Executive Summary:
The Record Industry in an Era of File Sharing
The record industry is undergoing substantial change from the expansion of the Internet and opportunities for transferring files. The main question, yet unanswered, is what are the record labels’ profit-maximizing reactions to these threats. The heated debate around how the record labels should respond to the Internet has, to date, been based on very general statements about the economic viability of introducing new services. Eli Snir’s research offers initial results for the music industry’s rational response based on rigorous economic analysis in “The Record Industry in an Era of File Sharing: Lessons from Quality Differentiation.”
Background
New opportunities through digital downloads of music, music on demand, and complementing CD sales with online content, offer new revenue streams for the record industry. However, the threat of substitution by new media and new distribution venues may be an even more formidable challenge. Free file sharing threatens to cannibalize the authorized sale of music by record labels. CD sales declined in the years 2001, 2002, and 2003; CD sales are now at 1999 levels. Meanwhile, music sharing services have seen tremendous growth. The Recording Industry Association of America (RIAA) blames free music sharing for the decline in sales. The labels’ main response to music sharing has been campaigning aggressively against file sharing and suing individuals and organizations that enable or even consent to music sharing. They have been slow to adopt technologies for direct downloading of music, such as musicmatch (musicmatch.com), Rhapsody (available from Listen.com), and the more recent and popular iTunes Music Store from Apple (applemusic.com).
Initial Results
The most surprising result is that introducing a downloadable music service does not increase profits for record labels, under a broad set of assumptions. This appears consistent with labels’ recent behavior. Additionally, closing music sharing services, suing individuals, ISPs and universities who are complacent about sharing, and “polluting” the pool of available music are all in the labels’ best interest. However, a number of results also contradict current practices. On the one hand, prices for CDs should decline with the introduction of music sharing services, recognizing that users have an alternative to purchasing CDs. On the other hand, the record labels should enhance the value of CDs. One such example is online content exclusively for CD purchasers, such as Bon Jovi’s CD “Bounce” by Universal Music Group. Video content readable on a PC and music DVDs also augment the value of the physical product.
Critics often complain that the industry places too much emphasis on combating file sharing, rather than adapting by adopting the Internet as a new media for distributing music. Consistent with the criticism of the industry, part of the response to file sharing should be lowering CD price. This maximizes the labels’ profits when a free, low-quality substitute exists by reducing the attractiveness of file sharing. Furthermore, both economic models used in this analysis show that labels’ benefit from increasing consumers’ value from purchasing CDs. Embracing the Internet to provide exclusive content for buyers of CDs, as a means of expanding entertainment value for buyers of legitimate music, would increase the value and profit of CD sales.
Economic analysis also indicates that the RIAA’s aggressive legal and advertising action against file sharing increases the labels’ profit. From an economic perspective these actions are aimed at impeding and de-legitimizing music sharing. The net result is reducing the quality of file sharing for potential users. It appears to be somewhat effective by the recent reduction in music sharing.
Contrary to the criticism of the labels, however, online distribution of music does not always increase the labels’ profits. Cannibalization of CD sales is a real threat. “If a consumer wants only 3 songs from a CD, he or she can pay $2.97 on iTunes instead of $16.99 for the entire CD. The net result is that consumers pay less and labels earn less,” Snir illustrates. This justifies the labels’ slow adoption of music downloading. For these services to be profitable they have to target a niche audience, while not cannibalizing CD sales.
Economic analysis shows that the profit opportunity for Internet music is quite narrow. First, with a linear relationship between quality and customer value, record labels do not increase profit by introducing a second product. Second, when the relationship between quality and value is unequal across customer segments the opportunity for a profitable Internet music service is quite narrow. “I think the results are a big surprise to most people in the music industry. There is a general belief that downloadable music (e.g., iTunes) is the future of the industry and will increase industry profits,” Snir explains. “However, this simplistic view ignores the cannibalization effect of downloadable music on CD sales.”
Concluding Remarks
The response to new technologies appears to be quite slow with many criticizing the industry for its stagnation. Missing from the debate, though, has been an economic analysis of the merits of different suggestions. More broadly, economic analysis of profitable opportunities in other industries, for example the movie and software industries, will provide guidance for traditional players in responding to networking technologies. In the future, Snir intends to extend this research and analyze the idea that downloadable music is a form of “sampling.” The idea is that downloading music provides an evaluation opportunity. Consumers who enjoy the music would choose to buy the CD. This also challenges record labels to enhance the value of purchasing a physical CD, adding content to complement music.
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