Economics for Business

The company that I am studying is Apple. The company is a designer and marketer of consumer electronics, specifically computers, smartphones, tablets, mp3 players and software. The company has experienced a strong run of great performance in recent years, but it has not always been that way for Apple. The company struggled considerably, especially in the 1990s, before breaking loose. The key thing about Apple is that it has always sought to differentiate itself. Over the course of the past ten years, we have seen most of Apple’s former competitors in the personal computer space leave the industry. The reason is that the computer industry is moving towards the strategic hell of perfect competition.

Strategy Hell

The term strategic hell reflects the condition of perfect competition. In the real world outside of economics textbooks, few markets can be truly understood to be perfectly competitive. Perhaps a vegetable market in a developing country, where everybody in the village knows what it takes to grow a head of lettuce, so they have perfect information, and nobody has any means of differentiating their lettuce. This example is extreme, and in most markets today the worst that can happen is that they can approach the conditions of perfect competition.

Perfect competition is strategy hell because businesses cannot turn a profit in a perfectly competitive market (Tutor2U.net, 2013). The products are not differentiated, there is no size difference between suppliers and consumers have perfect information, which means that producers sell at marginal cost in the long run. There may be an opportunity for profit in the short run, depending on the cost curve of the company. However, this is a very difficult type of market in which to operate, where turning a profit requires either collusion from the different suppliers to ensure the price is at a profitable level, or an unspoken social contract that the price paid will be higher than marginal cost in order to allow the sellers to survive — why people buying in the market accept prices higher than marginal cost.

In order to break out of strategy hell, a firm needs to eliminate the conditions of the perfect market. Our lettuce vendors at the market might seek to brand their stalls, or provide other products, as a means of earning profit. For computer makers, the situation was actually quite similar. Windows was the dominant platform, there were only a couple of serious chipmakers in the world, and many of the other key inputs into computers were becoming commoditized. The writing was on the wall for the industry, especially as consumers were starting to learn more about their machines. The computer industry was moving increasingly towards conditions of perfect competition. Strategic hell. While nobody expected it to become a perfectly competitive market, the closer the computer business go to that condition, the tighter the margins became. Apple has already been differentiating itself with proprietary design and especially with proprietary software and operating system, but its response went further than that.

Competition

The following chart illustrates the lack of profitability inherent in strategy hell:

source: Tutor2U.net

Apple

As Riley (2013) notes there are different ways to turn a profit under conditions of perfect competition. The first is to lower costs, so that average cost is below the margin cost. This gives the opportunity to price at marginal cost and still turn a profit. This is not, however, the approach that Apple took. The company instead took the opposite approach.. The low cost approach is one that is difficult to sustain in the long run, for a few reasons. First, the low cost approach relies on there being something less than perfect competition because in theory all firms are the same size and should have the same capacity to lower their costs, and consumers have perfect information. Second, the low cost approach is hard to sustain in a global marketplace where there is always a lower source for the good. This is why it is called strategy hell, because it is almost impossible to turn a profit and yet there is very little management can do to change the situation.

However, the other way to get out of strategy hell is to differentiate. This effectively takes the market out of a state of perfect competition, because firms compete on a variety of factors. This is a state of monopolistic competition. The competition is intense, but the monopoly element comes when a firm’s specific type of differentiation makes it unique to the customer, such that the customer is willing to pay a premium for a good of equivalent quality. Apple differentiates in a lot of different ways to ensure that it does not enter strategy hell

The first way that Apple differentiates is through diversification. Apple launched the iPod and iTunes and in that way began to build a business outside of computers. This provided another revenue stream for the company, meaning that even if computers entered into a state very close to perfect competition the company would still be able to earn profits.

The second way Apple got out of strategic hell is through branding. Mourdoukoutas (2013) notes that Apple pays a lot of attention to branding, because it recognizes that a brand is a means by which consumers will be convinced to pay more. With Apple, brand association is key, and the company made a point to create brand associations that had value. In this way, Apple convinced consumers that they were not just buying a computer, they were buying a Mac. That additional value allows them to earn monopoly rents, because some consumers are unwilling to consider other options.

A third major point of differentiation at Apple is with the products themselves. When Apple was trying to succeed in a computer market that was moving towards perfect competition, it wanted to do so with a differentiated product. Apple has its own operating system and software, and it has a focus on design that other computer makers lack. The result is that Apple has a differentiated product. It expended a lot of energy trying to avoid ending up in strategy hell, because it knows that the further it gets from strategy hell, the more profitable it will be. A quick look at the income statement and balance sheet for Apple indicates that their differentiation and financial success have both been substantial (MSN Moneycentral, 2013).

