The iTunes Business Model and its Widespread Effects
iTunes, love it or hate it, you can’t ignore it.
This is actually a research paper I wrote for a class some time back (pardon the occasionally dry tone), and I feel it’s worth sharing. It is indeed a long read, but give it a shot and hopefully you may learn something new!
Update: If you’d like to read my follow up paper about why iTunes hasn’t actually changed much, click HERE.
On April 28th 2003, the entire world of music – the business, the industry as a whole, our perceptions of it and interactions with it – would begin its most rapid change in history. Apple had just released iTunes, a proprietary digital media player application, along with the iTunes Music Store, a software-based online digital media store.
Within five years of its release, the iTunes Music Store became the number-one music vendor in the United States. In less than seven years, over 10 billion songs had been purchased from it.
While the immediate success of the iTunes Music Store is indisputable, its effects on every aspect of the music industry are at many times unclear. Has it revitalized a once rapidly failing industry? Has it allowed for more equal distribution among artists? Has it helped independent records labels’ reach? Has it given more freedom to artists? While there are an infinite number of questions that could be asked about iTunes’ effects, I would like to attempt to tackle some of the most important – and at many times disputed – issues.
The Failing Music Industry: Background in Brief
1998 marked the initial stage of the digital music revolution. With the emergence of Peer-to-Peer (P2P) networks such as Kazaa and Napster, music files could be copied and distributed freely over the internet. This technology allowed for users to bypass the established market for the music, eventually leading to accusations of copyright violations. Along with increasing hard drive sizes in computers, digital music was rapidly becoming an appealing, and not to mention “free”, alternative to CDs, the predominant form of music sales at the time.
In the year 2000, retail values of record sales in the US measured $14 billion. By the time the iTunes Music Store had been released in 2003, sales fell to $11.8 billion – a 14 percent decrease. By 2007, the industry fell to $10.4 billion – a 37.7 percent decrease from 2000 (with adjusted inflation[i] – further details can be found in Table 1 in the appendix). In Steve Knopper’s book, Appetite for Self-Destruction: the Spectacular Crash of the Record Industry in the Digital Age (2009), he discusses how the “major records labels consistently failed to heed warnings or to support any measures that embraced the change in technology.”
In their reluctance to adapt and embrace emerging technologies, the music industry chose to fight illegal P2P file sharing. In 2001, Napster was successfully shutdown and thousands of users were threatened with legal action. However as Knopper later mentions, this “failed to slow the decline in revenue and was a public relations disaster.”
The Failing Music Industry: Other Factors?
While nearly all would agree with the direct correlation between illegal downloading and the decline in music sales (much research has studied it), there was a study[i] published in 2004 that suggested otherwise. Performed by Harvard Business School associate professor Felix Overholzer and University of North Carolina, Chapel Hill associate professor Koleman Strumpf, the study observed 1.75 million downloads over a 17 week sample period.
In their models, they found that it would take nearly 5,000 downloads to shift sales of just one physical CD. I quote the authors: “While downloads occur on a vast scale, most users are likely individuals who would not have bought the album even in the absence of file sharing.” They point to other factors of the failing music industry: increased competition from other entertainment forms (DVDs, video games – each of which grew in sales over the same period).
While it is nearly impossible to validate either side of the research over the other, one fact remains clear: whether or not illegal downloading played a part in the decline of the music industry, the record labels are ultimately to blame for their persistent reluctance to embrace the digital revolution. When Nikki Hemming, chief executive officer of Kazaa, first heard of Overholzer’s and Strumpf’s study he said, “Consider the possibilities if the record industry actually cooperated with companies like us instead of fighting.”
Digital Music Retailers and the Release of iTunes
While online music retailers did exist in 2003, all were based on a subscription service, charging a monthly fee allowing users to access their “catalog”. One such retailer was Rhapsody, officially launched on December 3, 2001. By 2002, Rhapsody had secured licenses with the five major record labels of the time: EMI, BMG, Warner, Sony and Universal.
iTunes functions under a different pricing model: it is an à-la-carte MP3 store, where individual songs can be purchased all at the same price. The iTunes Store opened on April 28, 2003, after Apple signed deals with the five major record labels previously listed. In its first 18 hours, iTunes sold 275,000 tracks. In five days, it sold more than 1,000,000. And while at first iTunes was reserved solely for Mac users, Apple released Windows compatible version in October 2003. Within three days of the release of the Windows version, the iTunes software had been downloaded over 1,000,000 times and more than 1,000,000 songs had been downloaded.
iTunes Market Share
To date, the iTunes Store boasts over 14,000,000 songs worldwide. On February 24th 2010, iTunes hit 10 billion downloads (a full chart can be found in the appendix under Table 2). In April of 2008, the iTunes Store surpassed Wal-Mart in becoming the US’s largest music retailer. Apple currently holds a monopoly in the market, accounting for over 70 percent of all legal music downloads.
iTunes’ primary competitor is Amazon.com’s digital music store: AmazonMP3. Launched in September of 2007, AmazonMP3 currently has a 7.6% market share. Early reactions to AmazonMP3 were generally positive. Lack of DRM, higher quality audio files and cheaper prices made it a very appealing alternative. However, many users agreed that browsing the iTunes Store was a much more pleasurable experience, and once Apple removed DRM, it was clear that Amazon no longer had any advantage.
