The Role of Consumer Preference Development in Incremental Innovation: How Diamond Multimedia Helped Create the iPod*

The first digital music players, Eiger Labs's MPMan and Diamond Multimedia's Rio, were introduced to the American market in 1998. When Apple Computer released the iPod in 2001, total digital music player sales remained at $100 million, roughly the same level as in 1998. ' Four years later, Apple held seventy-five percent of a more than $4 billion market.2 But the strongest evidence of the iPod's popularity is not statistics; it is personal experience - one can hardly walk through a crowd without seeing the distinctive white earbuds. What made the iPod, rather than another player, a necessity for the American consumer? How was Apple able to succeed where its competitors failed? In addition to applying its considerable product design and manufacturing expertise, Apple also benefited from the earlier product releases. Before Eiger Labs and Diamond unveiled the first players, consumers were unfamiliar with players' capabilities.3 By contrast, Apple entered the market after consumers could articulate what features they wanted and how much they would pay for them. It achieved tremendous success, in large part, by correcting the flaws in its competitors' products.4 Purchasing, observing, using, and reading reviews of the earlier products developed consumer preferences, giving consumers an idea of what they wanted in a digital music player. Apple was then able to build a product targeted to meet those desires. The consumer preference development that takes place when a product is sold is an externality - a benefit conferred or a cost imposed on third parties to a transaction.5 Apple's competitors were not compensated for creating the valuable preferences that helped Apple design the iPod. Externalities lead to market failures - when costs are imposed on third parties, transactions occur that benefit the participants but harm society as a whole; when benefits are conferred on third parties, transactions fail to occur that would harm the participants but benefit society as a whole.6 Governments normally respond to these potential market failures with regulation. Intellectual property laws, for example, internalize the positive externality of technological research by preventing the use of inventions without permission of the inventor.7 Traditional regulatory mechanisms include direct legislation mandating or forbidding behavior (referred to as command and control), providing subsidies to encourage or taxes to discourage activities, and encouraging market solutions by establishing property rights. The nonexistence of any mechanism for rewarding companies for generating consumer preferences suggests that insufficient incentives currently exist for product release. In some markets, this danger is particularly pronounced. While product releases in any market will further develop consumer preferences, "radically innovative markets" such as the early digital music player market, are characterized by nonexistent preferences.8 These markets arise from technology that destroys the competencies of existing companies and that results in a major change in consumer habits and behaviors.9 The release of varied products by companies with different visions then plays a particularly crucial role in developing consumer preferences to the extent necessary to create a "dominant design" suitable for the mass market.10 This Note identifies the development of consumer preferences as a positive externality of product release, analyzes mechanisms that might be used to internalize this externality, and concludes that markets, even those resulting from radical innovations, can operate efficiently without additional regulation. I. Externalities and Incremental Innovation The utility of a transaction for society as a whole is the sum of the utility for individuals. When the only parties affected by a transaction are those directly involved, the economic benefit to society can be measured by the total profits received - the sum of the benefits conferred on the buyer and seller. …