Micro Economics

The paradox of commodities

SHANE GREENSTEIN
[email protected]

A commodity is available from charge prices at multiple levels above a made serious money was Apple—on the
many vendors without distinction. machine’s unit cost. Apple II. During the early years, virtually
Bananas are commodities. So are pota- Computing has come a long way since all successes were small, and eventually
toes, salt, and some types of potato chips. then. Today, very few firms can garner everybody sucked wind.
Can a microchip be a commodity? high margins on their products. This fact The second error stems from failing to
How about a consumer electronics prod- fosters a myth that all high-tech product recognize that IBM’s experience was the
uct, such as a cellular handset? These are markets eventually evolve into commodi- aberration, not the rule. From the outset,
not merely academic questions, but stan- ties. There is an element of truth to this IBM used very common parts for its PCs
dard topics of conversation in executive myth, but also plenty of confusion. to make them competitive. They also
board rooms, Silicon Valley coffee shops, Misunderstanding the role of obsoles- embedded a proprietary ROM BIOS. The
and Wall Street stock analysts’ confer- cence contributes to the myth. Rather company expected to protect this one
ence calls. trivially, every product eventually loses part from imitators and maintain its mar-
pricing power to obsolescence. There are gins with its distribution. Neither BIOS
What is not a commodity plenty of examples: mainframes, mini- nor distribution was unique for long.
Simply stated, a commodity is not a computers, VCRs, and a host of buggy- Compaq reverse engineered the BIOS,
high-margin product. For example, whip technologies from the past. and retailers figured out how to stock the
Microsoft prices Windows at more than Such examples are misleading because product.
20 times its unit cost. In contrast, Michael they overlook the fortunes of particular In other words, margins were high for
Dell feels lucky when a PC’s unit margin firms. For example, IBM’s mainframes a brief time because a particular player in
reaches 5 or 10 percent above cost. Get staved off commoditization for decades that market had some unique and special
the idea? and so did DEC’s minicomputers, even assets. These were useful and profitable
Pricing at multiples above unit cost when the market was shrinking. As assets, but could only remain uncommon
requires something special—valued another example, consider Computer for a short period.
brand, frontier features, unique service, Associates. For many years this compa- More generally, high margins do not
or lightening-fast distribution. Buyers ny earned tons of revenue from special- beget low margins in a predetermined
must be willing to resist the temptation izing in software markets with declining sequence. Rather, low margins are the
to obtain their product from another sup- demand. usual state of the world and occasionally
plier that offers it at a lower price but with- Another part of the myth arises from a a firm manages to break away. It is rare,
out something special. careless misreading of the history of the but possible. To be sure, it is also eye-
In the beginning, computers were not personal computer industry. Stated blunt- catching, but whether it happens early in
commodities. During its heyday, IBM had ly, in 1983 IBM priced its hardware at two- the history of the product category or
the most storied distribution and servic- times its cost; not anymore. later is just a side detail.
ing network in the world. IBM’s engi- There are three errors in the way peo- This last general observation intro-
neering was pretty good, too. The ple usually tell this story. First, many con- duces the third subtle error in using PCs
combination of advanced technology and veniently forget the less-glorious era that as an example: It simply overlooks the
tailored service was extremely potent. preceded IBM’s entry into the market. variance across firms in other electronics
IBM dominated the market. It was able to From 1975 until 1982, the only firm that markets. That is, some firms manage to

