While I agree that lower prices, not higher, make more sense, I don't think $0.50 competes with free much better, if at all, than $1. You don't compete with free on price alone, as demonstrated by The Penny Gap.
Or rather, the supply is only infinite if you think of iTunes as a merchant of music-- I don't. I've always thought of iTunes as a merchant of convenience. I pay iTunes (actually, I don't) because it's more convenient than alternatives, and my time is a finite resource.
However, under this conception of iTunes, charging more money for more popular songes makes even less sense because the more popular a song is, the more easily it can be found by other means. As such, a more popular song should cost less to correspond to the decreased inconveniences of obtaining it elsewhere.
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Re:
While I agree that lower prices, not higher, make more sense, I don't think $0.50 competes with free much better, if at all, than $1. You don't compete with free on price alone, as demonstrated by The Penny Gap.