Apple’s Chinese Wall of Worry: App Store Impunity and Vertical Foreclosure

Tech giant cuts off nose to spite face

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In case you missed it, Apple is facing a class action antitrust lawsuit. Here’s the background, from The Verge:

The [Supreme Court] will decide whether iPhone users can sue Apple for locking down the iOS ecosystem, something the suit’s plaintiffs say is creating an anti-competitive monopoly. And so far, the Supreme Court seems sympathetic to the argument…
Since [2013], the class action case has focused purely on the App Store… claiming that Apple’s locked-down ecosystem artificially inflates the prices of apps because all developers must go through a single store that takes a cut of their revenue. The buyers argue that Apple has established an unlawful monopoly over iOS apps, and they’re asking the courts to make Apple allow third-party iOS apps, in addition to repaying every iOS user it’s overcharged in the past…
Apple v. Pepper could theoretically affect how tech companies can build walled gardens around their products. The Supreme Court isn’t going to make a call on that specific issue… Instead, they’ve focused on whether iPhone users can sue Apple at all [due to the Supreme Court’s 1977] Illinois Brick doctrine, which says that “indirect purchasers” can’t sue a company for antitrust damages. Pepper’s lawsuit portrays Apple as directly selling iOS apps to users at a markup. But Apple claims that iOS users are essentially buying apps from developers, who are buying Apple’s software distribution services, which would make developers the only direct purchasers with the right to sue Apple.
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Sorry for that long excerpt, but you can read more in that explainer from The Verge. In sum, albeit an entree, this isn’t a real lawsuit yet; rather, it’s just an argument over whether or not iPhone consumers even have a right to sue Apple regarding the App Store. Based upon the precedent of Illinois Brick, that decision boils down to whether Apple is a direct seller of apps to consumers or a direct seller of distribution services to developers. Simply put, who is Apple’s customer: developers or consumers?

Not only is it worth noting how public scrutiny is slowly drawing Apple into the crosshairs — socially and politically — but it’s also important to understand the future consequences Cupertino might face as a result of these proceedings — legally and otherwise. Like a glacier carving up the continents, Apple can transform an industry (and even an economy) as its fortunes shift…

Inextricable tensions

The market has really teased-out a lot of the tensions in Big Tech’s business models over a little more than the last 18 months — from issues of infrastructure and censorship (“How do we guarantee that web companies don’t exploit this power to stifle free speech?”) to advertising and misincentives (“if you’re not paying for the product, you are the product”).

In that vein, Google Chairman Eric Schmidt talked about the search giant’s philosophy that “end users are the real users” in a book he coauthored, How Google Works. He also used the example of Motorola, whose Mobility unit always referred to wireless carriers like Verizon and AT&T as their “customers”, as opposed to true end users like smartphone consumers. Said Schmidt:

“Focus on the [end] user, and the money will follow.”

The user-first notion of ‘build something users will love and the business model will follow’ really shone-through in another Google book, In the Plex, which was written by an outsider. Amazon’s Jeff Bezos has espoused the same philosophy in his “obsess over customers”, “missionary over mercenary”, and “divinely discontent” mantras. Alibaba’s Jack Ma has a similar “customers first, employees second, and shareholders third” modus operandi.

These radical demand-side dispositions are widespread gospel among tech companies big and small, and for good reason, but Apple’s obsession over its user experience is perhaps the most famous of all.

While its free pass has not been entirely deserved, Apple has nonetheless been largely exempted from the scrutiny received by its peers — scrutiny that has not been entirely well-aimed for what it’s worth. These businesses do operate within a complex system in which inefficiencies cannot be entirely extricated and will always be exploited — not that this should discourage anyone from seeking a more perfect system. The following excerpt from “Revenue and the Three Body Problem” neatly characterizes that reality:

Every possible business model has its pluses and minuses — incentives and misincentives that can be exploited… there is no panacea. There are categorically bad business models, but there is not a ubiquitously good one.

Nevertheless, they’re now coming for Apple too. And, while I don’t think Apple v. Pepper is the right front on which to wage war against Cupertino, I do see an opening for plaintiffs to strike Apple’s flank, where the real vulnerabilities lay, having been exposed by the defense itself…

Casualties and causation

Ben Thompson over at Stratechery discussed the merits of Apple’s defense:

I believe that Apple has the stronger position in this case for two reasons…
[First, is the Illinois Brick defense in which] Apple argues that developers set the price of their apps, which determines Apple’s 30% cut, and to the extent developers set prices higher to compensate for that cut they are passing on alleged harm to consumers — which means consumers don’t have standing to sue…
[Second,] Apple has power over developers (supply) precisely because it has all of the consumers (demand); it follows, then, that it is far more likely that developers are pricing according to what the consumer market will bear and internalizing the App Store fee, as opposed to pricing their products artificially high in order to pass the cost of that fee on to customers.

