Network effects, lock-in, and how it’s affecting the ...



Group E

Ryan Herring

Jinghua Luo

Kevin Mack

Shahram Rezaei

Assessment of the Downloadable Music Industry

The downloadable music industry is a huge market in the United States and around the world. How this industry evolves in the future will depend on a number of factors including combating piracy, employing effective pricing and establishing technical standards. Additionally, the market forces at work, particularly network effects and lock-in, will play a big role in determining who comes out on top. Currently, Apple is dominating this industry from both the content and digital player perspective. For other companies to get a piece of Apple’s market share, they will need to take into consideration all of the factors discussed in this paper.

Intellectual Property and Piracy

Copyright

A copyright is an economic device designed to spur innovation. A "copyright" offers protection for original works of authorship fixed in a tangible medium, such as a compact disc (CD) or hard drive. A copyright owner has the exclusive right to reproduce the copyrighted work, to prepare derivative works based upon the copyrighted work, to distribute the copyrighted work to the public, to perform the copyrighted work in public, and to display the copyrighted work in public.

Generally, copyright protection extends to two elements in a sound recording: (1) the contribution of the performer(s) whose performance is captured and (2) the contribution of the person or persons responsible for capturing and processing the sounds to make the final recording. Copyright in the recording usually belongs to the relevant record company, and copyright in the lyrics usually belongs to the artists.

Online Piracy

When a user downloads copyrighted music without permission, the user is violating exclusive right of the recording company and the artist to reproduce the copyrighted work. When music is downloaded in such a fashion, both the recording company and the artist suffer. The recording company loses directly because a retail version of the album was not purchase through a legal channel, and the artist loses indirectly because the royalty payments the artist receives from the recording company are typically based upon the number of sales made through legitimate distribution channels. Piracy has dramatic effects on the music industry. For example, the Recording Industry Association of America (RIAA) estimates that each year the music industry loses $4.2 billion to piracy worldwide. To combat online piracy, the RIAA has started to file lawsuits against illegal downloaders. The music industry hopes that the threat of criminal and civil sanctions, coupled with the availability of low-cost downloadable music from providers such as iTunes, will dissuade internet users from continuing to pirate music.

No Electronic Theft Act of 1997

The No Electronic Theft (NET) Act sets forth that sound recording infringements (including by digital means) can be criminally prosecuted even where no monetary profit or commercial gain is derived from the infringing activity. Punishment in such instances includes up to 3 years in prison and up to $250,000 fines. The NET Act also extends the criminal statute of limitations for copyright infringement from 3 to 5 years. The RIAA is planning to use the Act to prosecute illegal music downloaders in the near future.

Digital Rights Management

Many digital music services, including iTunes, employ digital rights management (DRM). DRM, often referred to as copy protection, limits what functions a user may perform with digital media. Apple, for example, reserves the right to change at any time what you can do with the music you purchase at the iTunes Music Store. For instance, in April 2004, Apple decided to modify the DRM so people could burn the same playlist only 7 times, down from 10. Microsoft, similarly, utilizes Microsoft's Windows Media Audio (WMA) DRM. Although DRM is commonplace in the downloadable music industry, Sony has announced that it plans on shipping CDs with DRM built-in. A user who purchases such CDs will be allowed only to rip the music into specified formats a specified number of times. DRM has become and will continue to be an essential element of the downloadable music industry.

Standards

Downloadable music files are generally available in three incompatible formats: MPEG-1 Audio Layer 3 (MP3), Advanced Audio Coding (AAC), and Windows Media Audio (WMA). The MP3 format, which became ISO standard in 1993, has been the most popular digital music compression technology among users who engage in peer-to-peer file sharing. MP3 is also widely supported by a large variety of software and hardware including CD and DVD. However, only a few online stores sell music in MP3 format, and most of the music sold is indies or DIY music far away from the mainstream. Moreover, the popularity of MP3 began to enrode when Thomson Consumer Electronics, which controls MP3 patents, decided to charge licensing fees for MP3 encoders and decoders in 1998. Concerned about potential lock-in, many vendors of MP3 compatible products chose to move away from MP3 to other alternatives, notably AAC and WMA.

AAC has been designed as an open-source successor to MP3. The AAC format offers considerable performance improvement over MP3 and has become an ISO standard since 1997. Although less widely supported than MP3, a number of companies have developed products that are compatible with AAC, such as Apple’s iTunes and iPod, Sony’s PlayStation, and cell phones from Nokia, Motorola and Sony Ericsson. Apple’s iPod music player and iTunes music store have 74% and 85% of their respective worldwide markets,[1] and hence AAC is clearly the dominant standard for commercial music downloads. However, Apple has developed proprietary extension to the AAC format so that music downloaded from iTunes can only play on iPod and iPod cannot accept music downloaded from competing services.[2] Such incompatibility has caused enormous headaches for Apple’s competitors, consumers, and content providers.

