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The pricing war initiated by Google and Amazon, regarding the low price at which tablets are sold, does not reflect their full costs. The fact that two of the biggest players have decided to start selling tablets at no profit, might seem like a good thing in the short term. However, long term, it might prove detrimental for the entire industry as it could easily steer the industry’s’ focus away from providing quality devices and direct it into producing and selling cheap, minimum capabilities ones.

It is generally accepted that competitive markets fail due to four basic reasons: market power, incomplete information, externalities and public goods. Inefficiency arises when a producer or a supplier of a factor input has market power–both Google and Amazon undoubtedly have that power. Currently, they are the two biggest market players behind leading Apple, with Amazon also being the biggest online retail and content provider. Both competitors have decided on the quantities of devices to be produced and at which marginal revenue to sell. Both have conceded that the marginal revenue is going to be equal to the marginal cost, thereby voluntarily squeezing their profit margin for these devices to near zero, while projecting that the high profit margins will come from selling content and services to their consumers.

This marketing strategy succeeds in making competitive products/brands appear overpriced to the lay consumer, regardless of the fact they are costly to produce. As a result, they force other producers to lower their selling price and subsequently their profit margins. Further, they corner producers into the forced dilemma of choosing between quantity and quality when designing and producing new devices. All this, while Google is aiming to both make a profit and broaden the reach of its Android operating system, and Amazon is looking for ways to restore the profit gap when customers buy movies, books and magazines from its store.

Andrew Rassweiler, an IHS senior director, said Google’s tablet is also clearly aimed at Amazon.com, which shook up the tablet market last year by offering its own version at $199. “Google’s Nexus 7 represents less of an attempt to compete with Apple Inc.’s market-leading iPad, and more of a bid to battle with Amazon’s Kindle Fire,” he said in a statement. While the two are “similar in many regards,” he added that the Nexus 7 “has superior specifications to the Kindle Fire, giving it a more attractive feature set that may make it more desirable to consumers.” Amazon and Google don’t care to monopolize the market, but they do care to achieve a monopsony.

Amazon and Google appear to be simultaneously trying to establish a wholesale monopsony and a retail monopoly in the ebook and content/advertising sector. At the same time, it is important to note that Google and Amazon are in effect trying to apply a predatory pricing practice into the market of tablets and content. By selling a Nexus or a Kindle at rock bottom prices, they intend to drive competitors out of the market and/or create entry barriers to potential new competitors. What is even more important to realize is their attempt to establish in buyers’ mind the conviction that well-known products such as the iPad mini are by default overpriced. If competitors, such as Asus, Nook. Samsung or RIM  cannot sustain equal or lower prices without losing money, they are eventually driven out of business. Beyond that, potential competitors are discouraged from even attempting to enter the market.

In essence, Amazon and Google have chosen to undergo short-term pain for long-term gain. Therefore, for both to succeed, they must have sufficient strength (financial reserves, guaranteed financial backing or other sources of offsetting revenue) to endure the initial self-imposed lean period. In this case, it is really interesting to follow Amazon’s steps, since Google seems to have all the strength required to endure the initial period. Since Amazon had some rough quarters regarding revenues and profitability, this strategy may fail if competitors (like Apple or Samsung) are stronger than expected, or are driven out (like RIM, HTC or Acer) only to be replaced by others. In either case, this will force the Amazon and Google groups to either prolong or even abandon the price reduction policy.

Their strategy may fail, if both Amazon and Google prove unable to sustain the short-term losses, either because they last longer than expected or simply because they underestimated the loss. In the long term, it is questionable whether Amazon can endure while practicing the predatory pricing. And how will this would affect Apple and its ecosystem? Tablet makers selling a complete range at that break-even level could ultimately whittle down the market to those who either produced a winning formula at the right time (Apple) or have deep enough content stores and bank accounts to willingly give up large parts of their potential hardware profit (Amazon and Google).

It is a well documented fact that consumers do not have accurate information about market prices or product quality. As most consumers are price-driven, they tend to ignore or be indifferent to the fact, that it is difficult for companies who lack the proper profit margins, to access the funds required to develop new technologies and provide the market with innovative products. One tends to easily forget that devices sold by Google and Amazon gain their value from content, which has to be purchased at an extra price. So it is quite possible that consumers who are lured into buying a device because of it’s significantly cheaper price tag, to later discover to their dismay that either the app ecosystem is either not very safe nor well developed–or worse still, that in order to have the proper experience using the inexpensive device that they must spend a serious amount of money on different kinds of content purchases.

In our case, market prices do not reflect the activities of either producers or consumers. Prices are kept artificially low, as producers try to gain market share and revenues from content sales. This has an indirect effect on other consumption or production activities that is not reflected directly in market prices. There is an externality, because the price of tablets, which are sold by Amazon and Google, do not bear the true cost of their production nor leave reasonable profit margin. A viable profit margin would allow producers to spend the necessary funds on research and product development, enabling them to provide consumers with well-designed, well-made devices, able to improve and optimize the experience of consuming content or services through them. This causes an input inefficiency driving other competitors to push their profit margins lower, in order to match the low prices of Amazon and Google and forces on them the dilemma between money, potential market share and quality.

In essence, they are basically trying to equate profit margin in the table market segment with sin. As Google and Amazon are the two biggest players in the market of tablets after Apple, it is possible that the externality will prevail throughout the industry and the price of tablets will be lower than it would be if the cost of production reflected the effluent cost. As a result, competitors who struggle to remain in the market are bound to produce too many low quality tablets, which in turn will affect the experience of users. In short there will be output inefficiency.

Obviously in the short term, lower prices for tablets are only beneficial to consumers. By setting the price around $200 for a decent and well-made tablet branded by Amazon or Google, consumers have access to more content via a much cheaper tablet. The downside is that people come to expect or demand products to be sold at such low prices, forcing producers to focus in providing inexpensive products rather than quality ones. Amazon and Google might be at an advantage in the short term, by applying predatory pricing practice.

However, they are opening a Pandora’s box. Selling with no margin, or at a loss, as Amazon did with the first Kindle Fire, might be good business practice if you are a wealthy company, yet is a practice which can easily derail even the strongest plan if unexpected factors come into play, or markets start to ask for something more advanced or pricy than what producers are able to offer. Creating such a business environment is something which can easily turn against you, with buyers expecting to buy more or all of your products at cost. Amazon and Google might lean on content sales where they can still retain margins, but consumers can just as easily leave them for someone who will come up with an even more disruptive idea on how content is sold or distributed. (Similar to when Apple almost pushed mobile providers out of the content industry with the app store).

From the consumers ’ corner, there is an important question that needs to be answered: what is the right price for a tablet? Or what is a fair profit margin for producers to sell at? In both cases the answer is conceptually straightforward: the right price or the right profit margin will drive tablets’ price where all negative externalities, such as R&D costs, design, market development, are fully reflected on the tablet’s price. This point is not pegged where Apple sells its own tablets but for sure it is neither where Google and Amazon priced theirs. It is evident that in the long term, even the strongest producers, will face major difficulties in keeping the pace of innovation and technology development, when they will struggle to find the necessary money to fund research and development.

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George Achillias

About George Achillias

George Achillias is a physicist, specialized in solid state physics and quantum theory, but with long experience in product development and marketing. Able to connect the dots. Interested in things are to happen in the next 20 years. A rainmaker regarding mobile and connectivity. Understand mobility and keen to learn more about the nomadic behaviour of modern societies.

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