What is interesting about Apple’s approach is that it specifically avoided attempts to compete on cost. The company realized early on that commodity electronics will typically be sold at just over marginal cost, which is a point that is barely profitable in recognition of the fact that the product is barely differentiated. For Apple, it knew that inputs would still be commodity, and key inputs would almost assuredly be available to competitors as well. Its products use many of the same underlying technology as its competitors’ products. The key to success for Apple is that it has found a way, through external design and through software, to take a generally undifferentiated core technology and make it a truly differentiated product.

Vulnerabilities

The question remains as to how well Apple has insulated itself from the problems associated with strategy hell. For example, its vulnerability to external shocks must be considered. The company’s vulnerability to supply-related shocks is actually not much different than that of its main competitors like Samsung, since they rely on the same suppliers. However, Apple has also done an excellent job of protecting itself against other shocks. For example, the company has a strong focus on innovation, because it knows that demand and price elasticity of demand with respect to consumer electronics are not affected by prevailing economic circumstances. The company’ recent exceptional financial performance corresponds with the economic downturn starting in 2008, but also coincides with the launches of the iPhone (in 2007) and iPad (2009). Thus, Apple knows that innovation is a great hedge against external shocks, and the company’s business cycle at this point is almost entirely dependent on the state of its technological innovations.

Market exposure is another consideration. Apple is not immune to changes in its key markets. The company has, in particular, been driven by mobile products in recent years. That market is highly competitive with the different Android products, and that market is also in a state of rapid change. Competition from Android has dramatically reduced Apple’s market share, something that has not hurt the company yet because the industry was growing so rapidly, but which may come to hurt the company later. The following charts shows the worldwide smartphone market by operating system.

Source: Lunden, 2013

In this industry, Apple enjoys supernormal profit but many competitors do not. Google makes no money directly from Android, which skews the market. Blackberry is not making money at all. Of the companies that sell phones, Apple has most of the profits, Samsung has the remainder and every other firm in the industry is believed to be losing money (Worstall, 2013). Thus, Apple has found a way through its differentiation to earn supernormal profits. Arguably Samsung is earning normal profits, while the remainder of the firms in the industry are losing money. By logic, the other firms are still earning marginal revenue that is above marginal cost in order to stay in business in the short-run, but eventually such firms will come to the point where they must exit the business, and will delay only to the point where exit costs are no longer relevant.

Apple remains exposed, however, to the changes in the industry’s technological environment. New competitors and especially new technologies have changed Apple’s core markets many times in recent years. The company has generally thrived because it was the one driving market change. This is Apple’s basic strategy to defend against external shocks — it was to be the driver of change in its industry and sees this is the key to success. The external shocks did not affect Apple this time, but there is the risk that they will affect Apple in the future.

Recession

As noted, Apple thrived during the recession. This is not because Apple is a countercyclical company, but because it had two major innovations during that time. . These innovations represent a major strategy for the company, and drove the mobile industry to new heights. Technological innovation has always been a pathway to profit, because it allows for several economic conditions to occur. First, Apple gains a monopoly. The iPhone competed against products like the Blackberry that were targeting a different audience; the iPad had a monopoly for around a year. The result of monopoly markets is monopoly rents — Apple not only had high pricing to match its product positioning, but it had millions of people willing to pay high prices because there were no other options for these products. The other economic condition that occurs is that technology shifts a market. Demand for these devices went from modest (smartphones) or none (tablets) to tens of millions of units. This massive shift in demand sparked a massive increase in revenues for Apple by shifting the aggregate demand curve outward. Apple has also seen aggregate demand shift inwards, however, in the computer market, highlighting how challenging it is to compete in a market that remains close to conditions of strategy hell, even with a differentiated product.

