Effects of MP3 Technology on the Music Industry: An Examination of Market Structure and Apple iTunes
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Effects of MP3 Technology on the Music Industry:
An Examination of Market Structure and Apple iTunes
Kasie Blanchette
April 23, 2004
I would like to thank my advisor, Professor David Schap, for his encouragement, direction, and support throughout this study. I
would also like to thank Professor Kolleen Rask and Professor Miles Cahill for their guidance.1
History of Music Recording Technology
Beginning in the nineteenth century with the era of Tin Pan Alley, sheet music distribution was the source of
the music industry’s revenue. Little interest in the mechanical reproduction of sound existed until 1877 when Thomas
Edison developed a tinfoil-wrapped cylinder rotated with a handle (Vogel 148). The limited use and “tinny” sound of
this phonograph were discouraging because the foil could be used only a few times before it deteriorated, thus
creating enormous production costs. Other inventors improved the original phonograph by using a wax-coated
cardboard tube over the cylinder, creating the prototype for the current-day jukebox. Nickel machines, which allowed
for consumers to go to a parlor and pay a nickel to listen to wax cylinders reproduce songs and comic monologues,
became the latest fad at the time (149). During the turn of the nineteenth century, three major firms, namely Victor,
Columbia, and Edison, were the producers for most of these playback devices and audio products. From a technical
standpoint, the production and reproduction of even the wax cylinder was a barrier to entry for firms who wished to
enter the recording industry. Each cylinder was individually produced in a time-consuming and hardly foolproof
process, which incurred large initial fixed costs and many resources and connections to hire the appropriate band for
recording (Alexander 115).
The next noteworthy technological advance was the invention of the reverse metal master stamper. Several
thousand copies could be created from the original before the stamper was discarded. The cost of manufacturing
recorded products was reduced, which in turn reduced the payments received by the performers since they were no
longer required to be in a recording studio for such a lengthy time period (Alexander 116-117). Meanwhile, the
number of firms producing record players and records was quickly increasing as competition in the industry escalated
(117). As new firms were promoting innovative culture-based music, “race” records began to appear and black artist
recordings gained popularity in the music industry (118).
The development of the radio and an electrical recording process in the 1920s led to further sound
reproduction improvements. When radio became a mass medium, musicians and songwriters initially objected
persistently to anyone playing records on the air. By having their music given away for free, musicians thought that
radio stations were harming the musician’s ability to make a living (Walker 3). Radio station owners argued that once
they bought a particular recording, it was theirs to use without any additional financial obligation to composers. This2
led to a royalty payment system when the American Society of Composers, Authors and Publishers (ASCAP) took
the matter to court (Vogel 149). Copyright owners subsequently received royalty payments each time their songs
were aired (Walker 3). Although initially artists feared the presence of the radio, they soon realized radio was an
excellent advertising mechanism for records and concerts as well.
From 1930-1945, the music recording industry was idle as the Great Depression and World War II
decreased the demand for records and thus reduced record sales. Postwar development of tape recordings and the
creation of the 12-inch long-playing (LP) vinyl record initiated a tremendous wave of growth in the music industry
(Vogel 149). Compared to the old method of recording, for an investment of a few thousand dollars, a first-class tape
recorder could be purchased. As a result, between 1949 and 1954, the number of companies in America publishing
LP recordings increased from eleven to almost two hundred (Alexander 119). The low-cost recording equipment
allowed small independent companies to compete with RCA, Columbia, and Decca, the major recording labels of the
time. The independent labels are credited with bringing traditional jazz, southern rhythm and blues, gospel-based
music styles, and rock and roll music into the American mainstream (Vogel 149-150).
Business began to soar in the mid- to late-1960s as Universal introduced the truer-to-life hi-fi stereo sound
recordings at a time when the postwar baby boomers were attracted to the expanding rock genre. Continuing
through the 1970s, the high-growth phase was enhanced with the development of the standardized portable cassette
player. The music industry entered the 1980s strong, but soon became stagnant. According to Vogel (2001), this
noticeable decline in demand is due to a population with a weakened interest in new recordings and poor sound
quality control of vinyl pressings. He claims the decline in demand for recorded music was not reversed until the
introduction of the compact disc (CD) in 1983 (Vogel 150).1 The development of CDs led to growth in the music
industry over the last twenty years, affecting the copyright law and structure of the music industry as a whole.
1
See Vogel (2001) Figure 5.1 for a summary of the technological milestones in the history of recorded music from 1870 to 20003
Copyright Law
The emergence and success of independent record labels sparked a change in the concept of copyright.
Prior to the 1970s, copyright was merely a concept in the music industry, not a strictly enforced law. Up-and-coming
artists were constantly remaking songs. Occasionally, it became difficult to determine who was the original artist of a
particular song. The emergence of the Copyright Act in 1976 changed the ambiguity concerning music copyright in
the following way. A recording of a single song is generally protected by two copyrights: the copyright of the song
itself, known as the musical composition copyright, and the copyright of the actual recording of the song, known as
the sound recording copyright (Lupo and Radcliffe 244). As with other intellectual property, the owner of a
copyrighted musical composition has the exclusive right to:
• Reproduce and distribute the musical composition in sheet music and in phonorecords, defined in the
Copyright Act as “material objects in which sounds, other than those accompanying a motion picture or
other audiovisual work, are fixed…and from which the sounds can be perceived, reproduced, or
otherwise communicated, either directly or with the use of a machine or device.”
• Modify the composition to create imitative works based on the original composition
• Publicly display the composition
• And publicly perform the composition.
The Copyright Act defines sound recordings as “works that result from the fixation of a series of musical, spoken, or
other sounds regardless of the nature of the material objects, such as discs, tapes, or other phonorecords, in which
they are embodied” (Radcliffe 245, 247). According to United States law, only original sound recordings fixed and
published on or after February 15, 1972, are protected by copyright law; sound recordings produced before then are
not protected by federal copyright law, but they may be protected under state law (Radcliffe 247-248).
