Now that I’ve bought an iPod and other Apple peripherals after being disappointed with Microsoft’s attempt at entering the music service/player market, I thought I’d write up an article review describing some economics surrounding Apple’s iTunes/iPod business line. Cheers to Apple, and the music labels.

Two researchers at Harvard write about optimal licensing in complementary markets where the licensor provides a license for relatively little, but greatly enhances a licensee’s ability to profit from other revenue streams. Andrei Hagiu and Josh Lerner, Licensing IP in the Presence of Non-Contractible Complements (Oct 2006). Available at SSRN. The authors address how to maintain incentives for licensors by providing means for them to capture some of the increased value they facilitate. The risk of ignoring incentives for licensors is that breakdowns in licensing deals can lead to economic inefficiency. Further, the history of digital music is marked by the need to ensure that the incentives of all stake-holders is considered.

Excerpts from the article:

… the licensee may use the complementarities to shift its profits to the sales of products falling outside the scope of the licensing deal, thereby limiting the licensor’s ability to extract compensation for his license.

… when the licensor cannot use fixed fees, his choice between charging output-based royalties or pursuing a profit-sharing agreement with the licensee depends on the relative size of potential licensee revenues from complements and the fraction thereof that can be brought under the incidence of a licensing agreement.

…when the licensee can make more profits from complements and a lower share of these are contractible under licensing, the licensor is more likely to choose output-based royalties over profit-sharing in order to make sure the product based on his license is not given away for free.

The Harvard researchers use Apple in their economic model. Apple follows a strategy of making iTunes a “loss leader” where it makes almost no profit from its download services. Apple leverages iTunes sales to sell the iPod and complementary devices. By keeping prices for iTunes music downloads at 99 cents, Apple is also keeping down profits of music labels, which want Apple to offer diffentiated pricing schemes and hike up the cost of iTunes downloads. The licensing aspect that the Harvard researchers are interested in is the fact that Apple licenses songs from the labels for relatively very little, sells those songs as a loss leader to profit greatly from its sale of complementaries. The labels increase the value of Apple’s other complementary products but their returns don't scale to the value add.

iPod and iTunes are highly complementary and it is well known that Apple’s profits from this part of its business come largely from the sale of iPods (and other peripherals). This has led to continued confrontations with music labels, which… would like Apple to raise (prices)...

The record companies’ challenge of the iTunes ...pricing policy has been led by ...Sony BMG and Warner Music Group… Sony pointed out at a technology conference that Apple got two revenue streams (iTunes and iPod sales), while Sony only got one, which it claimed was extremely small.

To be fair to Apple, it did start one of the first successful and legal music service/player businesses. The ability to gain the blessing of the labels through licensing deals differentiated Apple from previous attempts at that market. Yet the value of the music labels' songs to Apple's overall products may not be reflected in current licensing deals. Should Apple give the music labels a larger part of the pie? Hmmm, it looks like Apple has turned the tables and gotten the upper hand in the past few years through the incredible success of iTunes/iPod. My guess is that if the music labels want to charge more for premium and new content, they will have to enable Apple to sell other content for less which would allow it to continue riding iTunes as a loss leader while focusing on its core margins in the peripheral space.