Some probably obvious observations on economics, inspired by Apple, which just suggest that I need to read more economics

(Attention conservation notice: 1400 words thinking aloud about innovation, Apple-style, and what connection it might have to the standard, boring sort of competition that you read about in introductory economics.)

I’ve become somewhat obsessed with Apple in recent months (see “The iPhone is a gateway Apple product”). They’re an easy company to get obsessed over, because they build the best products. When Google was building the best products, like their search engine or the maps app, I was obsessed with them too. Most of their other products are quite good, but they’re not perfect in the way that the iPhone is, in the way that the Google search app is, or in the way that Google Maps is. Every time I use Google Calendar — and I use it, mind you, a dozen times a day — I’m reminded of all the things it could do better. I never think that about Google search or about the iPhone. They are perfect.

It’s been remarkable to watch Apple’s competitors. Apple invented the iPod 10 years ago, and it has owned the category ever since. Others have tried to compete with them, but haven’t managed to produce anything even comparably good. Likewise with the iPhone. When I remember what preceded the iPhone, my mind is kind of blown. Pre-iPhone phones were thought to be such poor computers that manufacturers decided to invent their own alternate universe, including their own poor substitute for HTML, rather than just put a fast computer in your pocket. Other companies have had four years to respond, including at least one company that makes a lot of money and should, by all rights, have beaten Apple at this game.

Yet they’ve not. Not even close. Android continues to be the technology of tomorrow, just as Linux has always been, and one strains not to say that it will always will be the technology of tomorrow.

I see in this the simplified picture of markets that we read about in introductory economics. Someone starts a company — say, a bakery making artisanal bread in a big city. There’s unmet demand for this bread, so people flock to it. The lines run out the door, and the bakery is habitually sold out by noon. They ramp up their production and add some machines to augment human labor. Maybe they raise their prices. Now the lines are shorter (translation: prices have risen, so quantity demanded has decreased), but the bakery’s total amount of income has increased (translation: price elasticity is less than 1). Now the bakery is making lots of profit.

Other bakeries see this profit, and they want in. So they move into the market and try to do the same thing more cheaply. Maybe doing it more cheaply is harder, because the incumbent bakery makes its artisanal bread using giant machines that can produce individual loaves for not very much money at all (translation: high fixed cost to buy the machines, low marginal cost per loaf). Anyone who wants to move into the market would either have to make better bread for the same or higher price (think of Starbucks moving into a world of Maxwell House), or make equal-quality bread more cheaply. (Translation: high fixed costs are a barrier to entry, and make monopolies more likely.)

But if the incumbent baker makes money consistently for years, it may eventually happen that banks take notice and loan someone the money to start a competing bakery at scale. (Imagine here AMD moving into a world dominated by Intel.) Now the incumbent has to lower its prices. In some perfect-competition models, every last customer flocks to the cheaper bakery. The bakeries alternate investing huge amounts of capital to produce at cheaper prices at larger scale. We’re in a price war.

This may be a good thing — we get cheaper bread — but it’s not what Apple is doing. Instead, they’re innovating. They’re not running down the slippery slope of a price war. Instead, they’re making products that no one had and no one knew they wanted before. (I still don’t really need an iPad, though it would be handy for reading academic PDFs.) If they were a different kind of company, they could instead try to make cheaper widgets than their competitors, but where’s the joy in that? If that’s how companies operated, we wouldn’t even have BlackBerrys by now; we’d just have cheaper little knock-off LG or Nokia “feature phones.”

There are some models I remember learning in college that tried to capture this. They usually fall under the labels ‘imperfect competition’ or ‘monopolistic competition’. Coca-Cola has a legally enforced monopoly on the term ‘Coca-Cola’, for instance. But that doesn’t really capture innovation. Most of the models I remember learning, and nearly anything captured under the term ‘perfect competition’, don’t describe the sort of market where companies innovate.

I still need to finish reading Schumpeter’s Capitalism, Socialism, and Democracy, but he touches on a similar idea in there. His famous term from that book is “creative destruction”: capitalism’s great contribution to the world is that it constantly destroys industries and replaces them with new ones. No one laments all the horse-and-buggy drivers put out of business by the automobile. There are legitimate reasons to lament the end of businesses built around physical newspapers, and a just society will try to help laid-off newspaper workers land on their feet. But the innovation of the web, which gave rise to an entirely new industry that caught incumbents unawares, makes life better in many well-known ways.

One of Schumpeter’s main arguments (the book contains many arguments and ranges far afield; it argues, for instance, that soon capitalism will be destroyed when its large corporations turn into mere offices for the filling out of forms in triplicate) is that capitalist enterprises shouldn’t mainly fear that a new competitor will produce the same product for cheaper, but rather that an entire industry will come into being that renders the incumbents’ whole reason for being moot.

There’s an “innovation through cheapness” argument along these lines, most famously laid out in The Innovator's Dilemma. It goes like this: there’s some incumbent that makes a big, expensive product that’s the cream of the crop and whose lead seems impregnable. Think of Oracle databases, for instance, or the Sabre airline-reservation system, or Microsoft Windows. Some cheap competitor comes along, producing a product that doesn’t do most of what the big guys do, but does it for much less money (MySQL databases, Internet airfare searching, Linux). Initially, the big guy couldn’t care less about the newcomer — might not even notice the newcomer, in fact. The newcomer may have in fact taken away the big guy’s most annoying customers: those customers who care mostly about price, or those who demand a lot of features for not a lot of money. Good riddance, says the big guy.

Now that the newcomer has some customers, it can start adding features. Because the big guy has been around for a while, competitors have had a while to look at what customers are buying. The newcomer can bring fresh eyes to an existing market, too: the big guy has established sales forces that are trained at selling a specific kind of product, has a large bureaucracy that’s specialized in making their current product lines, and is slow to move in response to change. The newcomer is small and can be more agile. They keep adding features and taking away increasingly important customers from the big guy.

Eventually the big guy takes notice, but by this point it’s too late: the world has shifted entirely to the fresh, cheap product that the new guy is making. This hasn’t happened yet with Windows, of course. Oracle bought MySQL. A quick scan suggests only modest declines in travel-agent employment over the next 7 years. I should try to think of some other examples.

That’s at least two distinct types of innovation: innovating through inventing entirely new product lines that render existing products moot, and innovating through producing simplified subsets of existing products. The latter seems different than merely making a lower-cost version of the same product; that’s classic price competition.

Now, I’m pretty sure I never heard any coverage of innovation when I took economics classes in college. Is there any good modeling of this sort of thing?

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