So am I a chump for buying an iPad with a lot of storage?

Many smartphones and tablets come in a limited set of variants. Take the iPad. It comes in two colors and can be had with or without a cellular data capability (itself available from two different providers). And there is the issue of storage. (I keep wanting to say “disk space” but that doesn’t quite describe the technology correctly.)

Apple offers the iPad with three different levels of storage — 16GB, 32GB, and 64GB — and picking the right amount is one of the harder choices for tablet buyers. Now the tech columnist of Slate argues that most people are being taken for a ride when they consider buying more than the minimum storage capacity (Storage Suckers, Jul 12).

 Ever since the days of the iPod, Apple has boosted its bottom line through upgrades. The company offers the entry-level versions of its devices at a price that seems reasonable to many people. This entry-level price functions as a marketing come-on—a way to get you in the store. Once you’re there, your eye wanders to the next level. Is 16GB really enough space on my beautiful new iPad—won’t I feel cramped on a year or two? Shouldn’t I spring for more? It’s only $100 … .

That’s exactly what Apple wants you think. Once you decide to move beyond the entry-level iPad, the company’s profits soar. According to iSuppli, it costs Apple about $316 to make the low-end 16GB iPad, which the company sells for $499—a margin of about 37 percent, not including non-manufacturing costs. Doubling the storage space to 32GB costs Apple $17 more, but it charges you $599 for that model, boosting its margin to 45 percent. On the high-end Wi-Fi model, which offers you 64GB of space for $699, Apple’s non-manufacturing profit margin shoots up to 48 percent. But that’s not all! If you get an iPad with 4G cellular connectivity, you’re really in for it. The very top-end iPad, a 64GB model with 4G, will set you back $829 for a device that costs Apple $408 to make—a margin of 51 percent, or twice what Apple makes on the cheapest iPad. There may be other popular products that carry such a breathtaking markup, but I bet most of them are monitored by the DEA.

These enormous profit margins prompt two questions. First, why do tech companies charge so much for just a few dollars of extra stuff? Second, are they ripping you off? The answers are pretty simple: They gouge you because they can. And of course you’re getting ripped off! Try to remember this when you find yourself giving in to upgrade temptation. These days, for most people, upgrading to get extra space is usually overkill.

So I have one of those iPad with gobs of storage. Does that make me a sucker?

There are a couple of things to note here. First, just because a firm has a big mark up, it doesn’t mean that customers are per se getting a bad deal. If the buyer really values the option at the offered price, it is a fair transaction. Mini charges $1,500 to $2,000 extra for leather seats. I have to think that is mostly mark up. There is no change in the seat technology between the basic cloth seats and the leather seats. It is all about the covering and while leather is going to be more expensive than cloth, it can’t be that much more. But if I prefer sitting my fanny on cowhide, I would take this deal.

Second, the argument made in the article is that we see this pricing largely because consumers are irrational and duped into paying a premium for storage they don’t really need. That may be true — particularly if consumers underestimate how the market will shift toward cloud-based distribution as is argued in the article. (The article, however, ignores that consumers may be nervous about being beholden to rapacious mobile providers.)

I would counter that one can see this kind of product positioning and pricing even if consumers are completely rational and very sophisticated. Indeed, all it takes is a very standard model of consumers. Suppose that all consumers value more storage but that there are two segments that differ in how much they are willing to pay for storage. Call those segments high and low with the high segment being willing to pay more each unit of storage. If the firm could tell to which segment a customer belonged when they walked in the store, they would design and price an offering for each segment that would maximize the profit the firm could make from that segment. In the simplest model, both segments would have very little net utility from buying the product intended for them.

Now suppose that the firm cannot tell whether a customer belongs to the high or low segment. If the firm offers two models, it puts both out there and lets the customer choose (as opposed to showing an arriving customer just the product intended for them). It is possible that the products and prices that the firm put out when it could identify customers no longer work. In particular, high-value customers may enjoy a higher utility from the product (and price) intended for the low-value segment.

How can the firm fix this? It could jack up the price on the low-end product. That could force the high-value customers to buy the right product but would really hammer sales to the low-value customers. Or it could cut the price on the high-end product. That gives a windfall to the high-value customers and might induce the low-value segment to trade up.

There is a third possibility: Degrade the product for the low-value segment. That is, offer a crippled product with little storage. It would require a price cut to keep the low-value customers buying it but since they value storage less than the high-value customers, a price cut that keeps them buying doesn’t compensate the high-value customers completely for the drop in storage. (If it’s helpful, suppose that the low-value customers value each gig of storage at $5 while the high-value customers value storage at $10 per gig. If the storage in the low-end model is cut by ten gigs, then a $50 price cut leaves the low-value customer indifferent between the revised product and the original product. The high-value customers would still prefer the original product.) A price cut on the product intended for the high-value customer may still be necessary but it will not be as large as it would be before the low-end product was altered. Said another way, crippling the low-end offering reduces the “information rents” for the high-value segment, i.e., the windfall high-value customers would otherwise receive from a simple price cut on the high-end product.

There is a big difference between my model and the mechanism supposed in the Slate article. The Slate article suppose that most buyers of big storage machines are taken for a ride and should regret it in the long run when they learn Apple burned them. My model suggests that buyers who want lots of storage are better off because Apple can’t automatically identify them. They receive what they want at lower price than they would be charged if Apple knew their storage needs. As for buyers of low-end devices, they receive a device with too little storage but at least get a price break.