CESifo Economic Studies, Vol. 55, 2/2009, 306–325 doi:10.1093/cesifo/ifn036 Advance Access publication 23 December 2008 On the Impact of Digital Music Distribution Illtae Ahn* and Kiho Yoony Abstract We present a framework to evaluate the impact of digital music distribution. We set up a representative model that enables the comparative static analysis. We then interpret two empirical observations about the music industry, the sales decline and the price constancy, and fit the model to these observations. We find that, while the impact of digitalization on the producers’ profits is probably negative, it may not be as severe as the observed impact on the quantity. On the other hand, the impact of digitalization on the consumer surplus is unambiguously positive. The impact on the social welfare is rather ambiguous in general, but the social welfare may increase for plausible parameter values. (JEL codes: K11, L86, O34) Keywords: Music industry, digital music, copyright, file sharing. 1 Introduction The music industry has experienced significant changes in recent years. In particular, the advent of broadband networks made it possible to freely download unauthorized copies of prerecorded music files via peer-to-peer (P2P) technologies: consumers can transmit the music in digital format among themselves using the online ‘file-sharing’ technology provided by Napster, Kazaa, Grokster, and others. These changes have generated heated debates regarding the possible impacts on the sound-recording industry. Some argue that the decline in the sales of recorded music endan- gers the viability of the industry, while others say that these changes may ultimately benefit the producers. There exist some empirical works including Michel (2006), Oberholzer- Gee and Strumpf (2007), Peitz and Waelbroeck (2004), and Zentner (2006), as well as some theoretical discussion including Liebowitz (2005, 2006) and Peitz and Waelbroeck (2005, 2006b) on the impacts of file- sharing technology. Most of the works, however, are concerned with the * Department of Economics, Chung-Ang University, Heuksuk-dong, Dongjak-gu, Seoul, Korea 156-756. e-mail: [email protected] y Department of Economics, Korea University, Anam-dong, Sungbuk-gu, Seoul, Korea 136-701. e-mail: [email protected] The second author has benefited from the visit to the Institute of Innovation Research of Hitotsubashi University, whose generous provision of research opportunity is gratefully acknowledged. We thank Sadao Nagaoka and the seminar participants at the IIR work- shop for helpful comments. We also thank an anonymous reviewer for invaluable suggestions. ß The Author 2008. Published by Oxford University Press on behalf of Ifo Institute for Economic Research, Munich. All rights reserved. For permissions, please email: [email protected] 306 Impact of Digital Music Distribution causes for the sales decline of prerecorded music.1 In particular, no pre- vious work has studied the welfare consequences of these changes. This article aims to provide a framework to evaluate the impact of digital music distribution on the social welfare as well as on the profit and the consumer surplus. To do so, we set up a representative model that enables the comparative static analysis before and after the advent of digital distribution technology. The ‘digitalization’, i.e. the distribution of music files in digital format using online technology, affects several aspects of the industry. First, the unauthorized copies shared among end-users create competitive pressure on the legitimate products. That is, the copies are (inferior) substitutes for the original, and so possibly harm the producers of the music by decreas- ing their sales and profits. On the other hand, it is often argued that the ‘sampling’, i.e. consumers’ listening to the music before purchasing and finding the better fits for their tastes, afforded by the online technology may in effect boost the demand for the original, and help the producers. Finally, the digitalization may lower the producers’ costs of distribution, marketing, and promotion. It is ultimately an empirical question to determine the net impacts of digitalization. Hence, after setting up a framework to evaluate the impacts, we start with interpreting two empirical observations of the music industry. The first and the most obvious observation is the sales decline. Liebowitz (2006, p. 14), for example, estimates that the actual sales in the United States have dropped up to 30% after digitalization. While various explanations are possible, it is most plausible that the file sharing activity exerted a strong substitution effect. Another interesting and rather puzzling observation is the virtual constancy of price. Liebowitz (2006, p. 21) again observes that ‘the list prices adjusted for inflation have been virtually constant for the last decade’. If the unautho- rized copies are substitutes, then the price of the legitimate copies should have decreased due to the competitive pressure. That did not happen, however. Several reasons may be proposed for this ‘constant price puzzle’. First, it may be argued that the producers were in a competitive environment to begin with and so could not afford to decrease the price. But this can be easily discarded, since the big four record labels (Universal, Sony BMG, EMI, Warner) essentially dominate the market and they are sometimes alleged to collude on price fixing.2 Alternatively, it is possible that con- sumers are substantially differentiated with respect to their valuations and 1 See Section 3 below for some of their results. 