A correction has been made in this story. See below for details.

NEW YORK (AdAge.com) -- Through its iTunes Store, Apple dominates digital music sales. But did it just kneecap that business by approving two apps that could make iTunes itself obsolete?

Apple surprised the music business this month by approving apps for both Real Networks' Rhapsody and for the heavily-hyped Swedish-based music service Spotify, both of which operate free on-demand music-streaming services. Think of having the convenience of iTunes without the need to buy or download individual files -- and you choose from pretty much all the music in the world, all the time.

Apple, through iTunes, accounts for 70% of digital-music sales. (That amounted to about $958 million in sales for the third quarter, mostly from music, according to an Ad Age analysis.) And the iPod snares Cupertino 74% of the digital-music-player market. That doesn't include the iPhone, which accounts for half as many sales as the iPod, but is growing at a triple-digit rate. However, the growth of digital music sales is slowing and iPod sales are down 7% this year.

Apple has always been about selling the hardware, to the chagrin of studios, TV networks and labels that have long complained that the only one making significant money off downloads of TV, film and music was Apple. That means it cares less about how people consume content on their devices than it does that they're using (and buying) them.

The solution, ironically, is to approve the most appealing iPhone and iPod apps, even if it cuts into iTunes' business. "While in the case of Apple there may be some substitution in terms of buying tracks, they would hate to lose the bigger picture for want of iTunes," said Russ Crupnick, VP and analyst at NPD Entertainment.

Then again, users of services such as Pandora, Imeem and Spotify "are actually heavier consumers of paid digital downloads," he said.

Spotify app coming
But it does raise an issue for Apple and any other device-maker that opens its platform to potential competitors: What to do when an app actually erodes your business? This is also potentially an issue with Google Voice, which Apple has denied rejecting from the App Store, but has not yet approved because the app, it said, "appears to alter the iPhone's distinctive user experience by replacing the iPhone's core mobile-telephone functionality."

Spotify, in particular, has technology that streams music as fast as a typical digital-music player can load an MP3, replacing some iPod functionality, in a sense. It plans to launch its service in the U.S. by the end of the year and has developed mobile apps that work for both the iPhone and the iTouch through WiFi connections) and on Android phones.

Already the startup is carrying a lot of hope that it has cracked the code for the ailing music industry, with the added bonus of being a potential competitor to Apple. Its desktop interface even looks a lot like iTunes.'

Spotify uses peer-to-peer technology that allows songs to stream very fast -- as fast in most cases as a song stored locally on a computer or portable player. Its business model is similar to a lot of iPhone apps: There is a free version that includes advertising and a "premium" subscription service that's ad-free and costs roughly $16 a month in Europe. The startup is hiring a sales staff in New York with the intent to ramp up its advertising business once it does launch in the U.S.

So far, both of Spotify's main business models -- advertising and subscriptions -- are unproven. In the wake of the Apple news, for example, Spotify stopped taking new registrations in the U.K. because they were costing too much in royalty payments before Spotify is able to ramp up its advertising business or convert many users to paid subscribers.

Spotify, based in Stockholm, wasn't able to provide an exec for comment by deadline or respond to questions via e-mail. The service is now available in some form in six European countries and has 5 million European users. It has collected 100,000 U.S. e-mail addresses ahead of launch.

Perilous model
But just because it has Apple's stamp of approval doesn't mean smooth sailing, and if Spotify is an iTunes killer, it will have to overcome difficult odds on both its models. The track record for subscription music services in the U.S. is not great. Rhapsody is the most successful, and it has topped out at under 800,000 subscribers, which is why it, too, has launched a free version. Best Buy last year claimed its music service once known as Pressplay, and Napster had over 700,000 subscribers as of last year.

Similarly, ad-supported digital music has had a slow ramp-up, but clearly some think it has potential. Pandora raised $56 million, including another $35 million in August, and CBS paid $280 million for Last.fm in 2007. Imeem, which has also raised $21 million, claims to be on the cusp of profitability through a combination of ad sales and sponsorships, audio ads, ringtones, concert tickets and digital-music sales.

"We know the music space works well for advertisers," said David Wade, Imeem's head of sales. "For us, in the beginning, scale was a concern. We had to get to 20 million [users] to get a significant enough service to partner with Fortune 100 advertisers."

If and when it does launch in the U.S., Spotify will be starting at zero. Which is why some in the industry suspect that Spotify's ads are more an upsell technique to the paid service than an endgame.

If that is the strategy, will it work? Imagine, for a fee, you get a very close facsimile to iTunes except with all the music you could ever want, on-demand, all the time. Since the early Napster days, music geeks have been clamoring for just such a service. Now that it's here, will they pay for it?

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CORRECTION: A previous version of this story said Rhapsody's free version contains ads; it does not. And, while Rhapsody's iPhone app is free to download, it costs $14.99 a month to use.