When Apple dropped the price of its iPhone by a third after only two months on the market, even its most loyal buyers complained bitterly, forcing chief executive Steve Jobs to apologize and offer a partial rebate.

According to Wharton faculty and analysts, the iPhone episode reveals the perils of pricing in a marketplace where constant innovation, fierce competition and globalization are changing the rules of the game. “The product lifecycle is short and the market is moving quickly,” says Wharton marketing professor John Zhang. “You don’t have a lot of time to learn from your mistakes. You have to price the product right the first time.”

Pricing is gaining new interest as management looks for ways to increase revenues after years of focusing their attention on downsizing and cost-cutting. Firms are only now beginning to apply to pricing some of the data collection and management tools they have been using in supply chain management and other parts of their businesses. “Pricing is the last bastion of gut feel,” says Greg Cudahy, managing partner of Accenture’s pricing and profit optimization practice.

According to Cudahy, companies that take a strategic approach to pricing throughout their business and monitor their success with hard numbers can raise revenue by between 1% and 8%. “That’s a huge shift in pure revenue improvement.”

For example, New York drugstore chain Duane Reade increased baby product revenues by 27% after using pricing software to examine sales data, according to an article titled, The Price Is Right…Isn’t It?” that appeared in the January 2007 edition of Accenture’s business publication Outlook. In the article, Cudahy and George L. Coleman, a leader of Accenture’s retail pricing group, describe how the data showed that parents of newborns are not as price-sensitive as parents of toddlers. In response, the company cut prices on toddler diapers to remain competitive with other stores and raised prices on diapers for infants.

Cudahy says better pricing can help businesses on many other levels beyond revenue boosts. For example, he worked with a parcel delivery company that introduced a coherent pricing strategy to its operations and found it was able to reduce by 90% the time spent working out pricing for bids. That allowed the company to focus more time and effort on building up customer relationships.

Closer attention to pricing can have payoffs in other ways, he says. Accenture found that in some retail operations a price decrease in one area can lead to beneficial pricing elsewhere in the store. Research in retirement communities in the South, for example, observed that shoppers had a high sensitivity to the price of health care goods. But saving a few cents on those items may lead them to spend 50 cents more on other items. “Pricing is not only about trying to get people to pay more,” he says. “Pricing is used as a testing mechanism to find what consumers really want. It’s basic supply and demand. The surest way to find out if consumers want something is their willingness to pay for it.”

‘Temporal Price Discrimination’

According to Wharton marketing professor Jagmohan Raju, Apple’s price cut is an example of a strategy known as “temporal price discrimination.” Companies using this strategy charge people different prices depending on the buyer’s desire or ability to pay. As a result, companies win two ways. First, they reap wide profit margins from those willing to pay a premium price. In addition, they benefit from high volume, even at a lower per unit price, by building a wider customer base for the product later. Raju notes that price discrimination can also be structured across geographies, seasons and by adding or eliminating features, as is done with student software.

Consumers have come to accept this form of pricing in the airline industry. A last-minute traveler expects to pay vastly more than a frugal flyer who booked a seat on the same flight, in the same aisle, months earlier on the Internet. It is easier, Raju says, to apply temporal pricing structures in an industry with a service component — like airlines — than it is with a tangible manufactured item. Indeed, just last week, New York City’s transit agency proposed a two-tier system under which people would pay a lower fare if they ride subways or buses during off-peak periods. The plan, which would take effect in 2008, would raise agency revenues as well as offset overcrowding. And, according to a report in the New York Times, the Bush administration is considering a plan to charge airlines higher fees for landing during an airport’s rush hour than for landing during off-peak hours.

However, temporal pricing can be applied to other non-service industries as well, including the technology sector, where consumers expect to pay sharply lower prices if they are willing to hold off on buying an exciting new product the minute it hits the market. In many cases, Raju says, technology marketers must set pricing below profitable levels to build an installed user base that will lead to profitable levels of sales volume later. “If I’m the only one with a video phone, whom am I going to call?” Raju asks.

Wharton marketing professor David Reibstein notes that while pricing discrimination makes sense for businesses, it can be a touchy issue. He recalls that Coca-Cola faced a harsh backlash when it tried to charge more for drinks at vending machines on warm days than on cold ones. Coke ultimately backed down. Price discrimination “is a new phenomenon that is growing. But you must approach it very delicately as Coca-Cola found out.” He says professional sports teams are beginning to think about charging more for highly sought-after games, and grocery stores in Manhattan have experimented with charging less for items during the day when stores are not as crowded and consumers have more time to comparison shop.

