(Regular readers of this blog will know I consider that a good thing.)

Why did Apple enter an exclusive partnership with AT&T?  Michael Sinkinson has a nice theoretical model that shows how vertical exclusivity can soften competition.  A smartphone requires an accompanying wireless service in order to be useful.  While smartphones are differentiated goods, wireless service is pretty homogenous.  The market for wireless service is therefore perfectly competitive while the market for smartphones is oligopolistic.

Suppose smartphone manufacturers allow their phones to operate on any wireless network.  Then service plans for the iPhone and for the Blackberry would be priced perfectly competitively, at the marginal cost of providing service.  That means that the total price of an iPhone bundled with wireless service will be equal to the wholesale price that Apple charges the wireless providers.  In other words, Apple’s price increases are passed on dollar-for-dollar to the consumer.

At an equilibrium Apple raises its price for the iPhone up to the point where the revenues from additional price increases are offset by reduced sales (due to higher prices.) Blackberry does the same.

Now, suppose that Apple goes exclusive with AT&T.  That makes AT&T the monopoly retail supplier of the iPhone.  They will act like a monopoly and raise prices.  AT&T views Apple’s wholesale price as an input cost and we know from basic price theory that increases in input costs are passed on less than dollar-for-dollar to consumers.  The strategic effect for Apple is that now when Apple increases the wholesale price of the iPhone, sales fall off by less than they did in the non-exclusive arrangement.  It’s as if the demand curve has gotten steeper.  Relative to the non-exclusive arrangement Apple raises prices, and in fact as a response Blackberry also raises prices which has a secondary benefit for Apple.

Of course some of these new profits go to the retailer, AT&T.  No problem.  Forseeing all of this Apple and AT&T agreed to a large up-front transfer from AT&T to Apple equal to that amount.

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