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CHAPTER 13

WHAT’S BEHIND THE MUSIC INDUSTRY’S WOES?

The Sound of Market Power

Secrets can make or break market power. Sometimes the critical secrets are held by sellers. In 1925, the Coca-Cola Company deposited the formula for its market-dominating soft drink in an Atlanta bank and set a policy that only two company officials would be privy to the formula at any given time. Stashed in a vault in Louisville, Kentucky, is Colonel Sanders’s secret recipe for the eleven herbs and spices that make Kentucky Fried Chicken (KFC) finger-lickin’ good. For greater security, incomplete sets of KFC’s ingredients are mixed in two separate locations and then combined in a third location so that no one at any single location can identify all the seasonings.¹ Such trade secrets create informational barriers that prevent competitors from entering a market and pilfering profits.

¹ For more on the Coke and KFC stories, see www.snopes.com/cokelore/formula.asp.

In the case of the music industry, the consumers hold the most influential secrets, and they work to break down the barriers to competition. Music fans, perhaps even you, secretly duplicate CDs and cassettes and try to hide their true identities while swapping music files on-line. The songs are copyrighted, but relative secrecy and advancing technology allow the practice to compete with retail music venues. Is this development the death knell for the $32 billion global music industry? And how did the industry become so lucrative in the first place? The answers play to the tune of market power.

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When a single producer enjoys a monopoly on a product as its only seller and some sort of barrier prevents the entry of competitors, that producer can restrict the quantity sold and raise the price in pursuit of profits. For instance, glass artist Stephen Rolfe Powell can make a fair number of remarkable “vessels” in a month, but by selling fewer than he is able to make, he keeps his artwork relatively scarce and can charge more than $20,000 for a vessel.² This would not be the case if he flooded the market with his unique works of art.

² See, for example, www.bluespiral1.com/Master-HTML/artist/powell_stephe_10115/home.htm.

The typical monopoly is inefficient from the standpoint of society because it holds output below the level at which the marginal cost of production equals the price consumers are willing to pay. The failure to produce additional units that could be made for less than the benefit to consumers represents a deadweight loss³ equal to the difference between the missed benefits and the avoided costs. For example, if Powell could produce another glass vessel using $5,000 worth of materials, equipment, fuel, and labor time and sell it for $20,000, that vessel would create $15,000 worth of net benefits. It might not be in Powell’s best interest to create that net gain if he charges a standard price for each vessel (that is, if he can’t price discriminate by charging different customers different prices). Suppose Powell can either sell 8 vessels per month for $22,000 each or drop the price to $20,000 and sell 9. At the lower price he gains $20,000 − $5,000 = $15,000 in profit from the ninth unit but loses $2,000 on each of the 8 units he could otherwise sell for $22,000, for a net loss of ($2,000 × 8) − ($15,000) = $1,000. Powell is better off selling fewer units at the higher price. More generally, firms with market power often produce less than the quantity that is efficient for society and charge more than the price that would exist in a competitive market.

³ As explained in Chapter 9, a deadweight loss is a loss that is not balanced by any resulting gain.

An oligopoly exists when a small number of firms dominate the market. As in a monopoly, firms in an oligopoly can influence prices and quantities to their advantage, although the ability to earn profits typically falls as the number of firms in the market increases. To remedy that problem, producers of similar products sometimes organize into cartels, which are groups of firms working together to restrict production quantity and charge prices as a monopoly would. Cartels are prohibited in most countries; the U.S. Department of Justice has recently taken legal action against international cartels in the citric acid, vitamin, lysine, and graphite electrode industries.⁴

⁴ See www.usdoj.gov/atr/public/criminal/8279.pdf.

Market power can be measured by the market share held by the biggest competing firms. A four-firm concentration ratio, for example, is the sum of the market shares of the four largest firms in a market. Safeway, Kroger, Wal-Mart, and Albertson’s hold 34 percent of the retail food market in the United States. The market structure is considered an oligopoly if the four-firm concentration ratio is 40 percent or more. The United States clearly has oligopolies in tobacco, soft drinks, computer software, and long-distance telephone service, all of which have a four-firm concentration ratio higher than 90 percent. There are four major groups in the music industry—Universal, Sony/BMG, Warner, and EMI—and together they hold about 85 percent of the market.

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In previous chapters, it was explained how profits can draw competition, increase supply, and bring price down to equal average cost. Profits continue for firms that erect barriers to the entry of competitors. These barriers may include legal barriers, such as patents and licenses; information barriers, such as secret recipes; the control of resources, such as diamonds; and economies of scale, as with a small town that cannot support a second cineplex. Chapter 20 focuses on the struggle between the chief pros and cons of barriers to entry: incentives for innovation (pros) and high prices (cons). Here, how firms make use of market power and how some consumer vigilantes work against it are examined.

