April 23, 2014

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How Competitive is the Record Industry? A Natural Experiment

Derek Slater, responding to the recent Cato paper on DRM technologies, raises an important question: How competitive is the record industry?

The Cato paper argues that market competition will blunt the possible negative effects of DRM on consumers. The theory is that a variety of competing DRM systems will emerge for online music. These systems will offer differing levels of flexibility to consumers. They will face market pressure to meet consumers’ needs, because consumers can choose which one to buy. Record companies will face competitive pressure to license their music via the DRM systems that consumers want to buy. If the DRM market is competitive, and the music market is competitive, then market forces will foster a reasonable DRM technology.

This theory has much to recommend it. But the theory works, of course, only if the music business really is competitive. If the record companies act as a cartel, they can use the resulting monopoly power to dictate the design of DRM systems, regardless of consumer preferences. Tellingly, the Cato paper does not bother to argue that the major record companies behave competitively in this respect. Instead, the section on record company competition (p. 6) talks almost exclusively about indie labels, which account for only a small piece of the overall market.

How can we tell whether the record industry is responding competitively to DRM? An interesting natural experiment is about to start. MP3Tunes, a new startup headed by serial entrepreneur Michael Robertson, is launching a new music service that sells songs in MP3 format. Will the major record companies license their catalogs for sale on MP3Tunes?

In a competitive market, they would license to MP3Tunes. There are surely some customers who are willing to pay for music but don’t want to accept the hassles of other online music services. MP3Tunes will extract revenue from these customers.

You may object that the record companies won’t sell their content in an unprotected format. But of course they already do so, and in fact most of their revenue comes from sales in the unprotected CD format. And they can’t rationally be worried that their existing catalogs will leak to the P2P networks – that already happened, long ago. It’s hard to see how licensing their existing catalogs to MP3Tunes would make the P2P infringement problem any worse.

The record companies may feel that other music services meet their needs better, for example by increasing the likelihood that consumers will have to repurchase the same song later. These factors might affect the price they offer MP3Tunes, but they shouldn’t preclude negotiations altogether. In a competitive market, producers have to offer the products that consumers want, not the products the producers like.

It’s hard to see any economically rational reason for a major record company to refuse, categorically, to deal with MP3Tunes – unless we assume that the major record companies act as a cartel. That’s why the record industry’s response to MP3Tunes will tell us how competitive that industry really is.

(Let me preempt some rebuttals by pointing out that if you want to argue about what would happen in a competitive market, your argument cannot be based on assertions about what the record industry, as a whole, wants or needs. Assuming that “the record industry” is an actor whose needs, desires, or plans matter is tantamount to assuming that the industry is in fact a cartel. Nor can you assume that any individual company in a competitive market cares about the fortunes of the industry as a whole, as opposed to its own selfish interests. Much of the discourse about the record industry assumes, implicitly, that it is a cartel. If you want to rebut my argument about how a competitive industry would behave, be very careful to avoid adopting that assumption.)

Comments

  1. DirkMaster says:

    I would argue that the records labels are each a monopoly unto themselves, as they have exclusive rights to release an album. For example, if I want to listen to any particular musician, I have to buy the albums that his label produces. One artist does not release his/her music thru multiple labels, therefore each label is a monopoly of its own artists.

  2. Cypherpunk says:

    “The theory is that a variety of competing DRM systems will emerge for online music.” It’s more than theory! Anyone can see that there are a variety of DRM policies being used in the online music business today, from renters like Napster to sellers like Apple who let you rip to CD to other sellers who restrict that ability. And there have been DRM free sellers for years, there’s nothing novel about this new company.

    The point is, consumers have had choice in DRM for years, in a competitive marketplace. And what we have seen is that they are happy with it as long as it is not too invasive. That’s why iTunes is the biggest seller in the industry. The fact that big companies don’t give their music away as MP3s means only that doing so would undercut the sellers which give them more protection. Smaller companies want the exposure so for them it makes sense to go with MP3. No conspiracy theories are necessary.

