Antitrust, the App Store, and Apple

Yesterday the Supreme Court held a hearing in the case Apple Inc. v. Pepper. “Pepper” is Robert Pepper, an Apple customer who, along with three other plaintiffs, filed a class action lawsuit alleging that App Store customers have been overcharged for iOS apps, thanks to Apple’s 30% commission that Pepper alleges derives from Apple’s monopolistic control of the App Store.

There are three points to make about this case, and they are captured in the title:

  • First, the specific antitrust doctrine at question
  • Second, the question of whether the App Store is a monopoly
  • Third, what the very existence of these questions says about Apple

In my estimation, these three points move from less certain to more certain, and from less important to more important. In other words, whatever the Supreme Court decides matters less than what the very existence of this case says about the state of Apple and its future.

Antitrust and Standing

The question before the Supreme Court is whether or not Pepper et al. have standing to sue Apple for antitrust violations at all; in other words, the case — which was launched in 2011 — hasn’t even started yet. The Clayton Antitrust Act of 1914 stated that “any person who shall be injured in his business or property by reasons of anything forbidden in the antitrust laws” can bring an antitrust action, but in the 1977 case Illinois Brick Co. v. Illinois, the Supreme Court held that only direct purchasers of illegally priced goods had standing to sue.

The specifics of the Illinois Brick case are helpful in parsing out what makes the Apple case complex; specifically, the Illinois Brick value chain was very straightforward: concrete block makers (including the eponymous Illinois Brick Company) were accused of colluding to fix prices for concrete blocks, which were bought by masonry contractors; masonry contractors in turn submitted bids to general contractors for construction projects, which were ultimately paid for by the State of Illinois. The State of Illinois sued for damages, alleging that the higher prices resulting from the price fixing had been passed through to the State of Illinois.

The Illinois Block value chain

In this value chain it is obvious who the direct purchasers were: masonry contractors; to the extent the State of Illinois suffered harm it was indirect pass-through harm. Thus, the Supreme Court ruled that the State of Illinois did not have standing; if every party in the value chain were to sue, the infringing party could be subject to duplicative recovery for damages (and parsing out the share of damages would be extremely difficult).

Apple vs Pepper

The question in Apple vs. Pepper, then, is who is directly harmed by Apple’s alleged monopolistic practices. According to the plaintiffs, the value chain looks the same as the concrete block manufacturers:

The plaintiff's characterization of the App Store value chain

In this case Apple is in between developers and customers; the plaintiffs explain in their petition:

Apple charges apps purchasers a 30% commission on each app sale (unless it is a free app). The price paid by purchasers for an app is the amount set by the apps developer, plus Apple’s own supra-competitive 30% markup, both of which are paid directly to Apple, the alleged monopolist, every time an app is purchased. Apple keeps the entire supra-competitive portion of the purchase price for itself and remits the balance to the apps developers. The apps developers do not sell their apps to iPhone customers or collect any payment from iPhone customers, and iPhone customers are the only purchasers in the entire chain of distribution.

The plaintiffs argue that this makes consumers “direct purchasers”, giving them standing to sue:

Since Illinois Brick was decided 40 years ago, courts throughout the nation have had no trouble applying its “direct purchaser” standing requirement to various factual settings, including cases in which some form of payment is made to an alleged monopolist prior to the monopolist’s sale of a product.

Apple’s argument is that this misrepresents the transaction; the company wrote in its petition:

There is no basis for Respondents’ argument that pass-through damages claims are permitted whenever there is direct interaction between the plaintiff and alleged antitrust violator. This argument openly exalts form over substance by turning entirely on the formal identification of a “direct purchaser” and prohibiting any “further inquiry into the specifics of a case.”

Rather, Apple argues that the value chain looks like this:

Apple's characterization of the App Store value chain

Specifically, the company argues that “Apple does not buy and resell apps”:

Respondents suggest for the first time that Apple “has adopted the role of a retailer functionally buying from developers as wholesalers and selling to iPhone owners as consumers.” But their complaint does not allege that. And Respondents have repeatedly acknowledged that only consumers buy apps; Apple does not. The Apple developer agreements cited by Respondents confirm this: developers “do[] not give Apple any ownership interest in [their] [a]pplications.” So Apple is fundamentally unlike a traditional retail store.