The music industry also uses particular licensing terminology:
1. Mechanical license: This is a license to copy and distribute a song in the form of records, tapes, or
compact discs or by “digital phonorecord delivery,” that is, download from the Internet.
2. Synchronization license: This is a license to copy and distribute music in “synchronization with an
audiovisual work”; this is also known as a synch license.
3. Performance license: This license allows for the public performance of a song. There are two types of
performance licenses: nondramatic and dramatic.4
4. Parody authorization: This grants permission to modify the lyrics to a song. The music publisher’s
contract with the songwriter may require the songwriter to give consent for alternations to his/her
created musical works (Radcliffe 245-246).
Copyright law for intellectual property exists in order to protect works from inefficient duplication and
manipulation and provides creators with economic incentives to produce those works. Most poems, novels, musical
compositions, and other creative works build heavily on earlier masterpieces, borrowing plot details, characters,
chord progressions, and so forth from earlier works. According to Posner (1998):
“The greater the scope of copyright protection of the earlier works, the higher the cost of creating the
subsequent works. So while an increase in the scope of copyright protection will enhance an author’s
expected revenues from the sale or licensing of his own copyrights, it will also increase his cost of creating
the works that he copyrights” (Posner 47).
As noted later on, the notion of fair use is crucial to creative works. For example, the Supreme Court states the fair
use doctrine permits the sale of video recorders even though no royalty is paid to the copyright owners of television
programs for the privilege of recording those programs. Many people use their video recorders to record programs
aired at an inconvenient time or to watch them repeatedly. Such uses benefit the copyright owners even without a
royalty payment. Because advertisers pay more depending on the number of viewers they reach, fair use was
efficient for the use of video recorders.2 However, we now can use video recorders to edit out commercials and
advertisements, which may change the economic validity of the Court’s decision (Posner 48). This situation is
analogous to the music industry with regards to recording tapes off the radio, burning CDs for future listening, turning
CD songs into MP3s on one’s computer, etc. Therefore, fair use is an important element of copyright law in the
music industry and one that must be addressed when determining royalty payments and illegal distribution.
Another important aspect of copyright law is the characteristic of public performance of a work. Although
initially it seems obvious the copyright on a recorded song should extend to any performance of the song, this is not
always the case. For example, say someone sings a song at a wedding. If the guests of the wedding have never
heard the song and are then led to buy the recording of that particular song, then the copyright holder would be better
off especially if the host had paid a royalty for its performance. But suppose due to the vast amount of wedding
music available in the public domain, the host would not pay for any royalty and would simply be deterred from
playing the song for fear of heavy copyright violation penalties. Then the copyright holder would be worse off if
2 See Posner (1998) for more information regarding fair use5 copyright protection extended to such performances. Posner (1998) generalizes examples such as this with the economic distinction between complements and substitutes. He says a favorable book review is a complement of the book reviewed while the video recorder and the public performance are both complements and substitutes. Whether copyright holders will gain or lose from the invocation of fair use is determined by which effect is dominant (Posner 49).3 3 See Posner (1998) for property rights of broadcast frequencies and airwave auctions
6
Music Industry Structure
The music industry’s structure has undergone several changes over the past century as technological
advances force it to adapt to new innovations. According to Meisel and Sullivan (2000), the music industry currently
has three principal segments (Figure 1):
1. The industry for purchases of recorded music
2. The industry for broadcasting recorded music
3. And the industry for attending live performances.
These segments can be illustrated in a value chain configuration (Meisel and Sullivan 17-18). Vogel (2001)
structures the music industry in a similar fashion except he argues the structure of the music business evolved as a
result of the need to efficiently compensate authors, composers, publishers, and performing artists for their work in
creating the final product (Vogel 150). Examining Figure 2, one can see Vogel (2001) includes more detail about the
three principal segments than Meisel and Sullivan (2000) (152). Because about 60% of performance royalties are
derived from use in television, radio, and films, the major agencies have adopted extensive computerized logging and
sampling procedures to assure composers received proper remuneration for performances of their works (157-158).
Currently, consumer interest in the popularity of the Internet continues to rise. The music industry is
concerned about this development because it has opened the door for online music distribution. Writing before the
existence of legal online music distribution, the authors of three scholarly works focusing on the interaction between
the music industry and technology progress posed the followings questions in their writings:
Alexander (p. 113) How does new technology that lowers the cost and scale of production
affect the barriers to entry in the music recording industry?
Meisel and Sullivan By examining the music industry’s business model, what is the impact
(p. 17) of the Internet on the law and economics of the music industry?
Vogel (p. 150) How is the music industry affected by royalty and cost alterations due
to technological advances?
Alexander (1994) argues new technology has facilitated the entry of smaller and new, product-innovating firms by
citing the periods of deconcentration in the music recording industry. Graphing the concentration in the music
recording industry over the period 1890-1985, Alexander (1994) illustrates that the historical distribution of market
share among major and independent firms in the United States music recording industry displays two periods of7
relatively low concentration, namely the second half of the 1910s and 1950s, preceded and followed by several
periods of relatively high concentration. In the second half of the 1910s and 1950s, there were significant waves of
entry due to new production and manufacturing technology (Alexander 115). Alexander (1994) then writes in more
detail about each particular technological advance and how its scale-reducing quality has induced entry into the
music recording industry.