  3. Ed Felten says:

    Cypherpunk,

    I’ll grant that there are plenty of for-pay online music models available to consumers(the Cato paper argues that pretty convincingly), including services that sell MP3s.

    But I think you frame the question wrong when you ask why copyright holders would want to “give away” MP3s. Certainly they don’t want to give them away; the question is why they refuse to sell them. If the world is already awash in illegal MP3s of a song, and law-abiding customers can get legal MP3s by buying the CD and ripping (for personal use), then what’s the harm in giving those law-abiding customers the option of paying for faster online delivery of MP3s? (The benefit is obvious: revenue from sales of the legal MP3s.)

  4. Ed Felten says:

    DirkMaster:

    Yes, each copyright is a little monopoly. The question is whether, in exploiting its little monopolies, a record company is trying to maximize its own revenue, as opposed to doing what is best for the industry as a whole, or some mixture of the two. (In a competitive market, a company maximizes its own profit, without regard to the interests of its competitors.)

    Many people seem to believe that the major record companies act as a cartel in their online music strategy. I’m not sure to what extent that is true. I think their strategy with respect to MP3 sales will shed light on that question.

  5. Jeremy Leader says:

    An individual record company is only a monopoly to the extent that recorded musical performances are not substitutable goods. That is, if you have to have a recording of band X performing their hit Y, then the only (legal) way to get it is through X’s label. However, if what you really want is just some decent tunes in genre Z, you can probably shop around between several labels. Just as the Coca Cola bottling companies have a monopoly on Coke, but not on cola.

  6. Anonymous says:

    The record companies are also monopolies in the fact that they can absolutely control the availability of an artist. It is not uncommon for artists to sign multi-album deals, then have the record company shelve future projects. The artist is then locked into a contract that requires their next X albums, but won’t let them produce or release their next X albums.

    If anyone remembers the issue with Prince, and his infamous name change, it revolved around just such an issue.

  7. Iang says:

    Porter’s 5 forces and the behaviour of existing parties to new entrants explains. Also, the BCG Cash Cow square is relevant, dated thouugh it is.

    The one new thing about about the DRM / music industry battle is that the direct marginal cost of the song goes to zero for both producer and consumer (once hacked). No theory that I am aware of deals with that.

  8. Jeff says:

    A given record label may choose not to license mp3s based on market segmentation. I can only think of four classes of consumers that the licensed Mp3s could affect:

    1. Former CD buyers who will buy an album of unprotected Mp3s instead of CDs(but would not buy DRM protected music)
    2. Former CD buyers who will buy unprotected single Mp3s instead of CDs(but would not buy DRM protected music)
    3. Current P2P downloaders who would may for unprotected MP3 instead of stealing them (but would not by DRM protected music)
    4. Current buyers of DRM protected music who prefer unprotected Mp3s.

    As a simplifying assumption, I’m going to make the spurious assumption that category 1 and 4 are a wash to the record label revenues. That a label does not make more on an album of downloads than an purchased CD album or more money from one online source to another.

    A label will only license mp3s online if they believe the increase in revenue from category 3 will exceed the lost revenue from category 2. That the amount of money they will make in selling mp3s to people who would not otherwise buy the song will exceed the amount of revenue they lose because people choose to buy the mp3 single over a album full of “filler” material.

  9. Ed Felten says:

    Jeff,

    Your analysis seems to assume that DRM files and MP3s are sold at the same price. Suppose instead that DRMed files cost $0.99 and MP3s cost $1.09. Some customers will buy MP3s; and every one of them will net the record company an extra dime.

    Actually, if part of revenue from DRMed files must go to the DRM vendor as a technology license fee, then the record company could make more profit selling MP3s, even if it sells them at the same price as DRMed files.

  10. brian says:

    Is not the MP3 format in itself a licensed product? If a label wanted to not have to pay for a license fee it would us open formats like Ogg/FLAC.

