier will make a minimum of $2400.00 (assuming a typical $100.00 a month voice and data plan). What's equally important, is that AT&T is able to ensure those customers will continue to subscribe for a lengthy, predictable period of time regardless of quality of service, possible failure of future initiatives, or the strategies and practices of competitors. Considering all of this, if I'm a carrier, I would much prefer to overpay for a device like the iPhone, subsidize it for customers, and then recoup that initial loss over the life of the contract.
2. Timing
It's obvious that Apple, working with its partners, carefully times product introductions so as to maximize both sales and revenues. Of course, everyone does this. It's only good business. Education related products are introduced in time for back to school shopping. Just about everything else needs to be available for the holiday shopping season. It's not hard to understand that success depends not only on having a product consumers want, but also presenting them with the opportunity to buy, and ideally where and when the product might seem most appealing. Presenting the opportunity to buy can mean many different things, from choosing the right locations for retail stores and organizing products in those stores, to targeted advertising and promotion. Generally speaking, this isn't a bad thing for consumers. Who would complain about being able to buy the products they want exactly when and where happen to be, and at the time when motivated to make the purchase? Is there an amount of manipulation at work? Of course there is, but done in the right way consumers will gladly hand over their money in exchange for the desired product and be thankful for the privilege. Apple has learned this lesson as well as anyone and the result has been the opening of over 250 retail stores worldwide with more on the way. In the context of what we're discussing here, timing means something else.
When it comes to the iPhone 3GS, the timing is about something more than simply choosing to introduce a product at a time when it might be appealing to potential buyers. Instead it's a decision driven by the promise of increased revenue. Now that the iPhone has been available, and in roughly the same form, for a couple of years, the people most likely to immediately buy the iPhone 3GS at introduction aren't consumers looking for a mobile device and considering the iPhone among other options. They aren't consumers making rational decisions based on need and the value proposition of the various devices available. Rather, the first people to buy the iPhone 3GS, the majority of them at least, will be a subset of existing customers. These are people for whom price is not a primary consideration. For this group, it's not a question of if they will buy the iPhone 3GS but when, and as the saying goes, 'there's no better time than now'. The problem is that the vast majority of these people will not qualify for subsidized pricing. It's true there are customers who purchased the orginal iPhone two years ago and passed on the iPhone 3G last year. I'd hazard to guess they represent a small minority and that the majority of people either purchased both the original iPhone and the iPhone 3G or skipped the initial model and purchased the second generation device no more than twelve months ago. These people will all pay the upgrade price. What's wrong with that?
I would argue that what we're calling upgrade pricing is in essence a loyalty tax. Companies like Apple, with a dedicated customer base, but relatively small market share (though I believe this point, the smallness of their market share, is overstated in the case of Apple Inc.), always have the option of pressing existing customers, i.e. squeezing them for every possible penny. This is a strategy often employed by Apple, and one that has worked well for them over the years, but it's not the right thing to do in my opinion.
Many of these customers own multiple Apple products in addition to the iPhone. These same customers are often keenly aware of product offerings and knowledgeable enough to understand the advantages of combining multiple, complementary products and serves. These same people are often heavy (i.e. frequent) users of the products they do buy. Given proliferation and importance of add-on products, downloadable content, and subscription services (all of which are represented among Apple's growing catalog of offerings), these users typically spend a considerable amount of money on optional items after the initial purchase of a device like the iPhone. Furthermore, these people often help to deliver more sales and grow the installed base. They talk to their friends and associates, push for the use of more Apple Inc. products at work, and in general supply the socially credible promotion that has proven to be extremely effective marketing tool. These people should be praised, even rewarded for there efforts, and certainly not penalized for it.
By the way, it's too easy to say that all of these people are fanatical fans, who get what they deserve for kowtowing to Apple Inc. Many of them have simply invested a substantial amount of time and money in Apple products and either want or need to be able to take advantage of new capabilities and improvements.
