July 25, 2016

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Radiohead's Low Price Might Mean Higher Profit

Radiohead’s name-your-own-price sale of its new In Rainbows album has generated lots of commentary, especially since comscore released data claiming that 62% of customers set their price at zero, with the remaining 38% setting an average price of $6, which comes to an average price of $2.28 per customer. (There are reasons to question these numbers, but let’s take them as roughly accurate for the sake of argument.)

Bill Rosenblatt bemoaned the low price, calling it a race to the bottom. Tim Lee responded by pointing out that Rosenblatt’s “race to the bottom” is just another name for price competition, which is hardly a sign of an unhealthy market. The music market is more competitive than before, and production costs are lower, so naturally prices will go down.

But there’s another basic economic point missing in this debate: Lower average price does not imply lower profit. Radiohead may well be making more money because the price is lower.

To see why this might be true, imagine that there are 10 customers willing to pay $10 for your album, 100 customers willing to pay only $2, and 1000 customers who will only listen if the price is zero. (For simplicity assume the cost of producing an extra copy is zero.) If you price the album at $10, you get ten buyers and make $100. If you price it at $2, you get 110 buyers and make $220. Lowering the price makes you more money.

Or you can ask each customer to name their own price, with a minimum of $2. If all customers pay their own valuation, then you get $10 from 10 customers and $2 from 100 customers, for a total of $300. You get perfect price discrimination – each customer pays his own valuation – which extracts the maximum possible revenue from these 110 customers.

Of course, in real life some customers who value the album at $10 will name a price of $2, so your revenue won’t reach the full $300. But if even one customer pays more than $2, you’re still better off than you’d be with any fixed price. Your price discrimination is imperfect, but it’s still better than not discriminating at all.

Now imagine that you can extract some nonzero amount of revenue from the customers who aren’t willing to pay at all, perhaps because because listening will make them more likely to buy your next album or recommend it to their friends. If you keep the name-your-own-price deal, and remove the $2 minimum, then you’ll capture this value because customers can name a price of zero. Some of the $10-value or $2-value people might also name a price of zero, but if not too many do so you might be better off removing the minimum and capturing some value from every customer.

If customers are honest about their valuation, this last scenario is the most profitable – you make $300 immediately plus the indirect benefit from the zero-price listeners. Some pundits will be shocked and saddened that your revenue is only 27 cents per customer, and 90% of your customers paid nothing at all. But you won’t care – you’ll be too busy counting your money.

Finally, note that none of this analysis depends on any assumptions about customers’ infringement options. Even if it were physically impossible to make infringing copies of the album, the analysis would still hold because it depends only on how badly customers want to hear your music and how likely they are to name a price close to their true valuation. Indeed, factoring in the possibility of infringement only strengthens the argument for lowering the average price.

By all accounts, Radiohead’s album is a musical and financial success. Sure, it’s a gimmick, but it could very well be a smart pricing strategy.

Comments

  1. Glad somebody finally pointed out the obvious. I can’t believe others have seemingly overlooked this point.

  2. Ed,

    I came to a similar conclusion while considering whether itunes could earn more by charging less.

    I have also conducted an analysis (but not yet posted it) on the relative value of customer versus product price. I find that discriminatory by customers, as Radio Head has done, is good, but discriminating by product is on the order of 10x more valuable. In other words, it is more important for itunes (or radio head) to be able to charge a premium for its most valued content (and likewise nearly give away the commodity stuff) than it is to figure out which particular customers are willing to pay more.

    I don’t think radio head let’s users download individual songs, but imagine that they did. My point is that 98%+ of the value of the album comes from the 1 or 2 best songs. Of course, your logic still holds about pricing since we can’t tell how customers are valuing the individual tracks in the Radiohead example.

  3. avatar Per Jonsson says:

    Why don’t go one step further, pay the customer to download a album?

  4. something else I’m wondering is how much Radiohead is making on the album. First of all they did reduce the cost of production so there’s more money left over after the sale. Secondly, if by choosing this distribution method they also side-stepped the usual payment scheme more money might also be coming straight to the band rather than to executives and middle-men.

  5. It seems to me this price at the use’s discretion is pretty much the same model as charities have been using for years, and it really doesn’t get them lots of money.
    The next attempt will lack the hype and won’t get so much revenue etc. until the next hypeable event (next band aid song ?).
    The you’ve got the problem that once an album get’s old there will be the perception that it’s already been paid for and there is no need to keep paying (I wonder how old “old” is though).