  11. Jeff says:

    One more try…

    I still think that a completive label may choose not to offer music at any price . Removing my simplifying assumptions…

    The net affect on the profitability of a label offering Mp3s for sale is a function of the price at which the Mp3s are sold and the affect that offering Mp3s at that price has on the different market segments.

    Profitability = (C*(Cp – Cv) – Cf) + (D*(Dp – Dv) – Df) + (M*(Mp – Mv) – Mf)

    C = number of CDs sold
    Cp = Average price for a CD
    Cf = Fixed cost associated with sale of CDs
    Cv = variable cost associated with the sale of a CD
    D = number of DRM protected files sold
    Dp = Average price for a DRM file
    Df = Fixed cost associated with selling DRM files
    Dv* = Variable cost associated with selling a DRM file.
    M = number of Mp3 files sold
    Mp = Average price for an Mp3 file
    Mf = Fixed cost associated with selling Mp3 files
    Mv* = Variable cost associated with selling Mp3 files.

    * These values are affectively 0, but I kept them for sake of completeness.

    The values C, M, D are not independent of the values Dp, Mp, and Cp. As the price for one format changes it affects the number sold for all formats. If we assume that Dp and Cp are fixed, then we could graph the Profitability vs Mp. At either end of the spectrum profitability would suffer. Free Mp3s would devastate the rest of the market and Mp3s offered for $15 each would end up in 0 new sales but would still incur fixed cost Mf. As we move off the extremes, profitability begins to increase, and at some price, Mpmax, profitability is maximized.

    It remains possible, if unlikely, that at Mpmax profitability is still lower than it was before Mp3s were offered at all.
    And a profit motivated company would not offer them for sale.

  12. Neo says:

    “That a label does not make more on an album of downloads than an purchased CD album or more money from one online source to another.”

    Not true. Current online offerings (iTMS in particular) are at a price comparable to the per-track price of CDs, about a dollar. On the other hand, the marginal cost of reproduction is zero for one format, but not the other, so they would make more on an album of downloads than on a CD at a buck a track.

    As for different online sources, the prices of different DRM licensors might vary, and of course using an open format like ogg would avoid any licensing costs. This while the revenue per track remains a buck would translate into varying profits.

  13. kenan says:

    Some off the top of my head comments.

    Would free mp3s devastate the market? File sharing hasn’t devastated the market. Wilco seems to be doing well because of free mp3s. There is evidence also from the book market that free versions do not devastate the print market.

    (1) I don’t think we have enough data to show that Mp=0 always implies reduced C or D. In some cases it seems that Mp=0 acts as advertising and can increase C.

    (2) It seems reasonable to assume that (Cp-Cv) is smaller than (Mp-Mv). So any increase in M at the expense of C equates to more profit.

    (3) If (Mp-Mv)

  14. kenan says:

    (3) If (Mp-Mv) is smaller than (Cp-Cv) then it’s likely due to Mp being significantly smaller. Companies which offer at Mp are likely to start eroding the sales of companies which don’t. At least in a competitive market. A cartel could avoid the small Mp.

  15. Jesse Weinstein says:

    In response to Jeff’s claim, “a label could make … $2.84 per album … record labels make about $5 per CD sale. … labels get 65% of the cost of an apple download, or 64 cents.” – Wait a sec! That’s comparing album profit to single track profit. Apple sells single tracks for 99 cents, not albums. Assuming 10 songs per album, record labels make either 28 or 50 cents on CD sales per track, vs 64 cents from iTunes. So either they make *more* from iTunes, or maybe they need to sell 2 downloads per CD sale. Please be more careful.

  16. George Ziemann says:

    Judge Patel (in the Napster case) agreed with David Boies that the RIAA is a monopoly; the FTC has found the RIAA to be a monopoly: the Dept. of Justice tried to find the RIAA to be a monopoly, but the primary named members all asserted that they were foreign-owned companies not within the jurisdiction of the U.S. DOJ.

    The RIAA refused to negotiate licensing with Napster, Kazaa, Grokster, Morpheus and every other p2p venture, plus Michael Robertson’s original mp3.com.

