Why iTunes Works

Shopping pleasure, conspicuous consumption and creative expression add up to business success.

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Eddy Cue the Apple senior vice president of Internet Software and Services introduces the new iTunes Radio.

Apple did not attain the largest market cap in the world by selling legal downloads for 99 cents each. Steve Jobs' genius lay in his ability to capture the dollars consumers enjoyed spending on feelings associated with music and creativity – dollars they no longer had to shell out for CDs.

A generation ago, kids would drop their (or their parents') disposable income on $18 CDs at Tower Records. Then Napster came along, and within a decade the music stopped, or slowed significantly, for the record companies and their business model. Per capita music expenditures dropped from as much as $70 dollars a year at the end of the '90s to less than a third of that amount a decade later.

The music hadn't stopped, of course. People were still happy to spend money on music. But they spent it on fancy hard drives instead of playable plastic discs.

How is it that consumers fled from spending money on content the minute they had the opportunity – but gladly paid even greater premiums for the hard drive of choice for storing that content and playing it back, and, more recently, for the headphones that pipe it to their ears? (Compare the prices of the headphones used for decades by audio engineers to those consumers pay for "Beats by Dre.")

[ See a collection of political cartoons on the economy.]

Let's take up both sides of the question: on the one side, the factors that made consumers so eager to get their favorite tracks for free, even if the quality was inferior and the ethics were questionable, and on the other, those factors that made consumers so willing to pay a premium for the devices they used for storing those tracks and listening to them.

If you're old enough to remember Napster, or tools like "Oink's Pink Palace," the CD-quality-or-better torrent downloading community shut down by authorities in 2007, you remember the impact these platforms had. It was as if Tower Records had opened up its doors and said, "Here, come on in. You've got the run of the place." Young people began to download music by the virtual truckload, whether it was songs and albums via peer-to-peer services or whole music collections over university file sharing networks. Even after the growth of paid models like Spotify's, listeners never went back to paying on anything like the same scale for access to the tracks themselves.

Comic Mindy Kaling has a routine that encapsulates the response, in practice, of many listeners to the ethical questions regarding illegal downloading. (The routine is available for purchase on iTunes under the title "Comedy Death Ray ," and can be found on YouTube). Kaling describes a public service ad she sees playing before a movie that implores audiences: "You wouldn't steal a purse, would you? You wouldn't think of stealing a car." Her musings in response neatly encapsulate the behavioral economics at play:

You know what? I would steal a car if it was as easy as, like, touching the car and then thirty seconds later I owned the car. And … I would steal a car if by stealing the car, the person who owned the car, they got to keep the car. And… I would also steal a car if no one I had ever met had ever bought a car before in their whole lives.

As easy as … touching it, and 30 seconds later I owned it. Once songs could be downloaded for free, how much of a thrill was left in purchasing a disc with the same tracks on it?

[ See a collection of political cartoons on the budget and deficit.]

And yet, while buying an $18 CD might have lost its intuitive appeal to consumers who could obtain songs and albums with the stroke of a key or the touch of a screen, the core desire that music filled had never lost its appeal. Consumers remained ready to pay handsomely for the pleasure of buying something they associated with that desire. Especially if it was something they could consume conspicuously.

It was here that Jobs and his compatriots found gold. They seized upon the economic power of combining a pleasurable, candy store experience (been to an Apple Store recently?) that was conspicuous to others (white headphones, anyone?) and provided an escape from modern life (crowded cluttered existence, clean white interface), with … the emotional intensity of music.

Remember the classic iPod ads that showed dancing silhouettes with white "earbuds" set against their forms in stark relief? Try asking someone to describe the people represented by those silhouettes. When the authors pose this question to college students, the answers are invariably the same: the people represented by these silhouettes know which music is cool. They can dance. They are seldom stiff or awkward. They get into clubs without having to wait on line. They get dates with attractive people.

What Jobs and his compatriots did was seize upon the economic opportunity that the disruption of the music industry's business model opened up. The key was to find something else that would enable consumers to buy the kinds of associations record stores and album sleeves once purveyed en masse . (Not to put too fine a point on it, the most conspicuous use of classic Beatles images in 2012 was probably in ads for iTunes.) Sell consumers the associations of music, but locate the aspirational item, the tangible, just-out-of-reach object of desire, not in the disc but in the drive. Sell music fans hard drives, but not any old drives – sell them ones that glow from within with the power of those dancing silhouettes with the white headphones.

[ Read Steven Nelson: Nine Companies Tied to PRISM.]

Take one measure of shopping pleasure, add a healthy measure of conspicuous consumption, and mix well with emotionally charged creative expression. Research has established that shopping as an activity, for many, triggers the release of dopamine in the brain. This is the chemical, the release of which is associated with compulsive gambling.

The phrase "conspicuous consumption," for its part, was coined by Thorstein Veblen more than a century before outsized headphones became a fixture in malls and on subway cars. And you don't need to take more than a cursory look at the walls of your average college dorm room to recall how heavily invested youth identity is in self-assured personalities that flout day-to-day limitations in an uninhibited yet stylish expression of creativity and emotional intensity.

Today, music content companies (and some recording artists) continue to make money through royalties paid by services like Spotify. But those royalties are only a fraction of the ones that could be earned in the golden age of the CD. Business model, disrupted.

What's important, for would-be innovators, is to examine the value that can be captured when the "sweet spot" in a value chain moves (to borrow the late Tuck School of Business Professor John Shank's take on Porter's classic concept). At that point, there are often significant opportunities for innovators who find alternative ways to monetize the goods or services that have become cheap or free.

Often the disruption arises due to external factors, such as the emergence of digital downloading services, but sometimes it proceeds from changes driven in part by the company that benefits. Either way, smart innovators capitalize on changes in their economic ecosystem. We'll consider examples of that in our next post, in which we generalize the argument beyond the music industry and the well-known disruptions it has suffered.

For the moment, take a moment for a brief thought exercise. What is something we used to have to pay for, that has become cheap or free? What is the fundamental need we are trying to fill when we enjoy it? And what might we be only too happy to pay for in the process, if doing so promised to meet that fundamental need?

Alejandro Crawford is a senior consultant at Acceleration Group, and also teaches innovation, enterprise growth and digital strategy at NYU's Polytechnic Institute and Baruch's Zicklin School of Business. He graduated from the Tuck School of Business in 2003.

Lisa Chau recently returned to Manhattan after working for her alma mater, Dartmouth College, for more than five years. She will be offering consulting services as of July 2013.