I can sympathize with the inability of many folks to grok exactly what Apple is thinking with iPhone 5C pricing. I myself was confused until just before launch, when I wrote Thinking about iPhone Pricing and honed in on the idea of “good-enough.”

In the case of the iPhone, the 3G was clearly better than the 1st iPhone (enclosure notwithstanding), as was the 3GS relative to the 3G, and the 4 to the 3GS. Ultimately, Apple feels it was the iPhone 5 that is “good enough,” as seen by their willingness to finally make a mid-range version…the line has been set; clearly we won’t see a truly low-priced iPhone until Apple can include iPhone 5-level technology at a price they are comfortable with.

Tim Cook emphasized this point in an interview with Businessweek:

“We never had an objective to sell a low-cost phone,” says Cook. “Our primary objective is to sell a great phone and provide a great experience, and we figured out a way to do it at a lower cost.”

So that’s reason number one that the iPhone 5C is $550. Apple is focused on product-quality first, price second.

However, even if Apple had decided they could make a phone for less, it still wouldn’t have been a good idea for two additional reasons.

Apple’s Three Markets

The first thing to consider is that the iPhone is effectively offered in three very different markets, something I didn’t quite understand when I wrote a post last spring called The Visual Case for a Low-Cost iPhone:

I combined carrier ARPU by country with browser share data from StatCounter. Countries are ordered by ARPU.

• The gray area is the average revenue per mobile-cellular subscription
• The blue line is the linear trend line for iOS browser share
• The green line is the linear trend line for Android browser share

I find this very illuminative. If we assume ARPU is a good proxy for subsidization, then this strongly supports the idea that the iPhone is highly competitive¹ versus Android in subsidized markets (the left side), but is simply too expensive in non-subsidized markets (the right side).

The right side of this chart is the visual case for a low-cost iPhone.

The chart was useful, but my conclusion was totally wrong. I didn’t really think through the implications of there being three iPhone markets.

The first iPhone market is the extreme left: Canada, Japan, and the US. These markets disguise the true cost of an iPhone – you pay the same (high) contract rate no matter which phone you choose. Unsurprisingly, the iPhone is very successful here. For the sake of simplicity I’m going to call this the American-style market.

The second iPhone market is the rest of the left side (mostly Europe – again, for simplicity’s sake, I’m calling it European-style). These markets provide a subsidy along with contract rates that change with the price of the phone – it’s much clearer the iPhone is more expensive, although you don’t necessarily pay a large amount up front. In other words, if you get an iPhone, you’re paying more per month than you are for a very fine Android phone.

The third iPhone market is on the right side of the chart, and while European-style subsidies may be available, most consumers pay full price for the phone in a separate transaction from their mobile contract, or, more likely, their prepaid fill-up. I’m going to call this the Asian-style model (most of Asia fits here, but Japan and South Korea are notable exceptions).

Looking again at that chart, and with the realities of these three markets in mind, it’s not so much that the iPhone has saturated the American-style and European-style markets, and ought to focus on the Asian-style one; rather, the iPhone has saturated the high end in all three markets – the high end just varies in accessibility ($200 for American-style, $650 for Asian-style). And, if you accept that the iPhone is in roughly the same competitive position in all three markets – that the difference in market share is due to inherent structure of the market – then it’s not at all obvious Apple should focus on the SE Asia-style market. In fact, it’s obvious they shouldn’t.

While any discussion about the iPhone touches on subsidies, the subsidies themselves – and the degree to which the iPhone is accessible – are much more a function of the underlying economy. Countries to the left are more service-oriented, and have higher purchasing power. There is much higher credit-card penetration, and, generally speaking, greater respect for copyright. All of these factors make the left side of that chart much more attractive to Apple. Apple’s ecosystem and overall value prop is certainly the highest in the United States for all of the factors just listed, and the value-add of their ecosystem roughly tracks the same left-to-right listing of countries in the chart above.

Consider apps: Distimo just posted their list of the top global apps for August, including the top revenue generating companies:

There’s the American-style market – the United States; Japan; and Canada, clearly punching above its population size. Consumers in these countries are the type of customers for whom Apple can provide the most value with their ecosystem. Moreover, it’s customers in these countries who are driving Google Play revenue:

The 5C is squarely targeted at those blue pieces of pie, and thus, is priced in a way that makes sense for those markets – with a subsidy in mind. I wrote in Thinking About iPhone Pricing:

The fact the 5C needs to be sold in both subsidized and unsubsidized markets makes the pricing tricky; in [American-style] subsidized markets, Apple is currently receiving a subsidy of around $450 on the iPhone 5. It wouldn’t make sense to unilaterally lower that – after all, it’s not like the carriers are going to lower iPhone service bills. This sets a floor of $450 for the unsubsidized 5C ($0 with contract). This also lets Apple dump the 4S, with its 3.5″ screen, 30-pin connector, and lack of LTE.

