Wednesday, July 28, 2010

Smartphones and innovation

I don't own a smartphone, but I am interested in the technology. Many of my friends have iPhones or Blackberries, and I often see people on the bus using the commute time to check their e-mail and read the news. When I see people make such efficient use of their commute time, it makes me feel a bit left out. After all, I love efficiency and technology.

So, I've been looking into the pricing of smartphones and plans. If you are unfamiliar with the market, the primary cost of a smartphone is not the device itself. To get the most out of smartphone technology, you need a data plan in addition to a voice plan. On the AT&T network, a 200 MB per month plan will set you back $15 / month, while a 2 GB per month plan costs $30 / month. And, that's in addition to a monthly voice and text plan, which runs about $45/month at the low end.

There are a host of different options for these plans. Some networks offer unlimited data, voice and text all for one price (with no breakdown of different options). Other networks let you do family plans with added features for smartphones, and they'll let you customize the plan in a bunch of different ways. Regardless, all networks have their own set of plans, and their own set of phones.

This latter fact is intriguing. The iPhone cannot be used on any other network except for AT&T, which has an exclusive deal with Apple. This exclusive contract has frustrated consumers who might like the iPhone technology better than Droid or HTC, but are in an area that is better served by Verizon (i.e., Montana). Some of the more tech-savvy consumers have circumvented this problem by jailbreaking their phones (unlocking their phones for other networks). For the average consumer, however, these network restrictions are binding and continue to be frustrating.

Why is it that AT&T signed the exclusive deal with Apple in the first place? For AT&T, one reason is that these restrictions might stick consumers into expensive, long-term contracts with AT&T when they might prefer Verizon. This suggests that exclusivity between smartphone and network providers is an unambiguous anti-competitive restriction on trade... until you take a closer look at Apple's incentives to innovate.

Especially in high-tech industries, recent innovation has made consumers significantly better off, but how do you properly incentivize the innovation effort to come up with the next iPhone? On one hand, we have a stellar patenting system in the United States, and that system gives market power to the innovator for an extended period of time. Through this market power, the innovator can raise the price to be compensated for coming up with an innovation that sells. In this theory, we get the right amount of innovation in our society when we give innovators the right amount of market power as a reward.

On the other hand, once the iPhone is developed, competitors can innovate their own related product with added features (under separate patents). This "add a feature" competition is less expensive than the original innovation because the leader has to sink all of the failed attempts to see what works (i.e., what features are most attractive to consumers?), while the followers can save effort by observing the leader's successes and failures. If the original innovator thought that this sort of competition would too quickly erode the rewards of market power, the first iPhone wouldn't have been developed in the first place. That's because there wouldn't be enough profits on the table to properly incentivize the innovation.

In light of this theory of patents, how do exclusive contracts give the right incentives to innovate? First, tying the phone to the contract means that the smartphone developer won't be compensated unless it creates a phone worth the exclusivity in the first place. After all, smartphones have become one of the most important hooks into a new plan. If the smartphone is subpar, not many people will sign on with the network. Second, after the original innovation, the exclusivity acts as a buffer from the "add a feature" competition that is sure to follow. If a competitor is going to have a viable competing product, they'll have to produce their own product that's worth committing to an exclusive contract. The result is a market that is ripe for new innovation.

In the smartphone market, this is exactly what we have seen. Over the last five years, phones have gotten better at a torrid pace as smartphone manufacturers have scrambled to make fully-featured devices that make our lives more fun (and efficient). If you take a short view on the industry, you might think that it is a monopoly that makes life hard for consumers, but the long view is one of innovation, investment, and exciting new offerings for consumers. The technology is great, and it is certainly improving.

Who knows? Maybe I have a smartphone in my future. I hope so.

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