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English, Gestión e innovación, Política

Apple, innovation, imperfect markets and the role of standards in competition

The business of businesses is achieving differentiation. For a good reason.

This (almost off-the-cuff) article sketches something I’d like to gather serious data about. Not just anecdotal evidence but serious econometric-scale data. On the other hand, it seems plainly observable.

The gist (or summary) is this:

When looking at the value chain that delivers a type of good or service to the consumer, we will find many different layers, and several competitors in each them. The relative position (or pricing power) of each competitor AND of each layer lies in the relative differentiation of their deliverables. The less differentiation within a layer, the more commoditized it becomes, and the less margin it can retain on the global value created by the chain. The less differentiated a competitor within his layer, the more he’s forced, again, to compete in price, and thus to relinquish margin.

Innovation (to develop differentiation) is difficult. But it’s a relative thing. When players in a layer can force another layer to implement a publicly available standard, they are in fact commoditizing it, and can profit from the others’ loss of pricing power.

The recent flourishing of open technology standards is the latest wave of this phenomenon. By demolishing barriers to entry in a layer, players demolish also its pricing power. By opening the standards of items they use as inputs, firms allow many competitors to vie for its business and prevent the emergence of any differentiated, dominant provider. Within a layer, players who can’t differentiate can gather around shared standards that allow them to give lower-cost solutions (and sometimes thus overwhelm the leaders).

Some plain examples

In computing and consumer electronics, you can see this force at work at every level. Microsoft Windows was used as “freely available standard” to compete against the Mac OS (Apple’s operative system in the first personal computers), which was tied to its own hardware. The result was a plethora of computer makers who didn’t make a dime on their machines, but brought the average cost of personal computers down, and almost destroyed Apple.

Then IBM and other integrators started pushing (free, open) Linux into corporations and large organizations (including governments) to break Microsoft’s advantage on this market, born off Windows’ dominance.

The same trick is being played by mobile handset makers against Apple, RIM and HP-Palm now, using Android (Windows is much more expensive). And Apple is using it to break Adobe’s dominance on web video and animation (pushing open standards as an alternative to the almost-monopoly of Flash).

It doesn’t always work. The “x84” chip could have become a standard, thus commodifying Intel, but neither AMD nor other stalwarts ever managed to break the giant’s other advantages. And Android is not quite up to scratch yet with a really tactile OS like iOS.

But it was also the force that settled the battle of video-recording standards, for instance (VHS being an acknowledged inferior technology to Beta, but being tied to a dominant and expensive provider, its (media) competitors backed another (technical) standard). It has also helped Apple develop a viable competitor in digital media to the Windows Media behemoth, by putting QuickTime into the public MPEG4 standard. Apple and Google are using this method to kill Microsoft Explorer dominance, through Safari and Chrome, both based on the WebKit open source project run by Apple.

Those open standards are the very foundation of the interoperable web. On open standards, anybody can play. And on those standards, open source competitors have spawned in every product region, from content management to enterprise resource management to document and graphics edition, to heavy-duty databases.

Relative innovation

When you build a product upon a layer that is standards-based, you can incorporate your own differentiation with (comparatively) low costs. When you use standards from your own layer, you are relinquishing opportunities to innovate. “Closed models”, “walled gardens”, are vilifications of this differentiating attitude. When successful, the player can differentiate its offer within the layer so much that the customer (or the next layer) prefer to deal with it in spite of a price differential.

As every economist will recall, achieving this kind of (favourable) imperfect competition is the very dream of any business manager. Again, the best example could be Apple: its infamous 30% cut of purchases made on its platform is an order of magnitude higher than PayPal or its competitors can hope to tax for their services. The reason is simple: Apple can provide a buying environment so compelling (for buyers) that it is almost compulsory for a software or music distributor (seller) to access it. Apple has no competition within the mini-layer it has carved for itself.

Of course in a wider sense it does have competition. Anybody can sell music using standards, free storefront software and cheap payment processing. It just doesn’t work as well.

Therefore, the “monopolist price” that Apple gathers is high. But that in turn fuels the effort to neutralize it, by putting together a set of standards that can compete with it. The interesting part (and the reason this is an example) is that it is not only the directly affected parties who work on this: the music labels have tried, and the traditional distribution channels (Wal-mart, for instance, or FNAC in a different way). Amazon is still at it. But the main effort is led by players who don’t want to make money on that market, but simply to crush that layer into standardized, economical irrelevancy, so as to keep siphoning the value created in online distribution. In short, Google and Microsoft. The first wants to break any bounds in its ability to deliver (ad-powered) content to users, and thus tries to enable editors to sell content online (and on-tablet) without the Apple tax. The second wants to protect its dominance of core niches and technologies by diluting the weight of any potential rival, and thus pours money like crazy on a “mobile” operating system so derided that only ulterior motives can explain its existence.

The sand castle

In other words, competitive differentiation brings us back to my favourite simile: the shrinking and rebuilding of a sand castle.

Any advantage built carries in itself the seed of its destruction through competition. The more worthwhile (profitable) the advantage, the heavier the forces that will be brought to bear. And nowadays, very often, those forces will include shared, open, free (or extremely low cost) ways of doing things that can be adopted by any of your competitors to achieve results almost as good as yours, for a fraction of the cost. Yes, that will minimize their margins, but that is better that outright extermination.

On the other hand, if you can keep building faster than the sea can pull away your walls, your castle will eventually grow into a dyke, and its own size and weight (and the tangled vines and rocks) should make it very difficult to destroy. That’s the innovator’s dream. And it sometimes almost happens. See Edison’s General Electric: still there, minting money.

And by the bye, don’t think of technology as the only area where this applies. Forcing a predictable, replicable behavior on your business partners is what commercial legislation is all about. You can see it in trade organizations, trade treaties, and in countries’ own law codes. Or in German attempts to force a standard tax code on Ireland.

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