Apple (AAPL) missed expectations for the company's third quarter earnings, but this does not mean Apple is headed for a future of failure. Apple reported below analyst's expectations because iPhone sales missed by about 22%. Fortunately for Apple's holiday quarter, the iPhone 4s sold out everywhere it was for sale in October. Therefore expectations for the fourth quarter should be very high.
With that said, Apple is succeeding for two fundamental reasons. First, consumers buy Apple products at will. The second reason is the pricing of the products. For instance, Nokia (NOK) sells the most units every year, however because the vast majority of Nokia devices are inexpensive, Nokia has been unable to grow to the size of Apple with regards to margins and cash flow. Apple's pricing brings up an important point; which is, Apple continues to thrive while violating the kinked demand curve.
In its simplest form, the kinked demand curve theorizes that if a company raises the price of a product, demand will decrease substantially. However, if that same company decreases the price of a product, demand will increase minutely. This happens because the other companies in the same industry will theoretically lower their prices equally in order to maintain competitiveness. This same approach does not occur if one company increases the price of the product because not all businesses will raise the price.
There are some important notes regarding the kinked demand curve. One is that the curve works best when the market has monopolistic competition or an oligopoly. Also, it is important to note the kinked demand curve has been challenged. The most notable challenger is George Stigler. A Stanford University article discusses Stigler's argument as well as how the kinked demand curve does not work.
The debate of whether the kinked demand curve is valid is beside the point because Apple violates this important theory; yet the company continues to thrive. This can be taken one step further because Apple's competitors, who sell products at the same price as Apple, see lower demand. Why does this happen? Why does Apple's demand increase when prices are high? And why do other companies see less demand even when prices are reduced?
There are three reasons why this happens. First, Apple has been at the forefront of innovation for decades, therefore the company has been able to amass a large quantity of loyal costumers. Secondly, Apple's marketing campaign is very strong and makes Apple's products appear to be fun despite the steep prices. A third reason may have to do with trust. While smartphones and tablets are far from perfect, Apple's products are more durable than other competitors. Not only are Apple's products more durable, but also consumers are not willing to pay a price almost as high as an iPad or iPhone if they are not sure it will last.
Are Apple's Prices Really That High?
| Company | Device | Price |
|---|---|---|
| Apple | iPhone 4s | $699 |
| Motorola | Droid Bionic | $699 |
| Samsung | Galaxy S2 | $649 |
| HTC | Desire S | $649 |
| HTC | Evo 4G | $599 |
| HTC | Droid Incredible | $599 |
| Research in Motion | Blackberry Torch | $599 |
| HTC | HD7 Windows Phone 7 | $599 |
| Motorola | Droid X | $569 |
| Nexus One | $529 | |
| Nokia | N8 | $494 |
| Company | Device | Price |
|---|---|---|
| Apple | iPad 2 | $499 |
| Samsung | Galaxy Tab 10.1 | $499 |
| Research in Motion | Blackberry Playbook | $499 |
| Samsung | Galaxy Tab 8.9 | $449 |
| Motorola | Xoom | $399 |
| ASUS | Eee Pad Transformer | $399 |
| HTC | Flyer | $299 |
| Barnes & Noble | Nook Color | $249 |
| Amazon | Kindle Fire | $199 |
(The above prices are based upon retail price without a contract.)
Apple's prices are not abnormally high compared to the competition. However, Apple is at the top line of the spectrum. Even with these top notch prices, Apple sold out of the iPhone 4s everywhere it was available. The iPad 2 also received this same welcome celebration as it sold out back in March in about a day or two. After seeing the prices of the top products on the market, the initial question remains. How is Apple able to ignore the kinked demand curve and thrive while other competitors fall behind?
Traditional Demand Curve
Because the kinked demand curve cannot explain this anomaly, we must use the traditional demand curve along with traditional supply and demand economics. The demand curve essentially shows the price in which consumers are willing and able to pay for a product. However according to this logic, the Samsung Galaxy Tab 10.1; which is very similar to the iPad 2, should sell out because both are priced the same and it is obvious consumers are willing and able to buy the iPad 2.
Since the kinked demand curve does not explain Apple's prices, we must assume supply and demand is the driving force behind the high prices for Apple's products. By consulting supply and demand, we can easily argue there is a high demand for Apple products. Furthermore since Apple does not produce an infinite amount of products, the price for the product will remain high. In other words, as long as consumers are lining up for Apple's products, Apple has no reason to lower the price.
On the other hand, Apple's competitors have struggled and lowered their prices. Hewlett Packard (HPQ) is the prime example as the company has already had one fire sale to deplete the company's inventory of Touchpads. HP has not been the only company to face lower demand. Virtually every smartphone and tablet producer, excluding Apple, has lowered the price of their respective smartphone or tablet at some point.
This leads me back to the kinked demand curve. Since Apple's competitors have lowered their prices, and demand has increased minutely, this shows the kinked demand curve can be applied to this industry. It is important to note, HP violates this curve because the demand for the Touchpad immediately spiked to iPad 2 levels when HP set the price for the 16gb tablet at $99. Nevertheless, these kind of liquidation sales should not be applied to the long term kinked demand curve or the long term demand curve because liquidations are usually one day or one week sales that do not last.
How Have the Stock Prices of These Companies Performed?
One final issue to address is the stock price movements of the major companies listed above. It should be no surprise the strong selling companies have performed very well in the equities market. For instance, Apple and HTC's respective stock prices have grown over 100% in the past two years. Similarly, who companies whom have had to lower prices have struggled. For instance Research in Motion (RIMM), Nokia (NOK), and ASUS are down 64%, 48% and 13% respectively over the past two years.
The kinked demand curve can also be applied to the equities market to explain why some stocks dip while others surge higher. It should be apparent the three stocks that have slid the most have lowered the prices for their respective products over the past two years. Research in Motion's Blackberry was once priced the same as the iPhone; now the majority of Blackberry phones are priced well below the rival. And according to the kinked demand curve, when a business lowers the price of a product the demand minutely increases. This leads to a small percent increase in demand, yet a large decrease in margins. Over time this leads to missed earnings, lowered forecasts, and a share price with no bottom.
The kinked demand curve is a simple topic, however as you can see above, it can be violated. With that said, I must reiterate the fact that while Apple violates the kinked demand curve, the business also violates the traditional demand curve. Therefore I must leave you with two questions to ponder: Are popular and powerful companies invulnerable from traditional economic rules? And what will it take to bring these companies back into line?
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