    When is the last time Clear Channel played a song that wasn’t owned by the RIAA? Except for the people in LA and New York, when is the last time you heard music from any band in your city on the radio?

    Ever heard an original song on “American Idol”? Don’t hold your breath.

    There are hundreds of examples of the recording industry’s ongoing anti-competitive activity and the government has already acknowledged several of them as fact.

    With all due respect to Prof. Felden, do we really need an experiment to determine the record industry is a cartel? Isn’t that like running another study to determine if you get fat from sitting on the couch all day eating junk food?

  17. Michel J. Grenier says:

    Hi to all of you!

    I have grown-up with the 78 rpm, then the 45 rpm at $0.99 for 2 songs, then the 33 rpm, when recording companies began to put more songs, on a record, and still raising prices at the same time.

    It began hurting people when majors put 1 or 2 songs really liked by consumers, along with 12 to 15 others, and asked for a higher price. When the more appealing CD format hit the market, prices still went up, around $20 for 1 or 2 songs really liked by consumers. It is a very high price to be paid!

    The consumer had no choice at that time. Majors had found a way to sell the container instead of the content, at a gold price!

    It looks like if the Coca-Cola Company had tried to continue to sell its 6.5 ounces Coke bottle as the single size available on the market, at a big price.

    Coca-Cola has long since learned that product is a lot more important than its container and that you have to adapt yourself or perish. Its adaptation ability has made this company great, with the most well-known and most distributed product in the world.

    The Music industry still tries to sell the container instead of the content, when it should concentrate on the content . . . . . MUSIC.

    With the upcoming of the Internet and the mp2 and mp3 encodings, asking for intelligent and collaborative people, a new freedom culture was born.

    Consumers started to encode their old 45 and 33 rpms and store them on their computers, for content and space saving, and handiness.

    At last . . . !

    The consumer could listen to the songs he already highly paid for . . . .

    With high speed Internet connections spreading, P2P music sharing systems appeared. These systems have permitted many consumers to recuperate songs they already paid for, a long time ago, and no more accessible due to old and used “containers”.

    Some consumers have abused this system by getting songs they never bought before. Recording companies then started suing and closing most of the music sharing systems, without offering an alternate solution.

    Many underground systems were born overnight and the music industry’s problems were aggravated by consumers’ resistance and decreases in CDs sales.

    The best idea the music industry has found is the suing of young Netizens on University campuses and at home, still refusing to adapt itself to new realities. The worst case being a 12 years old girl’s one, in the USA.

    Personally, I know no industry succeeding to survive by suing its customers, and still refusing to adapt itself.

    In fact, consumers have been driven to think it is absolutely normal to download music from the Internet for free since the music industry tried to sell them a container for a big tag without a viable alternate solution.

    Recently, we have seen a drop in CDs prices, from the majors, as a desperate move to re-capture the lost market shares in a declining container market.

    Today the consumer wants to choose the music he wants, at a reasonable price, and to burn or use it on the support of his choice, his own CDs, or on his own player, fixed or on the go.

    Imagine traditional CDs printing, handling, shipping, warehousing, marketing and retailing costs. It is huge money spent for a container the consumer no longer wants under its present form.

    The new paradigm . . . . . .

    The WM-MW network founders previewed all these changes, as soon as 1997, and started working hard to design and create a new and unique music distribution system, still promoting independent composers and songwriters and helping valuable causes at local, regional, district, provincial, national and international levels.

    Today consumers are ready to pay or make a donation of $1 for a song they really like. They are no more ready to pay $20 for this song or its container.

    One of the consumers I interviewed said to me: “I would have preferred a lot more to pay $650 for music I like than paying $13,000 for the 650 CDs I have now on my shelves.”

    Consumers have now the choice with the Internet, thanks to pioneers who have understood the new market tendencies by creating new ways of owning music in a legal and ethical manner, and also respecting the composers and songwriters rights.