Rather, Apple acts as an “agent” for developers:

As Respondents note, [the Developer] Agreement confirms that “Apple acts as an agent for App Providers in providing the App Store and is not a party to the sales contract or user agreement between [the user] and the App Provider.” Thus, Respondents concede that the direct sale is actually between developers and consumers, facilitated by Apple as an agent and conduit.

Along those lines, 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.

Why Apple is Right in his Case

With the caveat that I am not a lawyer, I believe that Apple has the stronger position in this case for two reasons: the first are the arguments laid out above. The second, though, come back to Aggregation Theory: I believe that 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.

And, well, that goes back to the first point: even if they are pricing their products artificially high that is an ipso facto example of pass-through harm, which means consumers don’t have standing. The plaintiff’s case only makes sense in a world where there is 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 (along those lines, the degree to which Apple owns the customer relationship — and associated data — does suggest something much more meaningful than an agent relationship with developers).

That noted, many court observers felt yesterday’s oral arguments went the plaintiffs’ way; we won’t know if that is an indicator of the court’s decision until next year.1

The App Store Monopoly

If I am right, and the case is dismissed because the plaintiffs do not have standing, that does not mean Apple and the App Store are out of the antitrust hot water: first, developers can sue for antitrust damages, and second, most states — including California — do not follow the Illinois Brick precedent (this dual antitrust regime was upheld by the Supreme Court in California v. ARC America Corp). There is a decent chance the question of whether or not the App Store and Apple’s associated policies are an antitrust violation will make its way to court sooner or later.

To that end, one of the more humorous aspect of yesterday’s oral arguments was the way discussion presumed that Apple was an abusive monopoly; this was a matter of convenience, as the question at hand was if Apple were an abusive monopoly, then who was harmed directly — which means it was easier to discuss the the latter question while assuming the former was true. To be frank, though, the language felt appropriate: Apple is an abusive monopoly in terms of iOS apps.

Let’s review the facts:

  • The only way to install apps on an iOS device is through the App Store
  • All apps must use Apple’s purchase APIs for all digital transactions, which include a 30% fee paid to Apple
  • Apps are expressly forbidden from linking to or suggesting that users visit a website to acquire any sort of digital good or subscription

This has been the state of affairs since 2011 when Amazon’s Kindle app gave in to Apple’s demand that it remove a link to Amazon’s online store. To be sure, Amazon is no shrinking violet in this fight, but Kindle is a useful example of just how absurd this policy is:

  • Apple is not responsible for any aspect of the Kindle ecosystem. Amazon hosts the books, runs the store, makes the readers, apps, etc.
  • Apple does make the device that ~45% of potential customers in Amazon’s largest market (the United States) carry with them every day.
  • Ergo, Apple demands that Amazon either give Apple 30% of all purchases on the Kindle app for iPhone or leave it to customers to figure out how to buy a new book.

Amazon, of course, has chosen the latter option: they can do that because they are a brand just as well-known as Apple, and even more beloved. That’s not really an option for a whole host of smaller developers, who have no choice but to give Apple 30% of their revenue if they even want to build a business.

That gets at the crux of the issue: Apple has every right to the outsized profits it makes on the iPhone. Consumers could buy cheaper Android devices but they don’t because they value Apple’s hardware, or iOS, or the integration between the two. I have a hard time believing, though, that anyone buys iOS because that makes it harder to buy ebooks!

To put it another way, Apple profits handsomely from having a monopoly on iOS: if you want the Apple software experience, you have no choice but to buy Apple hardware. That is perfectly legitimate. The company, though, is leveraging that monopoly into an adjacent market — the digital content market — and rent-seeking. Apple does nothing to increase the value of Netflix shows or Spotify music or Amazon books or any number of digital services from any number of app providers; they simply skim off 30% because they can.

To be clear, Apple absolutely did create the modern app marketplace, and, as the company loves to brag, an entire new economy full of new types of jobs. That, though, is precisely the problem: the App Store is not a fun side diversion; it is one of the largest platforms we have ever seen, on which hundreds of thousands of people are seeking to build real businesses, and that carries different types of responsibilities — and legal limitations — than an OS feature. It is bad for society generally and, I strongly believe, illegal for Apple to have crafted App Store rules such that it can leverage its smartphone share into monopoly profits on digital goods and services that are on iOS not because iOS is anything special, but because that is the only possible way to reach nearly 50% of the U.S. population.