  6. Hi,

    The point I thought you were going to make about there being more profit with this model is simply that Radiohead would not normally get more than $2 per album! Typically the rest would be taken by the record company and other parties, and in this distribution scheme the two parties are solely the customer and the band’s management.

    – Chris.

  7. In Courtney Love Does the Math she suggests that only a very very lucky band would get $2 per album:

    http://archive.salon.com/tech/feature/2000/06/14/love/

    So the question here is “Did the band make money” not “What amount of money was made?”

  8. @Jean: They didn’t have a label for this release… it was a homebrew release method of their own (and it showed at times). See:

    Brandle, L. (2007). Radiohead In Direct-Licensing Deal For New CD. Billboard.com. Retrieved November 16, 2007, from http://www.billboard.com/bbcom/news/article_display.jsp?vnu_content_id=1003655864

  9. avatar Andrew Norris says:

    I’ve often wondered why there’s so little price elasticity with music — digital, or otherwise.

    The movie industry happily stocks the $5 bin at Wal-Mart, and they sell a *ton* of movies at this price. Even if the profit per unit is limited, (1) people get in the habit of buying movies, and (2) the marginal profit is still better than nothing.

    Meanwhile, there’s no $5 bin for music. Why not? Would the music industry really rather not sell you an album at all unless they can command a healthy rate for it? The result is that music sales are collapsing, and a lot of people over 30 don’t even consider buying music — they’re just out of the habit.

    On iTunes, everything is $0.99, but why? Why aren’t there online music stores offering $0.29 specials on certain tracks, or $3.99 albums, or whatever? The marginal cost of a digital copy is negligible, you could move a ton of units, and you could get disinterested bystanders to actually *buy* music again.

    Between actively combating the people who actually care about music (a story that’s been well-covered) and trying to drive everyone else away, it’s a wonder that the music industry still has any customers at all.

    It’s nice to see that bands, at least, are still willing to experiment and innovate to try and build back demand. I wish Radiohead all the best with this.

  10. By selling cheap, they annoy other people in the industry who loudly bemoan the coming doom. This moaning is much better value than an advertising budget.

  11. @Andrew:

    This is exactly what I was wondering about. Why are movie DVDs cheaper than music CDs?

    It’s even worse if you compare movie-DVDs with OST-CDs (Original Soundtrack). Why is the OST more expensive than the movie DVD? Where is the logic behind that? What about production costs? Making a music CD is way cheaper than making a movie.

    And it’s still getting worse: The movie-makers already paid for the music they used in their movie. Music costs are a regular part of the movie production costs. So why not include some MP3s on the movie-DVD? The music is there already (during opening/ending there aren’t even talking actors), we pay for it anyway whenever we buy a DVD.

    Something is very wrong here …

  12. avatar Bryan Feir says:

    @Ludwig:

    The main reason is actually fairly simple: by the time a movie is on DVD, it has normally already made back its production costs during the theatre run. Any money they make from the DVD over and above the duplication cost is pure profit.

    A CD, however, is usually the first release; so the production costs have to be included in the cost of the CD.

  13. I have been following the tragic and zany propaganda by the RIAA and their ilk for a couple of years now and they desperately hang on to and old and dying business model.

    When RadioHead came out with their new album, I paid them US $10. cause I wanted to support the launch. It was $10. less than I would have paid if I bought it in the store (not out yet) but when it gets to my neck of the woods it will be $19.95 + tax.

    Tarky7

  14. I fully support the “pay-what-you-want” model of music fees/subscriptions/whatever. If for no other reason, we get to hear the whining of RIAA execs. Worth the chuckle, as Tel pointed out. Also, we are pissing of Gene Simmons . You know you’re doing well when you manage to piss of a member of KISS.

    I figure Radiohead got all the money from the sale, and they didn’t have to share it with a middleman. We won’t know how well they did until they release their physical CD later in the year/early next year.

  15. Radiohead nicely segmented the market by offering the name-your-price, immediate gratification download encoded at 160k (good but not terrific quality). [Even people payng zero had to pay a service fee, which I presume is sufficient to prevent them losing money on downloads.] They then offer a $40 CD box edition pre-order – I don’t know what production costs are, but they capture the serious fan market with something much more expensive than a typical CD offering, and pre-ordering allows them to size the production run so they won’t lose money. If you’re a diehard fan this also makes it pretty likely that you will buy both the digital download for the immediacy AND the box set.

