Federal Court v. Apple on Tying Arrangements

Tying arrangements have become a common part of the tech industry’s pricing practices. HP printers tie buyers to HP Ink Cartridges. Xbox ties buyers to Xbox games. And iPhones tie buyers to the iTunes App store.  So common, we might forget that tying arrangements are not always legal. The third of these examples may be landing Apple in court. So, time to brush-up on some law.

As of November 27, 2018, the Supreme Court is determining whether a group of consumers have standing to sue Apple Inc. over the way they manage iPhone apps (1). The probability of this suit being adjudicated by the Supreme Court is definitely non-zero.

We will start with some basic questions: What are tying arrangements? When are they illegal? And then move to the nasty question: Is Apple likely to be found at fault?

Tying Arrangements

A tying arrangement is a seller’s requirement that if a customer purchases its “tying” product, they must also purchase the seller’s “tied” product. This is often thought of as a razor-and-blade pricing strategy.

Usually, the “tying” product is some sort of durable good, like a razor handle, printer, film projector, or even a button fastener. The “tied” product is some sort of consumable like razor blades, ink cartridges, films, or buttons respectively. The seller usually sells the durable “tying” product near or below costs to attract customers, and intends to recoup loses to generate profits through the consumable “tied” products.  Whether it works in the sellers’ or buyers’ favor largely depends on the customer lifetime value, and the willingness of customers to buy the tied products.

From a pricing strategy perspective, tying arrangements are two-part tariffs in reverse.

In a two-part tariff, the seller offers both durable and consumable goods once again, and once again buyers must buy both the durable and the consumable from the same seller. Unlike a tying arrangement, a two-part tariff encourages a seller to sell the durable product at a high profit—while selling the consumable at, or only slightly above, costs. Two-part tariffs are common with metered products, like electricity, gas, and water. In all these markets, customers pay both a metering fee (the durable part) and for the amount of the electricity, gas, or watered consumed (the consumable part).

Two-part tariffs are used primarily in natural monopoly markets. The ability of sellers to abuse customers with higher prices through two-part tariffs is a common subject of freshmen microeconomics courses. As a result, where two-part tariffs would be more profitable than tying arrangements, industries tend to be highly regulated.

Apple sells iPhones and Apps for iPhones in a relatively unregulated market. iPhones themselves are relatively expensive and profitable, and iPhone Apps can only be provided and approved through the iTunes App Store.  Any app sold on the iTunes App Store must give 30% of the revenue to Apple.  A highly profitable sale on the consumable side.

Hence, we have both durables and consumables sold by Apple, and once the customer buys the durable, they are locked into Apple’s App Store for consumables.

Is this a two-part tariff or a tying arrangement?  Despite the strong profits on the iPhone itself, the margin on individual sales in the App Store are higher. Q2 2018, Apple earned 11.5 billion in profits. 9.5 billion of their revenue came from services, primarily the iTunes App Store—where the margins are extremely high on the distribution of digital goods that Apple itself did not make. From the margin’s perspective, this looks more like a tying arrangement than a two-part tariff.

Legality of Tying Arrangements

For a tying arrangement to be found illegal, Joseph P. Bauer wrote in Vanderbilt Law Review the court must (2)

1. Determine that a tying arrangement exists.
2. Determine it harmed competitors or would-be competitors.
3. Determined it harmed customers.

One could make an argument for all three of these issues against any tying arrangement. But clearly there is more than this simple test to determine legality or we wouldn’t see tying arrangements in so many situations. Legal-ease isn’t plain English unfortunately.

On the first issue, determining whether or not the tying arrangement exists, we immediately hit some differences between legal definitions and what seems like plain English.

At times, the sale of a durable and its tied consumable product can be redefined as the sale of one good.  If customers want to purchase the good separately, they are deemed tied. If they don’t, they are deemed as one product. (The ambiguities surrounding how the court determines what customers want is one of the reasons why lawyers make so much money.)

As ambiguous as this legal definition of tying arrangements, it has been used to determine that the sale of film projectors and films are a tied sale but the sale of remote controls with batteries included may not be.  A related argument can be used to justify the original razor handle and razor blade arrangement.  Customers don’t really want the razor handle (the tying good) but rather they want the razor blade (the tied good), and the two really do work as one unit, hence, in a legal definition, the “tying arrangement” doesn’t exist though in a normal English definition, it does.

On the second and third issues, one gets caught in economic arguments with some interesting mathematical arguments to support varying claims.  On one side, we have those that claim most all tying arrangements harms competition or increase profits at the expense of customers, or else the supplier wouldn’t be creating them.

On the other side, we have those that claim tying arrangements are good for society due to having little to no overall negative impacts on society (notice the replacement of “customers” and “competitors” with “society” allows the maths of harm to be greatly shifted) (3), or that one must look at the overall innovation and the use of a tying arrangement to sell a good to a broader market. Then we see defense arguments based on market power (with a de-facto pre-requisite of having more than 30% market share) or on the concept of improving efficiency.

Apple Liability

As interesting as all this is, we are still left with a simple question: did Apple break the law by tying its App Store to the iPhone? This may be a simple question, but it’s not easy to answer.

I could easily see why some lawyers would sue Apple. Apple has decent U.S. market share in the smart-phone market. The market for apps for the Android operating system by Alphabet isn’t limited to their Google Play website hence we can see that analogous customers are comfortable buying apps through unrelated parties. And the profit streams do look like a tying arrangement.

Yet I can also easily see a number of defenses along many lines.

1. Apple may have high U.S. market share, but its global market share is relatively small compared to Samsung and others for smart markets, thus the suit has no merits.
2. Apple seeks to keep its technological ecosystem clean of malware and thus seeks to limit access to apps to authorized vendors, vendors which it monitors through controlling the distribution channel. Hence, this is a more efficient set-up than what could be constructed via other means.
3. Customers are well aware of the relationship between Apple hardware, software, and digital prices. Their awareness is demonstrated in the limited 12.7% market share of Apple in the PC market. In this market, customers are well aware that software and such for Apple computers are more expensive than for Window’s compatible PCs. And the higher price for such discourages their purchase of Apple’s computers. Thus, most customers of Apple smartphones really do think of, and want, the two products as one.

And I am confident other arguments can and will be made.

Arguments on both sides can be made. The minds of the Supreme Court justices are not completely predictable.  As such, I cannot tell what the courts are likely to determine.  Apple is not clearly violating the law nor are they clearly free from liability.  But if it were easy, it wouldn’t be reaching the Supreme Court of the U.S.  Shareholders, CEO’s, and pricing strategists should all be watching this decision.