The secret shame of Apple's success is that many of it's products are flawed in important ways. The iPhone 3G for example can be frustratingly slow and awkward to use. Many existing users who are quick embrace new versions of Apple products are not fanatical as much as they are desperate to move past some pressing issue or frustrating limitation. Earlier I said that Apple is a company with a dedicated customer base. That much is obvious. What's less clear is whether that dedication is inspired by sense of devotion or compulsion. I for one buy Apple products for two reasons. First, because they are occasionally best in class. Secondly, because I already own one or more complementary products from Apple and choosing something new from another company represents a real or imagined loss, and that in turn skews the perceived value of each of the options. Apple's MobileMe service is a perfect example of this. When compared to competing services, there is almost nothing appealing about MobileMe, from it's limited services (which seem unable to keep pace with the offerings from other, nimbler competitors), to it's sketchy history of performance and reliability issues. In my opinion, the only reason to opt for MobileMe is that fact that it is integrated so tightly into the Mac OS, the iPhone, and other Apple Inc. products, including iLife and iWork among others.
This sort of thing is ostensibly what has gotten Microsoft in trouble in the past. Apple plays this card more than anyone.
3. It's my understanding that existing in the present is something we're all entitled to for free.
For a lot reasons the world we live in is a pretty miserable place. If you don't immediately see the truth in that statement without me explaining it to you then you need to pay more attention to the news and maybe take a moment to think about life from the point of view of someone less fortunate than you. However, we also live in an exciting age of discovery and innovation, at least for the relatively small number of us who are able to take advantage of it. Mainstream computer technologies, consumer electronics, and the internet for example are pretty amazing. The impact of these technologies may very well be immeasurable. The functionally of current generation devices may seem extraordinary, and the capabilities of these devices can far exceed what was possible even a short time ago.
However, the simple fact is that there is nothing special (magical or miraculous) about any of it, including the iPhone. Apple Inc. should be applauded for all of the things they have done well, and criticized for those aspects of the hardware and software that is badly implemented or ill-conceived. They have certainly done their part, but they are also the inheritors of decades worth of research and innovation from others. As already mentioned, the iPhone OS is testament to that.
What's the point? We live in the present, however inspiring or depressing it might be. Simply put, it is what it is. That is certainly true of consumer products and technology. For example, it is a fact that the computers available today are exponentially more capable than they were a decade ago. It is also a fact that they are a fraction of the cost of what they were. Those are wonderful trends. (Except perhaps that these price reductions are in part due to efficiencies that come at the expense of jobs in places like the US, and lead to deplorable living conditions elsewhere in the world.) Prices for these products should be based on legitimate factors (e.g. materials, manufacturing, distribution, advertising, and real research and development costs). The mere fact that these devices have progressed to the point that they at times inspire admiration is not legitimate reason to raise prices. Where would we be if PC manufacturers set prices based on the perceived value of the device?
For these reasons I don't believe upgrade pricing for the iPhone 3GS is reasonable.
[Update: 2009-0617 3:36p] According to TechCrunch Apple and AT&T have decided to forgo the upgrade pricing for some iPhone 3G customers. More specifically customers who opted for higher priced contracts. It's a concession that likely won't cost them much.
Many customer still don't qualify, and those who do are paying for features like text messaging which bring in outlandish profits.
Consider this quote from a post titled Text 'Messages Cost Carriers Nothing' at Wired's Gadget Lab blog.
An SMS doesn’t even take any bandwidth away from the regular channels which carry calls:
That’s why a message is so limited in length: it must not exceed the length of the message used for internal communication between tower and handset to set up a call. The channel uses space whether or not a text message is inserted.
Cost to telco: $0.00. Cost to customers: $0.20. Number of text messages sent per year (worldwide): 2.5 trillion.
Here's the link to the original article at nytimes.com, 'What Carriers Aren’t Eager to Tell You About Texting.
Apple has created a page where new and existing customers can check their eligibility to purchase the iPhone 3GS and rate plans.
You can check to see if you qualify for best pricing
In case you're wondering, no this doesn't change my opinion about upgrade pricing or subsidies.