$0, though, is problematic from a branding perspective. While a new phone, heavily advertised (unlike the old iPhone 4) and sold for $0 would move an incredible number of units, it would also create consumer expectations around $0 and associate Apple with “cheap.” I would imagine Apple is very hesitant to go there. $99 makes more sense. (This point on branding applies to the unsubsidized cost as well; in Asia, in particular, the iPhone’s biggest selling point is brand prestige, not apps or user experience. Apple will be happy to err on the side of more expensive.)

$99, however, implies an unsubsidized cost of $550.

(Oh how I regret that “however”!)

To summarize,

• There are three different types of markets the iPhone competes in
• The iPhone has saturated the high-end in all three markets; the difference in overall market share is a function of the type of market it is
• The Apple ecosystem is of most value in the American markets first, the European markets next, and the Asian-style markets last

Therefore, it’s very rational for Apple to optimize its pricing for the American-style markets, and the most logical price is $550/$99.

Money on the Table

In Thinking About iPhone Pricing, I talked about demand curves:

The most elementary thing to understand about pricing is the demand curve. In general, and as one might expect, the quantity sold has an inverse correlation to price.

The amount to which price influences quantity – i.e. the slope of the line – is the product’s elasticity. If reducing the price of a product by 10% results in 10% more being sold, then the product has an elasticity of 1. If a 10% reduction results in 15% more being sold, then the elasticity is 1.5.

Depending on the elasticity, lower prices may or may not product additional profits. Consider a simplified example, using 5C pricing and a guess at component costs:

With an elasticity of 1, having a price of $450 would result in 22 more units over the 100 unit baseline, but lower profits overall.

An elasticity of 1.5, on the other hand, results in more profits at the $450 price point.

I bring this up for two reasons:

1. No one – probably including Apple – is quite sure exactly what the elasticity will be for the iPhone. See, the demand curve is usually, well, curved. It’s not as simple as I’ve presented it. Same with elasticity – it changes depending what price point you are at. While Apple could go lower cost, there is a very high likelihood they would, like the first example above, make less money than they could otherwise. It makes a lot more sense to gradually move down the demand curve and build out your knowledge of the market.
2. It’s not at all certain the iPhone will stop at two new models a year. In fact, I wouldn’t be surprised if 2014 brought a $450 5C 2nd generation, with all new colors. Now you’re optimizing for three different points on the demand curve instead of undershooting on the low end and leaving money on the table.

   

Summary and Risks

To summarize, Apple’s decisions with the 5C are completely rational.

1. Apple believe the iPhone 5 is the standard for “good enough” and won’t produce a “new” iPhone below that level. That means higher prices this year
2. Apple’s “best” markets are the American-style ones, for reasons beyond simply subsidies. Thus, it makes sense for them to optimize pricing for those markets – i.e. $550/$99
3. Expanding a product line is best done incrementally to ensure you are not leaving money on the table. You can’t have a high-end and low-end with nothing in the middle

There are two risks in this approach, both having to do with apps. The first is losing the “new and shiny” app advantage. Incremental change will only slightly slow Android’s expansion, and while much of that expansion has low engagement, low engagement/user x many more users still equals more total engagement. Were, based on this equation, new apps and features to start coming to Android first, Apple would lose a major differentiator.

However, I think this risk is a small one. The 5C will solidify Apple’s hold on the United States, where just under 50% of app developers live. Moreover, the 5C is focused on those blue pie slices – the Android users who are driving engagement.

The other risk, though, is more localized. Specifically, iOS is on the verge of being a complete non-factor in several countries on the right side of that chart. In India, for example, iOS penetration is minuscule, meaning the local app advantage tilts towards Android. China is another significant market on the right side, although Apple enjoys such brand prestige that they are probably safer for now. Regardless, missing out on the fastest-growing markets is absolutely a concern.

Ultimately, though, the $550 5C is very rational and a decision I now agree with.

There is one more objection: isn’t Apple setting itself up for modular-based disruption? I addressed that here: What Clayton Christensen Got Wrong

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1. In fact, the iPhone mostly wins on the left; the trend line is dragged down by the right ↩