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Thursday, April 27, 2006

iTunes, iPods, and Product Tying Arrangements

In Industrial Organization, which is not my main area, there is a concept known as tying. Tying is any requirement that two products be purchased in some combination. Pure bundling, e.g. textbooks and study guides, is one form of tying, but it is a more general concept than that. For example, a customer may be asked to purchase a second product, often through a specific contract, that a first product is useless without. A copy machine contract could require the use of a particular brand of paper or that the machine be serviced by their personnel. An automobile owner could be required to purchase a particular brand of parts, oil etc. or have the warranty voided. In other cases products are designed to thwart interchangeability, e.g. vacuum cleaner replacement bags with unique sizes, so tying can be accomplished through a variety of means.

Without getting into the specifics, tying can be used to price discriminate, protect a monopoly (e.g. require PC users to use a particular software such as IE), or to protect goodwill, i.e. if a customer is allowed to use inferior parts, the product may gain a reputation of inferiority. A copy machine fed low grade paper might jam often dmaging its reputation for reliability.

Courts do not always allow tying arrangements, but they are not always illegal either. The issue in this New York Times Economic Scene column by Austan Goolsbee of the University of Chicago is tying between iTunes and iPods. Is there an argument that the economic benefits of tying exceed the economic costs so that tying should be allowed? The focus here is on the ability of tying contracts to grant market power as a means of encouraging innovation, much the same as the argument for patents, and the goodwill argument that untying the two would lead to code leaks that would allow hackers to break the security features and denigrate the product:

In iTunes War, France Has Met the Enemy. Perhaps It Is France, by Austan Goolsbee, Economic Scene, Ny Times: The French take pride in their revolutions, which are usually hard to miss — mass uprisings, heads rolling and such. So, with the scent of tear gas in the air this past month from the giant protests against a youth labor law, it was easy to overlook the French National Assembly's approval of a bill that would require Apple Computer to crack open the software codes of its iTunes music store and let the files work on players other than the iPod. While seemingly minor, the move is actually rather startling and has left many experts wondering (as ever): What has possessed the French? ...

The move may signify a willingness to question the patents, copyrights and trade secrets of other successful products as well, like electronics, pharmaceuticals, even fast food. Might we soon see a French legislator demanding to know if it is fair that customers of the French fast-food chain Quick cannot get its signature burger, Le Giant, with McDonald's special sauce? ... French politicians have abandoned one of the guiding principles of antitrust economics: penalize companies that harm consumers, not the ones that succeed by building better products.

Antitrust authorities normally follow well-established procedures when considering such moves. They weigh the loss to consumers of not being able to play iTunes songs on other players against the damage that forcing iTunes to open might have on innovation. France's own Competition Council did a similar analysis in 2004 and ruled that Apple's refusal to share the iTunes codes did not harm consumers. The legislature paid no mind to such analysis and seems not to have considered innovation at all. Therein lies the danger.

Apple largely created the online market for legal music. The record labels' own attempts flopped embarrassingly. Until iTunes, virtually no one paid for online music. Since then, iTunes has sold more than one billion songs. Its success comes largely from two crucial innovations.

First, Apple's music store is simple and works extremely well with the iPod. Find the music. Click "Buy It." Drag the files onto the iPod icon. That's it. ... Further, iTunes keeps getting better. Apple has added video capability, celebrity play lists, exclusive music, the ability to convert home movies into iPod format, and many other features — all free.

Second, iTunes has lots of music. Largely because of the innovative iTunes FairPlay copy protection and digital rights management software, Apple persuaded major record labels to let them sell much of their best content online. The combination of simplicity and variety proved a huge winner.

If the French gave away the codes, Apple would lose much of its rationale for improving iTunes. ... it continues to add free features to iTunes because it helps sell iPods. Opening the codes threatens that link. Apple would need to pay for iTunes features with profits from iTunes itself. ... Innovation would slow.

Even worse, sharing the codes could make it easier for hackers to unravel Apple's FairPlay software. Without strong copy protection, labels would not supply as much new music. Indeed, Apple argues that sharing the codes could make the pirates' job easy enough to wipe out the legal market. ...

Sharing the iTunes codes would undermine the two innovations that Apple used to create the online market for legal music in the first place. With France accounting for only 5 percent of iTunes sales, Apple would probably shut down iTunes in France rather than give up the codes. ... Before declaring pre-emptive war on iTunes, however, perhaps the French would do best to remember a lesson from 1789. Sometimes the very people calling for revolution are the ones who end up losing their heads.

    Posted by on Thursday, April 27, 2006 at 12:24 AM in Economics, Market Failure, Policy, Regulation | Permalink  TrackBack (0)  Comments (9)

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