Using the value chain diagram as a representation for the flow of music from producer to consumer to artist,
Meisel and Sullivan (2000) argue online music distribution will disrupt the three-income business model illustrated in
Figure 1 by adding a new dimension to the flow of revenue. The artist receives most of its income from concert
performances and merchandise but little in record sales, as most of the revenue goes to marketing and distribution
costs. Addressing how the Internet affects the music industry as a whole, Meisel and Sullivan (2000) point out three
major effects: it bypasses the retailer, causes illegal distribution, and induces Internet radio. Relating to these three
effects, they noticed three public policy issues regarding online music distribution:
1. Copyright laws and “fair use”: Consumers and advocates of “free” downloading which existed in
Napster argue recording MP3s is a “fair use.” (Meisel and Sullivan 18-19). However, on Feb. 12, 2001,
the Ninth Circuit quickly disposed of Napster's argument, which said the Copyright Act's fair-use
provision, 17 U.S.C. § 107 protected its users. Fair use is intended to “protect certain copying that is
undertaken for personal, educational or other use and that does not prevent the copyright holder from
exploiting his or her rights” (“Napster” 6). The court also rejected Napster’s argument stating its users'
actions are protected by the Audio Home Recording Act of 1992, 17 U.S.C. § 1008, the law which
allows consumers to create audio recordings of copyrighted music for their individual use. The panel
credited evidence offered by the plaintiffs showing Napster harms copyright holders in two ways: by
reducing the market for CD purchases and by making it more difficult for the record companies to enter
the market for paid downloads of digital music.
2. Extension of copyright protection: One of the most significant of these efforts was the Digital
Performance Right in Sound Recordings Act of 1995. By request of the record labels, this act added a
public performance fee for Internet broadcasts: any song played over the Internet must pay the record
label and the musical publisher a broadcast royalty fee. This includes the typical radio station
transmitting its signal over the Internet (Meisel and Sullivan 18-19).
3. Amendment of Digital Millennium Copyright Act (DMCA): The DMCA was created to prohibit the
manufacture and distribution of devices designed with the sole intention and purpose of undermining
technology used to protect copyrighted works. This law also delineates the responsibilities of Internet
service providers in cases of infringement online (“Copyright Laws” 7). Congress encouraged the
industry to accept online music distribution, in particular file sharing, because of its immense popularity
with the consumer. The 1998 act included a provision mandating a “compulsory license that Internet
radio stations could use to pay the record labels for public performance of their recordings.” Online
music distributors favor such a proposition, which forces the labels to make their catalogs accessible in
return for a payment schedule of royalties. The major record companies are requesting Congress8
refrain from enforcing this mandate policy for they say they are arranging their own online joint venture
contributions (Meisel and Sullivan 18-19).
Finally, Vogel’s (2001) analysis of the technological developments of the music industry differs from the
other two examined papers because he focuses on the cost aspect of the music recording industry, including royalty
payments.4 Because production costs of manufacturing a typical CD are well under $1.00 a unit, the profitability of
the CD configuration is more impressive for the music production companies. However, there is little room for
distribution inefficiency. This is not surprising since the rate of project failure is so high, and all but the most
successful recorded music products of big name artists have a short life cycle. With this in mind, most records are
distributed by large organizations with sufficient capital to stock and ship hundreds of thousands of units on a
moment’s notice (Vogel 162-163).
Alexander (1994), Meisel and Sullivan (2000) and Vogel (2001) also predicted what the future of the music
recording industry might look like when the Internet is involved in legal online music distribution.
Alexander • “Digital delivery highway” (p. 121)
• Lessened barrier to entry (p. 121)
• Highly competitive product market (p. 121)
Meisel and Sullivan • Structural changes in emerging business model (p. 19)
• Disturbance of three-income structure (p. 22)
Vogel • Different shapes of online music distribution (p. 166)
• Difficulty in determining royalty payments (p. 166)
It is also important to examine future consequences of current technology. Alexander (1994) predicts the
effects of the Internet on the music industry when he writes the method of music distribution might be constructed in
the following way: a distributor, or group of distributors, transmits digital product samples to consumers via some
format; consumers then review the product samples and inform the distributor which products they are interested in;
these products are uploaded to consumers via the previous format and a charge is then made to the consumer.
Alexander (1994) argues that a distribution network such as this may ease the consequences of barriers to entry in
the music recording industry. By providing product samples, such as song clips, to consumers, this new distribution
network could also transmit information relating “product specifications,” lessening the need for promotional activities
4
See Vogel (2001) for details as to how financial provisions between artist and recording company are reached9
informing consumers of the existence and nature of products, such as radio airplay. Alexander (1994) predicts this is
likely to stimulate a highly competitive product market (Alexander 121). Although this is theoretically possible, record
companies may be reluctant to support such a system because some manufacturers may refuse to sell items directly
to consumers so as not to undercut the retail stores which carry their product.
Meisel and Sullivan (2000) characterize the emerging online distribution model in response to the online
distribution revolution:
1. Increased freedom for producers and consumers to design the product, for consumers to access the
music, and for the market to offer alternative payment plans: Meisel and Sullivan (2000) claim this
increased freedom allows the consumer to pick and choose the songs they enjoy, eliminating the
former limitation of only being able to buy the bundled selections offered by the traditional compact disc.
In addition to the consumer benefit, the record company will have increased freedom in its product
offerings in terms of artists, type of music, age of music, product enhancements and combinations with
other media, access to tickets, and access to artists. Thus, this increase in freedom is mutually
beneficial.
2. Internet-induced merger and joint venture activity to combine content creation entities with distribution
channels conduits: First in their entry to this market were the major record companies. A prominent
example is AOL Time Warner who initially proposed a subscription plan charging a flat monthly fee for
unlimited access to the catalog of Warner Music Group. The industry soon realized such a single
record company catalog model would not be successful. Since then, the majors have combined forces
to experiment with online distribution to provide services such as Pressplay, a Vivendi Universal and
Sony development containing music from several record labels.
