Is attracting attention by making less profit a good strategy?

Stocks had a mixed close yesterday with no economic numbers to contemplate. Mixed earnings and an outspoken Fed hawk set the mood in yesterday’s session.

It ain’t easy. Ok, so I hit you with lots of charts yesterday, delving, perhaps one layer deeper than usual to prove a point. I hope the point was well received 😉. Today is a new day and I approached my morning routine with high hopes that my mad dash to press time would yield something more interesting than another treatise on the mad Fed and its reactive interest rate strategy. And wouldn’t you know it, a small but telling headline sent me scrambling for my iPad so I can draw some pictures for you. No, I am not going to sketch a springtime landscape of my garden… which, by the way, is looking rather fabulous due to all the recent rain. Life is quite literally burgeoning outside my office window. Even the red foxes have come back, but in numbers I have never seen in the woods behind my garden. Eloise, my daughter’s cavapoo spends her days barking at her finest, attempting to catch the attention of one of those distant cousins who saunter about unfettered. Did I digress? I sure did. Let’s get to the drawing.

The headline that caught my eye read something like this: “Apple’s iPhone shipments in China jumped by +12% after the company lowered its prices.” While reading the headline, my emotions went from a happy “great news” to a confused “hmm, where have I seen this before,” to a disappointed “oh boy, now I am going to have to get into microeconomic theory.” And that, my friends, is where we are going to pick it up this morning. I am not only going one layer below the surface today, but all the way down to microeconomics. First, let me say that my initial emotion of happiness was because Apple has been losing market share in China and it’s nice to hear that, perhaps, they are regaining some ground. My second emotion of confusion was that I was quite concerned about Tesla’s constant price adjustments in China as its market share declined. I understand that the ability to dynamically shift prices can help a company efficiently find an equilibrium market price in a not-well-understood market. However, lots of movement, mostly down, is usually a sign of some potential distress below the surface.

In this case, Apple lowered the prices of its iPhones, and the gambit worked, demand increased. Check out this supply and demand chart.

I know you have seen charts like this before. If Apple lowers its price from P1 to P2, customers will demand more iPhones because, who doesn’t want better prices? The lower price causes the quantity demanded to increase to Q2 from Q1, however, Apple must now produce more iPhones as they were only producing Q1 units prior to the price shift. That should be no problem, and Apple can produce more, shifting the supply curve outward, and a new equilibrium price is established, and everyone goes home a winner, right? Come on, you know it’s not that simple. You may be thinking that this microeconomic stuff is too far removed from reality. A company can’t simply lower prices and increase supply with some implications to the bottom line. Don’t worry my seasoned businessperson reader, the economic elders have a graph for that too. Check this one out then follow me to the finish.

I know that this a very busy graph and there is lots of information here, but this morning I want to focus on only one thing. If you are looking at the chart, I am sure that it already popped out at you without even knowing what each curve means. Let’s assume that before Apple messed with prices that its Marginal Cost (the cost of producing 1 additional iPhone) was equal to the Marginal Revenue (the revenue for selling an additional iPhone). Everyone is happy at that level! If Apple lowers the price from P1 to P2 you can see that the Marginal Revenue line shifts down because Apple is quite literally selling the phone for less. The problem is that Apple’s Marginal Revenue is now below the average cost to produce the iPhone, so technically, the company is losing money. That is a problem… a big problem.

Now I know that this is quite abstracted from reality. I also know that in my chart where everything was equal, Apple was breaking even and the company, a rational company, would not do such a thing. So, let’s just assume that P1 is above its Average Cost line and that Apple is making money. In practical terms Apple may be selling the phone for $800 and the cost to produce it is roughly $400. The company’s gross profit would be… um, $400. If Apple lowers its price to $700, sure more buyers will cue up to buy it, but at the lower price Apple will only make a $300 profit. The downward sloping Average Cost curve does factor in the reality of economies of scale, so even if the cost may be slightly lower, the profit will still be lower, as the Average Revenue line is below the Cost curve.

I know you are thinking “wow, Mark, did you really need to go through all of that to tell me that Apple will make less money per phone, even though they are selling more phones in China?” Well, yes, I did, because I want to make sure that you got the point that anyone can lower prices, but it is not likely that those lower prices can be maintained, unless Apple is satisfied with lower profits. Just saying.

YESTERDAY’S MARKETS

NEXT UP

• MBA Mortgage Applications (May 3) were up by +2.6% after slipping by -2.3% in the previous week.
• Fed speakers today: Jefferson, Collins, and Cook.
• The Treasury will auction off $42 billion 10-year notes today.
• Earnings after the closing bell: AppLovin, Energy Transfer LP, Airbnb, Beyond Meat, HubSpot, Duolingo, Sunrun, Vista Outdoor, and AMC Entertainment.