Another well-known proprietary format is WMA, which was initially created by Microsoft to avoid the licensing issues associated with MP3 patents. However, with the growing popularity of iPod and iTunes, Microsoft has repositioned WMA to be the competing format against AAC. WMA files can be played on most portable players not named iPod and are sold at most online stores other than iTunes. Despite wider interoperability than AAC, WMA is still considered a minority in the world of legal music downloads.

With the growing popularity of commercial music downloads, Microsoft and Apple are once again fighting a fierce standards war, this time not between Windows and Mac, but between WMA and AAC. For Apple, winning this standards war will afford it monopolistic power in online music retailing and sustain the dominance of iPod. For windows, wide adoption of WMA can increase the sale of its DRM software. Both players have respective key assets that may help them winning this standards war. Table 1 provides a summary of the key assets possessed by the two companies In general, Apple has a competitive advantage over Microsoft in terms of first-mover advantage, manufacturing abilities, and control over a large installed base of customers. However, how the standards war will play out depends largely on how each company designs and implements strategies that make the best use of its key assets. The Network Effects and Lock-in section will discuss their strategies in more detail. Before a winner from the standards war emerge, however, MP3 is likely to remain as the dominant standard in peer-to-peer file sharing and serve as the medium to solve the interoperability problems between proprietary formats.

Table 1: Key assets comparison in music formats between Microsoft and Apple

|  |Apple |Microsoft |

|Control over an installed base of customers |X | |

|Intellectual property rights |X |X |

|Ability to innovate |X |X |

|First-mover advantage |X | |

|Manufacturing abilities |X | |

|Strength in complements |X |X |

|Reputation and brand names |X |X |

Pricing

The price of downloading a song is $0.99 almost every legal place on the web. However, it is cheaper if you buy an album. Since soon after the introduction of iTunes and iPod by Apple (2002), this company has held most of the market share. Currently, as mentioned earlier, Apple sells the vast majority of all songs sold online. Mainly because iPod and iTunes are closed off from Napster and other digital music services. Only files downloaded from the iTunes website are compatible with these devices. Napster used to be dominant a few years ago.

In terms of volume, the market for music downloads from the internet tripled in value during the first half of 2005 and now accounts for 6 percent of total record industry sales, a sign of how fast online delivery of music is catching on. The value of digital music downloads to computers and mobile phones rose to $790 million in the first half of this year, up from $220 million during the same time last year, according to the International Federation of the Phonographic Industry (IFPI).

Table 2 lists price for downloading and listening from iTunes (Apple), Yahoo!, Napster, and Wal-Mart. Wal-Mart is included because it offers $0.88/song price which is cheaper than everywhere else. Nevertheless, it contains over half a million song compared to like over two million songs available on iTunes.

Table 2. Music download and subscription price comparison

|Provider |iTunes |Yahoo! |Napster |Wal-Mart |

|Price |$0.99/song |$0.99/song |$0.99/song |$0.88/song |

| |$+9.99/album |Listen: $4.99/month |$+6.95/album |$+9.44/album |

| | |(+1 million songs) |Listen: $9.95/month |(+0.5 million songs) |

| |(+2 million songs) | |(+1.5 million songs) | |

Yahoo! announced in August 2005 that it will keep its subscription service at the trial price of $5 per month for a one year commitment, which is priced well below competitors' prices of about $10 a month. Trial subscriptions were launched in May 2005. Although, subscription service is not a downloading service, it has an impact on that. The more subscription becomes popular, the less interest there is for music downloads. In order to increase switching cost, providers ask for an annual subscription. In addition, users are required to install music engines. The music engine software is 5 MB, 11 MB and 32 MB for Yahoo!, Napster, and iTunes, respectively. After installing the engine, people become familiar with its features and gradually it becomes undesirable for them to move to another service and start over.

Apple’s revenue was $2 billion at the end of 2003, a year after the introduction of the iPod. The company's net income grew to $63 million, compared with a net loss of $8 million last year. That year, iPod and iTunes represented roughly 9 percent of whole revenue. They were expected to eventually account for more than 50 percent of Apple's revenue. This happened to some extent in the last fiscal quarter (July-September 2005), where about 6.5 million iPods were sold, accounting for nearly a third of Apple's revenue. Those sales resulted in 75 percent revenue gains on iPod and record profits. Apple's net income rose to $320 million, up from US$61 million in the year-ago quarter.

Network Effects and Lock-In

There is no disputing the fact that Apple is the dominant player in today’s downloadable music industry. Apple has a vast majority of the market for both downloadable music and portable music players. Naturally, there are many companies trying to get their own piece of Apple’s share and the decisions made by these companies in the coming years will determine how this industry evolves in the future. The continued dominance of Apple is subject to two essential questions: (1) how will Apple continue to innovate and market their technology in order to maintain their dominance? and (2) how will other companies work together in their attempts to cut into Apple’s market share? These two questions can be simplified into asking how Apple and others will deal with network effects and lock-in.

