A few weeks ago, Apple announced a new pricing policy for the songs it sells on iTunes. Instead of every song being $.99, they now have three tiers. Popular songs have increased to $1.29. Older songs have been cut to $.69. The rest are still at $.99.

Apple defended the policy saying that the vast majority of its collection is experiencing a price cut. According to them, this is a way of getting consumers to explore their favorite artists’ older albums. If that works, it might be a win-win for Apple and consumers: our demand for those older songs is likely more elastic (more sensitive to a price change) than for newer songs, so the low price means we finally can afford the product.

Of course, the majority of the songs bought on iTunes are the popular new releases, whose prices are likely to go up. Our demand for these is more inelastic, less sensitive to a price change. (How else can you explain people paying $5 for ringtones?) The 30% price hike here might only dissuade a small percentage of customers from buying, but everyone who still buys pays 30% more, so Apple’s revenues go up. Consumers are worse off in this case, no question about it.

Looking at the 100 most popular downloads, about 75% of them are listed at the $1.29 price, while only 25% are at $.99. While the majority of songs in the catalog see a price decrease, the majority of songs people buy see a price increase.

I haven’t heard about much of a backlash as a result of this, but Apple is rightly concerned that people might think they are being treated unfairly. Consumers love it when firms lower prices for goods that turn out to be not as popular as they hoped. But we get really upset when firms raise prices for goods that are more popular than they expected.

The policy interests me because of my research in the motion picture industry. Movie theaters charge the same price for each movie. Obviously some movies are better than others, so why don’t they charge different prices? A few different studies have been done on this (my favorite is this one by Orbach and Einav).

First, movies are not like songs. With songs, you hear it first and know whether you like it or not, so you know what you’re getting when you buy it, and the point is that you want to listen to it over and over again. Most of us only see a movie in theaters once, so you’re buying a product of uncertain quality. If theaters charged higher prices for good movies and lower prices for bad ones, it might hurt both markets.  The low price is a signal that nobody else wants to see it, from which we infer that it must not be good, and that might be enough to drive people away from those movies altogether. And the higher price of good movies might drive a significant percentage of people away from those movies too — why pay more when you can buy it on DVD in 4.5 months anyway? (That’s the average “release window” between when a movie opens in theaters and when it is available on DVD.)

Second, it puts theaters in a difficult situation when dealing with movie studios. When I was working with a theater in St. Louis for my graduate thesis, it was at the time when Star Wars Episode I: The Phantom Menace was released. Everyone knew the movie was going to be huge, and the contract terms that 20th Century Fox got on the movie were insane — the studio got more of the profits (in percentage terms) than on any movie contract I’ve ever seen. As a result, movie theaters understandably considered increasing ticket prices. Expecting this astronomical demand and people waiting in line for days to see the movie, the theater chain increased the price on Phantom Menace tickets by $.25. Not much at all, right? Probably not, but it was enough to have news stations do live coverage outside theaters, talking to customers who were mad at being taken advantage of. All because of twenty-five cents.

The unexpected consequence? There was just as much backlash from other studios as there was from the public at large. The vice president of the theater chain told me that he got calls from other studio representatives asking: “Why aren’t our movies good enough to warrant higher prices?” (Remember: movie studios get a percentage of the revenues, so if theaters can increase prices and still sell tickets, that helps the studios too.) The other studios were jealous! So to avoid irritating everybody else involved, the theater stopped the practice after the first week or two.

As an economist, I love what Apple is doing. While we have statistical techniques we can use when we do not observe price variation, they rely on sometimes unrealistic assumptions. The best way to determine what the demand curve in a market looks like is for firms to change prices and see what happens to the quantity sold. One of the most frustrating things about working on motion pictures is that a) every movie is the same price at the theater, and b) theaters change their prices usually just once a year to adjust for inflation. If we observed more price variation, and saw how consumers responded to it, it would inform our analysis of consumer behavior so much more. But any time a theater has tried dropping prices, movie studios get upset because they think it might hurt their profits, so theaters don’t do it.

How will this pricing change affect you in the future? If Apple determines that there’s a huge response to the dropping of prices on less popular songs, that might end up transferring over into their movie or TV downloads too, benefitting consumers even more. The downside? If they see that the price increase boosts profits, expect more of that in other areas too…