Digital music prices are too high and consumers prefer a-la-carte downloading to bundled pricing schemes. Those are the two key findings in new research by Wharton marketing professor Raghuram Iyengar. The study is detailed in an article at Knowledge@Wharton. Or you can download the 36-page PDF of the paper, “Optimal Pricing for a Menu of Service Plans: An Application to the Digital Music Industry.”

It should be noted that this is strictly an academic exercise. The study’s findings are based on surveys, not actual sales data. Anybody who has seen consumer survey results over the years knows there has been much evidence given that consumers would happily pay for an unlimited music plan that covers their mobile phone and PC. But when just such a service arrives (see Nokia’s Comes With Music), consumers are nowhere to be found.

In addition, a recommendation to lower track prices contrasts somewhat with ample evidence that consumers will pay more for hits. Billboard analysis, public statements by industry executives and comments from sources indicate a three-tiered variable pricing structure for single track downloads has actually increased revenue. Lower prices, however, could actually give retailers more flexibility to create pricing and bundle options that attract a greater number of buyers.

While Iyengar doesn’t help his case by erring with something as simple as webcasting royalty rates, the paper does offer a good deal of food for thought. Labels and digital service providers would be wise to re-think wholesale and retail rates. The creation of different types of services and pricing plans will require parties to detach themselves from traditional rates. It would be unwise for labels and services to allow download services to stagnate as they shift their attention to streaming services.

Iyengar explained to Knowledge@Wharton that labels and retailers are making less-than-achievable profits:

If I compare what their profits are when a record company charges a retailer 60 cents a song, I find that [the current] overall profits for the entire channel, which is the label and the retailer, are almost 50% lower than what they could optimally be when the record label charges lower wholesale prices.

Here’s quick rundown of what the study’s model says about prices and plans:

• For a retailer offering a single plan, the optimal per-song price is $0.54 and the optimal wholesale rate to be charged by the label is $0.23. That assumes no cost involved in producing the song. In reality, digital distribution costs are negligible but songs do come with costs. Many are sunk costs that should not influence wholesale price. Others are variable costs – such as marketing and promotion – that need to be taken into account.

• Retailers’ choice of offerings depends on the wholesale rate they are charged. When the per-song whole rate is under $0.15, a retailer is best off offering two differently priced bundles. When that rate is above $0.20, a hybrid of bundle and per-track offerings is best.

• The per-song price of the optimal subscription bundle pricing plan is lower than the per-song price, assuming the same wholesale rate. Of course, the point is that bundled pricing captures some sales that would not occur in just an a-la-carte system.

• Interestingly, the model-predicted optimal price for songs with a wholesale cost of $0.65, which is the typical rate, is close to the $0.99 being charged.

• The paper makes the case that lower wholesale prices would allow service providers to offer both an a-la-carte plan and a pay-per-song plan. In doing so, both label and retailer would make more profit.

For the study, Iyengar surveyed about 600 digital music consumers on five attributes: access fee, number of maximum available song downloads, per-song rate, audio quality and type of music available. Brand names (such as iTunes) were not used in the survey, so the study assumes there is a single player in the download market. He found that consumers prefer a-la-carte to subscription pricing, and that service providers that offer one of the two options should choose a-la-carte over subscription pricing.

A 2008 paper by two Wharton researchers (download 64-page PDF here) also approached different ways to price a-la-carte tracks. They based the study on a survey of 500 students’ valuations of 50 popular songs. When a-la-carte prices are constrained at $0.99, the pair found, the optimal bundle price is about $34. Overall, the researchers found numerous strategies (pure bundling, two-part tariffs) could raise profit over what is achievable with uniform per-song pricing.

In the real world, decisions on digital pricing and music plans are more complicated. The types of products offered are often just as much a function of service provider needs as content owner needs. For example, Apple has decided a-la-carte downloads, not streaming or subscription services, best suit its need to sell hardware. As a result, a-la-carte downloads dominate U.S. digital music sales. And to keep its proposition simple, Apple clearly does not want to offer both a pay-per-song option and a bundle option (although it does sell download cards that can be redeemed for tracks). In many cases, the value of a music store or service is not measured just in digital music profit. Apple makes more money selling iPods and iPhones that it could ever make selling music, videos and apps. Similarly, the value of a good music service is higher to an ISP (through improved customer retention and bundled services) than to a startup that doesn’t know how to properly monetize its users.

Substitution is another consideration in digital pricing. Record labels must walk a fine line between encouraging digital sales and harming CD sales (since the latter accounts for more revenue). The cannibalizing effects of lower digital prices could be disastrous in the short term. Physical retailers, who labels are working to keep in the CD business, could react negatively to being undercut by digital stores by such a great margin.

Turning back to track pricing, some experts feel track prices should be higher because tracks exist alongside albums. Note that Iyengar’s study did not account for the existence of both track and album sales. For a good discussion of the interplay between the two formats, go back to this September 2008 article in the Los Angeles Times. The topic was pricing of hit songs and how to convert track buyers into album buyers. John Healy interviewed pricing consultant Frank Luby back when Atlantic Records had pulled a track by Estelle from digital shelves in a failed attempt to improve album sales.

Luby's central assumption is that when people want to buy a song, they're insensitive to the price. That's not the same as saying the demand for music shows no price elasticity; Luby acknowledges that sales of some titles and types of music may increase disproportionately to a cut in price. But lower prices won't stimulate demand from fans of a band or a particular song, Luby argued, because they've already made up their mind to buy. In fact, he believes that labels should be raising the price of popular singles in order to generate more album sales. The right price might be $1.49 or even $1.99, Luby said. "If I've got to spend $1.99" to get each of two singles from an album, he said, "I might as well just make the leap and buy the album."