3. Early upstart prototypes searching for sustainable online business models that in many cases have
been integrated in the major record companies: The original business models used by upstarts such as
Napster and MP3.com are now illegal according to court rulings.5 However, the new, legal MP3.com
generates revenue by advertising on its site, by collecting subscription fees for access to music from
labels that negotiated a licensing deal, and by selling information to record companies regarding its
customers’ listening tastes (Meisel and Sullivan 19).
They argue the three-income business model becomes disrupted as the relationship between the artists and the
consumers draws closer at the expense of the record companies. Record companies are wary to accept that online
music has the potential to boost CD sales since music is an experienced good (Meisel and Sullivan 22).
Although Vogel’s (2001) main focus is not the effect of online music distribution on the music industry’s cost
function, he does recognize the several ways this development could take shape when he indicates:
“Some music on these emerging cyberlabels will be given away for free to build fan loyalty and make a profit
selling related merchandise and concert tour tickets. Other sites will follow a subscription model. And still
others, dominated by the major distribution companies, will sell downloaded music by the song, by the byte,
or by length of playing time” (Vogel 166).
5
See chart: Key Moments in the Online Music Battle, p. 1810
With online music purchases, distribution costs are almost nonexistent as a consumer can purchase a particular track
at any moment in time without failure. Production costs run low since CD manufacturing is not necessary. The most
difficult task of the online music distribution is simply sorting out royalty payments, which is now an easy computer
logging process.
The extant literature concerning technological advances in the music industry does not include the most up-
to-date developments of the Internet. Just two years ago, the concept of downloading music in an MP3 format was
still forming and not yet legalized. The term MP3 is short for Moving Pictures Experts Group (MPEG) 1 Audio Layer
3. It represents an encoding technology that compresses a digital music file by a ratio of approximately 12:1. This
compression technique is considered to be the most popular method of distributing music over the Internet because
of its low cost and preservation of the original sound recording (Anestopoulou 320). Unable to receive relief from the
court when suing file-sharing services themselves, music companies recently switched their focus from file-sharing
companies to users of file-sharing programs. On September 9, 2003, The Wall Street Journal reports:
“In a bold and risky move, the largest music companies made good on months of threats to crack down on
users of file-sharing networks, filing separate lawsuits against 261 individuals in federal courts across the
U.S. According to the Recording Industry Association of America (RIAA), the suits target users with large
libraries of pirated music—about 1,000 or more songs each—that they make available to others on the
Internet through file-sharing programs like KaZaA, Grokster and Blubster” (Smith B1).
Because the recording industry has started prosecuting consumers in addition to organizations for illegal file sharing,
some companies have taken the initiative to form a legalized method of online music distribution. Unlike online music
distribution in the PC realm, where many online music distributors are currently sharing the market, there is one
prominent online music provider for Mac users, namely Apple iTunes. By examining the structure and level of
success of iTunes, this paper will examine if the previous predictions of the reviewed literature are valid, and it will
also evaluate iTunes according to the following questions of interest:
1. Is online music distribution really a new era of technology that eases the barriers to entry in the music
industry? (c.f. Alexander p. 121)
2. How are legal issues such as royalty payments being managed? (c.f. Meisel and Sullivan p. 18-19, and
Vogel p. 166)
3. Who benefits and loses from services such as iTunes? (c.f. Meisel and Sullivan p. 19)
4. Will iTunes, and companies similar to it, grow, and how will its expansion to PCs affect online music
distribution? (c.f. Alexander, p. 121)11 This paper will investigate whether recent online music distribution technology generating services such as iTunes reduces barriers to entry in the music industry, and how technology has affected record companies, artists, and their interaction with one another.
12
Market Concentration (1999-2002), the RIAA, and the Consumer Profile
Market concentration can be used as a measurement for the barriers to entry in the music industry because
lower barriers to entry can arguably change concentration. In the music industry, according to Alexander (1994), the
shape of market concentration from 1890-1985 illustrated that new production and manufacturing technology was
one of the causes of significant waves of entry during the second half of the 1910s and 1950s. The cause of the
1910s wave was the expiration of patents the three major firms of the time held with respect to the production of
playback devices (Alexander 115). The introduction of the magnetic tape recording technology caused the 1950s
wave of entry because of its cost-reducing implications, which explains the rise of independent labels at the start of
the rock ‘n’ roll era. This paper will evaluate how changes in technology from 1985-2003 affected the market share
distribution of the music industry using the Herfindahl-Hirschman Index (HHI) and the CN index.
The HHI is one method of measuring market share in terms of concentration in a particular industry. In
order to calculate this index, one must first define the industry, then evaluate the market share of each individual firm.
In the present context, the HHI can be calculated by tracking individual firms’ U.S. revenues and U.S. market shares
in the music industry. The HHI is defined as:
f Where f = number of firms participating in an industry
Si = each firm’s market share
HHI= ∑ Si2 i = firm in a given industry
i=1
The U.S. Government’s antitrust enforcement guidelines classify market concentrations according to their HHI score:
HHI < 1,000 Unconcentrated Market
1,000 < HHI, Moderately Concentrated Market
1,800 < HHI, Highly Concentrated Market (Noam 3).
One can also use a second index, such as the C5 index, to crosscheck the HHI. The C5 index is the combined share
of the top five firms in a particular market. It is computed in the following way:
5 Where Sij = firm's i market share of a given industry j,
C5j = ∑ Sij where firms are ordered by size of
i market share (Noam 3).13
Figure 3 shows the HHI and C4 index over time by illustrating the changes occurring to the density of firms in the
music industry to 1988.
In 2003, roughly 85% of all the titles produced in the United States and the rest of the world are controlled
by what’s known as the “Big Five”: Warner Music, EMI Group, Universal Music Group (UMG), Bertelsmann Music
Group (BMG), and Sony (Oligopoly 2). As of September 2003, The Wall Street Journal states that Universal Music
Group holds the biggest share of the U.S. recorded-music market year-to-date with 29.4% (Smith, “Universal”). The
rest of the music industry can be categorized with the following market shares:
- 16.6% for Warner
- 16.3% for BMG
- 13% for Sony
- 9.8% for EMI
- 14.9% for all others.
