Knowledge Problem

Lynne Kiesling

Yesterday Apple announced two changes to its iTunes policies: they are introducing price discrimination, and they are removing DRM copy protection from the songs sold through iTunes. Resulting from extensive negotiations between Apple and record companies, these are two long-anticipated and welcome changes, and they are the consequence of competition in two different parts of the music value chain.

The price discrimination is something that’s been discussed for years — why sell all songs at 99 cents when some people are willing to pay more for some songs (such as new releases), and some songs are clearly not as popular? Furthermore, why not allow those prices to change as demand changes over time? Discount those bygone new releases! As noted in the New York Times article on the move,

… Apple, whose dominance in online music sales gives it powerful leverage, agreed to a longstanding demand of the music labels and said it would move away from its insistence on pricing all individual song downloads on iTunes at 99 cents.

Instead, the majority of songs will drop to 69 cents beginning in April, while the biggest hits and newest songs will go for $1.29. Others that are moderately popular will remain at 99 cents.

The other move, allowing the sale of DRM-free songs, is the record companies’ concession to Apple in return for allowing the price discrimination. From the Wall Street Journal article on the move:

Apple also said it is dropping digital rights management, or copy protection, from eight million songs in its catalog effective immediately, and from the remaining two million in its catalog by the end of March.

Apple’s DRM has made it complicated for iTunes customers to use competitors’ products, like SanDisk Corp. music players or Microsoft Corp.’s Zune. Among the limits imposed by the software locks, it is difficult or impossible to play songs purchased from the iTunes Store on devices other than the iPod or iPhone.

Apple already sells songs from some record labels, including EMI Group Ltd. and many independent labels, without DRM. Now it is moving to selling everything, including the catalogs of the other three major labels — Sony Corp.’s Sony Music Entertainment, Vivendi SA’s Universal Music Group and Warner Music Group Corp. — the same way.

I think Tyler Cowen is wrong that these moves are “first a way to raise prices, yet without the consumer seeing nothing in return.” They may be a way to raise revenue for both Apple and the record companies, but the only way that this move will raise prices is if the dramatic majority of songs purchased through iTunes are the higher-priced new releases. Moreover, sinced the songs are DRM-free, each song actually has more desirable qualities to consumers, so it makes economic sense that they would be willing to pay more per song for a DRM-free song than a DRM-encumbered song — so if prices are essentially higher, so what? Mutual exchange of value for value, and we all know that price discrimination is value- and efficiency-enhancing.

What’s really interesting in this story, though, is the dynamics of the rivalrous market process through which this outcome has come about. The first competitive driver here is Amazon’s DRM-free music store, which has been competing very effectively with iTunes since its opening and cutting into iTunes’ revenues. The second is the strategic interaction between the record companies and Apple, and how the lack of downstream competition for iTunes induced record companies to offer their music DRM-free through Amazon, but not through iTunes. This decision was part of a deliberate strategy to induce online retail music competitors for iTunes, because the record companies wanted to dilute iTunes’ downstream market power. Apparently they believe that they have achieved this outcome, because they were willing to strike this agreement with Apple; similarly, Apple has felt the revenue-reducing effects of competition from Amazon, inducing it to agree to change its pricing in return for getting to offer DRM-free music.

I love this. It’s a great case study in the dynamics and the strategic interaction inherent in rivalrous market processes.

You can also upgrade your old DRM-encumbered iTunes music to DRM-free for 30 cents per song and 30% of an album’s cost (around $3.00). CNet’s conclusion on this point is particularly important:

With the move, Apple’s iTunes is also making its strongest foray into interoperability. From now on, iTunes’ music should play on any digital player, meaning iTunes users don’t have to worry about their music libraries being locked out of some future digital music player.

In other words, DRM-free music in a standard format (and now both AAC and MP3 are standard) will “future proof” purchases of music in the face of possible future changes to music players, the firms making music players, etc. The move from a proprietary architecture to an open architecture using an industry standard is good for competition, good for consumers, and good for innovators who will develop these future music players, of whom Apple is likely to remain a large one.