The song remains the same? Technological change and search in the recorded music industry Mary Benner 3-365 Carlson School of Management University of Minnesota 321-19th Avenue South Minneapolis, MN 55455 [email protected] 612-626-6660 Joel Waldfogel 3-365 Carlson School of Management University of Minnesota 321-19th Avenue South Minneapolis, MN 55455 January 5, 2015 Preliminary draft – please do not quote, cite, or circulate 1 The song remains the same? Technological change and search in the recorded music industry Abstract Technological change has brought fundamental challenges, as well as opportunities, to the recorded music industry. One set of changes – file sharing – has facilitated unpaid music consumption, eroding the abilities of the existing firms to generate revenues and making it difficult for major record labels to continue releasing new music using traditional modes of production, distribution, and promotion. At the same time, other technological changes have reduced the costs of these industry activities, as well as the search for talent. These twin technological changes raise questions about the strategies pursued in response by organizations in the recorded music industry. Using data on over 60,000 albums released in the US 1990-2010, we examine the differing responses of major label and independent label organizations before and after the technological change. We find that major label releases reduce music releases while independent labels increase music releases, and that major labels increasingly select on previously successful artists. This selective approach appears to work as a growing share of major label releases achieve commercial success. Finally, we find that majors also achieve greater current success on debut albums, possibly reflecting greater availability of information about artists even prior to their first releases. 2 Technological change has brought fundamental challenges, as well as opportunities, to the recorded music industry. One set of changes – file sharing – has facilitated unpaid music consumption, eroding the abilities of the existing firms to generate revenues and capture value in traditional ways. Recorded music revenue has fallen by over half since Napster’s appearance in 1999 (Aguiar, Duch- Brown, and Waldfogel, 2014), making it difficult for major record labels to continue releasing new music using traditional modes of production, distribution, and promotion: pressing music onto physical media, transporting them to many retail locations, and promoting the new works on terrestrial radio. At the same time, other technological changes have reduced the costs of industry activities, such as producing, distributing, and promoting music products, as well as searching for talent. These twin technological changes – file sharing along with cost reduction – raise interesting questions about the strategies pursued in response by firms in the recorded music industry. The industry has traditionally been dominated by “major” record labels controlled by a handful of media conglomerates (Universal, Sony, BMG, etc.). These record labels release recordings that account for the vast majority of revenue, using the traditional high-cost, high-promotion approach. Alongside these major labels is a large fringe of “independent” labels releasing the vast majority of new music but accounting for a small share of sales, traditionally about 10-15 percent. Independent labels have also historically employed lower-cost approaches – for example, without radio airplay – that allow them to release music that has lower revenue potential. Although economists have recently begun to study technological change, ‘digitization,’ and ‘digital disintermediation’ in the music industry (e.g. Liebowitz, 2006; Waldfogel 2012a;b; Aguiar, Duch- Brown, & Waldfogel, 2014; Smith and Telang, 2010; Zentner, 2006), they have not explored questions at the firm level, i.e. how organizations innovate in response to the radical technological changes, or the associated performance outcomes. Thus, we know little about innovation and change within organizations in the music industry as radical technological change both threatens to destroy the relevance 3 of existing capabilities and business models, but at the same time offers new, lower-cost ways to pursue industry activities. A rich stream of prior work has explored the challenges for incumbent organizations faced with technological changes in their industries (e.g. Tushman & Anderson, 1986; Utterback, 1994; Christensen & Bower, 1996; Henderson & Clark, 1990; Tripsas & Gavetti 2000; Benner, 2010; Benner & Ranganathan, 2012; Sull, Tedlow, and Rosenbloom, 1997). Research in this area has further examined how ‘search’ behaviors within organizations into more distant technological and market domains (i.e. also termed innovation or exploration) can provide firms with the requisite knowledge, capabilities, or absorptive capacity (Cohen & Levinthal, 1990) to initiate – or respond to –such changes in their environments (e.g. Nelson and Winter, 1982; March, 1991; Levinthal & March 1993; Levinthal, 1997). The work on technological change often makes further distinctions between established incumbents, believed to be rigid and inertial, and the smaller organizations or new entrants that are viewed as more nimble and better able to survive these ‘gales of creative destruction’ (Schumpeter, 1934). In this study we examine how music organizations (i.e. record labels) have responded to the major technological changes sweeping the recorded music industry. Specifically, we study how search behaviors in record label organizations change in response to the challenges of technological change, as well as the resulting performance outcomes. Our research questions are: How does search for the ‘major label’ incumbent organizations in the recorded music industry change in response to major technological changes, what are the performance outcomes, and how do these behaviors and outcomes differ for the smaller scale ‘independent label’ organizations? Using a unique, extensive set of data on over 63,000 new music releases (i.e. products) of music producers from 1990 to 2010, we are able to study the influences of changes in both the abilities of producers to appropriate revenues and reductions in costs to produce, distribute, and promote music on both major label and smaller independent label organizations. The advent of Napster and the increase in unpaid file sharing after 1999 provides us with an exogenous shock, or “experiment,” that allows us to study the search behaviors of organizations both before and after the advent of file sharing. Our extensive 4 data on the music releases of both the major labels and smaller independent labels allows us to compare the changes at majors and independents with a research design built on these “differences-in-differences” before and after the technological change. Next we describe our context of technological change, followed by contextual hypotheses about firms’ search behaviors and the resulting performance outcomes in this setting. We then test the hypotheses and present findings. Empirical context: Technological change in the music industry Music is what is termed an “experience good.” Consumers generally cannot determine whether they like it until they have used it – e.g. listened to an album or song – repeatedly. The difficulty that consumers have determining how appealing they find new music has an important analogue on the producer side: the entities releasing music (record labels) find it difficult to predict which of the potential projects they might pursue will be successful with consumers. That is, investments in music products – particularly those by new artists but even those from established bands – are risky. These features of music stemming from the nature of the product affect many of the activities involved in bringing music to market. Record labels undertake a variety of activities in order to bring music products to market. It is helpful to describe these activities – and the traditional ways in which the activities have been undertaken – in order to understand how recent technological changes would be expected to influence the activities of various kinds of firms. Many would-be artists seek to make their music available to consumers. For example, many artists submit “demo tapes” to music labels.1 These possible projects differ substantially in both their ex ante promise (how appealing it seems that they might be if they were produced) as well as their ex post success (how successful they turn out to be, even holding constant how promising they seem at the 1 See Caves (2000) and Vogel (2007) for descriptions of the music industry. 5 outset).2 A very low percentage of the recorded material by traditional record labels has generally been successful, suggested by the industry analyst’s comment that “perhaps as little as 10 percent of new material must make a profit large enough to offset losses on the majority of releases...” (Vogel, 2007). Record labels produce much more material than would actually succeed and the vast majority of albums and records don’t cover their costs (Caves, 2000). Thus, the traditional discovery process in the music industry was analogous to taking ‘draws from an urn.’ Making music available to consumers has typically required a series of activities. First, music must be recorded and produced, which has traditionally required both expensive recording equipment as well as skilled labor. Once a master copy is recorded, it must