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Get In Line! The Ups and Downs of Excess Demand

April 8, 2011

Three weeks ago, Apple’s magical and revolutionary iPad 2 went on sale. Although Apple has not yet released any sales figures, demand appears to be extremely robust. Supply, on the other hand, has failed to keep pace – just ask anyone who has tried to pick one up.

I am certainly a member of that group. I have made three trips to my local Apple Stores since the iPad launch. According to one of the salespeople at the Palo Alto store, folks have been lining up starting at 4 or 5 in the morning just to plop down their $500 (or more – the average selling price for the original iPad was $645 in Q4).

Analysts were quick to call the iPad 2 launch a success. Piper Jaffray’s Gene Munster estimated that Apple sold between 400,000 and 500,000 for the weekend, while Chris Whitmore from Deutsche Bank called it “one of the company’s most successful product launches to date.”

Here’s the billion-dollar question: Is Apple leaving profit on the table with its handling of the iPad 2 launch? Does the fact that customers are willing to spend 5+ hours waiting in the rain constitute a dead-weight loss for Apple and its shareholders? And, most importantly, could Apple (or any other company) monetize this exuberance for their products?

First, a quick microeconomics refresher. The two fundamental market forces, supply and demand, set a price. If the price is too low, there will be excess demand (and/or not enough supply), while if the price is too high there will be excess supply (and/or not enough demand). Intuitively, many people will want to buy iPads if they are cheap, however Apple will not be willing to manufacture iPads to sell below cost. On the other hand, Apple would move any mountain to manufacture any number of million-dollar iPads, however they would find a very limited market.

The Case For Dynamic Pricing

Imagine, for a second, the Apple Store in Economistland. iPad 2 demand is still robust, and iPad 2 supply is still limited. But, this being Economistland, everyone behaves perfectly rationally. Understanding their opportunity costs and utility curves perfectly, and therefore is able to submit to Apple exactly how much they would be willing to pay for their preferred iPad 2 model on each day of its availability. Apple could then allocate each day’s availability of iPads to maximize revenues and profits, while each citizen of Economistland would get the opportunity to purchase his iPad at a price and on a date that he agreed would be acceptable. (Equivalently, Apple could hold a uniform price auction for each day’s inventory of iPads.) The result, at least for the Economistland Apple Store, would be increased profits, while customers would be no worse off, having exchanged one commodity (in this case, waiting in line for several hours in unpredictable weather conditions) for another (in this case, cash), and thereby implicitly valuing their time. Apple shareholders are happy, and the citizens of Economistland are warm, dry, and still get their iPads – a Pareto improvement.

We’ve already seen several notable examples of dynamic pricing. The San Francisco Giants started using dynamic pricing for all seats last season. Priceline.com allows hotels and airlines to clear unsold inventory at below-market prices. Finally, Smart Meters will allow public utilities to dynamically price electrical power to (hopefully) reduce peak demand. All of these cases share a common thread – limited, expiring inventory (baseball tickets or airline seats have very low marginal costs, so selling them for even $1 is better than leaving them unsold).

There are two scenarios that business owners want to avoid. In one, you have inventory and nobody willing to buy it at your listed price (for example, airlines, just before takeoff). In the other, you have credit card-wielding customers and no product to sell them (Apple). Microeconomics says that each of these problems can be solved by adjusting the price to bring supply and demand back into sync. Indeed, this guy was willing to pay $900 for the first spot in line at the 5th Avenue Apple Store, and there is a thriving gray market for iPads in Hong Kong. Finally, iPad 2s are still selling at a markup on eBay. So why should Apple leave those profits to bored college students and enterprising international businessmen? Moreover, if the first spot in line is worth $900, shouldn’t the second spot be worth something too?

What might such a pricing system look like? Let’s say that iPad #1 sells at a $900 premium, and that premium decays quadratically (1/x^2) to $0 over the course of the first 1 million iPads sold. Using a simple integral, this comes out to a $300 million profit, or about 30 cents per share. There’s even precedent for this from Apple! The original iPhone went on sale for $599, but was discounted to $399 a just few months later. (Apple offered the early adopters a $100 credit.)

The Case Against Dynamic Pricing

So why won’t Apple be adopting dynamic pricing any time soon? Well, for starters, we don’t live in Economistland. Real-world customers exhibit a divestiture aversion, meaning that they would require more money to give up their spot in line than they would be willing to pay for an equivalent spot in line. In trading lingo, the spread is too wide.

But what about the positive impact of lines? Let’s take a look at one case study, Ike’s Place in San Francisco. For those of you not in the loop with Ike’s, it’s a fantastic sandwich shop, known for notoriously long lines. (Their San Francisco location was recently forced to move after the neighbors complained about noise stemming from their waiting patrons.) Here’s the thing about Ike’s – of course their sandwiches are good, but it’s notable for the lines and not for the  quality of the sandwiches. Moreover, the long lines are a selling point and serve a business purpose. 

If Ike’s wanted to take a traditional approach to improving customer service, they could take steps to reduce their customers’ wait times. For example, by hiring a large staff during peak times, they could make more sandwiches. From my experience at their Stanford location, their ordering process is intentionally slowed down, which creates a buffer effect. By throttling the rate at which customers can order, a larger portion of the total wait is spent waiting in line, which is less painful than waiting at a table for a sandwich (since the line is of definite length and is visibly being serviced).

So what’s the benefit of lines? It’s all psychological.

  • Bandwagon effect: Lines provide social proof (Ike’s sandwiches are good, iPads are magical), which hopefully creates buzz and leads to increased sales.
  • Irrational escalation: If I wait in line and don’t get to buy and iPad, I will be willing to come earlier the next day to justify the time already spent waiting.

In other words, it’s all marketing. It’s all about creating an image, of your company or product as popular, underpriced. It’s all about cultivating a cult-like following for your brand (something Apple has done extremely well). Every company’s dream is to have customers lining up to buy their products.

(Ike’s lines also serve an economic benefit. Think about Ike’s in terms of fixed and variable costs. Ike’s has fixed costs, like space and training, and variable costs, like personnel hours and sandwich materials. If Ike’s were to change their business model to alleviate lines, they would have to service most of their customers between 12 and 1, which would require a large staff for a short time, and a lot of counter space. On the other hand, their current business model allows them to operate with a relatively small staff (over a longer period of time), and out of a small-ish shop, thereby reducing their fixed costs while keeping their variable costs approximately the same.)

In conclusion, pricing is an incredibly complex field. Apple’s corporate image requires simplicity, so they definitely won’t be moving to dynamic price anytime soon, but other businesses in the same situation (massive demand which exceeds an initially limited supply) may choose to charge early adopters a premium.

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