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Monday, June 24, 2013

Paul Krugman Knows Nothing About Apple, But That Doesn't Stop a Pundit from Pontificating

In a typically data-deficient column and blog post, Paul Krugman tosses off a few superficial observations about the increasing returns to intellectual property in the 21st century versus the 20th, selecting Apple as his example of the 21st century company.  (Lest anyone think I am insulting Krugman when I say these two pieces are "superficial", please note that Krugman himself warns "This isn't an original insight").

Going back to "The Conscience of a Liberal", Krugman has posited a gauzy, nostalgic 1950s America in which everything about the economy was somehow better than the 21st century, because unions were stronger and marginal tax rates were higher (as opposed to the rest of the industrialized world being behind the Iron Curtain or still rebuillding from WWII).  So, naturally, the column linked to above hearkens back to the 1950s to contrast "General Motors in the 1950s" with Apple today.   GM, he tells us, had "huge visible production activities" while Apple does "hardly any manufacturing" because it outsources that function.  Apple is not valuable for its "productive capacity" but its "technology, design and a brand identity".  In fact, Krugman claims, "Apple's market position is its most valuable asset."

He gives absolutely no evidence or explanation for that assertion.  It rests on nothing more than his ipse dixit, or say-so.  He just moves on, expecting Times readers to take that for granted (hmm, corporation, market, bad, yes, very bad), and shares the implications that he sees flow from that unsupported assertion: "One is that profits are no longer anything remotely resembling a “natural” aspect of the economy; they’re very much an artifact of antitrust policy or the lack thereof, intellectual property policy, etc. Another is that a lot of what we consider output is “produced” at low or zero marginal cost."

So I thought I would look more closely at those assertions.  How, for example, does Apple's "market position" today compare to GM's in the 1950's?  Well,  per this report from June 5, (a) Samsung, not Apple, had the most smartphone sales in the US in May, while (b) going back to April, Apple was number one among OEMs with 39% of the smartphone subscribers in the US, ranking number one, but only in 2d place if measured by software platform, with Google's Android having a significantly larger market share based on platform.  Considered globally, Apple has only about 9% of the worldwide market for smartphones, whereas Samsung's is  more than twice as large, according to Gartner. Hardly sounds like a market dominator!

But how does that compare with GM in the 1950's?  Well, this website says GM had a 54% market share in 1954; and even as late as the early 1980's, GM was consistently in possession of over 40% of the US market, per "Rude Awakening" by Maryann Keller. So clearly Apple has a lot less of a "market position" today than GM did in the 1950s and 1960s.

Does Apple's "market  position" in 2013 constitute some kind of entrenched position, as the reference to antitrust policy implies, where market power is used in some unfair way?  Obviously not -- Apple had zero share in smartphones as recently as 8 years ago.. As recently as Q12010, Blackberry's operating system had over 40% market share in the US, with Apple second at 24%.  And where is RIMM today?  Down to about 5%.  This headline from 2012 captures the dynamic nature of the smartphone market: "Over the Past 7 Years, Smartphone Marketshare Leaders in the US have Changed From Palm to Microsoft to RIM and Now to Android."  The author wrote:
  • smartphone marketshare leaders need to be constantly evolving to meet consumer demands as leaders have changed hands with new rivals every two or three years. Palm was leading the market in 2005, only to be out done by Microsoft in 2006, who then in turn lost to RIM in 2008, and now as of 2011 Android is the most dominant leader in the past 7 years.
  • A yearly snapshot of the US smartphone marketshare by OS over the past 7 years, based on Q4 data, is shown below:
      • Palm: 35% 2005, 28% 2006, 16% 2007, 12% 2008, 6% 2009, 4% 2010, less than 2% 2011
      • Microsoft: 17% 2005, 34% 2006, 36% 2007, 26% 2008, 18% 2009, 8% 2010, 5% 2011
      • RIM: 26% 2005, 28% 2006, 31% 2007, 40% 2008, 41% 2009, 32% 2010, 16% 2011
      • Android: 0% 2005, 0% 2006, 0% 2007, less than 1% 2008, less than 6% 2009, 29% 2010, 47% 2011
      • Apple: 0% 2005, 0% 2006, 9% 2007, 17% 2008, 25% 2009, 25% 2010, 30% 2011
      • Nokia Symbian: 23% 2005, 10% 2006, 8% 2007, 4% 2008, 4% 2009, 3% 2010, less than 2% 2011
That is pretty far removed from the kind of market data that would suggest antitrust practices are playing much of a role.  In contrast, GM's market share was obviously very stable in the 1950s, 1960s, etc., and the auto industry as a whole was pretty cozy - and a lot more ossified than the smartphone market over the past decade - with the same three companies generating substantially all of the sales for a generation.

Krugman makes the usual outsourcing complaint, yet fails, of course, to provide any data or put it in context.  66% of Apple's revenue came from sales outside the US, according to their latest quarterly press release.  So it's hardly surprising that some of their costs are lodged outside the US as well.  In this case, it's manufacturing which has to account for less than 66% of sales because gross margin is greater than 34%, so overall, there is no real outflow going on.  Most of its sales are overseas and so is a lesser amount of its costs.  How one derives a policy implication from that is hard to divine. It's absurdly unsophisticated to expect American companies to have a high level of global sales, but all their costs to be incurred at home. 

Krugman contends that "To a large extent, the price you pay for an iWhatever is disconnected from the cost of producing the gadget."  But he gives no data to prove that.  Whereas other economists, based on actual analysis as opposed to off the cuff mutterings, have estimated the cost of materials and labor for an iPhone or iPad at $229 - 275.  Gross margins like that, in the 60-70% range, are not unheard of in the technology industry.  So the price of the iPhone or iPad is not "disconnected from the cost of producing" them.  And they are certainly not produced at "low or zero marginal cost."