    Sure, there’s a lot of hype tied-in with this innovative move that will lead to more sales by them than the copycats — this is similar to Steven King’s experiment in 2000 with the ebook he sold on Amazon as one of their first downloads. But perhaps, variation and experimentation are exactly what the music industry need to do — not many entities in todays modern economy can sit on a static business model without disruptive forces coming in to eat their lunch – why should the music business expect things to remain business as usua,?

  16. @Bryan Feir:

    What about movies that don’t make it into the cinema and come out directly on DVD instead?

    What about music that already existed before the movie was made? Often movie makers take several existing songs from existing CD albums. Those songs/CDs were sold before, wouldn’t an OST be double profit as well?

    And even if there are zero OST CDs sold (or there is no OST CD at all), the musician (or the music label) gets some money from the movie makers. Using music for your movie isn’t free. You have to pay fees for every bit of music you use in movies, TV-shows, radio, videogames, DVDs, whatever.

    My thoughts about the reason for the price difference DVD vs. OST:
    The OST has low sales numbers, so it has to be expensive. Because it’s expensive, less people buy it, and the price has to be even higher. And so on …

    My suggestion for the industry:
    Sell those OSTs cheap and do it right in the cinema, after the movie ends, before people drive home. I would happily pay 5$ for the OST CD and listen to it while driving home. Or make it 4$ instead of 5$ if you turn in your cinema ticket. Getting 1$ discount on the on the OST CD is better than turning in your cinema ticket for some free French fries in the nearby fast food restaurant.

    Right after you have seen a good movie, you have the maximum urge to buy the OST. One day later you might have forgotten about the movie soundtrack, but right after the movie, you really want it. Sell the people what they want. JUST DAMN DO IT!

    Oh, and make sure every visitor of a movie can pre-order the DVD right in the cinema, right after the movie. And give them an “early bird discount” as intention to really do it.

    In other words: Change your business model! Stop beating a dead horse!

  17. I always wonder how much money is ‘enough’ for this kind of work? Just how rich rock star ‘should’ be? How much richer than school teacher or construction worker?

  18. I’m just sad. Alot of my favorite bands won’t put Cd’s out anymore. People just want disposable music and bands now. The local music / DVD store closed this year. Now I have to travel or use the Internet for a good CD. Damn you apple. Damn you MTV and damn whoever raised a bunch of people to expect everything for nothing. $ 9.99 per CD would be good. I can’t stand Walkmans so I don’t see a point in ipods. Get over it America. Listening to a bunch of compressed music. Buy a cool stereo and jam like it was meant to be jammed. What a forgetful generation this is. It will all come to a head soon.

  19. Remember songs last forever. It takes alot of talent to pour music from your soul. How about attacking athletes for being overpayed to play sports that we play in our yards at home. Millions for football, basketball, baseball. Come on. Rock stars should be rich. Music is not easy. Most artist spend years broke and most have to give up. This is killing the music industry.

  20. It takes alot of talent to pour building design from your soul. Engineers should be rich. Building engineering is not easy. Most students of that speciality spend years studing. They should be able to by their own jet liners, like rock stars do.

  21. This economic analysis ignores the most important point. Music, like other forms of information, falls into the category economists describe as “public goods”. A public good is defined as a good that is nonrival, meaning that if one person has it then someone else can still have it too, and nonexcludable, meaning that if you give it to one person you pretty much have given it to everyone. Clearly information goods are nonrival, and absent DRM they are nonexcludable as well.

    The problem is that in a market system, public goods will fall in price to the cost of reproduction, not creation. And since the cost of reproduction of information goods is almost zero, the market price is not enough to pay for the creation of the goods. This produces a classic case of market failure, in which the amount of good produced is less than that which optimizes the net total happiness of society.

    Without workable DRM, information goods will be permanently underproduced. If DRM could be made to work (perhaps for software and interactive games at least), the public good would become a private good and the fundamental theorem of economics would then apply, leading to optimal provision of the good.

    Understanding these fundamental principles of economics is IMO crucial to any consideration of laws and policies regarding information goods, intellectual property and the like. I would encourage analysts to familiarize themselves with these ideas.

  22. Hal,

    Two responses come immediately to mind.

