Source: RIAA, Year-End Shipments.
1. The Pre-digital Music Sector
To appreciate the scope and swiftness of the transformation brought about by digital technologies we must understand the economic structure of the pre-digital music sector. The challenge in the pre-digital music sector was to get songs onto the radio so consumers could sample (hear) them and into the record store so they could buy them. Four characteristics of the pre-digital music sector define its structure.
The challenge of bringing product to market involved high fixed costs associated with finding and developing talent, producing a master, reproducing recordings, and distributing product. This is a classic situation of scarcity, high cost and limited opportunities.
Opportunities to expose the consumer to products for purposes of sampling (radio airplay) were limited.
Opportunities to display product for consumers to purchase (retail shelf space) were limited.
A great deal of uncertainty existed about whether any specific product would sell, particularly because music is an experience good, whose value is not known until it is consumed.
22
The record labels developed a complex and aggressive set of practices to deal with the conditions of scarcity. The record labels spent large promotion budgets to convince the public to purchase the albums they wanted to make hits. This included a great deal of payola, described by Richard Caves, a well-known analyst of the economics of Creative Industries, as “a bribe paid in order to influence a gatekeeper’s choice among competing creative products.” (Caves, 2000, p. 286) These costs raised the need to make the favored albums bigger hits in a value chain that was already
focused on ensuring the profitability of a small number of releases.
With high fixed costs and uncertain markets, contractual relations between artists and record labels embodied accounting practices that delivered a very small percentage of the retail price to artists and shifted a great deal of the risk onto the backs of artists. The pre-digital music sector was notoriously hard on the artists, as one of the most often cited analysts of The Music Business and
Recording Industry put it:
The large record labels are fond of saying that fewer that 20 percent of the recordings they release ever recoup their costs. But is everything really as bad as the labels would say?... recording costs and some marketing costs are generally recouped (recovered) out of artist royalties…So, for a lot of artists who never seen any royalties on the sale of their albums the record companies are making money… In effect, artists are subsidizing the labels because recoupment of advances at the artist royalty rate is a lot slower than actual recovery of total fixed costs at the label’s gross margin per CD rate. (Hull, 2011, pp. 184… 186… 187)
These large intermediary costs can be seen as a source of inefficiency in two ways. First, the record companies that control distribution have an incentive to maximize profits at the expense of the artists and the public.
Music is owned by the artists, but in control of the sellers. There are traditional agency problems in this context. Those who have control of music distribution have incentives to sell the music that can bring them the most revenues, and distort the market by extensive and disproportional promotions in favor of a small number of works. Music listeners may not value the music produced by the big labels as much if they have a chance to know about smaller labels and new musicians; this is a severe distortion and source of social inefficiency. The overwhelming advertising campaign may further skew the consumers’ preferences and lead to distorted demand. (Zhang, 2002, p. 14)
This inefficiency was compounded by a significant information problem.
In essence, music consumers do not have accurate information on the quality of the music, because it is an experience good. Music publishers, because of the delay in obtaining market information for all of their music, may over-invest in certain music genres and under-invest in others. A typical strategy to overcome the inefficiencies and uncertainties in the market is to focus on superstars. (Gopal, Bhattacharjee and Sanders, 2004, p. 8)
2. The Digital Transformation
In a remarkably prescient article in 1994, Peter Alexander considered the prospects for change in industry structure that could flow from the introduction of digital technology.39 After
studying repeated historical examples of technological change leading to transitory outbreaks of
23
competition in the recording industry, Alexander provided the first reference to the potential impact of digital file distribution in the academic literature. He offered an analysis of the potential cost savings and the “exponential” increase in product creativity afforded by new digital technologies that were just a decade away. The key process in his view would loosen the control that a small number of powerful intermediaries exercised over the production and distribution process. The vision is so prescient, it deserves recognition.
The network for distribution in the music recording industry is highly concentrated, and many fringe firms and new entrants are unable to obtain national distribution. This trend limits the extent of competition in the industry, and possibly reduces the diversity and variety of product offerings (in part, because small new firms tend to be product innovators). If non-exclusive distribution networks existed, fringe firms and new entrants might provide robust competition for market share…. A digital delivery highway for the products of the music recording industry might take the following form. A distributor, or group of distributors, would transmit digital product samples to consumers via cable or telephone lines. The consumers could review the product samples… and then inform the
distributor… which products they wish to purchase. These products would then be uploaded to the consumers, and a charge made to the consumers’ account. A distribution network of this type may potentially attenuate the effects of the significant barriers to entry in the music business. First, it could give firms (particularly fringe firms and new entrants) the opportunity to have their products distributed in a less costly and non-exclusionary fashion. By providing product samples to consumers, the new distribution network would also transmit information relating to product specifications. This would lessen the need for more traditional and less efficient techniques, such as radio airplay and other costly
promotional activities, to inform consumers of the existence of new products. Given the modest marginal costs of adding a new product line to a digital delivery system, it is
conceivable that the number of product offerings could increase exponentially. The costs of distribution should decline dramatically, as physical distribution at national or international levels has significant scale features. A competitive digital delivery system would reduce substantially the minimum efficient scale of distribution, and likely stimulate a highly competitive producer market…. New scale-reducing technologies can erode existing market structures by facilitating new entry… [N]ew technology has fostered two periods of
significant structural turbulence in the music recording industry in which new firms, producing innovative products, displaced the existing firms. Reconcentration resulted from horizontal mergers among other factors. New digital distribution networks may promote greater competition in the industry, if they are non-exclusionary. This should promote greater levels of product diversity and variety in the offerings of the music recording industry. (Alexander, 2004, pp.121, 122)
As Alexander’s analysis foresaw and Exhibit II-2 summarizes, every one of the “functions” that the record labels had provided in the pre-digital music value chain would be dramatically altered by digital technologies. Whether we view the value chain as production, distribution, promotion and consumption or simply supply and demand it is clear that digitization affected it dramatically from start to finish. The intermediaries – primarily record labels and retailers – are squeezed from both the supply side and the demand side.
Many analysts hypothesized that by dramatically reducing the importance of key functions of the dominant intermediaries along the value chain digital disintermediation would shift the
24
deal from the labels. (Alexander, 1994, 2002; Clemons, Gu and Lang, 2002, Drapper, 2008, Kot, 2009) In fact, three other changes have had a much larger effect.