Table A lists the domestic market share of these firms in the last four years according to Alexander.6 This data is
collected from the data source Nielsen Soundscan.
Table A: Domestic Market Share of the Five Major Vertically-Integrated International Firms (in percent)
Year Universal Warner Bertelsmann Sony EMI
2002 28.9 15.9 14.8 15.7 8.4
2001 26.4 15.9 14.7 15.6 10.7
2000 28.0 15.4 19.4 13.5 8.7
1999 26.4 15.8 16.1 16.3 9.5
Since online music distribution did not take effect until 2001, this paper focuses on the C5 index for 1999 to
2003. Figure 4 graphs this index over time. Although there is a slight decrease in the concentration index in 2001, it
is hardly as momentous as the change occurring during the late 1910s and 1950s. At first thought, one might have
expected the barriers to entry to decrease, and the concentration index to decrease, since MP3 technology
decreases the cost of production and distribution of musical recordings. However, the C5 index is actually beginning
to rise from 2001 to 2003, possibly a byproduct of an increase in barriers to entry.
According to Alexander’s (1994) argument, which says technology affects barriers to entry, one might
expect a significant change in the concentration indices during the era of MP3 technology. Although MP3 technology
can reduce distribution and production costs, it also presents an additional cost to record companies: fighting piracy.
6
Forthcoming in the newest edition of the "Structure of American Industry," edited by Brock and Adams14
The piracy issue inherent in online music distribution, in conjunction with the lessened production and distribution
costs of MP3s, presents a struggle in the music industry’s barriers to entry. From a market concentration standpoint,
it is unclear at this point which factor will be dominant. Perhaps the technology is still too new and the entry lags of
the music market so great that the effects of this technology are not yet apparent. Either way, the C5 index does not
seem to be moving in any distinct direction.
Even though the replication of Alexander’s (1994) analysis technique for the years 1999-2003 does not
indicate an increase or decrease in the barriers to entry due to online music distribution technology, consider the
effects of post-1985 technology Alexander (1994) did not examine; that is, CD and MP3 technology. Since
Alexander’s (2003) market share data was limited and unable to assist in drawing precise conclusions, another
means of analysis was exploited. By examining the Recording Industry Association of America’s Consumer
Purchasing Trends for the years 1989-2002, it is possible to scrutinize the shifts in production in the music industry
and how technology might have affected such changes. Table 1 presents the data from 1989-2002 for full length
cassettes, full length CDs, singles (all types), Vinyl LPs, digital downloads, music videos/video DVDs, and DVD
audio. From the percentage values gathered from the RIAA website, the dollar volume for each of the categories
was calculated (Table 2). Examining the changes in each of these categories independently and in conjunction with
one another will create a clearer picture of the effects of technology on the music industry from 1989-2002.
As of 1989, compact disc technology had been in existence for nearly six years (Vogel 153). Similar to the
dilemma online music distribution faces in that it is simply “too new” to examine its effects on the market, Alexander’s
(1994) analysis was unable to capture the industry effects of the new CD technology as of 1985. It is clear from the
RIAA’s data that the dollar volume of full length CDs has increased dramatically since 1989, peaking in 2000 and
decreasing to its present volume or $11415.852 million. (Figure 5). In 1992, CD dollar volume surpasses cassettes
dollar volume as CD technology became the norm and cassette sales decreased (Figure 6).
Although initially the current dollar volume of vinyl LPs may be surprising, the percentage of vinyl LPs in the
total U.S. dollar value of the music industry has remained relatively constant over the last decade after a major
plunge between 1989 and 1991. With the growing popularity of rap and hip hop music, vinyl records continue to be
demanded by disc jockeys in order to perform a technique known as “scratching”; that is, when one manipulates a15
specific sound by pulling it backwards and forwards, cropping it up into parts, and then continuing with the sound
recording as it is. It is also not uncommon for music fanatics to collect and thus purchase new vinyl LPs from record
stores.
Singles of all types have fluctuated in dollar volume over nearly the past decade and a half (Figure 7). After
peaking in 1996 with a dollar volume of $1165.6434 million, singles seem to have lost their importance over the past
5 years. Because the original purpose of singles was to provide consumers with a way to avoid purchasing a CD in
its entirety, it is not surprising the dollar volume of singles has continued on its decreasing trend with the introduction
of online music distribution services such as Apple iTunes, where consumers can purchase and download a single
track onto their computer for just $.99. The gap between the full length CD dollar volume and singles dollar volume
has steadily grown as time progresses from one era of technology to another (Figure 8).
The year 2001 is predictably the turning point in the data. The full length CD dollar volume begins to drop
off, singles and full-length cassettes remain more unpopular than the previous year, and digital downloading is
introduced into the music market. Although there is only two years’ worth of data to examine since the introduction of
documenting dollar volume for digital downloads, it is not coincidental that this technology affected all of the
surrounding production and distribution mediums. With Internet and MP3 technology, consumers no longer have to
shop at their local record store for all their music listening needs. If these trends continue, full length CD sales will
continue to decline as consumers customize their own music libraries, cassettes will become even more outdated,
and digital downloads will unquestionably become favored over other means of music production/distribution.
