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 David & Goliath Series: Music Econ 101

 Eric de Fontenay


Although I had promised that this segment in the series would look at how the labels are increasingly embracing the Net while the RIAA clamps down, I believe that an Econ 101 course on the online music industry is necessary first.

The entertainment industry shares in many ways the same traits found in the broader media industry. The market can be segmented into three categories: (i) the content creator who produces the 'raw' good, (ii) the intermediary market where the good is packaged, marketed, distributed and retailed, and (iii) the consumer market where the good is consumed. While the upper content creator category is highly competitive, with a large number of participants and a relatively level playing field among them, the intermediary market is typically very concentrated and acts as the sole commercially viable access point to the consumer. In economics, they are often referred to as a bottleneck although I prefer the image of an hourglass.

If we take the hourglass image and apply it to the music industry, both ends would represent the first and last categories, artists/songwriters and consumers respectively. The intermediary market, which represents the bottleneck of the hourglass, is made up of the record labels, distributors, retailers and media outlets. As such, the industry is literally illustrated by grains of sand trying to fit through the bottleneck to reach the consumer.

Nearly all media markets exhibit this structure. From print, broadcast TV and radio to cable and film, a large number of players are competing for a very limited number of accesses to the consumer markets which are themselves controlled by an even smaller number of firms. In fact, these firms are often integrated into adjacent markets as exemplified by the AOL/Time Warner merger which would provide the 'Goliath' with a presence in nearly every major media market.

Why do we so consistently find this market structure and what are the implications for the three market categories? The first key is the upfront investment necessary to reach the retail market. This often requires a regional or national market presence for major media works, an upfront non-recuperable investment made in developing a production and/or distribution system. The investment is upfront because no units can be sold until the network is established. In the case of the film industry, the upfront production costs associated with building a studio are typically prohibitive, effectively limiting the number of players. In the cable industry, it is the cost in building a distribution cable network to carry programming to consumers. In the music industry, it has typically been a mix of both production and distribution. In order to achieve the market reach necessary to amorticize the cost incurred in the intermediary production stage, eg., packaging, distribution, marketing and retailing, and be commercially viable, each individual artists' work must build a critical mass of buyers.

Scope is another barrier to entry in the intermediary market. When I was a telecom consultant, I was in a meeting with high-level RoadRunner (Excaliber at the time) managers where they explained Time Warner's intrinsic advantage over large online players in combining content from their music, print, film and broadcast TV/cable divisions and delivering the whole package through cable broadband pipes (I guess AOL agreed). The ability to be integrated in several entertainment and distribution markets provides the firm with incomparable opportunities not only to resell the content in various manners to the consumer, but to create new content derived from existing and repurposed content.

It is the combination of this scale and scope in the intermediary market which has dictated the dynamics of the industry. In economics, we would describe the intermediary market as a highly concentrated oligopoly, eg. a market characterized by few players with significant market share. The first thing that one learns is that a concentrated oligopoly will results in supra-competitive prices in the retail market, and an associated stifling of consumer demand as compared to a competitive market. By limiting the supply and diversity of music offered in the consumer market, consumers will tend to buy less goods and pay more for them on a per unit basis.

This is one point the 'industry' is likely to vehemently disagree with. "But the market increased 10% over the last year!" was the universal mantra at the NY Music & Internet Expo to illustrate the health and growth of the industry. The fact is that the industry would have grown more than 10% if CDs were priced closer to their marginal cost. And it is this point that provides the best indication that the market is not a competitive one.

Typically, as new technology and innovation is introduced into a market it has three potential effects: (i) reduce production cost, (ii) provide increased quality and functionality, or (iii) both. For example, as technology has advanced in the computer industry, the cost of memory and capacity has continuously decreased as the speed and performance of chips increased. The result has been ever cheaper hardware with more functionality. But when there was the shift from the record to the CD (which I will define as music containers), the per unit price of the container increased (eg., CDs and consequently music were more expensive) although the marginal production cost decreased. And whatever benefit the consumer derived from the additional quality and functionality associated with CDs were partially or fully negated by the increased price borne by the consumer.

In fact, unlike a competitive market which would be characterized by marginal cost pricing (eg., the cost to produce an additional unit of the good), the industry has adopted a 'value of service' pricing. As such, as the value of the CD was superior to that of records, the labels charged to capture that added value from the consumer. Simply check any brick- store to compare an albums CD and cassette tape price. Take note that (i) artist development, music production, marketing and ancillary cost remain the same in both cases, (ii) the cost of duplicating a cassette tape is greater than that associated with reproducing a CD and (iii) the quality of a cassette tape is significantly lower than that of a CD.

Next issue, a look at the impact the traditional industry structure has had on content creators such artists/songwriters, and more broadly the independent industry, and the impact the Internet is having.


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