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Will consumers determine iTunes prices?

With seemingly everyone lamenting that iTunes' songs will now cost $1.29, they should remember that consumers determine prices--at least in theory.

Updated at 12:45 p.m. to include quotes from Harvard economist Anita Elberse.

If iTunes shoppers truly believe in our free-market system, then they shouldn't worry about a $1.29 price for songs.

On Tuesday, Apple's traditional 99-cent song price was shelved. From now on, record labels can choose to charge $1.29 for new releases. Some older catalog titles will sell for 69 cents, and everything else will be available for the tried-and-true 99 cents. CNET first reported the price changes in January.

The blogosphere is full of gloomy warnings about how Apple's new pricing structure will alienate customers. But aren't consumers supposed to have the final say on market prices, at least in theory? Earlier in the day I wrote that if shoppers reject iTunes' three-tiered pricing scale, the big recording companies and Apple will be forced to retreat. I've since talked to a Harvard economist who told me that's not necessarily true.

Anita Elberse, associate professor at Harvard Business School, says each consumer has a "reservation price," or the maximum price they are willing to pay. Even if some consumers are not willing to pay the higher price, it is unlikely that all consumers will refuse to pay more--particularly the most avid fans of an artist. Collectively, consumers may not be nearly as powerful as some assume.

Elberse said finding someone's reservation price, however, is very difficult. She said the key question for Apple and the music labels is whether the people willing to pay 30 cents more for a song can make up the losses from those unwilling to pay.

"Most people in the industry that I've talked to say, 'yes, it's going to make up for that," Elberse said. "We might lose some people that are dropping out because their reservation price is below $1.29, but we make it up when we get 30 cents more from the people that stay. That is constantly the trade-off that you make."

There are limits to this concept, Elberse said. Apple could "jack up the prices to $10, and sales of music at that figure may not cover the losses from people who would refuse to buy at that price."

The new pricing scheme at iTunes could test customer loyalty like never before. Since launching in January 2001, iTunes has been synonymous with digital-music sales. Prices at the site have cost 99 cents for over five years.

The strategy has served Apple well. A recent survey by research firm NPD Group showed that 87 percent of people who buy digital music in the United States download from iTunes.

Why change now?

For years, the four biggest record companies have clamored for more control over pricing on iTunes. Apple relented, presumably in exchange for the right to sell songs stripped of copy protection software.

The big question is what the new prices will mean for Apple and the music industry.

After doing numerous tests, the big labels are confident that music fans will pay $1.29 for hit songs, according to industry sources. But in these uncertain times, determining what kind of revenue this might generate is unclear, the sources said. The recording industry is hoping that charging 30 cents less for older titles than iTunes' traditional 99-cent standard will reinvigorate sales.

It must be noted that most of the prices on iTunes are unchanged or reduced. Brad Stone at The New York Times found that of the 100 best-selling songs, only 33 are now selling for $1.29.

Of course, the music industry is trying to make up for dwindling CD sales and the losses from illegal file sharing. A lot of digital-music fans see the struggles of the recording companies as self-inflicted. They are unlikely to dig deeper into their pockets just to help the industry.

Music fans likely will do what they have always done; pay for those songs they value. Most certainly, they will vote on iTunes' new pricing with their dollars.