Apple and the Services Narrative

Apple’s decision to embark on this strategy in 2011 was disappointing enough; the far more concerning development happened in January 2016. That was the first quarter when the iPhone basically stopped growing in terms of unit sales, and Apple’s response was the “Services Narrative”. CFO Luca Maestri opened his prepared remarks by covering a special supplemental document meant to emphasize that Apple had a thriving services business:

Each quarter, we report results for our Services category, which includes revenue from iTunes, the App Store, AppleCare, iCloud, Apple Pay, licensing, and some other items. Today, we would like to highlight the major drivers of growth in this category, which we have summarized on page three of our supplemental material. The vast majority of the services we provide to our customers, for instance, apps, movies and TV shows, are tied to our installed base of devices, rather than to current quarter sales.

For some of these services, such as content, we recognize revenue based on transaction value. For some of the services, such as the App Store, we share a portion of the value of each transaction with the app developer and only recognize revenue on the portion that we keep. To fully comprehend the scale of the services that we are delivering to our installed base and how fast this business is growing, we look at purchases in addition to revenue. When we aggregate the purchase value of services tied to our installed base during fiscal 2015, it adds up to more than $31 billion. That’s an increase of 23% over fiscal 2014.

First off, it is striking that when Apple was facing one of its most challenging years in the stock market, its first response was to basically make the plaintiff’s point in Apple v Pepper: suddenly the company wanted to recognize all of the App Revenue, “a portion” of which is shared with developers. That sounds like a company in the middle!

Secondly, though, the reason Apple wanted to include all app revenue is that the “Services Narrative” has always been first and foremost the App Store narrative. Apple makes a huge amount of money, with massive profit margins, by virtue of its monopolistic control of the App Store. It doesn’t make the games or the productivity applications or the digital content; it simply skims off 30%, and not because its purchasing experience is better,2 but because it is the only choice.

This is, to be sure, a narrative worth telling, at least when it comes to the stock market: Apple’s PE ratio, even with the recent slide in the stock price, is up 50% from that January 2016 call (two months ago it was up 100%). Investors believe — for good reason — that Apple can earn sustainable profits from something other than new devices (the company’s recent stock slide, interestingly, seems to have come from Apple’s insistence that its reporting emphasize revenue over unit sales).

At the same time, it seems incredibly worrisome to me anytime any company predicates its growth story on rent-seeking: it’s not that the growth isn’t real, but rather that the pursuit is corrosive on whatever it was that made the company great in the first place. That is a particularly large concern for Apple: the company has always succeeded by being the best; how does the company maintain that edge when its executives are more concerned with harvesting profits from other companies’ innovations?

To that end, perhaps it is not a surprise that the company’s other big growth driver has been rising prices across its product line: Apple deserves credit for building up the sort of customer loyalty that it can extract ever more revenue from its user base; more cynically, given the hassle of switching, where else are its customers going to go?

This is a view that is perhaps a tad pessimistic: Apple continues to show a lot of innovation in its wearables category, both Apple Watch and AirPods3, and the company is the best placed to make augmented reality a mainstream product. And, to be sure, the company has never been afraid of high prices.

Still, it always seemed that for Apple high profit margins were a by-product of the pursuit of great products, not the goal; it is much harder to make that case when it comes to the “Services Narrative” and App Store policies that seek to leverage genuine innovation in one market (smartphones) into rent-seeking in another (digital content). The latter may not be illegal, at least not yet, but the biggest potential victim is not consumers, nor app developers, but the product culture that gave Apple market power in the first place.

I wrote a follow-up to this article in this Daily Update.

  1. And, on the flipside, that the court granted certiorari at all suggests they may be looking to reverse the 9th Court of Appeals, which ruled in favor of the plaintiffs 

  2. In fact, its purchasing experience is better, particularly for free-to-play games; Apple should compete on the merits 

  3. Well, except for the mysterious disappearance of AirPods 2