Pricing Economics–Why do manufacturers price their gadgets so high? [Opinion]

While browsing Quora, one question about why handset manufacturers price their handsets so high piqued my interest. However, the question deserved a better treatment then was possible on Quora and hence I decided to discus the pricing strategies of manufacturers in some detail here.

If you have seen the estimates of the cost of manufacturing some of these gadgets, then you are likely to have this question in your mind. For example, the Galaxy Tab costs about $215 to manufacture and sells for around $800 or more. The 8GB iPod nano costs around $45, but sells for $149. The iPhone 4 costs around $190, but sells for well over $600 (unlocked version). These are not isolated examples, the huge margins among the latest gadgets is more of a rule than an exception. However, if you are wondering that manufacturers are making tons of money on every device, that is not always true. Let us look at some of the factors that drive the pricing strategy of firms:

1. Cost-based vs. Value-based pricing: The traditional method of pricing products was cost based, i.e., manufacturers would compute the cost of manufacturing, distributing, and marketing the product and then add a markup to determine the selling price. Manufacturers are increasingly moving away from cost-based pricing to value-based pricing.

Value-pricing is driven not only by the cost of the product, but also the (perceived) value that the product delivers to the consumers. Perceived value is some measure of benefits that a product delivers. Clearly, consumers will buy a product as long as the perceived value of the product is greater than the price of the product. The difference between the product price and the perceived value is the consumer surplus, whereas the difference between the cost of goods sold and the product price is the producer’s surplus. A producer wishes to maximize the producer surplus. Given the cost of manufacturing, one way to maximize the producer surplus is to charge higher price. However, since consumers will only buy the product as long as the consumer surplus is greater than 0, producers can enhance the perceived value of the product (through marketing efforts) and extract a higher price from the consumer.

2. Skimming the market: Since consumer are heterogeneous (have different preferences), it makes it easy for the manufacturers to use a skimming strategy, where the price is set high in the beginning. There are always early adopters who are willing to pay high prices for product. This follows from the previous point as early adopters derive higher value from trying new products and hence their perceived value is much higher than the broad population. Accordingly, manufacturers price the products high in the beginning so as to target the early adopters and then gradually drop the prices so as to facilitate broader adoption of the product. Haven’t we all have experienced this?

3. Signal for quality: The problem with new products is that their quality is difficult to ascertain. The manufacturer knows the true quality of the product, but the consumers have no way to gauge the same. Research in Marketing and economics indicates that in the absence of objective indicators of quality, consumers infer quality of a product from other observable factors that are associated with desired but unobservable attributes. Price, in general, is a very useful indicator of quality and hence manufacturers wish to price their products so as to convey the right image. So sometimes a manufacturer may just price a product high so as to convey a premium image, e.g., Apple has routinely practiced a premium pricing.

4. Prepare for the next generation products: Given the rapid pace of innovation in the technological space, the current products will be obsolete soon or will be imitated away by the competition. So, firms constantly need to invest in the next line of products. The high rate of failure and the significant R&D costs mean that the new line of breakthrough products does not come cheap. Where does this money come from? You guessed it right, the current products support the development of the next generation products. Some part of the profits from the current products is invested back in developing new products.

5. Product Support: Importantly, and often ignored, is the cost of supporting the product. This includes, but not limited to, support staff for technical troubleshooting, repairs, upgrades, bug fixes, spares, etc. We haven’t even talked about any thing significant (e.g., iPhone 4 antennagate) that may require recalls or any other drastic measure, which may significantly bump the costs. Given that the life of consumer electronic product is over 2 years, manufacturers also need to plan for all this for the life of the product.

In summary, the price of your latest gizmo is not solely determined by the costs alone. There are several things that go into pricing the product. Having said that, I have to admit that pricing is as much of an art as it is a science. However, I hope that this post has helped dispel some myths about pricing.

Let’s hear about what you feel about the pricing strategies that firms adopt and how would you change the same…

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