Cooperative Pricing in Digital Value Chains - the Case of Online Music

ABSTRACT In this paper we examine alternative pricing models for digital music from the perspective of the entire music value chain. By analyzing empirical data on the willingness to pay, we show that the turnover from music downloads could be increased by lower prices. However, such a low price strategy can only be realized if the actors of the value chain, i.e. artists, labels, collecting societies, service providers, and online shops act as cooperation partners. We develop a model to find profit-maximizing prices and show how to split up the resulting increasing revenues between the partners of the value chain to assure Pareto-efficient solutions. Keywords: Digital goods, digital value chain, cooperation, online music, empirical study. (ProQuest-CSA LLC: ... denotes formulae omitted.) 1. Introduction Even though the growth rates of online music services are remarkable we can observe an ongoing debate whether current prices are appropriate [CNN 2005; Menta 2005]. The record labels agreed to Apple iTunes' 99 Cent model three years ago. When negotiating the renewing of the contracts, some labels were pushing for higher prices. However, analysts expect that consumers would not accept such an increase of prices [Veiga 2006]. Apple's CEO Steve Jobs even characterized the respective labels as greedy [LeClaire 2006]. Against this background we explore whether low-price strategies might be a promising approach for digital music vendors. The main focus of our paper, however, is to show that an isolated analysis of pricing strategies from the perspective of a digital music retailer such as iTunes is not sufficient. In contrast, our approach suggests the need for cooperation among the actors involved in the music value chain, i.e. musicians, labels, distributors, collecting societies as well as network and financial service providers. We show that a cooperative pricing strategy can be profit-maximizing for the entire music value chain. Our approach is model-based, required data is obtained from an empirical survey. In section 2 we give an overview about related work, i.e. pricing of digital goods on the one hand and basic principles of digital value chain management on the other hand. In section 3 we use empirical data on the willingness to pay for online music to estimate a sales function using a non-linear regression analysis. This sales function serves as a basis to determine which price optimizes the turnover of digital music retailers. The results suggest a clear price cut. Section 4 shows that cooperation is prerequisite for such a price cut because the decisions of the players involved in the music value chain are interdependent. For example, it is obviously not reasonable for a distributor to set prices below the licence fee the distributor has to pay to the labels. Therefore, we develop a model which supports the determination of profit-maximizing prices from the perspective of the entire value chain. Moreover, we examine alternatives to split up the profit between the value chain partners. The empirical data serves as input parameters for the model. The paper closes with a summary and an outlook on further research. 2. Related Work Digital Goods are characterized by a specific cost structure. The production of the first copy, e. g. the writing and recording of a song or the development of software, usually leads to high costs. However, once the first copy is produced, the replication costs can be neglected [Shy 2002, p. 182]. This cost structure has an impact on pricing. While cost-oriented pricing is not reasonable in this context, the low marginal costs of digital goods enable a great variety of demand-oriented pricing strategies [Varian 2004, p.12]. In particular, research has revealed a lot of insight into the opportunities of price discrimination [Ulph and Vulkan 2000; Aron et al. 2005; Choudhary et al. 2005], versioning [Bhargava and Choudhary 2001; Jing 2002, Sundarajan 2003 and 2004; Alvisi et al. …