Texas Instruments - Inventing Learning Curve Pricing

Morris Chang is affectionately known as “The Godfather of Taiwan’s chip industry”. His comments about the industry are frequently taken as gospel. But before he founded TSMC in 1987 and helped lead it to become the 9th largest public company in the world (by market cap; in 2022), Chang was an employee at Texas Instruments (TI).

TI in the 1950s was mainly an industrial supplier of electronics. It was one of the places where the integrated circuit (IC) was invented, and so played a critical part in the shift from vacuum tubes to ICs. TI lab employee Jack Kilby developed the IC in 1958; in 2000, 42 years later, he would be co-awarded the Nobel Prize in Physics for that accomplishment.

The same year that Kilby invented the IC, Morris Chang left his job at Sylvania Semiconductor and joined TI as an engineering manager. He later described TI as a company that was “rising very fast”. It was only his second job after graduating from MIT, but he was soon put on the fast track.

Chang’s rise to the fast track came directly from his ability to raise yields on TI’s transistor production lines. His first production line as engineering manager was a problematic new germanium transistor for TI’s most important customer at the time, IBM. The line was problematic because it had a miserable yield of 0%. After Chang tinkered with the production process for about four months, he raised it to 20%. That yield was twice as good as IBM’s own production line, eventually leading this particular transistor to become very profitable for the company.

TI offered Chang a fully-sponsored PhD at Stanford and even offered to pay him his full salary while he completed the program. After a short two and a half years, Chang finished his PhD and returned to TI in 1964. He was then promoted, three years later, to general manager at one of their most important semiconductor departments — integrated circuits.

As general manager, Chang worked with a then little-known outfit called the Boston Consulting Group (BCG) to develop a revolutionary new pricing model for semiconductor manufacturing. It was eventually adopted by all the other players in the industry.

At the time, the pricing model for ICs was simple. Since semiconductor manufacturing had high capex, manufacturers would charge their customers high prices to recoup their large upfront costs. Chang knew from painful experience that it took a good amount of time and throughput in order to bring yields up — and therefore unit costs down — for every new production line.

But he also suspected that there was a better way of doing this. By then, Chang had much experience running transistor production lines, and he understood that new production lines typically started off with terrible yields. At the time, this could be as bad as 5% — which meant that for every 100 chips produced, only 5 would work. The low yields were attributable to a whole host of reasons, like dust contamination, defective equipment, or chemical impurities. It took time to fix all of these potential problems. Chang noticed that this fixing process could be sped up if the production line was operating at max capacity, allowing his staff to learn and iterate as fast as possible. The problem was, if TI continued to charge high prices for its semiconductors, customer demand and subsequent production capacity would be limited — slowing down the aforementioned improvement process.

Morris had BCG crunch numbers to work out an alternative pricing model — one that optimised for production volume. This eventually came to be known as ‘learning curve pricing’ (in Chang’s own words), or ‘experience curve pricing’ (in BCG’s words). The way it worked was like this: TI would price their chips way below initial costs, and therefore below prevailing market price. As a result, TI would aggressively expand market share for that particular chip. This high demand meant that production lines could be run at max capacity, driving down the time necessary to bring yields up. The pricing model also had the nice side effect of pressuring competitors to lower their prices at the risk of losing market share. Likewise, potential competitors who were hoping to enter the nascent industry would find it prohibitively expensive to compete with TI.

TI even went as far to reduce their prices every quarter, even if their customers didn’t demand it. Chang would later state that his strategy was to “sow despair in the minds of my opponents”. In an interview with Commonwealth Magazine in 2021, Chang said

‘In 1974, when I was still with Texas Instruments, I used the strategy of 'continuing to cut prices on TTL”.

This was a very successful strategy. At the time, Texas Instruments controlled nearly half of the market, but we still faced many competitors. Like Jack Welch, former Chairman and CEO of General Electric, famously told his workers: “We need to become number one or number two in every business we are in within five years, or else we need to get out of that business.”

In the semiconductor business, we always asked for profit margins in excess of 50%. My strategy at the time was to sow despair in the minds of my opponents. When even Texas Instruments could only achieve a profit margin of 40% by asking the lowest price, they knew they had to get out of the business.’

Chang attributed the controversial pricing decision, along with developing new products and ‘medium-scale integration’ (that is, embedding more transistors in each IC), as the reason for TI’s success as the biggest and most profitable integrated circuits business in the world. As a result of this innovation, Chang was promoted to VP of all of TI’s semiconductor business in 1972.

TI applied similar pricing tactics in its consumer facing business with the 1972 launch of their personal calculator. However, competitors in the calculator market were more determined — leading to a price war and an eventual US$16 million loss for TI in Q2 of 1975. Undeterred, TI launched their new electronic digital watch for a mere US$19.95 a year later. Again, the low prices here allowed TI to capture most of the digital watch market and drive out their higher-priced competitors like Bowmar and Ness Time. When these competitors went bankrupt, TI announced that they were the leading supplier of digital watches with an annual production of 18 million watches. A little more than a year later, TI further lowered the price of the watch to US$9.95.

However, cracks to the learning curve pricing model were beginning to show, at least in the consumer products division. Such low prices evaporated the already low profit margins of TI and stronger competitors learned to follow suit with price cuts. A race to the bottom had started. In 1978, Commodore introduced a LCD watch with prices starting at US$7.95. Chang was transferred from the IC business to become VP of consumer products around 1978. TI’s management wanted him to turn things around; Chang found it too difficult and eventually failed.

After two and a half years as VP, the consumer products division was still underperforming. TI shut down its once-dominant watch division in 1981 due to their failure to anticipate demand for always-on LCD watches and their inability to compete against even lower priced Asian imports. Almost 3,000 employees were laid off. TI’s watch competitors had outpriced and outproduced them.

In an industry driven by consumer preferences, TI had failed to anticipate and adapt to changing consumer tastes. LED watches, like the ones TI produced, went from a “distinctive symbol of status to a faceless commodity” as companies like Hewlett-Packard, Motorola, and American Microsystems crowded the market with their own LED watches. TI was thus saddled with a large and essentially worthless inventory of LED watches as consumer demand collapsed.

It is instructive to contrast TI’s experience in the LED watch market with Japanese watch company Seiko, which resisted the LED trend and focused on LCD and their traditional quartz analog watches. Seiko’s US chief, Hideaki Moriya, withstood pressure from department stores and stuck with his belief that the consumer LED fever would eventually pass.

TI’s application of volume pricing to consumer products ended ignominiously. To be clear, Chang was not the architect of this pricing model; TI chose to compete on price before he was put in charge of the division. Nevertheless, Chang was 'put out to pasture' with a TI staff job as senior VP in 1981. It would take at least two years, with Chang deliberating whether he should leave TI, before he made the final decision to quit in 1983 at the age of 52.

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