Pricing Innovation

The early adopters of Apple's iPhone paid $599 for the privilege of being the first to have the hot new consumer product when it was launched in June of 2007. But by September, Apple announced that it was slashing prices on its most expensive iPhone by a third. As the early adopters complained about the $200 price cut, Apple shares fell 8.6 percent, losing almost $11 billion in market value in the three days following the announcement. The iPhone illustrates both the challenges of getting pricing right for new products and the dynamic changes in pricing that are needed as the market is developed.

"When you have something new about the product, such as the sleeker design and touch-screen technology for the iPhone, it is a little harder to price it... Apple may have mispriced the product in the first place and then had to make painful, costly adjustments."
—Z. John Zhang, Professor of Marketing, The Wharton School

Secrecy adds to the problem. Zhang pointed to the reports that claimed Apple's partner AT&T did not even see the iPhone before its launch. "The whole thing is kept secret to build suspense and buzz," he said. "Just imagine — you have a product that you believe is pretty good, but can't show it to anyone. Then you have to price it properly."

Initial Pricing

Given the challenges of establishing a price for new products, there are several approaches that can be used to determine initial pricing:

• Benchmark against existing products. Where there are similar products on the market, the first step might be to benchmark against them to quantify how much customers will pay for positive features of a new product, such as a camera or MP3 player for a phone. Another consideration is how much customers would pay to avoid negative features, such as poor reception or bad on-screen navigation. The price also needs to be weighed against the company's current products, even if they are not in the same category. Since the iPhone can replace an iPod for playing music, for example, the price needs to recognize and reduce the potential for cannibalization. "Toyota Camry competes with Toyota Avalon, and the company needs to be aware of how its pricing might increase or decrease this competition," said Jagmohan Raju, professor of marketing and academic co-director of the Pricing Strategies program. "Different sizes of products also compete. A 16-ounce product might compete with the same product sold in a 32-ounce size. Companies need to decide when the price of the large size should be double, more than double, or less than double to maximize profits."
  
  
• Identify the target segment. A company can also set the price for a new product by identifying the target market segment and determining what this segment might be willing to pay. In the case of the iPhone, it was clearly not targeted toward high-school students, but rather high-end business users. For executives, high price could ensure exclusivity. "Some exclusivity makes a lot of sense for a high-end customer," Zhang said. "A cell phone has become a fashion product. Design matters a lot, and your cell phone should match your status and lifestyle. If you price it high enough to make the product exclusive, its users will be willing to pay a higher price."
  
  
• Price out specific features. Companies also can determine the value of specific features. Looking at existing products, for example, might indicate how much more customers are willing to pay for a digital camera, MP3 player, or touch screen built into the phone. 
  
  
• Assessing willingness to pay. One way to determine price, especially when you can give the potential customer a prototype to experience the product, is to ask for their willingness to pay. The problem is that asking flat out does not produce very accurate results. In general, the answers are biased downward. A customer who might pay $400 for a product would claim to be willing to pay only $200. At other times, the bias can be upward. A more accurate way to determine price is to gauge consumer willingness to pay indirectly by using "conjoint analysis," which asks subjects to make tradeoffs between different combinations of features and prices in context.
  
  
• Take into account partners' interests. When new technologies involve collaboration, pricing needs to ensure gains for partners. "In pricing its iPhone, Apple recognized that it would bring AT&T new customers. AT&T also was well aware of this benefit and cut a good deal with Apple," Raju said. "In other cases, your actions may hurt your partners. You need to keep in mind the entire value delivery chain as you set prices. If a company launches a new car that will never require servicing, surely there might be some resistance from the dealers. So you must give them high margins up front."

Pricing Over Time: Peeling the Onion

The more innovative the product is, the more secrecy surrounds its launch. This makes it harder to get the initial price right. "That may explain why Apple later felt the need to reprice the product," Zhang said. "Perhaps sales were not as great as they had expected. The product might not have been as good as they initially thought."

In general, innovative products are launched at a high price, and then later the price is lowered to expand the market or respond to increased competition. Early adopters are willing to pay more, a phenomenon called "temporal price discrimination." In general, companies might move from the segments with the highest willingness to pay to those with the lowest willingness to pay. This approach is to keep moving to the next level of consumers. "You peel the onion layer by layer to maximize profitability," Zhang said.

Pricing doesn't always start high and go low. In some cases it starts low and goes the other way. "Many software companies will give you the base software free and then charge you the next year for renewal," said Raju. "This may be the case when a product has positive network externalities — that is, it has more value when more consumers use it. For example, the only way a videophone has value is if other users have the same product."

When prices are adjusted downward, there is a delicate balance in determining how far and how fast to drop prices. There are several side effects of falling prices that managers need to watch out for:

• Diluting the brand. Dropping the price too far can lead to the dilution of value. If every teenager is talking on an iPhone, will the product still be attractive to high-end users? Motorola's RAZR suffered from this dilution, as the hot, high-end product was offered at lower and lower prices until the cachet of the brand was eroded. "A CEO who pays $600 for a phone and then sees high-school students using it will drop the phone," Zhang said. Because of this dilution, companies might decide to lower prices only so far, or to add new features.
  
  
• Buyer's remorse. The initial purchasers might also feel cheated when the price drops. This is particularly true when there is a significant price drop, as with the iPhone. Buyers who purchase a product at its initial price point are often the most loyal customers. They will feel cheated when it is later offered at a lower price. In lowering the price to expand the market, companies need to be careful about offending their established client base.
  
  
• Training consumers to wait for discounts. While a large, one-shot price drop might lead to buyer's remorse, a series of price cuts also carries risks. Consumers might expect prices to fall, and put off their purchases. This problem plagues the auto industry, where the purchasers of domestic brands expect huge rebates and markdowns before they will make their purchase. As a result, U.S. car manufacturers have to escalate discounts to make their sales goals.

Some of the pitfalls related to pricing can be addressed by recognizing that the list price of the product is not the whole story. Instead of dropping price, companies could add features. This gives customers more for their money, while making the impact on price less obvious. Car makers could include air conditioning or other features, for example, instead of relying on sales and rebates.

As the market develops, competition becomes an increasing concern in setting prices. Nokia, Samsung, and other rivals are introducing products to compete with the iPhone. "You are not alone for very long with this type of technology," Zhang said. "Then, you have to realign your pricing. However, even in that case, you probably do not want to lose your cool and overdo it. Otherwise, the product might lose its appeal to your high-end customers."

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