The Economist on iTunes

by on July 10, 2006 · 2 comments

The Economist discusses the economics of the iTunes-iPod tie in relation to the French interoperability law, which apparently was passed a couple of weeks ago. They make the familiar razors-and-blades analogy that has been discussed here on TLF before. The weird thing is, they never get around the actually making an economic argument about why the tie is economically beneficial:

The law’s opponents reach for different analogies. They compare the iPod not to the Walkman, but to printers, games consoles and razors. Buy an inkjet printer, for example, and you must buy the manufacturer’s cartridges to be sure that it will work properly. (Although French parliamentarians will not come to your rescue, European regulators might.) Indeed, manufacturers make much of their money from the cartridges, not the printer itself, which is often sold cheaply. Economists explain this business model as a clever way for companies to “meter” their customers, charging them according to use. If they could not tie their customers to their cartridges, they would charge more for the printer itself, and the kind of person who now uses his printer rarely would not buy one at all.

Apple’s business model, however, turns this on its head. Apple makes its money from sales of the iPod, not sales of music; the printer, not the cartridge; the razor, not the blade. As Bill Shope, an equity analyst at JPMorgan, puts it, the music store is a “loss leader” that serves only to boost sales of the iPod. It is as if record stores existed only to sell record players.

The article goes on to explain why this arrangement benefits Apple, but it never gets around to explaining why it’s good policy to allow Apple to tie the iPod to iTunes. I understand the argument when you’re selling cheap printers and expensive ink cartridges. That allows manufacturers to capture more of the value of the printer (by charging heavy users more) to cover development costs while simultaneously making the printer more affordable for light users, who otherwise might not be able to afford one at all.

But as The Economist notes, Apple has turned this formula on its head. And in the process, it’s made the economic argument for tying nonsensical. Now you’re over-charging light users and under-charging heavy users. By the logic of the razors-and-blades argument, that ought to simultaneously price light users out of the market while reducing the revenue captured from heavy users. It’s hard to see how that helps anyone.

Perhaps the songs are the razors and the iPods are the blades? Maybe everyone buys songs, but only certain consumers can afford to buy iPods? Or maybe “light” users buy a $69 iPod Shuffle, while “heavy” users buy a $399 video iPod? But the problem with that argument is that such a price discrimination scheme doesn’t depend on under-pricing iTunes songs. It would work just as well if Apple didn’t sell iTunes songs at all. The standard razors-and-blades argument just doesn’t seem to apply in this case.

The far more plausible explanation, it seems to me, is that iTunes songs have much stronger “lock-in” effects than iPods. This is for two reasons. First, the DMCA makes it illegal to transfer iTunes songs to a competing MP3 player without Apple’s permission. But another music store can transfer its songs to an iPod without Apple’s permission. (As eMusic does today) Secondly, consumers buy a new MP3 player every few years, but they expect to keep the music they buy for life. Hence, the costs of throwing out your music collection are much higher than the costs of pitching your iPod.

But although it’s obvious how that benefits Apple, it’s not obvious why the general public benefits from the arrangement. Indeed, I would argue that it doesn’t. While there might be good reasons to facilitate “tying” the current generation of razors to the current generation of blades, what Apple is doing is “tying” today’s blades to tomorrow’s razors. The primary effect of that, it seems to me, will be to reduce competition (and with it) in the market for tomorrow’s razors.

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