In other words, Apple’s defense lets the tech giant have its cake and eat it too: ‘We do not set the price of consumer apps, developers do’; and at the same time ‘developers do not pass-on the cost of our 30% revenue share to consumers, they eat that cost themselves’. That two-part argument exonerates both Apple and its 3rd party developers from wrongdoing. The second part of that is clever maneuvering by Apple, making sure it doesn’t implicate its developers in defending itself, which would’ve been the easy way out, albeit myopic.

But, there is still a problem with this defense, and it lay in that second part. Remember, the plaintiffs are “claiming that Apple’s locked-down ecosystem artificially inflates the prices of apps because all developers must go through a single store that takes a cut of their revenue”. To wit, there is empirical evidence that developers do not themselves eat the cost of Apple’s revenue share, but rather pass it on to consumers.

Apple’s argument and Thompson’s logic is certainly evidenced in the commoditized apps that really do lack sufficient pricing power to pass-on Apple’s fees to consumers. However, the fatal flaw is that there exists a subset of differentiated apps that are destinations unto themselves — despite often being accessed via App Store intermediary — and thus theoretically should be able to pass-on the cost of Apple’s fee to customers without having to “internalize” it.

In fact, some of those differentiated apps actually have explored and experimented with direct registrations via destination websites to pull an end-around app stores. Using those empirical examples — like Netflix for iOS and Fortnite for Android — we can establish an empirical control group…

To wit, does Apple allow apps to pull such an end around its App Store? No. (That alone is problematic from an antitrust standpoint, but more on that later.) Nevertheless, some have found loopholes — look at Spotify and Netflix’s attempts to bypass the App Store on iOS.

That brings us to this crucial question about Apple’s effect on consumer prices: Have these dissenters from the App Store discounted their consumer prices in lieu of Apple’s revenue share? The answer is emphatically “yes”. Spotify discounted direct registrations in 2015, explicitly attributing the discount to its circumvention of Apple’s revenue share:

“In case you didn’t know, the normal Premium price is only $9.99, but Apple charges 30 percent on all payments made through iTunes… You can get the exact same Spotify for only $9.99/month [compared to $12.99 thorough iTunes/App Store.]”

There is no greater smoking-gun for plaintiffs than that.

Thompson himself continued:

The plaintiff’s case only makes sense in a world where there are a scarcity of apps with pricing power such that consumers are forced to bear 100% of Apple’s add-on; the reality is that apps are already as cheap as can be and it is developers that are being directly harmed by Apple’s policies.

While there is a large cohort in which “apps are as cheap as can be”, as Thompson asserted, there is also a sample in which there exist pockets of “scarcity… with pricing power such that consumers are forced to bear 100% of Apple’s add-on”.

Nobody is talking about this case in these terms.

Broader implications

That all said, I personally do not think that this tack taken by the plaintiffs in Apple v. Pepper qualifies as antitrust, because Apple can (justifiably) argue that the App Store provides a valuable service compared to direct registrations. However, that’s where Apple exposes its own flank — cut off its nose to spite its face…

First, qualifying the value of its App Store service requires Apple to justify the enormity of its 15–30% revenue share in future tussles — if not legally (in court), then privately (in negotiations with its biggest 3rd party developers).

Furthermore, Apple’s attempt to justify, in particular, its huge gross margin on that revenue share gets to the heart of the matter, as discussed in “The Other Weakest Links”:

In contrast to Facebook — one of many apps in the industry — Apple and Google are centralized clearing houses for almost every app out there. Both are uniquely suited to enact consumer protections, given their hard-earned, well-deserved, privileged positions at this distribution bottleneck.
This would not be newly anointing Apple as an omnipotent moral arbiter, because they’ve already assume the role! Normally, we’d have to worry about the second-order effects of implementing such regulation — the unintended consequences — but I’d rather codify Apple’s role therein than let them continue to operate with such impunity.
We can debate App Store criteria all we want, but the fact is that Apple already governs to the letter of its own law, which is written. I’d rather formalize that than leave it flapping-in-the-wind. What use is the App Store review process if Apple can wash-its-hands of its standards whenever something goes wrong!?

As long as Apple assumes an implicit role in policing the App Store, without skin-in-the-game, then developers will increasingly push-the-envelope on nefarious means, while consumers will increasingly buckle under a false sense of security. Regulatory arbitrage and moral hazard all around. It’s akin to Fannie/Freddie’s roles in the pre-crisis mortgage market, and free markets always test the limits of inefficiencies like that “implicit” part of Apple, Fannie, or Freddie’s “implicit guarantee”. Again, inefficiencies cannot be entirely extricated and will always be exploited.

To be clear, there is an additional, entirely separate issue in that small/midsized/up-and-coming apps are facing vertical foreclosure. For every implacable Amazon, Facebook, Google, Netflix, or Spotify who can challenge Apple on its policies, there are thousands of small, independent developers who cannot.