Besides affecting distribution formats, the MP3 technology also affects the recording industry in other ways, such as
contracts with artists, royalty payments, and fighting piracy. Therefore, the importance of recognizing the effect of
technological advance on the music industry can mean the survival of record companies producing music in
mediums other than those for digital download.16
Strategies for Policing Piracy and the Dominant Firm Model
Recording companies have three strategies they can take in order to overcome the threat of piracy in the
music industry. They can fight the battle as individual firms, hire an “enforcer” to settle the issue, or coalesce and
fight the battle in a unified way. The first option to work as individual firms would be extremely difficult to successfully
implement in the music industry with so many record companies. The second scenario is similar to what currently
exists under the supervision of the Recording Industry Association of America (RIAA), which will be discussed further
in this section. The third alternative might have been a possibility if the RIAA had not pursued the piracy issue, and it
can be analyzed according to the Dominant Firm Model. Consider what the battle against piracy might have looked
like if the Dominant Firm Model was executed instead of the RIAA’s action on behalf of its member record
companies.
The Dominant Firm Model, also known as umbrella pricing or price leadership, occurs when firms in the
industry follow a price change initiated by one major firm. The leader’s price thus identifies the collusive outcome for
the industry. According to Rotemberg and Saloner (1990), in a differentiated duopoly the leading firm can enforce
this equilibrium price by punishing the follower with a price war if it does not properly follow. A model such as this
emerges if the leader is more knowledgeable about demand conditions and demand shocks affecting the two firms in
the market, and if the second firm finds it is more profitable to follow the more informed firm rather than attempt to be
the leader. Furthermore, Rotemberg and Saloner (1990) demonstrate price changes should be infrequent. The
leader can mitigate the incentives for the follower to cheat on the collusive agreement by keeping prices at a
particular level even as demand changes; this acts like a side payment from the leader to the follower (Church and
Ware 349-350).
The underlying meaning of this model is to demonstrate how the dominant firm controls an aspect of the
market, usually price, since the other firm simply follows the dominant firm’s actions. In the music industry, there are
five dominant firms instead of one, namely Universal, Warner, BMG, Sony, and EMI, and the aspect of the industry
requiring agreement is to fight piracy. Assuming the Big Five have solved the coalescence problem and act as one,
the Dominant Firm Model applies and argues that the Big Five will protect their rights jointly by policing illegal online
music distribution services such as Napster. With the coalescence of the Big Five, there are three possible outcomes17
for the independent labels. If the Big Five are unable to exclude the independent labels from the benefits of their
efforts, then the independent labels can be free-riders and enjoy these benefits at no cost. On the other hand, if the
Big Five are able to exclude the independent labels from the benefits associated with their efforts, one of two things
will happen:
1. The independent labels will be forced to pay for the protection from piracy, or
2. The independent labels will not be offered piracy protection for a fee because the Big Five want to
drive them out of business.
So the obvious question is whether the Big Five, controlling approximately 85% of the market, can exclude
independent labels. Consider the following analogy. A storeowner can hire a guard to protect his individual
inventory, or he can request the mayor to have the police patrol his property. The first choice is an excludable benefit
only the storeowner can retain. The second scenario has spillover benefits to the surrounding stores and homes
being patrolled because patrolling usually occurs over a distance parameter. If the Big Five were to coalesce and
bring suit against services such as Napster, they would retain all of the financial restitution since they are the
plaintiffs. With just the Big Five fighting Napster to have their music eliminated from the service, Napster would not
be able to survive off of the music from the independent labels. Therefore, Napster’s shutdown benefits all record
companies, and the incentive of independent labels to join the Big Five under the Dominant Firm Model must be
examined.
Although the immediate shutdown of illegal services benefits all record companies, in the long run
independent labels may be hurt by the results of future developments. As legal online distribution services for music
emerge, perhaps those services will only sign with the labels composing the Big Five. That is, the Big Five might
keep out independent labels while they control the legal market for online music as a reward for their battle against
piracy. Or, since the Big Five will have already coalesced in an anti-piracy campaign, it would be quite simple to join
forces and latch on to an online music distributor, thus easily giving that distributor access to 85% of the music
market via only five record companies. If this was the case, one might see the fall of several independent labels,
thus increasing the concentration of the music industry.
Knowing the problems piracy creates, the music industry must choose either to take action for the industry
as a whole or to let the Dominant Firm Model emerge. The RIAA chose to solve the issues created by MP318
technology rather than allowing for the possibility of the Dominant Firm Model. MP3 technology was the source of
the creation for online music swapping services such as Napster and KaZaA. Consumers simply uploaded their
music onto their computers into an MP3 format, and then proceeded to download music from other users who
completed a similar process. Record companies were discouraged at this development because they claimed
consumers were being drawn into a world of “free music,” causing a decrease in record sales, royalty payments, and
artist compensation. The fight against piracy became reality after the Recording Industry Association of America, on
behalf of its recording company members, sued Napster alleging copyright infringements. Napster settled with music
publishers and their representatives for $26 million and permission to proceed to become a paid subscription service
(Napster 1). Free services were the target of many lawsuits to prevent the spread of music piracy. When it became
too difficult to pinpoint the creator of different file-sharing companies, file-sharing program users were the next best
option in the eyes of record companies.
Smith and Wingfield (September 9, 2003) give a summary of the recording industry’s efforts to end illegal
online music swapping:
Key Moments in the Online Music Battle
May 1999 Napster file-sharing service founded by Shawn Fanning and Sean Parker
December 7, 1999 RIAA sues Napster alleging copyright infringements and accusing it of being a haven
for music piracy.
July 26, 2000 Federal judge grants the RIAA’s request for a preliminary injunction and orders Napster
to shut down, but the injunction is stayed two days later.
February 12, 2001 Ninth Circuit says Napster must stop allowing music fans to use its free Internet-based
service to share copyrighted material.
September 3, 2002 Napster lays off nearly all its remaining employees. Announces plans to liquidate
assets.
April 25, 2003 Court rules that Grokster and Streamcast Networks can keep distributing Internet file-
sharing software, forcing music industry to intensify legal pursuit of individuals who
distribute copyrighted works online.
