How Sustainable Are High Margins?

Apple’s iPhone is set to launch in the U.S. in June and will be available for $499 (for the 4GB version; the 8GB version will be $599) as part of a Cingular call plan. One analyst, iSuppli, looked at what it would cost to make an iPhone and calculated that a unit would cost $245.83. That is a gross margin of 50.7%. iSuppli concluded that:

For Apple, such a strong hardware profit is par for the course, with the company having achieved margins of 45% and more in products including the iMac and iPod nano, according to iSuppli. However, because Apple is facing extensive competition in the music-phone market, the company may need to cut into its margins to reduce pricing in the future.

“With a 50% gross margin, Apple is setting itself up for aggressive price declines going forward,” said Jagdish Rebello, PhD, director and principal analyst with iSuppli.

But is it the case that a 50% gross margin is unsustainable?

A margin is one thing, but the incentive to drop prices is governed by the elasticity of demand. In particular, the rule of thumb for pricing (also known as the Lerner Index) suggests that in order to maximize profits, Apple should set its retail price (P) so that (P - c)/P = -1/e, where c is marginal cost and e is the price elasticity of demand for the iPhone. So the figures imply that e = -1.97. What that means is that if Apple raised its price by 1%, it would stand to lose almost 2% in sales. That seems plausible.

Discussion Questions

1. Take a look at the breakdown of costs at iSuppli (click here). Do you think that all of these costs are marginal costs paid by Apple?

2. Apple has two versions of the iPhone. According to the iSuppli estimates, the 8GB version costs only $35 more to produce (the cost of additional flash memory). Apple is set to earn a gross margin—(P - c)/P—of 53.1%. Does this suggest that the 8GB iPhone has more or less price elasticity than the 4GB phone? What theory of price setting would you use to work this out?

3. As a gut reaction, what do you think the price elasticity for the iPhone will be when it first hits the shelves? What about six months from now? What could explain any difference between those two time horizons?

Joshua Gans is Professor of Management (Information Economics) at the University of Melbourne. He maintains his own blog at economics.com.au.

The Football Price Index and Elasticity

From both sides of the Atlantic this week, we have news reports of increases in football ticket prices. In England, where the word "football" sensibly refers to a sport in which one kicks a ball with one's foot, the Sun proclaims that "Prices will kill football." In the United States, where the same word refers to a game in which one's feet are generally used only to carry the rather substantial weight of an American football player, colleges and professional teams alike are also raising their prices. Case in point: LSU will raise the prices on its base tickets and on fees for season ticket holders.

Whether those price hikes are sensible depends on the elasticity of demand for tickets in each case. In the British case, a survey by Virgin Money shows that attendance has dropped dramatically in the face of price hikes. Just as the CPI uses a bundle of goods to measure inflation, the Virgin survey takes into account the price of a "bundle" consisting of such items as club merchandise, food and drink at the games, and transportation costs for home and away games in addition to the cost of tickets. By their calculations, the inflation rate in this index has been greater than 17%—more than five times that of general prices in England. The impact on attendance has been severe: according to the survey, more than 40% of fans have cut back on their attendance at games.

Of course, prices cannot actually kill football, no matter what the Sun fears. Firms will only continue to raise their prices as long as doing so also raises their revenues. If teams hike their prices by 17% and see attendance drop by more than 17%, they'll see a drop in overall revenue. In general, if we assume that the marginal cost of hosting an individual football fan is negligible, then teams will eventually set ticket prices at such a level that if they were to raise prices, they would lose more money from lost sales than they would make from higher revenue per fan; and if they were to lower prices, they would lose more money from decreased revenue per fan than they would gain in increased sales.

The economic concept used to analyze this situation is elasticity—the ratio of the percentage change in quantity demanded to the percentage change in price. As we can see in the example of the English football league, when the elasticity of demand is less than one (that is, the percentage decline in attendance is smaller than the percentage change in price), teams can raise their prices and see their revenues increase.

