March 02, 2005

The Economics of Digital Music

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I've been sort of following this issue of illegal download of music and the efforts of the Recording Industry to stop it. I follow it because, and I assume much like all of you, I like music a lot. Music is not just a hobby is a pleasure for me.

As we know, this issue is being hotly contested in the higher courts of the US. On the one side stand the Recording Industry, which wants to stop P2P services like Kazza because they "contribute" to the illegal download of digital music. In the process, the industry is being seriously affected as well as the artists. On the other side, we have the file sharing companies, the Kazzas of the world, obviously arguing for their existence.

As an individual who loves music and doesn't want to brake the law, I find myself in a difficult situation. Do I succumb to temptation and start downloading music for free, in the process braking the law and possibly end up being sued by the industry? or do I go legit and spend lots of dollars or Euros (depending where you are) on the music that I love so much.

My preferred way would be to go legit and buy the music I want. That way, I, first, am not braking any law. Second, I am paying for all the value added in a song. And third, I am also not making it more difficult for other new artist to have the opportunity to record. Although, I have to say, others would have a point or two to argue against my third reason.

But, how can I be legit and buy my music and not go broke at the same time? As much as I like music, if I would have my way, I would buy, realistically, at least one CD per week. That is not counting all the old releases I haven't got yet. If I would do that I would end up spending at least, and this is the bottom line, between US$50 and US$60 a month. This is crazy!

Now, I can accept the argument coming from the industry that making a CD with more or less 10 songs costs that much. Looking at the case, the cover and the CD, I could understand that. (hum, do I really?) Making CDs is expensive. But, and this is a big BUT, when we talk about digital music, how much does it really cost to make a digital song?

The Washington Post's David McGuire, in his article "Downloading: The Next Generation" (I think you have to be registered to read this) says "Finally, the question of how much digital music should cost remains unanswered. Some market observers and retailers say the current prices, particularly for individual downloads, may be too high. One-time promotions aside, the industry's standard rate for downloads has hovered fairly steadily at the dollar-per-song level since its inception.

RealNetworks offers both the Rhapsody subscription service and an a la carte download store. When the company offered downloads at 49 cents a song during promotions, sales tripled, Wolpert said. But RealNetworks took a loss to offer those promotions, he said, because the record companies won't lower their per-song rates.

IDC's Kay said more pricing flexibility would help, but added that he doesn't see much downward pressure on prices: "If Apple has managed to sell a quarter of a billion songs, it would be hard to tell them they're overpriced, but I would like to see it cheaper and more portable."

It is the thinking from the part of the Recording Industry that the "price is right" which interferes with my desire to buy music. Like McGuire reports, they (the industry) do not want to lower their prices per song, thus maintaining them at a level they deem "right". Now, the way I think recording companies like Sony or EMI price their products is as follows: But, before here is a bit of Microeconomics theory. A firm operating in a perfectly competitive market is pretty much a price taker. It cannot influence the market because it is not big enough. So according to the theory, the price is set by the market. So from that point of view the firms cannot do much but take the prevalent price. But, the market in the US is far from being perfectly competitive, and so the theory does not entirely hold.

What I think happens is that, since these companies are relatively big players, they tend to control the market to a certain extent and as such are able to impose prices. These prices are set much higher than just taking into account cost and profit. The process used is pretty much trial an error, which the industry has gotten pretty good at using. The aim is to find the highest price at which consumers are willing to pay for that product. This sounds reasonable, but the catch is in the "kind of product" the individual product is, and the magnitude of the elasticity of demand.

The price elasticity of demand measures the responsiveness of quantity demanded to a change in price, with all other factors held constant. Having defined elasticity, we can say that if we consider music to be a necessary product, the elasticity of demand for music will be relatively inelastic (E < 1). This means that as the price of music changes (holding income constant) our demand for music will not change much. The recording industry is very much aware of this apparently simple fact. This way the highest price at which consumers are willing to buy their music will be much higher than the normal profits they could achieve with a normal good, in a perfectly competitive market.

The result is higher prices even for digital music. I cannot believe (I have not been able to find data) that a digital song costs US$ 1 to produce. If the recording industry wants to stop illegal downloading, it should stop first bullying everybody and start appealing to the pockets of music lovers. It should bring the prices down to more real levels and stop profiting as much as it can from consumers. After all, braking the oligopolistic characteristics of the industry is, for now, just an idea.