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James McQuivey is an analyst at Forrester Research, where he serves Consumer Product Strategy professionals. James blogs here.

The most imp…

Money - dollars
photo: Flickr / Tracy O

James McQuivey is an analyst at Forrester Research, where he serves Consumer Product Strategy professionals. James blogs here.

The most important outcome of this week’s emerging tussle between Apple (NSDQ: AAPL) and Google (NSDQ: GOOG) 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 percent a fair price for Apple to charge? 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 percent 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 percent 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 percent price. But will it land on Google’s 10 percent?

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 percent 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 percent 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 percent or Google’s 10 percent (or Amazon’s 30 percent 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 percent to as much as 5 percent 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 percent. 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 (NSDQ: AMZN) 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.

This article originally appeared in Forrester Research.

  1. While 30% is obscenely huge for payment processing, it is tiny compared to what Publishers Clearing House kept on paper magazine subscriptions they sold (> 70%). Important to note:
    1) Customer acquisition is expensive.
    2) Total picture of costs and revenues (and alternatives) must be considered in considering whether any one component is “fair” or economically viable.

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  2. This is an excellent round-up, but it seems that one key point didn’t get mentioned: How much margin are Apple resellers getting? If the content creaters have to bear the cost of generating interest (aka marketing) then Apple should not charge more to the content developers than they themselves give to their resellers. Especially as the resellers have to deal with physical good and delivery, whereas Apple only has to deal with electronic delivery.

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  3. @wunderman, this is an important point. But I do want to contest it a bit. Publishers Clearing House spent millions to acquire customers, purely to deliver them subscriptions. They got no other benefit from that effort — consumers didn’t pay (or have to buy anything) to sign up for the PCH sweepstakes. This is equivalent to a newsstand where a stand owner invests in the space, the labor, the soda, etc. to attract you to the newsstand even if you don’t buy anything. That’s a legitimate cost and it has to be figured in to the cost. In Apple’s case, however, it has also spent millions, but consumers have already paid Apple back for that investment by spending hundreds of dollars each on the devices.

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  4. James – I completely agree. Further, that market evolved over time and the magazines accepted the deal with the belief/knowledge that their real revenue would come from advertising. Almost anything they had to pay to get a subscription was worth it to them.

    The only conclusion I am comfortable with right now is: no one really knows how the economics will play out!

    It is hard to imagine the same ad to editorial ratio in e-mags — will there be full page ads? If ad revenue does drop, then the publishers have to make money on subscriptions. This is totally foreign territory to them, so I expect it to take quite a while for them to understand it.

    The challenge for almost all “old media” is that they have all been a conglomeration of several component businesses – some that attract attention and cost money, some that deliver revenue, some that provide distribution, cost money and deliver some revenue. The “digital” world changes details within each component business and the ways they can fit together. Tough to redesign on the fly.

    Expect many missteps!

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  5. Apple is charging 30% to publishers that want to offer what they perceive as a premium experience, i.e. a stand-alone app. Google is charging 10% to publishers that want to offer an experience that’s really best-suited to content delivery via a web browser. The important point is that while Apple completely owns the APP-on-tablet market, they have zero control over the CONTENT-on-tablet market. So long as Apple doesn’t try to ban the delivery of paid content via a web browser, then the anti-competitive questions start to look a lot like the discussions around the XM/Sirius merger.

    Really what this re-raises is the question of why publishers are focused on developing apps as opposed to tablet-designed websites.

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  6. For me it’s a question of where does the power now lie. Once upon a time when food was scarce the power lay with farmers producing meat, eggs and milk. Today when food is plentiful the power lies with the distributors: Sainsbury’s, Tesco’s and the like.
    In pre-internet days when content was scarce the power lay with the publishers producing news, magazines and music. Today when content is plentiful, the power lies with the distributors: Google, Apple and the like.
    Good thing or bad? The jury’s out.

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  7. Nick, you are totally in line with my thinking. This is really about economic scarcity. Whoever controls the scarce resource will exploit it, even if that scarce resource was contrived (as is the case with Apple’s platform). What digital suggests, however, if that our old urge to exploit a scarce resource might actually be counterproductive in a world where the scarce thing is virtual, not real. I’m developing this thought a bit more and hope to write on it at length later this year.

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  8. Arnet Bangetilli Friday, February 18, 2011

    The author is totally out to lunch without a fucking clue!

    Let him set up a competing platform for say half a billion dollars minimum and then sing this song about negligible costs. Clearly he’s whoring for one of the publishing entities who simply couldn’t believe their good fortune to get access to 150 million customers at nearly zero cost.

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  9. I don’t disagree that the 30% is over the top but take issue with at a totally different layer. You argue that electronic distribution is vastly cheaper and thus the per transaction cost should be similarly cheaper. But you only argue it for the distributor and not for the content creator. Hmmm? The cost of creating an electronic piece of media is a fixed cost, just like an App. The profit per unit is effectively 100% (well 70% in the App store).
    So do you think that electronic media will plummet in price too? I mean with near zero distribution costs you could reduce the cost of your media to only a few percent over the cost of initial creation.

    You are quibbling about Apple making too much on electronic distribution but someone else is making over twice that much and it is just as wrong.

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  10. Why on earth would you use “fair” to mean economically efficient. That would only happen in a perfectly competitive (read: completely commoditized) market for it’s services, which is exactly what every tech and media company in the world is fighting as hard as it possibly can to avoid.

    Once there’s free entry into the smartphone business then you can bring this up again, but that’s not going to happen.

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