An article in the Wall Street Journal caught my attention while I was supposed to be vacationing on the Oregon Coast and I couldn't resist. It seems that Sprint is having a problem signing new customers to their superfast 4G network because they don't have enough phones. Click here for the article.
Cellular phone companies typically offer deeply discounted phones when customers sign long term expensive contracts. The higher contract rates create a negative substitution effect - customers are inclined to purchase something else. The higher rates also create an income effect - a reduction in general purchasing power. When the substitution effect is small and the income effect is large, firms can increase profits by offsetting the income effect. In the case of Sprint, this means offering the 4G phone at a deep discount.
Economists use a technique known as "decomposition" to determine the sizes of the two effects. The details can be found in an intermediate micro text. If done correctly, the profit maximizing contract rate and length, and the profit maximizing price of the phone can be set. In Sprint's case, it appears that the elasticity of demand was overestimated. Consumers were not as responsive to the price increase as Sprint believed. This causes the income effect to be overestimated and the phones priced too cheaply (or the service priced too cheaply).
The effect - when you underprice something, there is bound to be a shortage.
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I remember that decomposition. I think I still remember the difference between Income and Substitution effects, too.
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