    WebMusic-MusiqueWeb uses the 3 A’s that have sent Coca-Cola to the summit, with an excellent product:

    * Availability: Worldwide availability thanks to the Internet
    * Affordability: Affordable price for consumer
    * Acceptability: Socially acceptable by community and the way the consumer wants it

    And . . . . it’s just the beginning . . . .

    Success belongs to people ready to catch it!

    Will you be one of them?

    Together!

    Michel J. Grenier
    President

    WM-MW network
    A Non-Profit Corporation

  18. Jeff says:

    Jesse,

    The typical CD contains 1 or 2 tracks that are worth buying, but when was the last time you purchased 20% of a CD? You can’t, instead you are forced to purchase 8+ tracks that you don’t want. By packaging the songs together the labels make more money than they would packaging them separately.

    Suppose 10 people buy a CD in order to acquire 2 tracks they want. The label makes $50 (10 * 5) profit. Suppose, instead, that they purchase 2 DRM downloads, the label makes $13 (2 * 10 * .65)

    In order to replace the profits from those 10 CD purchasers they have to sell 77 ($50 / $0.65) downloaded tracks. They’ve already sold 20, so they need to sell 57 more. And thats just to break even.

    Of course, as Professor Felten pointed out, the price for an Mp3 may be more than $0.99 and that would correspondingly change the equation.

    I also realize that some people will buy the full album in a downloaded form and that will offset some of the of the people who only buy tracks (since downloads are more profitable on a per song basis) putting together a complete model is just way more trouble than it’s worth.

    On a side note, it was both unnecessary and rude to say that I wasn’t being careful. I haven’t been disrespectful to anyone and I don’t appreciate the trolling.

  19. Neo says:

    “The typical CD contains 1 or 2 tracks that are worth buying, but when was the last time you purchased 20% of a CD? You can’t, instead you are forced to purchase 8+ tracks that you don’t want. By packaging the songs together the labels make more money than they would packaging them separately.

    Suppose 10 people buy a CD in order to acquire 2 tracks they want. The label makes $50 (10 * 5) profit. Suppose, instead, that they purchase 2 DRM downloads, the label makes $13 (2 * 10 * .65)”

    That they can get away with this “bundling” is itself proof positive that they are NOT a competitive industry. In a competitive market consumers could buy individual tracks and not only pre-filled containers. You can buy pringles and, if you don’t like fat, you can buy low-fat pringles. You can buy CDs, but if you don’t like 13 of the 15 tracks you can’t buy just the 2 tracks. The potato chip market is obviously more competitive than the music one. If low-fat pringles suddenly become hard to find and there’s a new CMAA (Chip makers association of america) in town, you’ll be reasonable to suspect that a potato chip cartel has been born.

  20. Will says:

    I must concur with George Ziemann, it is clear that the major labels act as a cartel. I guess it’d be more interesting to study the methods to destroy such a cartel.

    As a side note, I’m one of those would will not purchase DRM music online. I tried iTunes once at my Aunt’s house, Toxic is a fun song, I could not get the song to play on my computer when I e-mailed myself at home. That was enough to end my participation with any DRM that I’m currently aware of (I wouldn’t be totally opposed to the idea in theory, but I can’t concieve of a reasonable approach).

    Now if there was a service that offered .99 MP3s or other formats that I could own (instead of some DRM company) I’d be more than happy to avoid P2P and enjoy music I paid for and now own.

  21. Neo says:

    Thing is, they lie when they say they want to ensure you pay for it.

    What they really want to do is ensure you don’t own it.

    That way they can make you pay for it again and again and again…

  22. Ulrich Hobelmann says:

    Why is everyone assuming that MP3s have to be sold on their own? If the music industry doesn’t like selling single tracks, then they are certainly free to sell single albums (zipped or whatever) for, say $9.

    I personally only buy CDs on which I mostly like around 70% of the songs a lot. If I only like two tracks from a CD, then that’s a sign that I don’t really like the artist, hence I don’t buy that CD.

    That the music industry is embracing the single-track-for-sale iTunes store, indicates that many customers might want to buy more than one or two tracks anyway, so the music industry doesn’t really lose much.