Samsung’s exploding battery debacle will go down in history as the “tortoise vs. hare” fable of the digital age. Except, instead of running too fast and taking a nap, Samsung competed too hard to produce the world’s greatest smartphone, a race which ended in disaster.
On October 11th, after a failed attempt to roll out a replacement of the Galaxy Note 7 that did not include the risk of spontaneous combustion, Samsung announced that it would permanently discontinue its flagship phone. And to colour the point that this was a devastating blow to the South Korean giant of technology’s balance sheet, it slashed its profit forecast by a third the following day. Now, left with near irreparable harm to its brand and reputation as a premium device supplier, Samsung is stuck between a rock and a hard place: should it drop the Note brand entirely; move further into software; or follow the trend of pushing into artificial-intelligence enabled hardware, such as smart speakers? Aside from this, an interesting question is how and why the smartphone race became so intense that Samsung ultimately produced an exploding phone. And an even deeper question is whether Google was really to blame.
The answer to the first question lies in the evolution of the smartphone industry, which has seen the smartphone itself become increasingly commoditised (like corn or wheat, but a smartphone). In economics, a fundamental assumption of perfect competition is that all goods are homogeneous. In practice, firms that sell products that closely resemble each other should differentiate their own products in order to reap greater profits. The greater extent to which they do this, the less competition and greater profits there will be in an industry. The force of these competitive pressures has rattled the smartphone industry — and Google was a key contributor.
According to a working paper by the Boston Consulting Group, there are 273 smartphone manufacturers present in the market today, 88% of which entered after 2007. There is also a high turnover of firms: only two of the top ten producers in volume in 2015 were already in that league by 2007. In other words, the market is characterised by low concentration and low barriers to entry. With so many producers competing vigorously with each other for market share, prices have dropped significantly over time. According to the same report, the overall average selling price of smartphones declined by 33% from 2008 through to 2015 (excluding Apple’s iPhone, the decline was 46%).
Four key changes in the competitive landscape of the industry have brought about this heated competition between smartphone manufacturers and significantly reduced the cost of entering the smartphone manufacturing market. First, handset manufacturers now largely outsource the production of silicon and non-silicon components for their devices, often playing different manufacturers off against each other to achieve the lowest possible prices. Second, previously separate components are now combined into System-On-Chips, which integrate various processing capabilities into one chip and save space in the handset for things like batteries, better camera lenses and the like. This has reduced smartphone manufacturers’ assembly costs significantly. Third, there has been a global standardisation of mobile communications in the form of LTE for 4G, which is available for licence to any smartphone manufacturer on fair and reasonable terms. Last, and perhaps the most important factor in the commoditisation of the smartphone, is the free availability of smartphone operating systems. This is where Google comes in.
In the mid-2000s, the fragmented market for mobile operating systems (OS) was bad news for both developers, who couldn’t achieve economies of scale in the distribution of their apps, and smartphone manufacturers, who either had to build their own in-house OSs or license an OS from another supplier (which often competed in device manufacturing too). For example, there was Symbian OS, developed by manufacturers such as Motorola and Nokia, Microsoft’s mobile OS, and PalmSource, which Palm used on its own devices and licensed to manufacturers like Samsung and Sony. Other firms, like Samsung (circa. 2007) and Blackberry, produced their own OSs.
This all changed when Google acquired Android and released its operating system to the world on a free and open-source basis. Since 2007, smartphone manufacturers have no longer needed to invest millions in creating their own OS or licensing another firm’s and could instead adopt Android wholesale, including a whole bunch of Google’s stock apps. Android’s subsequent success is a testament to how much device manufacturers yearned for a free, open source OS whose apps were compatible with other devices. This is because OS ecosystems benefit from indirect network effects, whereby a greater number of app developers and apps attracts more users, which in turn attracts more developers. This was one reason for the explosive growth of Apple’s iOS platform. However, prior to Android, other device manufacturers were at a loss for a solution to this fragmentation problem (different manufacturers using different OSs) that plagued the industry and which prevented any one OS achieiving sufficient scale to compete with Apple.
These days, Android is preinstalled on 86% of smartphones, while OSs that previously bounced around the market have either exited or have been left with a minuscule share. Around 70% of manufacturers that pre-install Android on their phones, including market leaders like Samsung and HTC, use an “un-forked” version provided by Google. As a result, the user’s out-of-the-box experience is largely the same across the devices of multiple, competing manufacturers. Of course, manufacturers can customise Android to some degree, but in order to take part in the “Google experience” (and pre-install Google’s apps), the degree of customisation possible is significantly limited (see my post on why Google is entering the handset industry itself). Therefore, the availability of Android as a free and open-source operating system has both reduced barriers to entry to smartphone manufacturing and increased homogeneity across the smartphones provided by different manufacturers. This has induced greater price and quality competition across different manufacturers.
Imagine if all smartphones were exactly the same and the cost of entering the industry was zer0. If consumers viewed all devices as perfect substitutes, competition in the industry would be perfect: firms would continue to enter the industry until ecomomic profit was competed down to zero. On the other hand, firms that differentiate their products can charge positive prices as a result of the fact that consumers have heterogeneous preferences. It follows that the greater extent of differentiation in the industry, the larger the industry profits will be.
Now consider Samsung’s options when designing its device. If it positions its products too close to a rival’s, there will be increased price competition and its profits will fall. So it has to differentiate itself. But its options are limited because of the factors we already discussed: it can’t boast a better 4G connection, because it outsources the production of its chips and LTE for 4G is standardised across the industry. Its choices are also limited with respect to the OS because the un-forked Android OS is not fully customisable, and is therefore very similar to rivals’. Compare this with Amazon’s strategy. It attempted to differentiate its devices by forking Android to create a wholly “Amazon” experience, with a bespoke app store and no Google Play — its lack of success speaks words for the popularity of the “Google experience” adopted by Samsung, HTC and the like.
And now we get to Samsung’s exploding battery. Because smartphones have become so similar in their functionality, largely due to the prevalence of the un-forked Android OS, device manufacturers strive to improve features they can control: like the camera, the screen resolution, and the battery power. Call this “feature competition”. Samsung’s devices often trump the iPhone on these aspects because the iPhone is differentiated on a different parameter, viz. the attractive OS. So in order to charge higher prices, Samsung has committed itself to improve a limited number of features. If Samsung wants to keep releasing new models year-on-year, it has to keep improving these features (or adding new ones). Consequently, it has been pushing the boundaries of science to pack bigger and more efficient Lithium-ion batteries into its devices, while also meeting consumer demand for ever-more thinner devices. The danger with packing the components of the battery so tightly together is that the heat produced by the battery may not escape quickly enough, resulting in a “thermal runaway” whereby the temperature keeps increasing until eventually the battery catches fire. And, of course, this is exactly what happened. If Samsung could instead have differentiated itself on other parameters, like the OS, it would not have been burdened with the pressure to keep improving its own battery. And now that Android is such a popular platform, both with users and developers, Samsung and other manufacturers face significant costs of switching to another OS.
By reducing the structure of the smartphone industry to simple economic theory, we can see how the release of Android as an open-source operating system induced greater competition in the smartphone industry and resulted in lower prices and more rapid innovation to the benefit of consumers. Samsung was at the forefront of this competitive culture of pushing the envelope, with catastrophic consequences.