Discussion Questions

1. According to the article in the Sun, why are Virgin Money researchers fairly sure the decrease in attendance at games is due to increased costs?

2. LSU has had back-to-back banner seasons. What effect is this likely to have on the elasticity of demand for LSU tickets?

3. Interesting questions of elasticity come into play when firms price discriminate. For example, LSU is raising its ticket prices, parking-lot fees, and motor-home prices, but not student ticket prices. Why do you think this is the case?

California Freezing

Freezing temperatures destroyed significant portions of fruit and vegetable crops in California over the weekend of January 13. An article from the LA Times documents the cold snap's immediate impact on wholesale prices for citrus. The cold snap will be felt in other markets as well: an article in the Seattle Times assesses potential impacts on apple and pear prices, and a USA Today piece considers the fallout in the labor market for farmhands in California.

Discussion Questions

1. According to the LA Times article: "The freeze has left the nation with about 14 million 40-pound cartons of California navel oranges—less than half of what America would eat between now and next season…" The sharp reduction in the supply of navel oranges will cause prices to rise, but by how much? To what extent will consumers substitute away from citrus towards other fruits in response to higher prices? Is demand for navel oranges relatively unresponsive to price changes (less elastic), or will consumers simply switch from citrus to alternative fruits when prices rise (more elastic)?


2. As the LA Times article mentions, California is the major producer of navel oranges for domestic consumption and also exports a significant amount of fruit. Fruit distributors will try to import as much citrus as possible from places like Mexico and Chile. That is, the supply of citrus exports from the U.S. will plunge and the demand for citrus imports will rise. What do you expect to happen to world citrus prices?

3. The USA Today article notes that many California farmhands will be laid off in the wake of the freeze. What will happen to farmhand wages and employment levels in California? Given that undocumented migrant workers will not be eligible for unemployment insurance, what do you expect to happen in markets for low-skilled labor in other parts of the United States?

4. How, according to the Seattle Times article, is the reduction in citrus supply affecting the demand for apples and pears?

Beeps per Minute

How do peer preferences affect your own? Recently, this blog examined a paper by economists Michael Kremer and Dan Levy about the peer effects of alcohol use among college students (archived link here). The paper suggests that students who are randomly assigned to frequent-drinking roommates will, on average, earn a lower grade point average (GPA) than students matched with non-drinkers. According to the authors, students exposed to frequent-drinking roommates develop a strong taste for booze--a taste that sticks around and continues to lower their GPAs in the years after the roommate situation changes. More broadly, the paper suggests that peer consumption preferences may exert an eerily strong influence over our own. Economists also refer to this phenomenon as the "demonstration effect."

What about the peer effects of our coworkers? In his latest column, Tim Harford--the Undercover Economist--writes about research by UC Berkeley economists Alexander Mas and Enrico Moretti on the peer effect among supermarket clerks. How do checkout clerks change their behavior when an especially fast clerk joins their shift? Do they slack off as the faster clerk picks up more of the workload? Or does the presence of a faster worker encourage them to boost their effort? Read Harford's latest Slate column to find out more.

Discussion Questions

1. Productivity is the amount of output per unit of labor input. How do Mas and Moretti measure the productivity of supermarket clerks?

2. According to Mas and Moretti, the presence of a quicker clerk encourages the other clerks to work harder. What is the size of the peer effect?

3. Mas and Moretti are convinced that peer effects, not checkout-stand congestion or managerial decisions, explain the changes in productivity. What makes them so sure?

4. A clerk's productivity rises only when a particularly fast colleague is facing (watching) her. If a clerk is looking at the back of a particularly fast colleague, her productivity does not change. What does this say about our motivation to work harder in the presence of an especially productive coworker? Given this evidence, what effect do you think automated checkout stands have on the work habits of supermarket clerks?

5. Suppose you're an analyst for a major supermarket chain. Given the results of Mas and Moretti's research, how would you go about designing shifts of workers with different productivity levels in order to maximize the number of beeps (checked items) per minute?

To view the abstract of Mas and Moretti's research paper, click here.