ROUND #1 OF THE DIGITAL INTELLECTUAL PROPERTY WARS: ECONOMIC FUNDAMENTALS, NOT PIRACY, EXPLAIN HOW CONSUMERS AND ARTISTS WON IN THE MUSIC SECTOR MARK COOPER, DIRECTOR OF RESEARCH, CONSUMER FEDERATION OF AMERICA FELLOW, CENTER FOR INTERNET AND SOCIETY 504 HIGHGATE TERRACE SILVER SPRING, MARYLAND 20904 (301) 384-2204 [email protected] ROUND #1 OF THE DIGITAL INTELLECTUAL PROPERTY WARS: ECONOMIC FUNDAMENTALS, NOT PIRACY, EXPLAIN How Consumers and Artists Won in the Music Sector ABSTRACT Piracy may have been the solvent that dissolved the glue of an anticompetitive, anti- consumer market structure, but its magnitude has been vastly overestimated by the industry and the transformation of the industry is perfectly consistent with economic theory. With the advent of digital technologies, three quarters of the cost of producing a CD come under severe pressure. The fixed costs of distribution all but disappear and intermediary functions of promotion are transformed. The effort by record companies to keep singles out of the market and to keep CD prices high was a bald effort to use market power to prevent consumers from enjoying the benefits of more efficient distribution that would flow to them in a competitive market. The benefits were huge. The number of units purchased by the public has more than tripled – but the vast majority of units sold are singles and most are not owned by record companies. The average price per unit shipped has declined by 70 percent. Gains in consumer surplus are close to $6 billion in 2007 alone. The vast majority of artists were beneficiaries as well. Comparing the sales claimed by record companies to the sales claimed by digital distribution companies, it appears that for every single sold by a record company there are three additional songs sold by an unsigned artist. Of course, the dominant firms in the tight, music oligopoly and the handful of artists who benefits from the blockbuster/star system have suffered a reduction in the rents they collect. 1 I. INTRODUCTION In April 2006, the Journal of Law and Economics published a symposium on “Piracy and File Sharing”1 that included versions of several of the major analyses that had played a role in the intense policy debate on file sharing in response to the Supreme Court deliberations in the Grokster case.2 Given the academic production cycle, the empirical evidence in the papers was very early in the development of digital distribution of music. Most of it was based on the pre- iTunes period, essentially examining developments from 1998 to 2003. Moreover, because the papers were framed in terms of the “piracy” and copyright issue, they did not delve deeply into the fundamental economics of the music industry. They were fixated on the question of whether file sharing helped or hurt the incumbent firms – ‘were people stealing and if so, how much was it costing the record companies?’ – and paid little attention to the structure of the music industry just prior to the arrival of file sharing, or the likely impact of the new digital technologies on the economics of the industry. The early studies were all over the map. Some studies found increases in sales resulting from stimulation in certain population segments (older consumers) that offset losses in others (younger users).3 Other studies found little or no effect.4 Still others found losses that are not large.5 Moreover, because of recording industry pricing practices, even where recording industry revenue declined as a result of file sharing, consumer welfare may have increased.6 One econometric study of downloading found that the increase in consumer surplus was almost 200 percent larger than the loss of industry revenue. With another half decade of development in the industry, it has become clear that there was a lot more going on than “piracy.” This paper assesses the outcome of the battle over digital music distribution, from a broader perspective with a full decade of data. It concludes that, while there was some privacy, it has been vastly over estimated and its primary impact was to provide the solvent to dissolve the glue that had held an anti-competitive, anti-consumer oligopoly together. The new industry structure is much more consumer and artist friendly and “pircacy” plays little, if any, role. Based on a series of assumptions that this paper argues were erroneous, the industry put forward vastly overblown claims of piracy and revenue loss. At the end of the 1990s, the industry assumed that the bubble of sales created by the previous change in formats (from 8- track tapes to CDs) would continue (along the high growth trend line in Exhibit I-1). At the same time, the industry intended to preserve its anticompetitive pricing structure of the mid- 1990s that jacked up the price of CDs, in spite of the dramatic reduction in costs made possible by digital production and distribution. It also hoped its policy of forcing consumers to buy bundles of songs rather than singles could be maintained in spite of the advent of digital technology, which dramatically altered the economics of music distribution in favor of singles. A decade later, the mid-term (10 year) developments in the industry point in a different direction. It appears that sales had already flattened out before file sharing came along, as existing libraries had already been updated, and high prices suppressed sales (along the low growth trend line in Exhibit I-1). It also appears that once the industry accepted the new distribution technology, the sales of singles exploded. Sales of singles would naturally suppress sales of albums. 