Steady As She Goes

Expectations were high, and so were the prices—the cheapest model with only 4 GB of storage sold for $499, hundreds of dollars more than even that era’s smartphones. Initial sales were brisk, but many consumers and commentators balked at the high prices. So in September, Apple dropped the 4 GB model and cut the price of the 8 GB version by $200 to $399. People were outraged.

“I just felt so used as a consumer,” early customer Kevin Tofel told the New York Times in an interview the day the price drop was announced. “They hyped up the iPhone for six months and built up our expectations, and then they grabbed our extra $200 and ran.” Apple also announced that people who paid the higher price would receive $100 store credit. For Tofel, that gesture was enough. But other customers were not as forgiving.

Prior to the iPhone’s launch, Apple knew demand was building, and they priced the phone accordingly. It sold well, but they soon realized the high price would limit the device’s appeal. By dropping the price, Apple gained access to a new market. But in the process they learned a tough lesson about price stickiness and customer antagonism.

Price stickiness is both a concept that underpins theories and a theory in and of itself. As a concept, it supports many theories of monetary policy. If prices were not sticky—that is, if they did not remain stable for some period of time—then much of what central banks do to control prices would be useless.

As a theory, price stickiness guides managers when they make decisions on how to price goods and services. Many managers say they keep prices stable so as to not antagonize customers, as Apple did. But those same managers also admit they make that decision based on intuition, not data.

Data to the Rescue
Fortunately for managers, there is now some research to back their intuition. Consumers are in fact antagonized by price drops immediately following their purchase, according to a paper by Eric T. Anderson, a professor of marketing at the Kellogg School of Management, and Duncan I. Simester, a professor at MIT. And perhaps even more inauspiciously for Apple, the customers who are most antagonized—the least likely to purchase from that company again—are typically the best customers.

“Who was likely to buy the iPhone at $599? The people that love Apple,” Anderson said. “They were going to buy it as soon as it was on the market at a full price. And who did Apple upset when they dropped the price in September? Their best customers.”

“The question is, how sticky are they going to be with Apple? Will they come back and buy a MacBook? Will they come back and buy an iPad?”

To answer that question, Anderson and Simester worked with a retailer that specialized in selling durable goods, like software, electronics, apparel, or books. In the past, the retailer had typically kept prices high but frequently offered small discounts and the occasional deep discount.

Anderson and Simester worked with them to create test catalogs to determine whether and which customers would be antagonized by price changes. (Most of the retailer’s customers purchased via catalog at the time of the study.) The two types of test catalog were mailed according to the regular schedule and included 86 products, 36 of which were discounted by varying amounts depending on which test catalog people received. The deep-discount version offered the 36 items at an average of 62 percent off, while the shallow-discount version offered an average discount of 34 percent.

After the catalogs were mailed, Anderson and Simester tracked the purchasing habits of the 55,000 customers who were involved in the test. As expected, lower prices led to more demand in the short run. Diving into the results further, Anderson and Simester found a substantial segment of customers whose behavior reflected the sentiments expressed by antagonized Apple customers.

In particular, Anderson and Simester looked at customers who had recently paid full price for an item, much like the $599 price of the 8 GB iPhone. When these customers received a catalog with deep discounts, they were much less likely to buy. “When you look at this segment of customers, what you see is that a substantial portion just stop buying,” Anderson said. “We call this the boycott effect.”

Customers who received the deep-discount test catalog placed 14.8 percent fewer subsequent orders than those who received the shallow-discount version. But even worse, the proportion of customers who placed no order at all after the test catalogs were mailed was 34 percent for recipients of deep discounts and 27.1 percent for recipients of shallow discounts. “Merely sending these customers a catalog containing lower prices reduced purchases,” Anderson and Simester wrote.

The ill will continued on for some time, too. Anderson and Simester estimate that customers upset by the deep-discount catalogs purchased less for 20 months after receiving the test catalog. And though those customers made up only 25 percent of the sample, they represented 52 percent of the revenue after the test catalogs were mailed. Anderson and Simester estimate that if the retailer had mailed the deep-discount catalog only—and not the shallow-discount version—profits would have declined by about $155,000.

Broadly Applicable
Anderson and Simester also tested their hypothesis with a clothing retailer that also relied heavily on catalogs. For that part of the study, 110,000 customers received a test catalog just days after Christmas. Since sales are common after Christmas, Anderson and Simester reasoned that the test catalogs should not offend people’s sense of timing when it comes to discounts. Yet orders still dropped 4 percent after the mailing.

“Our study showed that the customers who are antagonized are not the worst customers—they’re the best customers,” Anderson said. “This helps explain why managers are so concerned about adjusting their prices—you risk antagonizing your most profitable customers,” he added. “It’s a phenomenon that is important for both macroeconomic policy and managers.”

Judging by these results, it would seem that deep price discounts are a bad business decision. But Anderson concedes they can be useful and suggests steps managers can take to minimize customer antagonism.

“If you’ve got to discount your product for whatever reason, try and make the offers more private,” he said. “If you’re going to send the offer via e-mail, don’t send the e-mail to customers that just paid full price; send it to customers who haven’t bought that particular item. Whatever your communication is, try to be a little bit more targeted and segmented so that you don’t antagonize your best customers.”

Related reading on Kellogg Insight

Solving a Pricey Riddle: How monetary policy influences the economy

A (Sales)Taxing Proposition: How Internet sales taxes affect customer behavior

Really, I Can Return It? Sold! Optimizing your returns policy