Subscription based retailers really aren’t much competition for iTunes. Rhapsody currently charges a $10 monthly fee for access to their catalogue of over 9,000,000 songs. Napster – which after being shutdown in 2001 from copyright lawsuits, was bought out and has since become a legal service – is the current leader in subscription based online music retailers. In 2008, Napster’s net revenue for the quarter ending in June 30, 2008 was $30.3 million – iTunes profits are near 2-3 billion (Apple does not release separate figures of iTunes sales).
How Does iTunes Work?
iTunes functions as an intermediary between a label and a consumer, just as a label is an intermediary between an artist and a consumer. With each added intermediary, the artist receives less percentage of each sale. While I am a firm believer in the artist seeing most, if not all, of the money, it is important to understand the function and at many times the necessity of the intermediary services of labels and iTunes.
While the functions of a record label are many, quite possibly the most important is the distribution of music. With the popularity of internet music distribution through iTunes, artists have become less reliant on labels. This has scared many labels into developing new business strategies leaning heavily towards revenue in live performances such as “360 deals” or “multiple rights” deals.
Many new artists are choosing to avoid record deals completely, believing that they not at all essential to their business plans. This has also greatly affected recording studios. As the digital revolution has greatly increased availability of non-expensive home recording hardware and software, artists can create high quality music from a garage or bedroom and instantly distribute it to a worldwide audience through the web and iTunes.
As David Kusek and Gerd Leonhard mention in their article from 2005, “The Future of Music: Manifesto for the Digital Music Revolution”, consumers have greatly benefited from the ease with which music can be discovered and shared: “this has given consumers unparalleled choice in music consumption and has opened up performers to niche markets to which they previously had little access.”
Another interesting change in music consumption is the introduction of “recommendations” and iTunes Genius. The release of iTunes 8 in September 2008 introduced the iTunes Genius feature. Genius, using various algorithms and collaborative filtering, recommended new music to listeners based on their current library and musical preferences. This marked an important change in the way listeners could actually discover music. The radio, long saturated by commercial music from the top record labels, was no longer the only source for discovering new music. Unfortunately, most listeners tend to purchase only what they hear on the radio – accounting for their still large dominance of sales. While this is slowly changing, it is still essential to understand that this was basically the first time listeners could choose for themselves. Even record stores offered limited choice – especially considering the vicious cycle taking place in stocking CDs. Because the falling sales of CD, “big retailers such as Wal-Mart were cutting the amount of shelf-space they gave to music, which in turn accelerated the decline.[i]” Genius greatly increased accessibility to lesser known artists and labels (the last chart in Table 3 shows the recommendation process), allowing for a much more democratic and user oriented process for discovering music.
However, as a music lover and crate digger myself, I cannot refrain from commenting on the recommendation process from a more personal perspective. Finding new music, much like love between people, is an incredible adventure. It is an exhilarating rush to find something new, with no previous expectations. However, when reduced to simple algorithms, the recommendation system removes the entire process of discovery. In fact, it removes all processes – it is instant gratification. Losing the self-adventure removes much of the satisfaction of discovering new music. This is why I refuse to use recommendation services.
However, I am aware that the love for music discovery is not a widespread trait, and that ultimately, the recommendation process has enabled more apathetic users to “discover” for themselves. Maybe not great for a few, but it has turned out to be a great resource for countless others.
The ability of listeners to pick and choose has also created many changes in the actual sales process. But before I discuss these, it is important to understand how iTunes sales functions.
For every 99 cents song sold on iTunes, Apple receives a 35 percent cut. While this seems quite large at first, any transaction involving a credit card through iTunes incurs a 25 cent fee from the credit card company. However this fee is charged only for each transaction (meaning six songs downloaded will still only have a 25 cent fee). Apple has created a highly intelligent and nearly profitable system of delaying reporting transactions, waiting several days to group a user’s transactions together, therefore only paying a single fee. Record labels receive the remaining 65 percent and then pay the artist between 8 and 11 cents. According to these numbers, and artist must sell 1,229 albums or 12,399 individual tracks via iTunes per month to earn US minimum wage.