Apple and Network Effects

The downloadable music industry has no inherent reason for there to be significant network effects. As mentioned in the section on standards, there is a widely available and used open source format for digital music called AAC. Additionally, the other proprietary formats MP3 and WMA have free players available. It is therefore possible for there to be complete collaboration between companies so as to make it possible to download any song to be played by any program and used in any way a consumer chooses. Such collaboration is clearly not commonplace in today’s digital music industry, though. With the introduction of the iPod/iTunes combination several years ago, Apple created an environment in which network effects would play a huge role. By only allowing their customers to download and listen to music through Apple products, Apple quickly locked-in a substantial customer base through clever marketing and strategic deals with several recording companies. Almost immediately, Apple was able to convince music consumers that the iPod was the music player. This caused more recording companies to jump on the iTunes bandwagon, which in turn made it even more enticing for consumers to buy iPods over competing products since there was greater choice through iTunes. The interaction here between consumers desire for a product influencing recording companies behavior and similarly, recording companies desire to make their music available through iTunes influencing consumer buying behavior, was something Apple clearly recognized and capitalized on.

Moving forward, Apple continues to enhance the network effects at work here by expanding the capabilities of the iPod as well as adding new features and content available through iTunes. The recent introduction of a video capable iPod is an excellent example of Apple’s ability to manipulate an industry. While the initial available video content is small, the fact that Apple has convinced ABC to make its television shows available for small prices indicates that this industry will probably flock to Apple much as the recording industry did. By adding these new capabilities to the iPod, Apple continues to make the iPod the most attractive choice to potential buyers.

Responding to Apple’s Dominance

Many companies have been trying for the past several years to make a dent in Apple’s market dominance. For the most part, these attempts have been unsuccessful, but several companies are beginning to figure out what it takes to compete with Apple. Recently, Microsoft and RealNetworks joined forces to take on Apple. Microsoft currently has its MSN music download service as well as Windows Media Player software for playing music on a computer. Microsoft’s main interest in the music industry is to convince people to use Windows Media Player instead of competing products like iTunes. The reason for this goal is that Microsoft wants to continue its dominance of Windows products and if everyone uses Windows Media Player, Microsoft can more easily enforce digital copyright protection and prevent piracy. In essence, Microsoft hopes to be providing the means for any and all digital consumption. On the other hand, RealNetworks has established itself primarily as a subscription service company, providing music, video and games. RealNetworks hopes to convince consumers that they need not deal with Apple in order to access digital media. By forming their partnership, Microsoft and RealNetworks are attempting to make music and other digital media available on as many portable devices as possible. By allowing consumers the power of choice for their portable player, they decrease the strength of the network effects currently working to Apple’s advantage. In the long run, consumers will shift towards more flexible means of consuming digital media, which means they will choose portable players that work on as many platforms as possible, allowing them access to as much content as possible.

One important thing to note is that Microsoft is NOT trying to make the digital music industry completely open so that consumers can choose any product they want, but rather Microsoft is trying to promote generic players in order to help them create a dominant position in the software portion of this market. Microsoft’s goal is that everyone will be consuming digital media through Windows Media Player and to that end, Microsoft is promoting standards for how digital players download media from a computer as well as attempting to provide as much content as possible by combining forces with RealNetworks and potentially others. The forces at work here in both the case of Microsoft and Apple are that each company is trying to establish a competitive market for the complementary products to their main products. Windows Media Player gains market dominance with the existence of cheap portable players and downloadable content. The iPod gains market dominance with the existence of cheap downloadable music. RealNetworks can gain market share if consumers can purchase cheap portable players and easily download media onto those players. The iPod is the product that has achieved market dominance to this point, establishing a competitive market for a wide range of digital media.

In addition to establishing cheap complements, companies are also trying to develop “all-in-one” devices. Consumers are already seeing the possibilities of having a cell phone, personal digital assistant, music player, video player, email, internet, and more all in one device. By bundling their services, companies hope to lock-in customers to their line of products and services. Why buy an iPod and a Blackberry if you can buy a product that will function as both at less cost than the combined prices? These “all-in-one” devices will result in industry-wide consolidation over time as companies realize that they will not be able to compete as a provider for only one type of content. Apple has realized this fact, which is why they have added video to the iPod and have also helped develop an iTunes capable cellular phone. Ultimately, Apple will need to do more in order to maintain its dominant position.

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[1] Source: Apple Computer, September 2005. The number for iTunes is calculated based on commercial music downloads.

[2] Music downloaded from online stores can be converted to MP3 which is supported by almost all music playing devices. However, the conversion is usually prohibitively cumbersome.

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