At its peak, the music industry enjoyed $40 billion in annual sales, thanks to barriers to competition. Particular songs are copyrighted so that 1 firm controls their sale. Media giants have the incentive to develop relationships with radio stations and concert venues that enable the corporations to promote their own artists over those of smaller, independent record companies and to influence the amount of airtime granted to particular songs. Competing firms that crop up and pose threats are often acquired through mergers. The history of the music industry resembles a feeding frenzy, with big fish, such as Sony and Universal, eating former threats, such as CBS Records and PolyGram, and merging with others, such as BMG and Geffen.⁵

⁵ For a description of this history, see www.tangentsunset.com/recordindustry.htm.

From the perspective of Eagles singer and drummer Don Henley, “The industry, which was once composed of hundreds of big and small record labels, is now controlled by just a handful of unregulated, multinational corporations determined to continue their mad rush toward further consolidation and merger.”⁶ According to economic theory, the market power held by music companies is not simply a reason for high prices but also a source of diminished quality. Henley writes that since the days of greater competition ended, the variety of music has eroded, as have the meaningful relationships between artists and music company executives and the “unique and personal way” in which music once touched listeners.

⁶ Don Henley, “Killing the Music,” Washington Post, February 17, 2004, p. A-19.

With their “say yes to creativity and say no to concentration” campaign, members of the Independent Music Publishers and Labels Association (IMPALA) are fighting the consolidation of major firms. They say that “to flourish, creativity requires diversity, plurality, fair competition and an open society.”⁷ IMPALA successfully fought the proposed merger of Time Warner and EMI in 2000. IMPALA is also litigating against the European Commission for allowing Sony and BMG to merge in 2004, and the association is vigilant against new merger proposals, threatening similar legal actions to prevent them.⁸

⁷ See www.forculturaldiversity.org/intro.html.

⁸ See www.impalasite.org.

Music piracy can involve duplicating a music recording; counterfeiting of products and packaging to mislead consumers into thinking they’re buying a legal product; and bootlegging, which involves the unauthorized recording and sale of live or broadcast performances. The International Federation of the Phonographic Industry estimates that 1.1 billion CDs are pirated each year, representing 35 percent of all music CDs sold worldwide.⁹ The Recording Industry Association of America (RIAA) blames illegal file sharing for slumping CD sales, which decreased by 22 percent between 1999 and 2004. In the view of Steve Marks, general counsel for the RIAA, “Millions and millions of people now download billions of songs for free that they used to buy. Simply stated, an industry cannot survive when its content can be acquired for free with no more effort than the click of a mouse.”¹⁰

⁹ See www.ifpi.org.

¹⁰ See www.riaa.com/news/newsletter/041504.asp.

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Pernicious symptoms of market power may have contributed to the decline in CD sales. Rolling Stone magazine’s ranking of the top 500 albums reveals that the perceived quality of music has gone downhill since the early 1970s. As suggested by Don Henley, the lack of competition may have led to reluctance among the consolidated music groups to take risks with new artists and unconventional approaches. Conservative tactics and complacency may have opened the door for competitors such as purevolume.com, which offers free music by unsigned groups. Regardless of whether you’re a fan of independent bands, such as Fat Kid Running, the ability to find alternative music on-line has an appeal similar to that of used bookstores, where one can finally find an array of titles beyond those on the best-seller list.

The big firms are also losing control of bricks-and-mortar sales outlets. Historically, record stores, such as Virgin Records, which was purchased by EMI Music in 1992, have allowed the music industry greater influence on the marketing, product mix, and prices of the albums they issue. Although Internet sales constitute less than 5 percent of the legal market, Wal-Mart makes one-fifth of all retail CD sales in the United States.¹¹ Superstores, such as Kmart and Wal-Mart, are pricing specialty stores, big and small, out of existence and stocking only a narrow list of music titles. Adding to all these woes—competition from Internet piracy, physical CD piracy, independent record labels, and megaretailers that control and limit music offerings—other forms of entertainment, including DVDs and videogames, are vying for consumers’ CD dollars. These alternatives offer retailers higher profit margins, thereby garnering increasing shares of available shelf space.

¹¹ See “Music’s Brighter Future,” The Economist, October 28, 2004, available at http://www.economist.com/displaystory.cfm?story_id5E1_PPNJTGJ.

The music industry has responded with efforts to maintain and rebuild barriers. The RIAA initiated several thousand lawsuits for alleged copyright violations using peer-to-peer (P2P) file-sharing systems, such as Napster, Grokster, and Kazaa. Legal competitors in the music-downloading business have also created barriers against the use of music sold by their legitimate rivals. For example, Apple’s iPod digital music players can receive music purchased from the associated iTunes Web site but not from Sony Connect or Microsoft’s MSN Music Store. Because these barriers generally apply to proprietary music files and not to the more general MP3 files shared illegally, these restrictions on the usability of purchased files may, in fact, encourage the use of illegal files.