Krugman, in fact, displays a complete lack of understanding of how smartphone pricing.  In the US, one rarely buys just a smartphone.  One buys a smartphone and a voice and data package from a carrier like Verizon Wireless, ATT, etc.  And the price of a contract does not vary directly with the price of the smartphone, because the carriers are trying to stimulate subscriber and usage growth.  So, it turns out, the carriers, who subsidize most of the cost of a smartphone, wind up absorb a larger chunk of the price of an iPhone compared to another brand, like Samsung.   In fact, other economists have concluded that the carriers make several times as much gross profit from a typical 2-year smartphone contract as Apple or any other headset supplier does from that contract. So neither the carriers nor the customer are terribly price-sensitive where the device is concerned.  The customers are product - focused and the carriers are close to indifferent. That doesn't mean anything as far as the application of antitrust or intellectual property law to Apple.

And as far as IP law goes, the iPhone and iPad have been out for less than a decade each.  Is there some suggestion that the degree of patent and copyright protection covering them - assuming any - is too great?   If so, what is the right amount - less than 10 years?  What would be the implication of that curtailment for technological innovation?   Krugman provides no insights, just a throwaway reference to "intellectual property law, etc."  Maybe the answer lies in the "etc."

To say Apple is not valued for its "productive capacity", as Krugman writes, is basically to denigrate human capital.  Design and innovation are, as far as I can tell, the result of human beings' "capacity" to be "productive". In fact, the whole thrust of Krugman's column and blog post, elevating the physical capital of factories over human capital and innovation, is a kind of super-reactionary, antiquated rejection of most of what has been learned about productivity in the last few decades.

Productivity stems from three sources: physical capital, human capital and total factor productivity growth.  According to a recent Economic Report of the President (Obama), at 265, "Research has not just identified changes in these three factors (physical capital, human capital, and total factor productivity) as critical determinants of productivity growth; it has also come to a fairly clear view about their relative importance."  That research shows that the least contribution is made by physical capital; whereas (at 266) "the most important determinant is not physical or human capital accumulation, but changes in how much can be produced with them—that is, total factor productivity growth.".  And "improvements in total factor productivity can be described broadly as 'innovations.'” In other words, innovation is the most important factor in producing value.   Of course, that is just the opposite of what Krugman nostalgically concludes, longing for the days when people put value on an "old-style manufacturing giant, with many factories".

Krugman observes that GM employed over 400,000 people at its height. What did that mean in terms of productivity?  He doesn't give the year that happened but let's try to approximate it.  Its market share was at its height in the mid-50s.  In 1954, when, as noted above, GM had 54% of the market, the total auto and truck sales were 6.9 million, of which 54% equals 3.726 million.  So each GM worker, in the course of a year, at the height of GM's hold on the US economy, produced about 9 cars in a year, less than one a month.  How productive was that?

I can't derive a comparable productivity number for Apple -- because of the outsourcing, it would be oranges to apples, forgive the pun.  But Apple sold 37.4 million iPhones, 19.5 million iPads and just under 4 million Macs in just the most recently reported fiscal quarterper its press release.  A total of 61 million devices of one kind of another in just three months. To appreciate that the productivity difference is so orders-of-magnitude greater, let's look at some numbers:  the entire auto industry - not just GM but the entire industry - sold 58 million units in the US in the entire decade of the 1950s.   Alternatively, at the 9 units per employee per year of the 1950's GM, Apple would require almost 28 million employees to generate the annualized equivalent of its Q113 units.  Of course, someone might say, a 21st century smartphone is a lot different than a 1950's Chevrolet.  Right -- the smartphone embeds much more technology, by orders of magnitude. Decades of incredibly difficult science are reflected in it. That's innovation and productivity.  

Apple makes great products that people want. The iPhone was a quantum leap in functionality over what Blackberry, Motorola and Nokia had on the market at the time;  the iPad succeeded as a tablet where dozens of other companies had failed.  The hundreds of millions of people who use them are better off for Apple's innovation.

The economist William Nordhaus has analyzed from time to time in the course of his career how little profit entrepreneurs capture from their innovations and how much benefit leaks away from them to the larger society.  As one author sums up his work, "Entrepreneurs typically generate a surplus benefit above and beyond the profits they reap, finds the eminent Yale University economist William Nordhaus. Nordhaus has calculated that entrepreneurs capture only about 2 percent of this surplus, with the remainder passed on to society in the form of jobs, wages, and value." Here is a link to a more detailed explanation of Nordhaus' work in this area.

And, yes, Apple has a giant cash hoard.  But you look at the turbulence in market share in its principal market over the past decade, you look at the bankruptcies or near bankruptcies of Ericsson, Northern Telecom and many other telecom players, the ongoing financial disasters at Nokia (losing billions each year) and RIMM (barely alive), who led the industry just ten years ago, and it is hard to figure out exactly what is the right amount of cash that a responsible fiduciary can say is enough in this industry.  And the GM of the 1950's?  Well, as we all know, they were bankrupted and liquidated in 2009.   And I wonder if, deep down inside,  that isn't what Krugman's agenda really is, the destruction of capital to satisfy a progressive agenda.

But, a progressive would ask, how much should Apple's owners be rewarded for its productivity? What's a "fair amount" or a "fair return"? I couldn't independently come up with one and I don't know who could; all I know is that in the 90 days of Q113, 61 million times someone chose to enter into a transaction that rewarded them $299, or $499 or $699 or whatever for an iPhone or iPad or iMac and, as between 61 million individual consumer decisions and a guy who won a Nobel Prize in Economics for largely unrelated work thirty plus years ago, the judgment expressed in those 61 million decisions is a better guide.