Apple’s controversial decision to remove the universal 3.5mm audio jack from its just-released iPhone 7 has several economic dimensions. All of them are a consequence of Apple’s proprietary architecture (colloquially known as “Steve’s walled garden”) and the extent to which Apple is trying to/able to exercise incumbent vertical market power. How much market power does Apple have?
Incumbent vertical market power arises when an existing firm in a market can increase costs for its competitors in that market in a way that can erect an entry barrier, reducing entry and thus reducing competition in that market. Reduced competition enables the incumbent to maintain higher prices that it would otherwise. I used the concept in a paper in 2014 to analyze why retail electricity competition has been so sluggish in the restructured states (except for Texas).
With the iPhone 7 the only external wired interface now will be through the proprietary Lightning port; Apple has a patent on the Lightning interface and charges a royalty to third-party device manufacturers for its use. If you are a headphone manufacturer, you now have to pay a royalty to make Lightning headphones, and those headphones can’t be used in other devices without a Lightning/3.5mm jack adapter. Similarly, standard headphones won’t work with the iPhone 7 without a 3.5mm jack/Lightning adapter, the manufacturer of which will have to pay Apple a royalty. That also means that consumers who don’t want to buy new headphones will still have to buy an adapter.
What we have here, friends, is a failure of interoperability. This is not Apple’s first interoperability failure; in the move from FireWire 1.0 to FireWire 2.0 to Lightning, Apple demonstrates deliberate disinterest in interoperable device interfaces. It’s their market power that enables them to do so. They typically make a technical argument (faster, more streamlined, better for the user!), and while technical features provide some justification, it’s no coincidence that these failures of interoperability impose costs on their competitors in downstream related markets.
Now this failure of interoperability extends to encompass a new interface, the audio interface. The technical aspects of this move are that now the iPhone 7 will be water resistant, fit a larger capacity battery in a given space, and have more sophisticated camera technology. Benefits, to be sure, but benefits that come at a cost borne largely by Apple’s competitors. One related downstream market where this exertion of incumbent vertical market power will impose costs on competitors is the headphone market:
For many, Apple’s design decision with the iPhone 7 is alarming because it effectively abandons a universal, simple, reliable and durable technology for an entirely proprietary alternative. If you’re a headphone manufacturer who wants to make Lightning-based headphones, you’ll have to pay Apple for the privilege. If you own a pair of Lightning-based headphones, the only device in the world that can make use of them is the iPhone 7, unless, of course, you want to carry around an adapter with you everywhere you go.
At the margin this makes a consumer more likely to use the stock Lightning headphones that come with the iPhone, rather than purchasing headphones with different features that the consumer may value. It also makes consumers more likely to purchase Apple’s new wireless AirPod headphones at $159, although the sound quality isn’t that great and the real feature seems to be a superior microphone for talking to Siri. That’s the ability to exercise incumbent vertical market power, and it harms Apple’s competitors and Apple’s customers who aren’t fully invested in Apple’s proprietary architecture, in Steve’s walled garden. However, it’s also true that the AirPods can be used as standard headsets operating on the open Bluetooth standard, and that other wireless headphones will work, but not integrate with Siri as seamlessly.
This architectural choice affects a second, and more futuristically interesting, downstream market into which Apple is integrated vertically: payment systems.
While the coverage of this move has largely focused on the company’s new wireless headphones, there may be another reason Apple chose to remove the headphone jack: third-party payment systems like Square, Intuit, and PayPal will no longer be able to compete with Apple Pay on Apple product lines.
Each of the aforementioned companies relies heavily on an attachment device that hooks into the 3.5mm headphone jack. The attachment allows businesses to swipe consumer credit or debit cards when they make a purchase.
Apple Pay, conversely, allows users to pay for goods and services with just a touch of the iPhone. Essentially, Apple Pay makes physical cards obsolete. If cards are obsolete, Apple has a monopoly on the growing instant-pay market. Eliminating the 3.5mm jack could be the first step in ensuring that debit and credit cards become useless in the marketplace, opening the doors to a future cashless society.
Apple Pay competes with other mobile payment processing platforms that enable small vendors to accept credit card payments (e.g., Square, PayPal). If it’s more costly for those vendors to accept Square and PayPal because they don’t have a jack into which to plug the card reader, then at the margin they are more likely to accept ApplePay and consumers are more likely to set up and use ApplePay (and Android Pay, for that matter, which dilutes the market power in this market somewhat).
Of course, Square and PayPal can develop Lightning-based card readers. The real test of market power would come if they did so and Apple refused to license them to use Lightning. That won’t happen, though:
But now that new versions of the iPhone won’t have a headphone jack, how will that affect Square and these other payment processors?
Not much, actually. Included in every iPhone 7 purchase will be an adapter that can be inserted into the Lightning port, a connectivity option previously reserved for charging and syncing data. With the iPhone 7 and iPhone 7 Pro, owners will be able to use this connectivity port (with the adapter) to plug in anything that would plug into a standard headphone jack. Square users could simply use that dongle for the foreseeable future.
Square (SQ -0.80%) has also expanded its payment processing methods beyond just the tiny white dongle for the headphone jack. The San Francisco-based company also hawks an iPad register, called Square Stand, which costs $99 and doesn’t use the headphone jack. In 2015, Square debuted a new contactless method, which lets consumers use both Apple’s contactless mobile payments technology, Apple Pay, and Google’s payments technology, Android Pay (GOOG 0.54%). That new reader was also integrated for chip-enabled cards. Instead of using the headphone jack, this reader uses Bluetooth technology to connect a merchant’s phone with the credit card reader.
I think this illustrates that there is a limit to Apple’s ability to exercise incumbent vertical market power in these very fluid and dynamic markets. While Apple may seem able to exercise market power in the physical card-processing payment market, the payment market is already evolving into a wireless and contactless one.
So Steve’s walled garden has windows and doors, and its nature is ever-changing, as is the world in which it competes. This is the Schumpeterian point about the dynamism of competition.