Historically, the music industry has weathered many a technology-based storm. Along the way, eight-track tapes lost a war over media formats,¹² cassette tapes allowed illegal copying that records did not, and CD burners dramatically improved the quality of copied music. After some casualties, the industry has always adapted with new strategies and business models, a recent example being on-line stores’ practice of selling low-priced music downloads.

¹² See www.8trackheaven.com/8THistory.html.

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Firms in contestable markets, into which competitors could enter, can be enticed to approximate the prices, quantities, and qualities of a competitive industry to forestall the entry of new competitors. Rampant music piracy in the oligopolistic music industry provides a persistent, if illegal, threat of competition. No sooner did a court dismember the original Napster than myriad alternatives made the scene. As lawsuits against second-generation P2P systems, such as Grokster, come to a head, “censorship-resistant” substitutes, such as Freenet, are waiting in the wings with improved opportunities for anonymous file sharing. Given the unlikely prospects of reining in the expanding universe of P2P technology, the music industry may need to act more like a competitive firm, taking risks with innovative acts, lowering prices, and providing more variety. Along these lines, Universal and Warner are investing in independent labels, such as Canada’s Maple Music, to help them identify promising new artists.

When something is cheap or free, it is sometimes said that it can be bought “for a song,” but saying that an illegal music download can be had for a song is both misleading and a bad pun. As firms in the contestable market for music address their clandestine competition, it is important for them to assess the true costs inherent in file sharing. Beyond the negligible “click of a mouse” cost mentioned by Steve Marks, P2P music downloads impose several other types of costs. The expected legal cost is the probability of detection multiplied by the fine if detected. Risk-averse people are uncomfortable with uncertain prospects, and the risk burden is the amount above the expected legal cost that a risk-averse individual would pay to avoid uncertainty about being caught. The guilt burden is the amount an individual would pay to avoid feeling guilty about breaking the law and depriving workers in the music industry of compensation. Music downloads also take time and thus impose an opportunity cost equal to the value of the next-best alternative use of the time spent downloading.

When similar music variety and quality are available from both legal and illegal sources, consumers must compare the price of legal music with the sum of the expected legal cost, risk burden, guilt burden, and opportunity cost of time required for illegal downloads. The common 99-cent price of legal downloads may be the industry’s closest approximation of that sum (in this case, minus the opportunity cost of time spent downloading the music, which is paid by the consumer for either type of download). More than 300 million 99-cent downloads were purchased from the iTunes music store during its first two years,¹³ so apparently that price hits the mark for many consumers. The continuing popularity of P2P file sharing indicates that, for many, either that price is too high or the limited legal offerings are inadequate.

¹³ See www.answers.com/topic/itunes-music-store.

The lessons from the music industry are relevant to a broad set of related industries. Movies, photos, and audio books are all among the items that can be accessed at file-sharing sites, such as Kazaa. Piracy and Internet sales are a growing problem for textbook publishers in an industry dominated by a similarly small number of giants. And the power of the large media companies, such as News Corp. (parent company to Fox News), Time Warner, and GE (parent company to NBC), may become diluted by a growing number of free, on-line news and entertainment services and new entries, such as satellite radio, that are made available by advancing technology.

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About 1900, seashells inscribed with ancient Chinese characters turned up in Xiaotun, China, and commanded handsome profits from scholars and collectors. Dealers kept the source a secret to maintain their monopoly. Villagers caught up in the trade of these “dragon bones” subsequently engaged in fights and lawsuits.¹⁴ In the music industry the dragon bones are songs and the secrets are held by clandestine copiers of music, but the fierce fight for market power is the same. Market power confers profits that cannot be maintained in a competitive industry, and that power comes from barriers to entry. When the walls come tumbling down, competitors enter the market and bring profits down as well. Competition is good for consumers in terms of price, quantity, and quality, but it’s bad for business.

¹⁴ See Peter Hessler, “The New Story of China’s Ancient Past,” National Geographic, July 2003, p. 65.

Firms have long fought to establish and maintain what barriers they could. For example, in the fifteenth and sixteenth centuries, spices such as nutmeg, cinnamon, and myrrh garnered high profits in Europe. In hopes of preventing competitors from entering the market, spice merchants claimed that their source was Africa, although the goods really came from the Far East. Today, pharmaceutical companies create barriers with patents and update products when old patents run out. Movie theaters, convention centers, and school food-service providers typically forbid consumers to bring food in from elsewhere in order to maintain a monopoly. And the recording industry fights to uphold the copyrights to songs for the same reason. New technology makes P2P file sharing an available-yet-illegal competitor to the big music-recording firms. As consumers grapple with their consciences and firms weigh the wisdom of litigating against young perpetrators, artists and fans alike argue that the temptation to steal music and to patronize P2P sites would be eased if the music industry would offer prices and variety that more closely resemble the competitive ideal.