Wednesday, January 16, 2013

Why the Innovation Premium Is Diminishing

The acceleration of competition as high-tech tools and skills have dispersed throughout the global economy is an under-appreciated trend.

In the late 1980s, Apple famously reaped $1,000 in gross profit on each Macintosh computer sold: Apple was able to charge a very high premium for the innovations the Mac embodied. (Note: this was back when $1,000 was a substantial sum; that is over $2,000 in 2012 dollars.)

This ability to reap a substantial premium for innovation is fundamentally what drives the technology marketplace: since competition arises in any high-profit space, the premium for innovation degrades as competitors enter the space.

In the good old days, it took years for serious competition to arise. As the bumper sticker crowed, "Windows 95 = Mac 1985." (As I worked with both Mac 1985 and the crash-prone Windows 95, I would say Win95 was still substantially behind the Mac in stability.)

The acceleration of competition as high-tech tools and skills have dispersed throughout the global economy is an under-appreciated trend. Apple has earned billions of dollars in profits over the decades as its innovations enabled the company to charge a high premium in the marketplace. Since Apple leapfrogged the competition, this premium could be levied not just on "early adapters" of the new technology but the mass consumers who came after.

The iPod, iPhone and iPad have all followed a trajectory of constant innovation that enabled Apple to continue reaping still-hefty premiums, even years after the initial launch of the product line.

This chart depicts the dynamic. The red line is product price: it declines over time as the innovator company lowers price to maintain sales as competition arises.

The blue line represents the previous era of innovation/competition, where competitors arose slowly, and competing products reached parity of features late in the game. This enabled the innovator to continue to reap a slowly diminishing premium for years, as long as the product line was refreshed often enough to stay ahead of competitors.

The green line represents the New Era of widely dispersed global technology: competitors enter high-profit spaces quickly and reach features parity much sooner than in the previous era. Once competitors reach features parity, the innovator's premium vanishes or quickly trends toward zero.

The latest iPad models (9.7-inch screen) sell for between $500 and $700, and the iPad Mini (7.9-inch screen) sells for around $300. The Samsung Galaxy sells for about $200 (with a a 7-inch screen). Meanwhile, in China, full-function tablets sell for $50 ("Hardware is dead").
Are the $50 ($35 in bulk) tablets as good as a Galaxy or iPad? Undoubtedly they are lacking in features or qualities, but the point is that for those who cannot afford the features or qualities of a $500 tablet or $200 phone, they are "good enough."

I expect this trend of accelerating degradation of the innovation premium to continue on its current vector. The initial product cycle during which which innovators can charge a high premium will shrink, and competitors will reach features parity much faster. The profit margins of the innovating company will degrade more quickly as a result, and price will decline at a steeper rate as well.

Put another way, the price and features offered by the innovator and its competitors will converge much faster than in previous eras.

From one point of view, the recent weakness in Apple shares may reflect this trend: Apple's ability to charge a high premium is degrading faster than many expected.

This is not to say Apple's premium will vanish; as everyone knows, the Apple premium is based not on hardware features so much as the integration of intuitively easy-to-use software and hardware in a pleasing, stylish form-factor.

That said, the Android software suite is spreading fast in the open-source model; the innovative integrations of software and hardware that may emerge from this vast petri dish are unpredictable.

Looking ahead, we can speculate what this new era will mean for all technology sectors. If this trend holds, then profits within the entire space will slide as the premium slips ever-faster toward near-zero, i.e. every device and software become commoditized.

This slide in total product-cycle profits may inhibit innovation as the pay-off dwindles. This trend may also spark greater efforts to erect moats around innovations, for example, more lawsuits against global corporate competitors and louder demands for the U.S. and other advanced nations to limit the importation of knock-off products based on pirated/stolen designs and software.

Many observers are of the view that intellectual property rights are impediments, and their weakening is a good thing. But that ignores the motive for innovation: will everyone have to be a Linus Torvalds and innovate in the open-source space?

Hardware innovations often require substantial investments of capital. Will those with capital invest in innovations if the premium degrades too quickly to earn a high return? Or have we become greedy, and a lower total return on innovation is an outcome that we should welcome as both inevitable and positive?

"Faster, better, cheaper" eventually wins-- but that should not be a justification for theft. Competition should be based on innovation, not on piracy and theft. If someone doesn't like the premium being charged for someone else's innovation, then they can create their own innovation that fills the moat with a lower-cost alternative. That is the sustainable path of "faster, better, cheaper."

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