May 2, 2003 Four university students who were sued for operating campus-wide music-sharing
programs reach settlements under which they will each pay between $12,000 and
$17,500 to the recording industry.
July 18, 2003 RIAA issues hundreds of federal subpoenas demanding Internet service providers and
some universities turn over names of users suspected of illegally sharing music.19
September 8, 2003 RIAA files 261 lawsuits against individuals it says have illegally used file-sharing
software to distribute copyrighted music online, the first in what it says could be
thousands of copyright infringement suits against individuals (Smith and Wingfield,
“High”).
Not all record companies, however, are members of the RIAA. According the RIAA website, legitimate
record companies with main offices in the United States that are engaged in the production and sale of recordings of
performances for home use are eligible for corporate membership in the RIAA (“About Us”). In order to become a
member, a record company must submit the signed, completed application, a signed confidentiality agreement, and a
product sample. After being reviewed over a 45-day period in order to assure the company’s eligibility for
membership, the company may be approved for membership. Once the record company has received, completed,
and sent the sales declaration to PricewaterhouseCoopers (PWC), PWC then calculates the appropriate dues for the
record company according to a confidential formula based on the gross revenues/market share of the particular
record company. Thus, the Big Five play a bigger role in the financial contributions to the RIAA since their market
shares are higher relative to independent labels. Dues are submitted confidentially to PWC, not the RIAA. After
dues are paid, the record company is an official member of the RIAA.
Regarding membership, the RIAA has more than 350 member companies who together are responsible for
creating, manufacturing, or distributing 90 percent of all legitimate sound recordings sold in the United States. The
RIAA takes an active role in the fight against piracy when it claims its company members will be part of the RIAA
effort to protect their artists and products (“About Us”, 2003). Most record companies do benefit from the RIAA’s
efforts either directly, through financial compensation from successful lawsuits, or indirectly, with the shut down of
illegal online distributors and the creation of legal services.7 The RIAA, not solely the Big Five, acts as the dominant
firm that controls certain aspects of the music industry. By belonging to this organization, record companies are
following the RIAA’s efforts to fight piracy. As time progresses, it will be interesting to note what happens to the 10%
of record companies not belonging to the RIAA.
7 See Distributed Labels of Reporting Companies on the RIAA website for details concerning its specific members;
http://www.riaa.com/about/members/default.asp20
Contracts, Royalties, and iTunes
As technology changes in music production and distribution, contracts between artists and recording
companies must adapt to these new media forms. Contracts serve as a deterrent for people to behave
opportunistically toward their contracting parties “in order to encourage the optimal timing of economic activity and
obviate costly self-protective measures” (Posner 103). An implied term of every contract is good faith performance—
which means not trying to take advantage of the vulnerabilities created by the sequential character of contractual
performance (103). Generally, contract law has five distinct economic functions:
1. To prevent opportunism
2. To interpolate efficient terms
3. To prevent avoidable mistakes in the contracting process
4. To allocate risk to the superior risk bearer
5. And to reduce the costs of resolving contract disputes (Posner 108).
Another important feature of a contract is the presence of consideration. Consistent with the economic
interpretation of the doctrine of consideration, courts are only concerned with the existence, not the adequacy of, the
consideration of a promise. According to Posner (1998):
“To ask whether there is consideration is simply to inquire whether the situation is one of exchange and a
bargain has been struck. To go further and ask whether the consideration is adequate would require the
court to do what we have said it is less well equipped to do than the parties—decide whether the price
specified in the contract is reasonable. This also shows the wisdom of the judicial trend toward using the
doctrine of duress rather than the doctrine of consideration to decide when to enforce a contract
modification” (Posner 111).
Sometimes a fixed-price contract is implemented with the intention of assigning to the performing party the risk of
problems encountered in performance since that party is better able to overcome them (Posner 118).8 Many
contracts are offered on a take-it-or-leave-it basis. The seller hands the purchaser a standard printed contract
describing the respective obligations of the parties. It seems the purchaser lacks a free choice and therefore should
not be bound by onerous terms. But there is a simple explanation to this: the seller is trying to avoid negotiating
costs associated with drafting a separate agreement for each individual purchaser. These costs will most likely be
high for a large company with many contracts, such as a recording company. On the same note, when a seller
refuses to negotiate with each purchaser because it thinks the buyer has no choice but the accept these terms, the
seller is assuming the absence of competition. If one seller offers unattractive terms, a competing seller will offer
8 See Posner (1998) for information on contracts as insurance21
more attractive terms, and vice versa, until optimal terms are reached. Thus, all the firms in the industry may find it
economical to use standard contracts and refuse to negotiate with purchasers (Posner 127).
Within a contract between a recording company and an individual artist/artists/songwriter, royalty payments
must be laid out or assumed according to a legal statute. Two basic royalty streams for songwriters exist:
1. Royalties for the public performance of a work, which is overseen by performing rights organizations
such as American Society of Composers, Authors and Publishers (ASCAP), Broadcast Music Inc. (BMI)
and Society of European Stage Authors and Composers (SESAC).
2. Mechanical royalties derives from the use of a song for records, tapes and CD sales, where the
principal payers of these royalties are record companies (Wolfe 5).
The Copyright Arbitration Royalty Panel (CARP) is responsible for setting the mechanical royalty rate; this rate is
increased in order to follow changes in the economy, usually based on the Consumer Price Index. The “statutory” or
compulsory rate is based upon the greater of either a flat fee (per song/per record) or a per minute/per song/per
record rate. The current fee for January 1, 2002-December 31, 2003 decided in the 1997 Mechanical Rate
Adjustment Proceeding is “8.0 cents or 1.55 cents per minute of playing time or fraction thereof, whichever is greater”
(Mechanical). Figure 9 shows the mechanical rates for the previous two decades and also the expected future rates.