Production Efficiency

As already noted, Apple is not a manufacturer but a marketer and designer. The company has third party firms manufacture its devices. Some of these also manufacture for the competition and all market leaders will use the same physical components. Where Apple avoids strategic hell is not related to the production side at all, but rather in what Apple does. This is the marketing, the design and the software. Apple’s labor force is highly skilled as the company seeks to hire top people and make human resources a source of competitive advantage. Its main rival, Samsung, drawn from a different labor pool, one that is also highly-skilled (Samsung also draws on Russian technical skills). Apple must compete for skilled personnel with a host of other major firms in its area, including Google which makes the rival Android operating system. It is also worth noting that there is no particular link between the company’s cost structure and its pricing strategy. This is largely because Apple customers have low price elasticity of demand — the company has essentially surrendered the component of the market that is price sensitive to other companies and sought to reinforce its high-end positioning. The result is that Apple has captured the lion’s share of the non-price-sensitive market, and it is here that it extracts is supernatural profits. Apple’s profits are so great that fixed and variable cost fluctuations are easily absorbed by the company. Apple can only maintain this ability to the extent that it can maintain its superiority in design and marketing, both of which will require human resources superiority. It has lost market share to the two first that can rival its innovation capabilities, but its well-established brand and high-end positioning have allowed it to remain out of strategic hell by almost removing it from the mainstream mobile device market as that market rapidly heads to commodity status.

Other Factors

Apple is exposed to some macroeconomic variables, most notably exchange rates. It no doubt buys its inputs in dollars, but the laborers at its suppliers are pain in yuan, which faces strong inflationary pressure, and that is not to speak of Apple’s offering higher pay after the whole Foxconn issue (Worstall, 2012). Apple is also exposed to foreign exchange in its revenue around the world. These are usually not offset by operating hedges, except in China, so must be repatriated. The result of this is that the company faces both translation risk and transaction risk. For Apple, it is necessary to minimize these economic risks. Thankfully, the company has amassed so much wealth that there seems little need for it to worry too much because these risks are rather minimal in comparison to the wealth Apple has.

Conclusion

Apple has done an excellent job of avoiding strategy hell. This is especially good when you consider that the computer market is moving closer and closer to the conditions of strategy hell. Many smart companies like IBM have exited that market altogether, but Apple continues because it can earn profits there still, due to its high rate of differentiation. Apple has been able to differentiate in a number of ways, all with the objective of exploiting the market condition of monopolistic competition. Apple’s differentiation takes it far from the conditions of perfect competition, and that allows it to earn healthy margins on its products, something that has kept the company in business to this point.

It will be interesting to see what happens next with Apple. There is little doubt that the company has been successful over the past decade. It was even able to enjoy considerable success during the recession. This reflects positively on the role that innovation played at giving Apple the opportunity to exit strategy hell. However, there is reason to believe that the markets that have to this point been key drivers of growth are now maturing. This calls into question whether those markets are set to return to conditions that trend towards perfect competition. If this is the case, the consequences will be interesting for Apple. The company clearly is in a position where innovation has allowed it to avoid strategy hell, but now its products are once again moving in that direction. Apple therefore needs to come up with the next idea that will move the company forward, creating new monopolies and allowing Apple to avoid economic challenge for many more years.

References

Lunden, I. (2013). Android at 82% share, Samsung a flat leader. TechCrunch.. Retrieved November 25, 2013 from http://techcrunch.com/2013/11/14/gartner-456m-phones-sold-in-q3-55-smartphone-android-at-82-share-samsung-a-flat-leader/

Mourdoukoutas, P. (2013). Apple’s most important branding lessons for marketers. Forbes Retrieved November 21, 2013 from http://www.forbes.com/sites/panosmourdoukoutas/2013/10/05/apples-most-important-branding-lesson-for-marketers/

MSN Moneycentral. (2013). Apple Inc. MSN Moneycentral. Retrieved November 22, 2013 from http://investing.money.msn.com/investments/stock-income-statement/?symbol=AAPL

Riley, G. (2013). Strategic choice: Apple: Differentiation v scale. Tutor2U.net. Retrieved November 21, 2013 from http://www.tutor2u.net/blog/index.php/business-studies/comments/strategic-choice-apple-differentiation-v-scale

Tutor2U.net. (2013). Perfect competition — the economics of competitive markets. Tutor2U.net. Retrieved November 21, 2013 from http://tutor2u.net/economics/content/topics/competition/competition.htm

Worstall, T. (2012) Apple’s Foxconn to double wages again. Forbes. Retrieved November 22, 2013 from http://www.forbes.com/sites/timworstall/2012/05/28/apples-foxconn-to-double-wages-again/

Worstall, T. (2013). Apple has the majority of smartphone profits and Samsung has more than all the rest. Forbes. Retrieved November 25, 2013 from http://www.forbes.com/sites/timworstall/2013/11/16/apple-has-the-majority-of-smartphone-profits-and-samsung-more-than-all-the-rest/

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