2 See FTC Press Release on 10 May 2000, ‘Record Companies Settle FTC Charges of Restraining Competition in CD Music Market.’ CESifo Economic Studies, 55, 2/2009 307 I. Ahn and K. Yoon attitudes toward the music so that the producers reacted by concentrating on the higher segment of the consumer population. In other words, the digitalization may have made it possible for the producers to provide more value to the high-valuation consumers so it was best to take a price strategy on them (while sacrificing the quantity on the low-valuation consumers). Our framework supports the latter interpretation. We find that the sampling effect substantially increased consumers’ benefits and it worked better for the high-valuation consumers. We then fit the model to these empirical observations. We first find that, while the impact of digitalization on the producers’ profits is probably negative, it may not be as severe as the observed impact on the quantity. In particular, digitalization may lower the fixed costs of distribution as well as increasing the additional revenue from complementary products such as live performance. On the other hand, the impact of digitalization on the consumer surplus is unambiguously positive: consumers have benefited from all the possible effects of digitalization. We find that the impact on the social welfare is rather ambiguous in general. However, we show that the impact may be positive for plausible parameter values in our model. We also show that enhanced copyright protection to counteract the impacts of digitalization may have an unexpected effect on the social welfare. The rest of the article is organized as follows. Section 2 sets up the model to evaluate the impacts of digitalization, and does some comparative stat- ics before and after digitalization. Section 3 discusses the empirical obser- vations and determines the possible impacts of digitalization. It also briefly discusses the possible effect of enhanced copyright protection on the social welfare. Section 4 concludes. 2 The model Consider a music product that is produced by a monopolistic producer (record company, music label, or publisher). We first study the benchmark case of traditional distribution. We then see how the digitalization of music distribution affects the relevant variables. The model we employ is the one developed in Yoon (2002) for the study of copyright protection. Similar models are used in subsequent works including Belleflamme (2003) and Bae and Choi (2006).3 3 Peitz and Waelbroeck (2006a) is a comprehensive review of the relevant literature. 308 CESifo Economic Studies, 55, 2/2009 Impact of Digital Music Distribution 2.1 The benchmark There are consumers who are interested in the product. Each consumer consumes at most one unit of the product. We denote the set of consumers by I and the valuation of consumer i 2 I by vi. Consumers can consume the product either by purchasing from the original producer or by making unauthorized reproductions, i.e. by making copies. When i 2 I buys the product, her net utility is vi À p, where p is the monopolist’s price. When i 2 I copies the product, her net utility is ð1 À Þvi À z. The parameter measures the quality degradation of a copy, with 0 5 5 1.4 The para- meter z captures the reproduction costs, including the physical costs as well as the inconveniences consumers have to bear in making the copies. If we let wi vi þ z be termed as the gross reproduction cost, the net utility from a copy is vi À wi. The utility when a consumer does not consume the product is normalized to zero. Consumer i will make the following choices depending on the relative magnitudes of vi, wi, and p. When p ¼ minfvi, wi, pg, consumer i purchases from the producer. When wi ¼ minfvi, wi, pg, consumer i makes an unauthorized copy. When vi ¼ minfvi, wi, pg, consumer i does not consume the product. For a concrete analysis, assume that consumers’ valuations are uni- formly distributed over the unit interval ½0, 1. Thus, we can identify the set I of consumers with the set of valuations, which is the unit interval. Then, consumers’ choices given the price can be summarized as follows. (a) When p 5 z=ð1 À Þ: this is the case when the monopolist’s price is set low enough that no consumer makes an unauthorized copy.