With iPod Success, Apple Takes "Network Effect" from Microsoft

During the epic Microsoft antitrust trial with the US Department of Justice (DOJ), witnesses and government experts spoke of the "network effect" that Microsoft enjoyed because of the success of its relatively low-price Windows products. Today, however, the company that's most obviously enjoying the benefits of the network effect is Apple Computer, whose iPod portable audio player now dominates an important emerging market. And, ironically, Apple's success with the iPod is coming at the expense of Microsoft and its partners, which have watched as competitor after competitor fail to make a dent in the iPod's armor.
  
The iPod, which Apple released in November 2001, wasn't the first hard disk-based portable audio player, and it didn't become a smash success until a year and a half later, when it finally tallied sales of more than 1 million units. Since then, sales have been phenomenal and have risen over time. To date, Apple has sold about 6 million iPods--2 million in the most recent quarter alone. Today, the iPod enjoys a 65 percent market share of the digital portable audio player market and a whopping 92 percent share of the market for hard disk-based players such as the Dell Digital Jukebox (DJ) and the Rio Carbon. The iPod enjoys such success despite some disadvantages compared with the competition, which often sport better battery life, better compatibility with online stores, more storage, and lower prices.
  
So why has the iPod been so successful? One reason is that Apple has been able to parlay its device into a must-have fashion accessory. Unlike the company's Macintosh computers, which are excellent but expensive, the iPod is an affordable luxury, one that young professionals and even students--or at least their parents--can afford. As Apple CEO Steve Jobs said during a recent special event marking the release of new iPod models, "iPod has become a cultural phenomenon." And he's right. Sometimes products transcend their market categories and reach into the public consciousness at a much deeper level than would usually be possible.
  
Clearly, the iPod is such a product. This situation makes it difficult for competitors such as Dell, Rio, or even Creative Labs, which arguably created this market, to make inroads with other products. Consumers aren't asking for portable audio players this holiday season; they're asking for iPods. And a Dell DJ or Creative NOMAD Jukebox Zen isn't going to cut it. Any parent or other gift-giver who believes otherwise simply doesn't understand the emotional connection Apple created between the tiny white devices and their owners.
  
But the iPod's network effect doesn't consist only of loyal fans. Apple deserves credit for steadily building on the iPod's success by introducing new products and services based on the device's platform and by nurturing a third-party market of accessories that elevates the iPod's success. Last week, Apple introduced two new iPod models, the iPod Photo and iPod U2 Special Edition, which I personally find to be lackluster, for the most part. But to the iPod Nation, these products are simply the latest validation that they've made the right choice. The iPod product line is growing, and when these loyal customers are ready to upgrade--and no doubt hand off their current iPod to another family member--they'll find exciting new choices awaiting them.
  
An obviously successful add-on for the iPod is the Apple iTunes Music Store, which offers more than 1 million legal song downloads and has sold more than 100 million songs. Currently, the iTunes Music Store dominates the online music services market with a 70 percent market share. And as Apple adds to the list of countries in which the iTunes Music Store is available, sales are rising dramatically. In May, the company sold almost 11 million songs, but that figure rose to 17.7 million songs by October. And these sales come in the face of increasing pressure from competing services such as MSN Music, Napster, and RealPlayer Music Store. As with the iPod, almost all these competitors offer real advantages over the Apple offering--including better quality songs and lower prices, in many cases--but those advantages haven't mattered. Despite the presence of several competing online services, most of which offer songs that are interoperable on a variety of software-based players and portable audio players, no one has been able to chip away at the iTunes Music Store's lead.
  
Celebrity endorsement helps. Thanks to the Mac computer line, creative professionals have long preferred Apple's products. But the iPod brings out the musicians, athletes, moviemakers, and other creative types in a most unprecedented fashion. U2, one of the most popular musical groups in the world today, has endorsed a specific iPod model and offered its entire musical catalog available for sale only through the iTunes Music Store. But U2 is only the most obvious example. All around the world, celebrities of every stripe not only use iPods but talk about them endlessly. To a nation obsessed with celebrity, this attention hasn't gone unheeded by the teaming youth of America. They want iPods, and they want them now.
  
And no iPod should stand alone. Although the Dell DJ or Rio Carbon each sport a few accessories, such as cases or belt clips, the iPod enjoys a booming market of hundreds of accessories and services, from the obvious (cases) to the sublime (a professional painting service that will apply car paint to your iPod and, optionally, its dock). To say that the iPod even competes with other products is to completely misunderstand the market. The iPod is a lifestyle. Put another way, two groups exist: the iPod and all other portable digital audio players. And the two groups don't necessarily have a lot to do with each other.
  
One area into which the iPod's success hasn't translated is Apple's long-languishing Mac line. Although Apple had hoped that a swell of iPod customers would result in higher sales of the pricey but elegant Mac, that hasn't been the case. According to Gartner, Mac's worldwide market share fell to 1.8 percent in the most recent quarter, down from 2.1 percent in the same quarter a year ago. (Annual computer sales figures placed the Mac market share at 1.7 percent for calendar year 2003.) In the United States, the Mac's market share dropped from 3.6 percent to 3.2 percent in the same time period.
  
Why has the Mac failed where the iPod succeeded? Curiously, the pundits--and I'll count myself among this group--seemingly were wrong about one crucial aspect of Apple's iPod strategy. We said that Apple was making the same mistakes with the iPod that it made with the Mac by keeping the system proprietary. But the markets for the Mac and iPod can't be compared so simply. Today, the Mac is an excellent computer but it doesn't offer much value over Wintel-based systems and is correspondingly too expensive, both in out-of-pocket costs and in the cost of migrating to a new computer platform. The Mac and the computers that compete with it typically cost $1000 to $3000, which is beyond the reach of many consumers and not a purchase to be made lightly by anyone but the truly affluent.
  
The iPod, meanwhile, is in a completely different price category. It's both more expensive and more nicely styled than the competition, but customers believe that they're getting value for the extra cost. As noted previously, the iPod is also an affordable luxury. As with iPods, celebrities also use Macs, but celebrities can afford Macs. Most regular people can't. The iPod is a celebrity accessory many more people can afford.
  
In these ways, Apple's iPod strategy can't fairly be compared with the company's Mac strategy because the iPod isn't a product you'll be stuck with for several years, as you might be with an expensive computer. Apple has done something unique with the iPod. More important, perhaps, Apple has finally beaten Microsoft at its own game. The iPod, not Microsoft's extensive platform and ecosystem, is defining the market for portable digital media. And for a company that has long struggled in the shadow of its massive competitor to the north, that's good news indeed.