Posted by James McQuivey on February 17, 2011
The most important outcome of this week’s emerging tussle between Apple and Google is that we are about to have an intense and financially difficult conversation about what a fair price is for delivering customers to developers, publishers, and producers. Economically, this is one of the most critical issues that has to be resolved for the future of electronic content. Very soon, a majority of consumer experiences (that which we used to refer to as the media) will be digital. But not until the people who will develop those experiences have unambiguous, market-clearing rules for how they can expect to profit from those experiences.
The question comes down to this: Is 30% a fair price for Apple to charge? I must be clear about my intentions here. I do not employ the word “fair” the way my children often do. I am not whining about Apple’s right to charge whatever it wants. Apple may do whatever is best for shareholders in the short- and long-run. I argued yesterday that Apple’s recent decision does not serve its shareholders in the long run. Google announced One Pass yesterday – hastily, I might add – in order to signal to Apple and its shareholders that monopoly power rarely lasts forever. But none of that questions the ultimate morality of Apple’s decision or its rights.
I use the word “fair” to refer to a state of economic efficiency. A fair price is one that maximizes not just individual revenue, but total revenue across all players. Such revenue maximization cannot be achieved without simultaneously satisfying the largest possible number of consumers with the greatest possible amount of innovation.
It is on that basis that I declare Apple’s 30% pricing unfair. How do we know what a fair price is? In an efficient market, fair prices land somewhere close to the cost of delivering services. This happens thanks to competition: As long as there is excess profit in the system, a rational competitor will lower prices to attract more customers until margins are thin enough to survive on but not amply so.
Right now there is no competition in this market. Apple owns more than 90% of the tablet PC business and is therefore immune to the effects of competition, at least for now. But as we’ve seen in the phone business, it only took Android a few years to catch up and I expect the same to happen in tablets. When it does, Apple will have to reevalute its 30% price. But will it land on Google’s 10%?
In the short run, maybe, though I don’t expect Apple to counter price directly, it’s just not in keeping with the company’s style. More to my point, however, in the long run, even Google’s 10% is too much to ask of experience providers.
Some will disagree with me, vehemently. They’ll raise examples like newsstand sales of magazines, where the publisher only gets a minority of the newsstand price. Or any physical retail business, where a 70% cut of the sales price would seem like a boon from on high. But none of those examples are relevant.
In the world of retail – including physical media distribution on CD, DVD or even in movie theaters – margins are slim for everyone in the supply chain. The producer, distributor, wholesaler, and retailer. Because everyone has physical costs to bear in a competitive market, they all offer their services at just above their own costs.
In the app world, however, the biggest incremental cost of a content experience is its creation. Once it is created and properly formatted for delivery – costs both born by the publisher or producer – the distribution of the digital asset is nearly free. Managing the customer relationship, maintaining secure login and credit authorization processes, delivering the bits to the device – these are all negligible costs that the platform operator bears as a service to the market. Any claim that these costs are burdensome is exaggerated.
Arguably, the biggest cost an app platform developer endured was building the device and creating the developer tools. These companies deserve to recoup that investment. And they do: Apple charges a fabulous premium for all of its devices. Plus, it expects the user to pick up the last mile of distribution costs. In other words, Apple paid for its investment already, many times over, and only has small residual expenses left to cover. This is why Apple’s stock is so popular. The device owner pays for all of Apple’s investments. Any cash Apple gets from developers is just gravy.
Again, there is nothing morally wrong with this. Apple can do this all it wants (though eventually, someone will call a Senator or two and the FTC will get involved; it’s just inevitable, even if there is ultimately no finding of fault).
So if we can’t compare Apple’s 30% or Google’s 10% (or Amazon’s 30% Kindle bounty, by the way) to other media or retail distribution businesses, what can we compare it to? The most direct analog is the credit card processing business. It’s similarly structured: One entity acts as a secure platform on which millions of consumers can transact with thousands of businesses. What do these companies charge? From just below 2% to as much as 5% for low-volume, high risk merchants. How do they justify this charge? Easily: They have to have a large physical and labor infrastructure to manage the process. Some of this infrastructure is paid for by partners and customers (your annual fee or the cost for a merchant to buy a credit card reader), but most is not.
This system works well. In fact, it works too well and we overuse it, a problem the last recession hopefully curtailed at least for a while.
Seen in this light, you can better understand why I argue that the long-term resting point for these kinds of platform fees is going to end up below 10%. It won’t happen until after 2012, when there’s enough competition among platforms and enough people going around the platforms altogether using HTML (expect Amazon to be among the first). That competitive pressure will lower prices and encourage more innovation. Apple will still have billions in the bank and its shareholders will still be very happy. But the happiness of other companies (measured in revenues) will also have risen and so will the enjoyment level of the end customers who will have better content experiences at more efficient, market-clearing prices.
That’s why Google’s announcement is so important. Because it signals the eventual arrival of this future and provides frazzled content companies with some hope that they can someday return their focus to generating the best content. That’s why they’ll sign up for One Pass, even if they dislike Google as much as they now distrust Apple.
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