2 Exhibit I RIAA Statistics on Units Sold with Projections -1: Alternative Expectations and Interpretations of the Napster Rebellion: 1500 ) 1200 s n o li il M ( d 900 e p ip h S s it 600 n U 300 0 Source: Recording Industry1990 of Am are linear projections described199 in1 text. 1992 Total Units,RIAA1993 upending the oligopoly of record companyLow market Growth power, Total1 Units 9but94 alsoProjection the digital revolution radically transformed the fundamental economics1995 of the industry in a direction that is Thisconsumer paper argues not only that the industry vastly overestimated the role piracy played in dust has settled, the outcome of t 1996 fundamental changes in economic structure that the content oligopolies of the industrial1997 age abhor, but will have great difficulty resisting. Beyond the narrow question of the overestimatio of “piracy,” the recent evidence points overwhelmingly in favor of those who saw it as 1998 improving the performance of the market. erica, Annual Statistics,1 various999 years. Growth trends O 2000 UTLINE 2001 -friendly and also benefited the vast majority of artists. Now that the of the digital revolutio Album Units,2 RIAl002 High Growth Total Units Projection Section II describes the salient economic characteristics of the music industry on the eve 2003 he first round of the digital intellectual property wars suggests 2004 Section III provides a quantitative description of the consumer and artist gains, and offers 2005 2006 n. 2007 , more importantly, that that n 3 an explanation of the changes in the music industry in a classic, economic welfare framework. Section IV provides an estimate of the extent of “piracy.” Section V presents a brief conclusion. II. THE OLIGOPOLY, PHYSICAL MUSIC BUSINESS THE CONSUMER VIEW Any analysis of the economic impact of digital distribution on the recording industry must start from an understanding of the structure and conduct of the industry in the years just prior to the digital revolution.7 The picture is not pretty. “The music recording industry is a highly-concentrated five firm oligopoly. Much of the dominance achieved by large firms in the industry results from control over the distribution and promotion of the products of the industry.”8 Well before digital distribution mechanisms were in place, the industry was engaged in a series of anti-consumer, anti-competitive practices. Anti-Competitive Pricing Two lawsuits, one by state Attorneys General and an earlier one by the Federal Trade Commission were settled in 2002 and 2000 respectively. As the complaint filed by 41 state Attorneys General put it: The purpose of the illegal agreements was to raise prices and reduce retail price competition which threatened the high and stable profit margins for CDs enjoyed by both the defendant labels and distributors and many music retailers. This competitive threat arose with the entry into music retailing of several discount retailers (for example, Best Buy, Circuit City and Target), which could profitably undercut the prevailing retail prices charged for CDs by traditional retailers. Consumers flocked to the discount retailers which rapidly gained market share at the expense of traditional retailers. The traditional retailers reacted by pressuring defendant distributors to impose minimum advertised pricing (“MAP”) policies which established the retail price levels at which CDs were sold, thereby effectively reducing and/or eliminating retail price competition for CDs. The effect of these anticompetitive agreements has been twofold. First, retail CD prices, which had been dropping, were stabilized and then raised industry-wide. Second, the oligopoly of defendant distributors was able to maintain high wholesale prices and margins for CDs. As a result of both effects, consumers have paid higher prices for CDs than they would have absent the illegal agreements. 9 4 The history of the anticompetitive behavior outlined by the Attorneys General makes fascinating reading in light of subsequent developments. CDs entered the market in the mid- 1980s, constituted a quarter of total sales by 1990, and three-quarters by 1995. Competition arrived in the early 1990s along with the expansion of CDs, a new technology of distribution that was lower cost and easier to store and handle.