While I have previously criticized Apple for recycling an aged business model, I was surprised to learn that, despite their incredible amount of sales, Apple does not see much profit from iTunes. This is definitely a topic of contention. In 2008, Saul Hansell wrote an article for The New York Times titled: “The iTunes Store: Profit Machine.” While at first Hansell discussed the highly profitable business model of iTunes, he was later informed how the credit card fees functioned, and had to update the article. Despite Apple’s intelligent system of grouping transactions together, most users purchase only single songs at a time, greatly reducing overall profit margin.
Once again, I point my finger back at the record labels, but they’re not really making any money either. As The Economist reported in 2008[i], “paid digital downloads grew rapidly, but did not begin to make up for the loss of revenue from CDs.” iTunes isn’t making much profit, nor are the record labels, and artists make next to nothing through individual song sales. Is there any money to be made in the world of online music retail?
The Long Tail: A Rapidly Changing Economic System
An interesting statistical property has been studied in the world of online retail. It is called the “Long Tail,” popularized by Chris Anderson in an October 2004 Wired magazine article[i] (check it out to see the detailed graphs that explain a lot). While Anderson used Rhapsody and Amazon for his study model, all concepts are just as applicable to iTunes – if not even more. I highly recommend reading the entire article as there are many other incredibly interesting implications, but in short, Anderson describes this retailing concept of “the niche strategy of selling a large number of unique items in relatively small quantities – usually in addition to selling fewer popular items in large quantities”.
Anderson describes that “far too we’ve been suffering the lowest-common-denominator fare, […] subjected to manufactured pop. Why? Economics. Many of our assumptions about popular taste are actually artifacts of poor supply-and-demand matching – a market response to inefficient distribution.”
The beauty of online retail is that there are no actual shelves distributors must fight for. A digital retailer does not have to worry about selling only what is most popular (profitable). Because of near-infinite space, iTunes can host anything and everything – from current number 1 Katy Perry to my favorite techno producers who, unfortunately, no one in a mile from me has heard of.
Much of iTunes’ success comes from their ability to host an enormous catalogue without having to worry about what will sell. This has been an incredible revolution for artists. As I mentioned earlier, artists are now able to instantly distribute their music to a worldwide audience, what I consider to be a reasonable trade-off for lack of profit in digital sales.
The Demise of Mass Appeal Manufactured Pop?
Unfortunately, my title comes from wishful thinking. According to charts, current popular music from the top four record labels still dominates sales; accounting for 85 percent of all downloads. However this number is slowly changing. In 2004, Nielsen SoundScan reported independent record labels at a 17.36 percent market share. In 2005, this number rose to 18.13 percent. Sure, it’s only 1 percent. But 1 percent of $12 billion is $120 million, $120 million more towards music that actually deserves its title.
The downfall of the recording industry was inevitable. The digital revolution and the idea of selling intangible media have radically changed all media industries. Many criticize iTunes for not supporting artists enough, but artists really weren’t making much money right before iTunes anyways.
I believe iTunes was a necessary development. It has given artists more freedom than ever before, allowing them to reach niche markets. Consumers can actually choose now. Long gone are the days of going to Tower Records to purchase a CD from an artist I had heard only one song of from the radio – only to find out it was the only good song on the album.
However, I believe iTunes is a necessary development through the digital revolution only as a transitional phase. In 2010, a Nielsen study showed that digital sales for single track downloads were flat in the U.S. market in 2010. Current trends show that there is less of an incentive to download and own music. Web-based music streaming sites have had a surge in popularity. Once again, artists make even less money through streaming: an artist must stream one of their songs nearly 1 million times in a month to make minimum wage. Is there really no money to be made in digital music distribution?
Perhaps the future model of music releases will be à la Girl Talk: “pay what you want”, if anything. While artists may be frustrated or scared now, I remain optimistic. The world of music is changing at an indescribable rate. We are still in the transition phase of applying dated economic and business models to an intangible media. Those who attempt to embrace this change (Girl Talk, Radiohead, etc…) and create a new system are already beginning to implement more sustainable systems – at least for now.
[i] Anderson, Chris. “The Long Tail” Wired, October 2004.
[i] “The music industry”. The Economist. Jan 10, 2008.
[i] The music industry”. The Economist. Jan 10, 2008.
 Digital Rights Management – Originally, iTunes files were encoded, making them only playable with iTunes or an iPod. Also, users could only access their purchased songs in the m4p file format on a maximum of five computers. In his Thoughts on Music open letter in 2007, Steve Jobs discussed the constraints of DRM, arguing that it only hurt customers who chose to legally download music. In April that year, “iTunes Plus” became an option: DRM-free music and higher audio quality, but at a higher price. In October, iTunes Plus files became automatic and were reverted to the DRM Price.
[i] The Effect of File Sharing on Record Sales, An Empirical Analysis, http://www.unc.edu/~cigar/papers/FileSharing_March2004.pdf, 2004