On Sept. 26, the federal government revealed that economic growth in the second quarter was an anemic 1.3 percent, rather than the previously estimated lackluster 1.7 percent.
Is there economic hope for the future? A widely reported JPMorgan study released in early September suggested that Apple's iPhone 5 would increase 4th quarter economic growth by between 0.25 percent and 0.5 percent. Surely the iPhone 5 is a great device and will have many sales around the world. Unfortunately, I believe the JPMorgan calculations are not accurate.
Like a good tall tale, this one has a superhero, the Apple iPhone 5. It single-handedly comes to rescue a damsel in distress, or at least the American economy. And like the stories of Paul Bunyan or Johnny Appleseed, generations of Americans were destined to retell the story of the Apple iPhone 5 rescuing the American economy. If only it were so.
The JPMorgan study estimates that each iPhone 5 costs $200 landed from China, and that the effective retail price of the iPhone 5 would be $600. JPMorgan assumes the difference of $400 is all value added, and multiplies that amount by 8 million projected U.S. sales in the fourth quarter to achieve claimed $3.2 billion in American value added, or $12.8 on annualized basis. Then, mysteriously, the $3.2 billion is associated with a 0.3 percent increase in GDP growth.
There are several mistakes in the calculation, some inaccurately expanding the plausible growth, and others reducing the growth. First is an arithmetic mistake: in a $16 trillion economy, an increase in value added of $12.8 billion would be less than 0.1 percent growth, not 0.3 percent growth.
Even the $3.2 billion in "value added" is likely illusory. On the revenue side, Apple receives less than $600 as the wholesale price that it sells handsets to carriers. Depending on the contracts with the carriers, Apple's wholesale compensation may not come immediately with each retail sale of iPhone 5 and may stretch long past the 4th quarter of 2012. Even the credit card payments for many of iPhone 5s that Apple sells directly to the public in the fourth quarter of 2012 might not clear until the first quarter of 2013.
Moreover, Apple's sales distribution network is not costless and not purely value added. Thus, Apple's margin on its sales of the iPhone 5 in the 4th quarter are likely to be substantially less than the $400 in the illustrative example, and not all of the margin is attributable to value added.
Margin and value added are related but not identical concepts. Margin is the difference between revenue and a measure of cost; value added, in contrast is the value of the contribution of labor and capital in a product or service. Macroeconomic concepts, such as GDP, are constructed from value added, not margins. A product or service such as an unprofitable wireless service can have a negative margin but substantial value added.
Calculating the margin on iPhone 5s for wireless carriers is even more problematic. Few sales are based on the full retail payment for the iPhone 5, but instead are largely based on a heavily discounted price plus a 2-year contract. If a carrier pays Apple $400 for an iPhone but charges its customer only $200 for the phone, the margin is a negative $200, at least in the 4th quarter of 2012.
As noted above, a negative margin for carriers on iPhone 5 sales in the fourth quarter does not mean that value added is negative. But it is very difficult to allocate a portion of the value added of a wireless carrier to individual handsets. Customers purchase a package of services from carriers--handset, wireless service, network services, customer services, billing services, maintenance and repair services, and other less visible services. There are many possible ways of allocating the value added of a wireless carrier to one of the dozens of handsets used by customers, but no single allocation method is necessarily correct.
For the reasons above, to mention just a few, the calculation of $3.2 billion in value added on U.S. sales of iPhone 5s in the fourth quarter is difficult to support unambiguously.
There is a more troubling aspect of the JPMorgan calculation. In measuring a contribution to the growth of GDP, one must assume that the alternative is no activity. The JPMorgan study implicitly assumes that, but for the iPhone 5, there would be no economic activity to absorb some or all of the $3.2 billion in claimed value added. This assumption cannot be right.
Some or all of the economic value added that goes into the iPhone 5 might have alternatively gone into other Apple products, or other wireless products manufactured and distributed by other companies, or even into other products and services favored by consumers. Under the scenario, American consumers want to purchase 8 million iPhone 5s in the 4th quarter. No doubt, based on revealed preference, consumers choose the iPhone 5s rather than any of countless alternatives available in the market. But it does not follow that, but for the presence of the iPhone 5, consumers would have not engaged in other transactions.
Thus, to measure the contribution to incremental economic growth, the real economic contribution of the iPhone 5 should be measured in terms of the added economic activity that would not have happened had the iPhone 5 not been in the market. That is a calculation that JPMorgan has yet to make. More accurately, the iPhone 5 will account for substantial, but as of yet unmeasured, economic activity, but economic activity that largely or at least partially would have gone elsewhere had there been no iPhone 5.
While most of the errors in the JPMorgan study tend to overstate the value added of the iPhone 5 in the 4th quarter, other errors go in the opposite direction. In particular, the study excludes the vast majority of Apple sales--those outside the United States. In the first three quarters of 2012, Apple sold 98 million iPhones globally, only a fraction of those in the United States. There is some American value added in each of those sales: substantial returns on American capital and American management. Moreover, in 2011 Apple had $25 billion in net income, all value added from capital.
So we are left with an America with an economy growing at 1.3 percent and a sad state of affairs. JPMorgan estimates, erroneously, that the iPhone 5 will add 0.3 percent to GDP growth in the fourth quarter. No one knows exactly how much the iPhone 5 will contribute to GDP, but there is no doubt that the broader wireless sector, including manufacturers such as Apple, have been among the few bright spots in a dismal economy. This broader wireless sector continues to innovate and to offer new products and services that consumers demand. The sector, relatively unregulated, grows at rates substantially greater than the rest of the economy. If only the remainder of the economy could do even half as well as the wireless sector, America would be a rapidly growing economy.