    First, whether DRM is feasible is not something that you or I or anyone can just decide. It is, to a large extent, a fundamental question in computer science. The answer is what it is; we can’t decide it any more than we can decide what the speed of light is or whether the Goldbach Conjecture is true.

    Second, the economic model you cite fails to predict the behavior of Radiohead’s customers. Why, in your model, would anybody pay even a penny for Radiohead’s music, when they could have it for free, without infringing? Something else must be going on.

  23. Ed:

    Good point about the failure of Hal’s model to predict the behavior which has been observed. To that end I would suggest this quote from Joseph Schumpeter:

    Economists are at long last emerging from the stage in which price competition was all they saw. As soon as quality competition and sales effort are admitted into the sacred precincts of theory, the price variable is ousted from its dominant position. However, it is still competition within a rigid pattern of invariant conditions, methods of production and forms of industrial organization in particular, that practically monopolizes attention. But in capitalist reality as distinguished from its textbook picture, it is not that kind of competition which counts but the competition from the new commodity, the new technology, the new source of supply, the new type of organization (the largest-scale unit of control for instance) – competition which commands a decisive cost or quality advantage and which strikes not at the margins of the profits and the outputs of the existing firms but at their foundations and their very lives. This kind of competition is as much more effective than the other as a bombardment is in comparison with forcing a door, and so much more important that it becomes a matter of comparative indifference whether competition in the ordinary sense functions more or less promptly; the powerful lever that in the long run expands output and brings down prices is in any case made of other stuff.

    For two reasons:

    1. It focuses on the variety of competition, excluding only price competition, which is very often what those promoting bad policies are often pre-occupied with. They usually say ” needs more payback, so saddle the economy with this disadvantage or take away this freedom, so we can make a buck.

    2. It reminds us that taking away freedoms can have unintended consequences, as no one can predict the variety of forms possible competition will take. In particular the “largest scale unit of control” and “the new type of organization” does relate to phenomena like free software.

    The “DRM is necessary so it must be workable” is an example of an informational exclusion–something doesn’t fit your theory, so you don’t see it.

  24. I agree that our preferences do not determine whether DRM works or not. I thought that was clear when I said, “If DRM could be made to work…” and further pointed to types of information where it might arguably be better suited, namely dynamic content which cannot be passively recorded and played back.

    The real thrust of my message is that we should *hope* that DRM can work, otherwise the world will be a more impoverished place. The insight that DRM adds to the net total well-being of the world seems to be completely missed in most analyses I see of the issue, yet it is a straightforward prediction of elementary economics. You can argue against it but at least you should recognize the existence of this first-order prediction and then perhaps go into why the standard conclusion would not apply in your case.

    As far as the existence of charitable giving and other seemingly non-renumerative economic activities, yes, of course they occur, but historically they have been at a small level relative to what can be achieved via selfish motives. That is why we have governments that take care of the poor rather than relying on purely voluntary donations. Hoping to base content creation on a similar voluntary basis is never going to provide the levels of support that would occur if appropriate property rights could be assigned and enforced. I suspect that in the end we will see “socialized music” paid for out of government taxation, just as the government has stepped in to deal with other forms of market failure.

  25. There’re more sources of income than just selling recordings. In countries where piracy blooms, artists are pretty rich nevertheless. Their business model is completely different though. Recordings are published only after artists capitalize on new material. They do it in the form of live public perfomances/tours, perfomances on private/corporate parties and various TV/radio apperances. Popular artist can live a year with money he/she earned on New Year corporate parties.
    Just an example of amounts of money in this business – Jennifer Lopez was paid $2m for perfomance on a private party. And that is not an isolated case.

  26. Hal has written an odious lump of balderdash that is in serious need of public correction here.

    Let’s begin with “I thought that was clear when I said, “If DRM could be made to work…””

    This is rather like starting a proposal to the UN with “We could easily solve third world hunger if the moon were made of cheese”. All that cheese! There for the mining, and perfectly preserved against spoilage by the airless vacuum of space. Too bad it would cost around $1 billion a pound to mine and ship with present technology — and what they actually brought back at roughly that price point was pounds of dusty ancient rocks instead.

    “The real thrust of my message is that we should *hope* that DRM can work”

    Then you are either a nut or a shill for the entertainment industry. In fact we should hope nothing of the kind. Workable DRM could and would be used to undermine all freedoms and ultimately might even kill us all. How fortunate that it turns out to be impossible then.

    “otherwise the world will be a more impoverished place.”

