iPhone Pricing

An EMBA student points out that Apple announced yesterday some incredibly cheap iPhones --- $99 for the 3G second generation with 8 GB.

What is going on?

Well, a lot. But part of what's going on is that Apple's trying to manipulate a coordination game that's happening between customers and software developers.

I'll explain in a minute, but first let's talk about what a coordination game is.

It's a game where the players' best choices depend on what other players are doing. If you're a former student of mine, you've probably seen me talk through the "Battle of the Sexes" game, where two people want to spend the day together, but they have different preferences about where to spend it. In this game box, Rachel has to choose whether she wants to go to Wrigley Field or the Field Museum. Scott has the same set of choices. If Rachel chooses Wrigley and Scott chooses Museum, the outcome is in the upper-right cell, where Rachel's payoff (represented in lower-left of the cell) is five, and Scott's payoff (upper-right) is also five.

The notable thing about this game is that there are two Nash Equilibria. One is where Rachel and Scott both go the Museum. Another is where both go to Wrigley. At any of the other cells, a player could unilaterally change his or her strategy and achieve a higher payoff --- so those cells aren't equilibria.

Coordination games aren't just classroom trivia --- they're real and they're real important.

Here's another game box. The players here are software developers and end users of smartphones. The choices for the developers are "develop for iPhone" and "develop for Palm Pre". The choices for end-users are "buy an iPhone" and "buy a Palm Pre". With the payoffs I've drawn, the developers don't really care whether they develop for iPhone or Pre --- they just want to be where the customers are. Further, customers don't care about which platform they're on, they just want to be where the apps are.

This is a coordination game, and it has two Nash Equilibria, just like the Battle of the Sexes.

If the developers don't care which platform they're on and the end users don't care which platform they're on, then who does care? Apple (and Palm) care a lot.

My guess is that Apple's super aggressive iPhone pricing is driven (in part) by the recent introduction of the Palm Pre, which has been getting some good reviews. Apple knows that it can't win (indefinitely) by having a better device than other smartphone makers --- device features are just too easy to copy. But it can win (indefinitely) if it can get developers and end-users to coordinate on the iPhone platform. The reason is that no developer will develop for the Pre if developers don't expect end-users to buy it. And no user will buy one if users don't expect developers to develop. By pricing aggressively and pulling as many end-users over to its platform as possible, Apple is trying manipulate the equilibrium of this coordination game, and reduce developer incentives to develop for Pre.