Thursday, September 20, 2007

NBC Breaks the IPod's Chains

NBC is ending sales of its popular programs on Apple's popular Itunes, making digital versions of "The Office" and its kin available for free from the network. Viewers will watch the programs for 7 days before the file self destructs, but they won't be allowed to avoid the commercials. The network will also sell commercial-free versions that don't vanish from the customer's hard drive.

There are good reasons to question the move, which comes as Apple is reintroducing its ubiquitous Ipods with attractive new features, colors and advertising. But there is a chance NBC will succeed at bending the economics of the Web away from Apple and toward the network's own interests. If NBC succeeds other producers and distributors are also likely to abandon Itunes.

Problems the Network Must Overcome

NBC will lose serendipitous sales to the horde of Ipod customers who --they have no other choice --repeatedly visit the site searching for particular videos or music, and then pick up a couple of NBC programs along the way. The customers who arrived at Itunes actually looking for NBC programs will now have to find and navigate a separate website before they can watch their favorite shows.

NBC may raise the price for commercial-free downloads of its programs, charging as much as $3 more than Apple's current price of $1.99. Viewers who don't want to pay more will be left with nothing 7 days after downloading the version that won't let them avoid commercials.

All of these changes mean NBC must expect a decrease in paying customers. The potential rewards, however, could more than make up for any short-term losses.

Fighting the Power of Steve Jobs

Apple still enjoys its image as a benevolent revolutionary created by the famous commercial comparing Microsoft to Big Brother. But to NBC, Apple is using its power to produce profits by limiting its suppliers' choices.

This is because Apple is a hardware company, and Ipods provide a major part of its revenue. Ipods are useless without videos or music, so Apple created Itunes to offer downloads at uniform, relatively low, prices. This encourages consumers to buy more videos and music than they might otherwise be willing to buy.

However, Itunes only works with Ipods. The more downloads that a customer buys, the more expensive it becomes to switch from Apple's Ipod to a rival's video and music player, even if the rival is cheaper.

This leaves producers and distributors like NBC almost no leverage to negotiate with Apple. An estimated 40 percent of downloads on Itunes come from NBC. But NBC must accept whatever wholesale price Apple offers, even if that price is below NBC's costs, or below what NBC thinks it could earn if it wasn't forced to sell programs through Itunes.

How NBC Hopes to Earn a Profit

So the network will instead turn itself into a rival to Itunes. At first, it will only offer the free version of its videos. A service that allows customers to buy programs for PCs and portable players, including Ipods, should be available by the middle of 2008.

By offering free videos, NBC is using a classic strategy for entering markets by selling a product below cost. NBC expects to build demand for its new service this way, then begin offering the versions that viewers must pay for. (This strategy is frequently used with new software products).

But I expect NBC will not stop offering the free, self-destructing versions of its programs. These versions will be downloaded by viewers who are not willing to pay, or are not interested in repeatedly watching the same episode over long periods. NBC will earn revenue from the commercials.

Viewers who place a higher value on repeatedly watching programs over long periods will pay for the commercial-free versions. Even if the new price is higher than Itunes, NBC can increase its total revenues if the Itunes price was below the range where most viewers are sensitive to price increases.

Formally, changing different consumers different prices for versions of the same product is called price discrimination. Economist Hal Varian argues the low cost of digital reproduction makes what he calls "versioning" to allow price discrimination increasingly important to the Web.

Other scholars criticized media companies in an article in the International Journal on Media Management 1 for not taking advantage of digitization to adopt price-discrimination strategies that can increase the profitable distribution of their products.

NBC has now decided to try just that. The network's experiment will test the theoretical arguments in demanding market conditions. If NBC succeeds, the dynamics of Internet competition will once again change in dramatic and interesting ways.
1 Chang, B.H., Lee, S.E., & Lee, Y.H. (2004). Devising video distribution strategies via the Internet: Focusing on the economic properties of video products. The International Journal on Media Management, 6(1 & 2), 36-45.

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