With the iPhone, Apple schools the market in economics

A high-priced product dominates a market full of cheaper options -- Apple's advantage is that it solved the Innovator's Dilemma

Economics isn't supposed to work this way. That is, Apple shouldn't be sitting atop an Everest-sized bank balance, not with a high-priced product in a commodity market.

But then, as I and others have gotten completely wrong, the smartphone market is not a commodity market (yet).

As Stratechery's Ben Thompson deftly describes, the fundamental problem in my thesis about the smartphone market and Apple's place in it comes down to a basic misunderstanding about smartphones. In short: So long as we're addicted to our smartphones, Apple will continue to make mountains of cash.

Apple misses the memo

I have argued for years that Apple's star in the smartphone constellation was destined to fall. In the early smartphone market, I reasoned, Apple's tightly integrated software-to-hardware-to-cloud-services products could charge a premium and still win, but it would give way to low-cost, commodity Android over time.

Or as I concluded in 2012, "Apple is going to have to figure out how to be cheap if it wants market share." Sadly (for me), no one at Apple got my memo.

Last quarter, 30 percent of Apple's iPhone buyers who previously owned a smartphone switched from Android devices, according to Apple CEO Tim Cook. Meanwhile, one of the markets that shouldn't have enough disposable income to afford Apple products -- China -- drove 24 percent of Apple's global iPhone revenues, up from 15 percent a year ago.

No, Apple isn't cleaning up in the poorest of economies, which buy Android smartphones. But even in these poverty-stricken markets, Apple is the aspirational brand that consumers long to buy.

Which, as it turns out, could be the key to understanding Apple's continued rise.

Smartphones are different

Thompson describes several "key realities" that underpin Apple's success and undermine the arguments of those (like me) who have believed Apple was always one quarter away from a reality that bites.

But it is the first of his realities that carries the biggest persuasive punch: Smartphones are the most important products in people's lives, which means the willingness to pay for the "best" is higher than it is for nearly anything else; relatedly, the smartphone budget is likely the last to be cut in any sort of economic tightening

Ironically, I got this right back in 2009 when criticizing then-Microsoft CEO Steve Ballmer's attack on Apple as too expensive, but I got it completely wrong in 2012 when I argued that "ultimately the mobile ecosystem is going to revolve around one big player, and Google's low-cost strategy positions Android to be that player unless Apple can figure out a way to be both cool and cheap."

I was wrong because, as Thompson says, smartphones are different. We care about them more. We check them hundreds of times every day. They never leave our sides, whether we're in a meeting or the toilet stall.

Given that we care so much about them, we want the best. And no matter how much we may wish it otherwise, Apple builds the best smartphones, with an overall experience that treats consumers like royalty and not data to be bought and sold.

We scrimp and save to ensure we can buy Apple's best. And to help us along to that decision, the best Android phones cost as much as an iPhone.

Innovating around the Innovator's Dilemma

Of course, our fetish for smartphones isn't the only thing driving Apple's iPhone success. As InfoWorld executive editor Galen Gruman reminded me, "Apple is a company that actually understands the Innovator's Dilemma and is working to address it."

How? By constantly being willing to commoditize its blockbuster hits (such as designing the iPhone to supplant the iPod), but also by rigorously seeking to shore up its winning positions with winning complements (for example, the Apple Watch reinforces and extends the iPhone's value).

As Gruman puts it: "In a very Apple approach, all the new stuff [like Apple Pay or Apple TV] leverages the old, so it helps extend their lives, too, while also being possible big businesses in and of themselves."

It's smart business, and it's why Apple is worth several hundred billion dollars in market cap.

Maybe there's an argument that Apple should go downmarket, that it should make it easier for poorer people and countries to afford its products. But that's a moral argument.

For now, at least, the economics argument has been won: Yes, a company can sell a high-margin product at high volumes so long as it's an aspirational brand in a must-have product category, with high-value complements that support and strengthen its position.

Which, of course, describes the iPhone perfectly.