February 3rd, 2013 by Andre Guggenberger

WHY APPLE IS DRIVING APP PRICES DOWN: AN ECONOMIC EXPLANATION

Apple’s App Store was and is a huge opportunity for Indie developers and has revived a whole industry and created countless new jobs. But besides the hype and the success stories subtle criticisms have emerged over the last few months. Reports have shown that much fewer Indie developers profit from the App Store than many have expected. Some think that low prices of the apps are the problem and advocate to rise prices. But that’s very difficult because it seems that nowadays users have become to expect those low prices or even expect to get apps for free. This trend does not only apply to the App Store - an even more extreme case is the Google Playstore. But there is someone who profits from low app prices in the App Store and actually encourages free and low prices apps: Apple. (I’ve even heard rumours that free apps are favoured in the App Store search ranking - I don’t know if that’s true, but if someone has more information about that I would like to hear it)

In this post I will introduce some very basic economic concepts which explain why it is in Apple’s interest that software prices on iOS fall (note: the same is true for software on OS X). Of course these concepts are not the sole explanation - there are some additional factors to be considered but nevertheless I think these concepts provide a good explanation.

One of the courses I attended at university while I was studying Computer Science was economics - and surprisingly it was one of my favourite courses. One of the first things we learned was the relationship between supply and demand, what price elasticity is and the concept of substitutes and complements. And these are exactly the concepts I will use to explain why app prices has fallen significantly. To get started first let me briefly explain these terms:

  • supply and demand determine the price of a good. Basically if supply increases and demand remains unchanged the price of a good declines. Consequently if supply decreases and demand remains unchanged the price of a good rises. Similarly if demand increases and supply remains unchanged prices increase. And if demand decreases and supply remains unchanged prices declines (more precisely the price here is the equilibrium price - but for the sake of simplicity I go with price).
  • price elasticity measures how strong the supply/demand of a good changes when the price changes. The greater the elasticity the greater the change of supply/demand in relation to the price change.
  • substitutes and complements: Substitute goods are goods which serve similar needs than other goods and are seen as valid replacements for them by consumers. One example would be butter and margarine - or an iPhone and a Samsung Galaxy S3. Normally someone would buy an iPhone or a Samsung Galaxy S3 - but typically not both. Complements are goods which are typically bought together with another product - like ink cartridges and a printer or DVDs and DVD players. In most cases it just makes no sense to buy DVDs if you don’t have a DVD player.

Now let’s look how the demand for a substitute develops if the price of the substituted product increases: If the price of butter increases we can expect that more people will buy margarine. So we can generalise: if the price of a good increases demand for it’s substitutes will rise.

We can make a similar observation for complements: if the price of ink cartridges decreases demand for printers will increase. Cheaper BluRay discs are an incentive for people to buy BluRay players and so demand will rise. And if prices for mobile internet fall it’s likely that more people will buy Smartphones. Again the generalised rule is: if the price of a complement decreases demand for the complemented product increases.

So the important generalization here is: The demand for a product increases if the prices of its complement decreases.

Now let’s apply these considerations to the AppStore: Apps are clearly the complement of iPhone and iPad (another complement of iPhone, iPad and iPod would be the music available on the iTunes Store). So using the above generalization we can say that if the prices of apps decrease then the demand for iPhones and iPads will increase. Therefore it’s in Apple interest that prices of apps fall (while assuring that there are still enough developers out there to develop high quality apps). That’s also the reason why Apple’s own software has become very cheap (e.g. OS X). And this should not be a surprise - software was always considered to be a complement of the hardware. And Apple’s main business and the area where it has unrivaled profit margins is still hardware.

But how big is the influence of falling app prices on the demand for devices? As explained earlier the measurement for this is the price elasticity. If the price elasticity is high the demand would significantly increase. Actually I’m not sure if it is even remotely possible to calculate the price elasticity for apps and iPhones/iPads because there are so many different factors at play. Clearly the success of iPhone and iPad is somehow coupled to the rise of apps. Apple repeatedly emphasizes the importance and the success of the App Store at various events and also in their ads. Empirically I would say that there is a significant correlation - that the availability of the large number of apps have helped selling iOS devices a lot - but I cannot put a number on it.

To be clear: I don’t like it that app prices have fallen to such low levels. But I don’t blame Apple. It’s a perfectly viable strategy for a company to reduce prices of complements to increase the demand for their own products. And it’s something we can learn from. If you are a selling a product and there are complements to that product, lowering the price of those complements might help increase the demand for your product.

Of course reality is a little bit more complex than these explanations suggest - prices, demand/supply and price elasticity are influenced by a wide variety of factors. But even so these simple economic concepts form a decent model which can help us to explain what’s happening in the app market at the moment. Using these concepts we can also explain why large companies support Open Source projects, why Android is free or why Microsoft has payed developers to develop software for Windows Phone.

Falling app prices are a consequence of a deliberate, strategic and logical decision by Apple and very basic, economic principles. We can use these principles to try to explain certain trends in markets or as tools for our own businesses - to get a strategically advantage over our competitors.

Questions? Don’t agree? Wanna discuss? Contact us: Twitter/via mail.