By: Paolo Morganti
Amazon just announced its impressive line of new tablets. Only one year ago the announcement of the Kindle Fire, the 7-inch tablet sold at the outrageous price of USD 199, opened an intellectual debate among analysts, journalists and computer geeks: could the new tablet compete successfully with the undefeated champion, the iPad 2? Does that mean that for the first time Apple would have to reduce the price of its celebrated tablet, possibly starting a price war?
It seems intuitive: when a cheaper substitute enters the market, the price of more expensive products will fall because of competitive pressure. It is an elementary economic argument. Yet, one year has passed and Apple has never touched its prices even though the Kindle Fire had entered successfully the market. Where is the price war we had been promised?
Truth is, competition does not always lower prices.
We can show this point using the concept of elasticity. The elasticity of demand represents the reactivity of quantity demanded to a change in prices. If the demand for a product is characterized by a low elasticity, then the manufacturer could feel confident in setting a large markup without fear of alienating customers. On the other hand, if for some reason the elasticity of demand bumped up the manufacturer would have to drop the prices.
When a cheaper substitute enters a market, we tend to assume that the elasticity of the residual demand will increase: the iPad loyalist now have a credible alternative, so – at least in principle – they should pay more attention to differences in prices.
However, the opposite might also happen: the elasticity of the residual demand might drop or stay flat. This is the result of two effects. First, it is correct to say that Apple will reach fewer consumers because of its high prices after the competitor has entered. But on the other hand, its residual demand will now have a lower average elasticity (the part of demand with high elasticity has left for the Kindle). If these customers are sufficiently insensitive to prices, then there is no point in responding.
And this was the case, and not because of a coincidence. Amazon made sure that the gluttonous Apple could keep its core of appetible customers.
Amazon played brilliantly its strategy, choosing a market position that would not disturb the Leviathan while cutting its piece of the pie from the Android market. This should serve as a lesson for all the confused companies that are trying to follow the leaders without establishing a clear market identity. Even though the pie is still growing, they should understand that, more than before, they need accurate strategic positioning to survive an uncertain future.♦
Paolo Riccardo Morganti
1) Pauly and Satterthwaite (1981) “The Pricing of Primary Care Physicians’ Services: A Test of the Role of Consumer Information”, Bell Journal of Economics, 12: 488-506
2) Bresnahan and Reiss (1990) “Entry in Monopoly Markets”, Review of Economic Studies 57: 531-553