Was Apple's huge success just due to market distortion? iPhones shouldn't be $700...

At least not in 2013.

(Photo: Peter Dejong/AP)

(Photo: Peter Dejong/AP)

The big question on tech watchers’ minds heading into Apple’s latest quarterly earnings report on Tuesday is: what’s wrong with the company? While Apple could once do no wrong, it has seen its share price swoon more than 40% over the past few months, closing below $400 last week for the first time since Dec. 2011.

As I wrote on Thursday, there’s nothing really wrong with the company per se—it’s just that Moore’s Law is finally catching up to it. Apple is almost entirely a hardware company, with 94% of its revenue coming from selling iPhones, iPads, Macs and iPods. Only 6% of its hefty cash flow comes from iTunes, apps and software sales (it’s doubtful this will change materially for the current quarter).

With Moore’s Law continually accelerating the price-performance ratio of all hardware, those companies that make most of their money from such goods will inevitably come back down to earth, regardless of what kind of run they have. And boy did Apple have a run—its decade of iPod-to-iPhone-to-iPad was an unprecedented string of hardware hits that will be difficult for anyone, including the company itself, to duplicate.

In the grand scheme of things, it’s virtually impossible for a hardware maker to stay out ahead of exponentially advancing technology for very long. Inevitably, competitors catch up and either make better stuff, or they make the same stuff, but cheaper, which is exactly what has happened in both smartphones and tablets.

Here’s an interesting thought, though: Apple may never have become a huge success in the first place were it not for a distortion in its bread-and-butter market: smartphones.

All of its other products are sold directly to consumers through various retail outlets, whether they’re physical or online, which means they’re competing for (virtual) shelf space with every other manufacturer. Apple of course likes to maintain a premium price on its products, but that bare-knuckle competition generally disciplines the company from taking too high a margin.

The iPad is a prime example. The device made its debut in 2010 at a basic price of $500. Rivals were determined to prevent the company from running away with the market like it did with iPods and iPhones, so the competing tablets came fast and fierce. Amazon and Google were the first to the mark with decent alternatives, both of which came in at significantly lower prices. The Kindle Fire and the Nexus 7 both initially sold around $200, with Amazon now selling its basic tablet at just $159.

Apple had no choice but to follow suit, fighting back with the $300 iPad Mini last year. As chief executive Tim Cook put it, the company had no choice but to cannibalize its own higher-priced iPads with the lower-price option, because if it didn’t, someone else would.

So there you have it—the forces of competition worked exactly how they should have, with prices coming down quickly.

Conversely, there are smartphones. The basic model of the first iPhone, when it was released in 2007, cost $599, although Apple quickly slashed it down to $399 after people complained it was too expensive. Now, six years later, a basic iPhone 5 costs $699 flat out.

What gives? Sure, today’s model is much, much better than yesterday’s, but isn’t Moore’s Law—coupled with competition—supposed to make technology cheaper as time goes by? That certainly is what happened in tablets and with pretty much every other category of electronics in history, from TVs and computers to GPS devices and e-readers.

The difference is, phones generally aren’t sold directly to the consumer; they instead go through a middle man in the form of a wireless carrier. The carrier buys the phone from the manufacturer, then tries to recoup its cost by bumping up monthly charges to customers, who have to sign on for multi-year contracts in exchange for the subsidy.

This is supposedly how customers can acquire those $699 phones without having to pay for them fully up front. But is this the best way to assure that they’re getting the benefits of competition between manufacturers? The experience in every other electronics category suggests not.

Imagine if, somehow, all cellphone contracts were made illegal. All of a sudden, phones would have to be sold on store (and virtual) shelves through unfettered competition, just like every other gadget. The likely result: prices would shoot downward, the same way they’ve done in tablets and every other category. You can’t help but wonder how much that initial $399 iPhone’s descendent might be selling for now if that was how the market worked.

Apple has benefited tremendously from the current setup. In its previous quarter, 55% of the company’s $54 billion revenue came from iPhone sales, while iPad sales accounted for 18%. In other words, Apple pulled in about triple the revenue from the iPhone as it did from iPads, despite only selling twice as many of the former as of the latter. Put simply: each individual iPhone makes a lot more money than a comparative iPad, and it’s all because of the distortion.

This phenomenon has not been lost on other hardware makers, and it was indeed the focus of a feature I wrote last year. Microsoft, for one, has experimented with selling Xbox consoles on a contract tied to its online Xbox Live service. Not only are software and services more resistant to Moore’s Law, the iPhone has also demonstrated that inserting middle men into the equation is also a good way of inflating the price of hardware. When the consumer is removed from paying the true cost of a product, prices don’t come down as fast. It’s only a matter of time before someone tries this—and perhaps even succeeds—in other electronics categories.