(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.
Cheap Talk 
5 comments
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January 6, 2012 at 1:24 am
Brett
Sounds interesting. Do you have thoughts on why such arrangements ultimately disintegrate?
January 6, 2012 at 2:26 pm
Nageeb Ali
This is very cool. (WordPress needs a +1 / Like).
January 7, 2012 at 8:48 pm
Benjamin Thompson
Nice theory, except that it has nothing to do with reality. The iPhone was exclusive to AT&T because they were the only carrier that would allow Apple to control the entire experience. Why? Because Verizon was stealing customers from them at an alarming rate. In exchange, Apple gave them iPhone exclusivity for 5 years (later negotiated to 3).
Apple bet, correctly, that controlling the entire experience would make their phone differentiated and provide demand-side pressure on Verizon to give Apple total control. Of course that happened, and when it did, Verizon paid Apple the EXACT SAME amount it always paid AT&T. This time, it was AT&T who was stealing Verizon customers at an alarming rate.
A correct of analysis of Apple is simply lacking if one focuses solely on the numbers. There is an aspect that involves experience, that involves design, and all too often that aspect is ignored by conventional business school analysis.
January 8, 2012 at 7:02 pm
Alex F
“We know from basic price theory that increases in input costs are passed on less than dollar-for-dollar to consumers”
Um, says who? That’s not what I learned in basic price theory.
Skimming through my old notes from TAing Jeremy Bulow’s class, it looks like marginal costs are passed through at a rate of 1/2 for linear demand; at a rate of something greater than 1 for constant elasticity demand; and exactly 1 for log-linear demand. Am I missing something?
January 8, 2012 at 9:42 pm
jeff
🙂 yes when i wrote that i thought “MR = MC, and now MC increases by a dollar so MR must increase by a dollar, so quantity must decline and then i imagined a diagram with demand and MR and saw in my imaginary diagram that MR is steeper than demand and so P must rise by less than MR rises.” but yes my picture had linear demand 🙂
i should have asked glen weyl, or looked at this:
Click to access Pass-through_10_09.pdf
thanks alex f.