Why is the new iPhone only $199?

Unless you’re living in a cave or have taken the Four Hour Work Week to heart and have abandoned reading any news then you’ve heard about the new iPhone coming out July 11th. I have been interested in the next version of the iPhone not because it would be a 3G phone (i.e. faster Internet connection), nor because I guessed it would probably be thinner, nor because I could have guessed it would have an upgraded OS with more features (i.e. developer community = unlimited apps), but mostly because it was going to have support for Microsoft’s Exchange Server, which I use, and which is a must for me if I’m going to buy a phone and check email on it. What I was not expecting was for the new phone to cost half what the old phone currently costs, and that’s got me thinking about why Apple would do such a thing.

Disclaimer: I am not a Mac fanatic. I do not own an iPhone, nor a Mac. I am also not a PC fanatic. I am an objective bystander with no ulterior motives, other than to impress Steve Jobs with my wit and get him to send me a free iPhone.

If you’ve ever read Inside the Tornado or Crossing the Chasm by Geoffrey Moore then you’re fully versed on the technology adoption lifecycle. If you haven’t read the books, the concept is simple to understand and perfectly logical. The basic idea is that when new technology products come out, there is a certain group that will use them (i.e. geeks), but most people will wait until they’ve been tested, refined, improved, and accepted by others. Good technologies eventually make it into the mainstream, where the big money is to be made.

How does this apply to the iPhone? This means that when Apple released the iPhone, they knew there was a certain group of people who would flock to the phone immediately. These were Mac fanatics who will buy anything Apple releases and uber-geeks who will buy any new technology simply because it’s new. These people are relatively price insensitive. I can imagine the conversations going on inside Apple two years ago as somebody says “Nobody is going to buy a cell phone for $600, even if it is really cool looking!” and Steve Jobs says “Wanna bet?” Somebody was willing to buy Mac’s first cell phone for $600, and that person was the Mac fanatic. They may have paid $800 for the phone. To date about six million people have bought the iPhone, and although the price has come down from $600 it only came down to $400, which still makes it just about the most expensive cell phone out there.

So what would have happened if Apple had released the phone at $199 to begin with? Would they have sold more than six million of them? It’s probably unlikely. The people who were not buying the iPhone weren’t staying away because of the price, they were staying away because they’re not the kind of people who buy new technologies. They’re the people who will wait and see. These are business users and the mainstream public.

But now the iPhone has been around for a year. It’s been all over the news, and it’s old news. It has been tried and proven, and mainstream users were staying to say “You know, I’d really like to try out the iPhone, if only…” (add your desired functionality here, like “if only it supported Microsoft Exchange Server”). But if Apple were to release the new iPhone for $400-600 and drop the price of the old iPhone to $199, what would happen? In all likelihood, their sales wouldn’t exactly take off. That’s because while the early adopters are price insensitive, the mainstream is, and the mainstream isn’t simply interested in a cheaper old iPhone, they’re interested in a cheaper iPhone with new features that are must-haves for this crowd, and that means increased compatibility with Microsoft/Windows products.

So Apple release a new phone with those must-have features, and they drop the price to half the price of an old iPhone. Now, is a $200 phone a cheap phone? No, not by a stretch, although it is within the competitive range. However, when you’ve had it stuck in your head that iPhone’s are super expensive because they’re $400-600 phones, and all of a sudden they come out with a new, thinner, and better model with all the features you want in it and it’s only $199!!! Well, suddenly $199 sounds quite affordable.

Add to this the fact that Apple only makes $100 on the sale of each phone vs. $200 from service fees and it makes sense for Apple to lower the price in the interest of getting as many people signed up as possible.

So, to recap:

1. Apple was right to release the phone at an expensive price initially, because the only people who would buy the phone anyway were price insensitive. In addition to the obvious cash benefit, the high price also established the product as a “luxury” or “high quality” product, and set Apple up to be able to get people very excited about a lower but still high priced item down the road.

2. Apple was also right to drop the price on the new iPhone, rather than dropping the price on the old iPhone, because they are now marketing to an entirely different set of people. These people are price sensitive, and would likely not buy the phone at a $400 price, but they will jump at $200. The fact that the phone was so expensive before only helps make the $200 seem that much lower.

Apple hopes to sell 10 million phones this year. Certainly the economy will affect that, but given that they sold 6 million phones last year to the relatively small group of innovators and early adopters, many of whom will upgrade to the new iPhone, I think they might be undershooting the potential at only 10 million.

As for me, I think I might choose to be a laggard and hold out for the day when iPhones become the free phone they give away when you sign up for new cellphone service.