    Balderdash!

    “The insight that DRM adds to the net total well-being of the world seems to be completely missed in most analyses I see of the issue”

    That’s because it’s completely bogus. DRM makes whatever it’s attached to less valuable and more scarce; it follows that developing DRM or applying it to anything is a negative-sum game. Much like vandalism, theft, or murder, though less severely on a case by case basis, DRM drags down an economy; it is not Pareto optimal and its presence is always a symptom of either market failure or bad government interference.

    Apple’s iPod monopoly and various government-granted monopolies are the primary market failures and government interferences responsible for present-day DRM.

    DRM stopped a relative of mine from playing on her iPod a free downloadable extra track she was able to get with proof of purchase of a CD she bought. I don’t see any way in which this benefits the economy. The DRM made both the iPod and the extra track less valuable; the tracks on the CD itself are more valuable because they can be played on the iPod quite easily. The loss of utility due to that DRM is a deadweight loss to the economy, which you’d apparently defend as desirable.

    “yet it is a straightforward prediction of elementary economics.”

    No, it isn’t. Rather the reverse; see above.

  27. “The real thrust of my message is that we should *hope* that DRM can work”

    If DRM really worked this would only help to preserve existing business models.

    Is this really what we should hope for?

    To me the current situation is a bit similar to medieval times, when Gutenberg invented book printing. There had been monks/friars who created books by handwriting, but their “business model” was no longer viable. Books suddenly became cheap and available to everyone.

    Imagine Gutenberg had stopped his work because it would destroy the existing business model of the writing monks. What would our world look like today? We would be stuck in medieval age, eh? You and I probably wouldn’t be able to read or write.

    Now instead we live in the digital information age, where we are able to copy books, music, videos and all other forms of information at basically no cost at all. Everybody can do it with his computer at home. Information can be published and exchanged via Internet. Information is available everywhere, to everyone.

    Information technology will change our world in a massive way. It already does, and it wont stop.

    … no wait, someone is trying to stop it. The content industry, by inventing DRM technology. They want to make books, music and videos un-copy-able. In other words: They want to stop the digital information age, because it might kill their business model.

    Is this really what we should hope for?

    (excuse my bad grammar, english is not my mother language)

  28. The Church tried to burn all them new printed books back in the day too, but in the long run they didn’t succeed in stopping the clock, nevermind actually turning it back. The RIAA’s efforts are equally futile. They may cause some damage — mostly to themselves — but they are physically incapable of prevailing; at the root, they’re actually up against the second law of thermodynamics. One corollary of which is sometimes stated as “information wants to be free”.

  29. An interesting example is the admission cost to the Metropolitan Museum in NYC. In fact, admission is pay what you want, but you have to pay something unless you are a NY school kid with an ID. The list price is $20 for admission, $15 for seniors and $10 for students. Most people pay $20, and that is that. I usually pay the full admission, except for one time when I arrived less than an hour before closing, and the ticket taker was most sympathetic.

    Pay what you want won’t work for goods with high marginal costs, but the cost of an additional visitor at the museum, or an additional download of a song, is low. Once they’ve decided to open the building, or finished production of the song, they may as well get what they can.

    You can probably come up with a list of properties that work with pay what you want:

    – minimal marginal cost
    – low or no resale value
    – no indirect resale value, that is, can’t be used to build something to sell
    – not a necessity, that is, purchase is a matter of taste

    Music and museum visits work like this.

    Events have a slightly different pricing model. Once an event is over, its value goes to zero, so one expects the price to start low, to grab the early planners, then rise to catch the late planners, then plummet to capture any money that happens to be flopping around. Broadway plays follow this model with advanced ticket sales, scalped ticket sales, then discount TKTS booth sales. Air travel used to follow this model with cheap advance purchase fares, expensive walk up fares, and cheap standby fares. Unfortunately, security has made standby fares impractical.

    Too many people act as if things have intrinsic value. Gold bugs are almost religious, as are music and movie executives. The simple fact is that in a market there is no such thing as value. Value is a derived property, like temperature or pressure. The only thing real is price.

  30. You learn this in the first day of Economics 101: Price Elasticity

  31. A. Smith:

    Yes, this is basic economics. Which makes it even stranger that this has been virtually missing from all of the commentary about Radiohead’s model.

  32. I described a mechanism to enable an audience to haggle with the artist over the price of copies a few years ago: The Digital Art Auction.