iTunes: friendly or foxy?

It seems Apple’s thinking about giving iPod owners free access to the iTunes download service! Are they just good souls or is there a more sinister, profit-seeking motive behind their announcement (tongue firmly in cheek)? The first thought of every economist when they see something like this is to scream “price discrimination”. It looks like a classic case of a two-part tariff where the marginal cost of providing the tunes to a customer is zero; which it probably is, since Apple will likely pay a lump sum to the record companies rather than a per track sum. However, this is only half the story here.

Apple is indeed using the two-part tariff to try to encourage more people to buy tracks on iTunes in order to boost their profits. But why would having more tracks bought increase their profits? Well, first, they are getting more people into the iTunes network by bundling it with an iPod. Thus they directly gain revenue from extra membership fees.

Secondly, it is important to recognise that iTunes is a platform for record companies and consumers to interact. In a two-sided market like that there are strategic complementarities between the two user groups. When Apple recruits more people to the iTunes network it increases the value of its platform to the record labels. That is why Apple can afford to offer a lower price to the record labels for their tracks than Nokia: their platform is more valuable to the labels. The labels can leverage the large customer base of iTunes to gain physical disc sales and revenues from associated merchandise. The more valuable the iTunes customer base, the better Apple’s bargaining position relative to the labels.

So the reason Apple would want to switch to bundling the iTunes service with iPods and do away with a charge for the tracks is twofold: they want more customers to increase their revenues. This is the classic price discrimination. They also want to increase their customer base so that they can reduce the price they pay to the record labels and boost their profits from that side of the market, too.