These fees are typically shared equally between the publishing company and the songwriter, except when there is no
designated publishing company; in this case the songwriter is entitled to receive the entire fee (Wolfe 5).
Unless the recording contract specifically reduces the statutory mechanical rate, the songwriter is to be paid
it in full on each record mechanically reproduced. Most recording agreements, especially when the songwriter is also
the recording artist, do provide for a reduction in the statutory mechanical rate, typically to 75 percent of the minimum
rate noted earlier. According to Obringer (2003), sometimes it is in the best interest of all contracting parties to agree
to a lower rate. Although on the surface recording artist’s royalties seem fairly simple to calculate, they are actually
complex computations.9 Typically the artist receives between 8% and 25% of the suggested retail price of the
recording. A newer artist will probably receive a lower percentage while an artist with large clout will receive a higher
payment. From this percentage, a 25% deduction for packaging is made, even though packaging rarely costs 25% of
the price of a CD or cassette. This seems simple enough, but there are three other main issues affecting the royalty
payments an artist receives:
9 See Wolfe (2003) for further explanation concerning possible scenarios between artist and recording company22
1. Free goods: Recording artists only earn royalties on net records sold; that is, not those given away free
as a promotion. Instead of discounting the price to distributors, record companies usually give away
about 5% to 10% of recordings depending in the artist. Radio stations also receive free records from
recording companies as "promo" copies. There is even a reduction in royalties made for copies of the
recording sold through record clubs.
2. Return Privilege: CD and cassette recordings have a 100% return privilege. This means record stores
have no fear about being stuck with records they cannot sell. Most businesses typically do not work in
this way, but the music industry has to be more flexible and timed to demand. The hit song today could
easily be forgotten tomorrow. This allows for reserves; the recording company may hold back a portion,
typically 35%, of the artist’s royalties for reserves returned from record stores.
3. 90%: At the time where record production consisted of vinyl records, there was a lot of breakage when
albums were shipped out for distribution. Because of this, recording companies only paid artists based
on 90% on the shipment assuming 10% would be broken in the process. Even when vinyl was no
longer the prominent form of recordings, this practice continued occasionally (Obringer).
To put all of this into perspective, take the following example. Consider a CD selling for $15. Automatically 25% is
deducted for packaging from the $15, which decreases the royalty base to $11.25. Now assume the artist has a 10%
royalty rate and that his CD sells one million copies. On the surface, it sounds as if the artist would earn $1,125,000.
However, assume 5% of those were actually distributed as free copies. So the royalty really needs to be calculated
based on 950,000 CDs, which makes the royalty $1,068,750. To sum up:
$15 price of CD
$11.25 royalty base after packaging deduction
$1,125,000 royalties with 10% royalty rate
$1,068,750 royalty after free CDs deducted
But the costs to the recording artist do not end there. Typically, when recording artists sign a recording contract or
record an album, the record company pays them an advance, which must be paid back out of their royalties, called
recoupment. Besides paying back their advance, record artists are usually required to pay for several other
expenses under their contract. These recoupable expenses usually include recording costs, promotional and
marketing costs, tour costs, music video production costs, etc. Although the record company is making the upfront
investment and taking the risk, in the end the artist eventually pays for most of the costs. Referring back to the
$1,068,750 royalty we calculated earlier, suppose the record costs were $300,000 (100% recoupable), promotion
costs were $250,000 (100% recoupable), tour costs were $200,000 (50% recoupable), and a music video costs
$300,000 (50% recoupable). These expenses add up to $800,000, thus leaving the artist with only $268,750. The23
manager, as well as a producer and possibly several band members, typically receives 20% of these royalty
payments.10
How are royalty payments calculated for music downloaded from the Internet? Record companies usually
treat downloads as “new media/technology,” meaning they can reduce the royalty by 20% to 50%. This means rather
than paying artists a 10% royalty rate on recordings sold, they pay them a 5% to 8% rate when their song is
downloaded from the Internet. Even though there is no packaging expense with downloaded music, many record
company contracts still deduct the 25% packaging fee. An alternative to the previous royalty payment method also
exists. Currently used most often by Internet record labels, this other method creates an equal split of the net dollars
made on music downloads between the record label and the artist. This net figure is arrived at after all costs have
been deducted, including sale costs, digital rights management costs, bandwidth fees, transaction fees, mechanical
royalties to songwriters/publishers, marketing costs, etc (Obringer).
Online music distribution services developed in response to royalty compensation issues. Services like
Napster and KaZaA simply ignored royalty payments since they argued it was their “fair use” to exchange music in
this manner. However, once it became clear record companies and courts would not tolerate these types of “free”
services, new, legal methods of online music distribution emerged. According to a special report in AdAge:
“They say that the legitimate services will need to create unique marketing propositions to differentiate
themselves from one another. Marketing on the basis of ease-of-use, high quality downloads, extra
features, value-added incentives and strong customer service will all be important in coming months as the
for-pay services compete for market share” (Elkin S-8).
For PC users, no one service truly dominates all others. A simple web search for “online music” will hit PC services
such as MP3.com, RealOne Rhapsody, Pressplay, MP3rox, MP3GrandCentral, etc. The multitude of these types of
services are relatively the same, mostly promoting $.99 cents or less per song, unlimited monthly downloads for
$9.99, unlimited “jukebox” access for a low monthly fee, etc.11 For Mac users, Apple iTunes is the only online music
distribution service that sells songs or albums. Mac services such as Emusic charge a subscription fee of roughly
$10 a month, let one download an unlimited number of MP3 files, and share them with an infinite number of
machines and people (Seff 67). It is not surprising many labels are reluctant to allow their songs on these services
10 See Obringer (2003) for information regarding royalties for the songwriter as the artist under the controlled-composition clause
11 see Dreier (2003) for more detailed information regarding particular PC servicesYou can also read