There are other issues on which arcane research might focus, like “peak iPhone” and product treadmills, but App Store impunity and vertical foreclosure are the two issues that public consciousness will grow to know, because they’re existential for a beloved consumer brand. They’re the biggest bricks in Apple’s wall of worry, so I want to continue troubleshooting each of them…

The solution

As I said above, none of this should discourage anyone from seeking a more perfect system…

First off, Apple can justify its enormous gross margins on its enormous App Store revenue share were it to become an explicit policeman of the App Store — with limited liability for malfeasance therein. But that’s not their only option. Apple’s choices for compliance are as follows:

  1. get skin in the game to justify the fee;
  2. lower the fee; or
  3. give developers the option to host their own digital download storefronts (like Google’s Android Play Store does)

Next, there are the issues of developers’ platform risk, disenfranchisement, and vertical foreclosure. Were Apple to comply with one of the three “choices for compliance” above, then developers’ legal gripes are reduced to what’s know as the “principal-agent problem”, for which I’ve proposed the “Chinese Wall solution”:

…principal offerings (like iOS) should have to operate on the other side of a Chinese Wall from the agent platform (like apps). Amazon’s private label products should be independent of the core ecommerce platform; treated the same as 3rd party products by the algorithm; and subject to the same data/intelligence/information access as 3rd parties.

As we spitball regulatory solutions, our instincts warn us that limitations on Apple’s product architectures would serve to either destroy its best-in-class consumer experience or mire its innovation in the muck. On one hand, letting Apple release whatever proprietary/integrated apps it wants could make for the best user experience — much to the consumer’s benefit with which US antitrust law is primarily concerned. On the other hand, that still leaves developers exposed to vertical foreclosure.

But, the Chinese Wall solution doesn’t prohibit Apple from innovating and integrating the kinds of hardware/software services that make its user experiences best-in-class; rather, it merely necessitates a separation of Apple’s proprietary and 3rd party systems. It delineates between kosher integrations by proprietary aggregators and non-kosher infringements upon developers by principals-cum-agents.

App Store ratings: “5★” Google Maps vs “n/a” Apple Maps

Let’s use Apple Maps as our guinea pig. It’s the perfect example because Apple Maps did not — and still has not — improved the user experience relative to its predecessor, Google Maps, which was the iPhone’s default mapping app from the launch of the App Store in 2008 until Apple’s encroachment in 2012. So, not only was this an example of vertical foreclosure, but it was also one that poorly served consumers. Double-whammy.

Some say that Apple cannot allow 3rd parties to integrate with its silicone or OS because security. But, Google Maps-as-a-service was fully integrated with iOS for the whole of iPhone’s history — up until the point where Apple Maps gatecrashed it. (The semi-autobiographical Never Lost Again: The Google Mapping Revolution dabbles in the history of Google Maps’ relationship with iOS.) Case in point, here’s what Apple’s mapping arrangement with Google was ante bellum, per The New York Times:

“Apple’s previous versions of iOS, its mobile software system, included a Maps app that was made by Apple but powered by Google’s mapping service.”

The Chinese Wall solution would provide Apple the discretion to use 3rd party partnerships like this when it needs to leverage a depth of integration that could otherwise threaten end-user security. And, Google Maps proves that the consumer experience didn’t suffer from such a partnership. Not one iota.

Apple Dictionary via “Look Up”

Another example is the iPhone’s native dictionary (i.e. the “Look Up” option in iOS’s tooltip), for which Apple currently allows users to change their default source provider. In other words, the built-in dictionary is already replaceable by 3rd parties’. In fact, the default Apple Dictionary is currently a partnership with a 3rd party, New Oxford, via an arrangement much like Google Maps’!

If anything, far be it from kludgy, the partnership option seems to be the gold standard. But it’s not one-size-fits-all…

Apple’s Spotlight search feature is an example of something that warrants a different touch. Under the Chinese Wall solution, Spotlight would not have to open-up to 3rd party search engines. To my knowledge, Apple never opened the App Store to 3rd party deep OS or device search applications. Accordingly, Spotlight is very much a proprietary, principal product. There’s no agency problem there — no platform risk, no disenfranchisement, no vertical foreclosure.

If Apple already has a proprietary product in the space, then it’s not subject to the Chinese Wall; but if it’s a blank canvas and a developer wants to submit an extension, then he/she can go through the App Store process. That distinction avoids a tragedy of the commons, in which developers would otherwise strip-mine any and all components of the operating system in a gold rush to monetize every possible extension.

Let’s not lose track of the raison d’être of a developer platform: To enhance the operating system’s user experience by enlisting 3rd parties to do the work that the OS’s proprietary team doesn’t have the resources to do by itself. From Ben Thompson again:

…by providing a consistent set of interfaces for software, operating systems create network effects: the more users there are of an operating system the more software applications that are developed for that operating system; this in turn drives more users which increases the addressable market for developers further still.
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The Chinese Wall solution asks for “a consistent set of interfaces” in instances when the user experience is not being served.

Nobody’s arguing for general regulation that serves as a blunt instrument. (Do you think the Chinese Wall solution, where it’s already applied in other industries, is less complex than it would be in tech? Is the the financial services industry less complex? insurance? law? journalism?) The working examples herein build upon my preexisting body of work in this space, helping address some of the grey-area and granularity cited by the community here.

One example of a differentiated app

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