At the moment, the acceptance of pricing discrimination varies widely among product categories, according to Reibstein. While consumers have long accepted the idea of matinee prices and senior-citizen discounts, they are outraged when street vendors jack up the price of umbrellas on a rainy day and they would never expect to receive a senior citizen discount on a new car. Reibstein says the best way to inaugurate a price discrimination scheme is to be open about the economic reasoning behind the decision. Don’t “try and sneak it past the public. Be very open and honest about your rationale for doing it.”

Frank Luby, a partner in the Boston office of the price consulting firm Simon-Kucher & Partners (SKP), cautions that many companies fail to take into account how their competitors will react when they lower their prices. Continued price responses among competitors can lead to an all-out price war that can be disastrous for all sides. “We would argue, in some cases, that the best response to a potential price war is none,” says Luby.

He also notes that companies must take “price contamination” into account when developing pricing strategy. At the business-to-business level, the power of pricing discrimination erodes as employees move from firm to firm sharing internal information about pricing. Acquisitions also put pressure on prices as companies open their books to one another and see disparities. “What you charge one place has a risk of leaking out and coming back to haunt you. That’s an incentive to keep prices as high as possible.”

According to Raju, certain industries are more advanced than others in developing successful pricing strategies. In addition to airlines and mobile phones, retailers are among the most sophisticated. Wal-Mart, for example, collects detailed customer and competitor data to make pricing decisions. The apparel industry, he says, is not as complicated. Clothing retailers charge high prices when garments arrive at the beginning of a season, but then systematically make markdowns as the season progresses. “The value of the product lowers as time goes by.”

Pricing is growing increasingly complex as companies expand into new markets around the world, Raju notes. “As globalization takes over, there is wide variation in willingness to pay, yet the markets are very attractive. How do you go after people who don’t have high income, but whom you would like to have touch your product?”

The pharmaceutical industry, he adds, has attempted to create differential pricing structures to reach patients in developing countries while protecting profits in their traditional markets in Europe and the United States.

Zhang says companies are realizing that pricing is critically important, but difficult to do right. Typically, managers have avoided new approaches to pricing, not only because it is complex but also because it is so important. “If the decision is impactful, you don’t want to do anything new. If you don’t have a very sophisticated knowledge of pricing, you don’t have the confidence to make those kinds of decisions. The safe thing to do is to follow whatever the convention is.” Usually, he says, companies take their cost to produce a product and add a certain percentage to that as profit. Isuppli, a technology market research firm, has estimated the cost to produce the 8GB iPhone at $265.83.

Zhang points out that another obstacle to pricing new products, particularly technology gadgets, is an inability to do wide market tests without trading off the secrecy necessary to protect a developing product from copycats.

Part of the Family

Often pricing defies traditional models when products carry an emotional attachment or become a symbol of the owner’s sense of self, which can happen with cars, handbags and technology products, including phones and music players.

The reversal on Apple’s iPhone may have been more dramatic because the company has marketed itself as consumer friendly, says Wharton marketing professor Stephen Hoch. “People have strong positive feelings about Apple. They feel they are part of the Apple family.” When Jobs announced the price decrease, “people felt betrayed. I don’t know whether they should or not. It’s not as though this is the first time a technology company lowered prices.”

Hoch says he does not believe Apple was under pressure to boost unit sales because of lower-than-expected purchases. He notes that the company sold one million phones in a little more than two months, nearly a month ahead of its announced target. To compare, it took Apple two years to sell one million iPods. While the iPod was more or less in a class by itself, the iPhone is a new player in a fully developed, competitive cellular phone market. “The competitors will work hard to defend their positions. There will be a lot of new products and pricing.”

For Luby, the iPhone pricing controversy shows that even a sophisticated marketer like Apple can be tripped up by the complexity and hidden effects of a pricing decision. “It seems like Apple made a mistake — and many people believe it did — but there are a lot of moving parts here.” He points to the phone’s new features, its exclusive tie to wireless carrier AT&T and all the hype associated with its launch. He challenges Apple’s critics to present a model of how they would tease out all these elements to determine the right price: “I’d like to see their math.”