0272-1732/04/$20.00  2004 IEEE

73
Published by the IEEE computer Society
MICRO ECONOMICS

stave off commodity status year after There is a third approach for overcom- have occurred whether or not Intel and
year. They figure out something that oth- ing commodification. Instead of beating Microsoft helped it along. Second,
ers do not. This last point is a big one and it, the firm revels in it. Just as McDonald’s Microsoft and Intel are both pretty good
will take some explaining. makes tons of money selling French fries, at the four positive strategies I’ve outlined
so too can an electronics firm from sell- and would not be where they are without
Fighting against commodity status ing tons of low-margin products. After all, them. Third, many seemingly negative
There are four positive and three nega- a penny times a very big volume results strategies are reactive, not proactive. For
tive strategies firms use to fight com- in a very big number. example, Intel saw the demand for Wi-Fi
modification. Let’s start with the positive. This strategy requires the lowest cost explode and reacted strategically by
and highest volume. It requires extraordi- inventing Centrino. Sure, this branding
Positive strategies nary execution. Also, it is not for the faint- commodified a number of Wi-Fi card pro-
One positive strategy focuses on a hearted. Unexpected downturns in ducers as a result. But I find it hard to crit-
niche with loyal buyers. Many software demand can be devastating. icize Intel for that. Intel would fire CEO
game firms have tried this approach. The Best Buy and Circuit City operate this Craig Barrett if he did not try to market
BlackBerry handheld is the latest con- way. So did Egghead and many other something like Centrino, so is he really to
sumer device to also use this approach. retailers who are now long gone. That blame for doing his job?
The Palm handheld started this way. The said, for sheer guts, the top dog is Dell A second negative approach is to try to
list goes on. over the last decade. Dell doesn’t focus kick out any potential rivals by fair or foul
To be sure, this strategy relies on a cool much on margin, but it sure sells a lot of means. After all, nothing staves off com-
idea, a novel approach, or a fad among product. moditification like unthreatened monop-
fanatics. But this does not guarantee high A fourth positive approach combines all oly status. On this score, many firms
margins in perpetuity. Companies can the preceding three, but with the addi- deserve awards. Yet, nobody holds a can-
keep margins high only with careful tional twist that the managers think like dle to Bill Gates for this behavior, so I
updating of the core concept and intelli- marathon runners. The managers contin- focus on him.
gent marketing to an enthusiastic audi- ually discuss how to remain strategically Perhaps Gate’s most imaginative strat-
ence with predictable tastes. consistent, that is, how to stick to the egy was the per-processor licensing con-
A related and second approach in fight- game plan, accumulate learning, and wait tract with assemblers at the end of the
ing commodification is to expand beyond for others to misstep. It requires a special DOS era. This meant that assemblers paid
a niche into a broad product line. It sort of organizational discipline. for a license whether or not they included
involves manipulating product replace- Nokia has thrived through this strategy. it in the product that shipped out the door.
ment cycles for maximal effect. For years its products were not the best Assemblers certainly did not like pay-
There are several firms with a history of nor the worst. It managed to ship a new ing for something they did not ask for.
doing this well. Sony is one of them. Sony release about the same time as its Gates just had his lawyers insert it into
has spent decades developing its reputa- biggest rivals, Motorola and Erikson, the contract. He told the assemblers to
tion for making frontier products that do among others. Then eventually those live with it or go out of business. They
not fall apart after consumers open the rivals tripped, erred in some way, and relented and kept quiet in public, lest they
box. They extract a premium for that repu- angered their customers. It left Nokia anger their important supplier.
tation. Visit any electronics retailer and reaping the rewards for not screwing up. Here’s the rub: The folks at DR-DOS
compare Sony’s prices with everyone thought that it closed the market to them,
else’s. Sony’s are higher. Yet many cus- Negative strategies which it did. DR-DOS also thought it had
tomers will think about it for a minute, then There are also three negative strategies a chance to do well. Alas, you and I never
pay the premium and walk out with a Sony. for delaying commodification. All are con- found out who was right, because
Another honorable mention goes to troversial. Microsoft’s contracts closed the distribu-
Hewlett-Packard with its laser printer One strategy is to commodify every- tion channel to everyone but itself.
product line. HP introduces a new broad one else in a value chain so that it leaves By the way, that strategy is now a stan-
line of printers about every six months, only one brand with something special. dard example in MBA courses. You know
charges little for them, and then soaks Intel and Microsoft have tried this from something is clever if it makes the MBA
consumers later with the cartridge time to time in the PC value chain and canon.
replacement price. Everybody knows the have met with varying degrees of suc- The third negative strategy is to com-
game plan and yet HP has stayed atop cess. That said, the importance of this bine the two preceding ones, commodify
sales charts for more than 15 years; over strategy is exaggerated. others, and solidify monopoly at the same
half of the market goes to HP. That is an First of all, the key PC parts are com- time. Again, nobody does this better than
impressive run. mon, so most commodification would Gates.

74 IEEE MICRO
 The browser wars brought many such Did it matter? Arguments about the cannot make money in a commodity tech-
actions to the public’s and court’s atten- importance of this clause can become nology market.
tion. Of all the stuff Gates authorized, heated in a Silicon Valley coffee shop. My Yet, that leads to the central paradox of
the most audacious were the first- own view is that without this illegal stuff, commodity markets: Staving off com-
screen restrictions on all contracts with the browser wars would have been much modification requires investing in some-
assemblers. This forbade firms such as more expensive for Redmond and more thing special. But if that were easy to do,
HP from putting help screens on their protracted than the fight everyone wit- then everybody would make such invest-
systems, which HP wanted to do to nessed. It might have become a marathon. ments, which would make the “some-
compete with Compaq. At the heart of But, alas, you and I will never find out who thing special” common. If they were
it, Microsoft did not want business part- would have won in that situation. common, then they no longer would be
ners to profit from peddling the Internet, Even the most conservative appeals useful for staving off commodification.
and they did not want HP to help their court in the country singled out this clause
users navigate the Internet with a for removal. Once again, you know some-
Netscape browser. thing is clever when seven appellate court
Again, nobody wanted these restric- judges agree it has to go. For further information on this or any
tions. Gates just put it in the contract and other computing topic, visit our
made sure everyone knew he was watch- The paradox of commodities Digital Library at http://computer.org/
ing for compliance. It is simply wrong to argue that firms publications/dlib.

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