Standard economic theory posits self-interest drives buyers to obtain goods and services at low prices and sellers to offer goods and services at high prices. If the market consists of many buyers and sellers, competition drives prices together to create a functioning market. Self-interest is the motivator. Competition is the regulator.
At the center of any market is the price mechanism competition creates. There’s always some difference between buyers’ and sellers’ desired prices. In a functioning market that difference is minimal, or at least negotiable; buyers and sellers agree on pricing. Sales result. Economists call this a price equilibrium.
Online, price equilibrium appears to exist in several markets, notably games, greeting cards, and dating services. Sellers offer services at prices agreeable to buyers. Millions of consumers use these markets. Most online content revenues are from these markets.
What happens when the difference between the prices sellers want and what buyers are willing to pay is too different? A malfunctioning market.
Two online examples are music and textual content (such as news, entertainment, and sports).
My next column will discuss the pricing problem causing the online textual content market to malfunction. In this one, I’ll examine online music — a classic example of a malfunctioning market.
Music: A Malfunctioning Market
The online music market was created by audio encoding and downloading technologies. Napster, KaZaA, and other popular file sharing services prove consumer demand. As economic theory warrants, that demand attracted the attention of traditional music sellers — recording companies. However, those companies feared downloadable music would cut into sales in their traditional markets. Motivated by that fear, the companies failed to take advantage of and adapt to the new market. They committed major errors in economic theory.
The first is an attempt to shut down the new market. A mistake, because audio encoding and downloading technologies won’t cease to exist. Recording companies can’t sue and shut down everyone using these flexible, relatively open-source technologies. The recording companies’ copyright infringement lawsuit closed Napster, but KaZaA and other services have been more legally resilient. Their software will continue to operate.
The recording companies next error is their attempt to control the new market they couldn’t shut down. They belatedly started their own music download services: MusicNet (operated by EMI, Warner, and BMG and now offered only through RealOne’s MusicPass Service) and pressplay (operated by Sony and Universal).
For $9.95 to $24.95 per month, each allows consumer downloads from song catalogs. But the services come with restrictions. Full song catalogs aren’t available, only about 200,000 tracks. There are rarely new songs by major artists. MusicNet prevents its songs from being burned to CD. pressplay allows consumers to burn only two tracks per artist each month (making it almost impossible to assemble a copy of a CD). MusicNet doesn’t allow its downloadable songs to be ported to portable music players; pressplay normally allows only 10 songs to be ported per month. An ironically apt description is the audio welcome at one service, “MusicNet will redefine the way you own and experience music.”
Recording companies’ third economic mistake is lack of competition. MusicNet and pressplay are cartels. Competition is healthy. Companies unable to compete die. Those that compete successfully thrive. Cartels are slower than individual companies to adapt to change. By forming cartels and failing to compete online among themselves, major recording companies seriously hindered their ability to adapt to a new market.
The fourth mistake is a stunning misunderstanding of the laws of supply and demand. They forgot they weren’t the only ones in possession of the music supply. Millions of CD owners possess music, too. As I write, 3,367,227 people are on KaZaA offering 644,021,111 files. Most are music. Millions of people offer free music without restrictions.
Considering the laws of supply and demand, it’s easy to see why MusicNet, pressplay, and music companies’ attempts to control the online market haven’t succeeded. The major recording companies offer a limited supply of music at a high price, with restrictions. Meanwhile, millions of people offer an unlimited supply for free, without restrictions.
The online market is malfunctioning because the difference between the price at which the music companies are offering to sell downloads and the price at which consumers can download from other people is so vast there’s no agreement between buyers and sellers. No price equilibrium means no market.
Some recording executives claim there can never be a functioning market as long as people rip CDs and offer music files for free. Some even claim the price consumers will ultimately pay for free sharing will be the collapse of the music industry and the end of music recording.
Neither statement is true. Consumers do pay for free music. That price is poor quality. The sound quality of files ripped from CDs is mediocre at best. The quality of downloadable files offered by recording companies is far superior.
Quality has value. The trouble is that value isn’t $9.95 to $24.95 per month, plus restrictions.
Given a choice between free music of at best mediocre quality without restrictions and paying to download a quality file without restrictions, most consumers would pay an agreeable price. But that price is probably ranges from $0.10 to $0.30 per song. Add usage restrictions, and that range will decline.
Economic theory dictates the best solution is for companies to drop prices to near what consumers are willing to pay for quality downloads. Not the price companies ideally want, but near a price consumers, who have an alternative, will pay. That would create price equilibrium and a functioning market in which recording companies could play a major, ongoing role. This is proper application of the price mechanism. Economics 101.
Unfortunately, recording companies don’t want to drop prices. They fear downloadable songs at less than $1.00 each will eviscerate profit margins and undercut CD sales. True. But there’s no choice.
Audio encoding and download technologies changed recording companies’ traditional business model: finding, promoting, and distributing music. New technologies took distribution control out of their hands. Like scribes in about 1436, when Gutenberg invented the printing press, a major component of the business model is eliminated by technology. Companies may play a major marketing role but can no longer demand high distribution prices.
The steamboat, livery, railroad, steel, and other industries faced technologies that radically changed their roles. The music industry is denying reality in its attempt to sustain traditional pricing. Its economic mistakes will cause some major recording companies to collapse in the next decade. Others will adapt practices and adjust pricing to fit new technologies. New music companies will arise to take advantage of those technologies and changed business model. All this is normal.
Meanwhile, the music download market will continue to malfunction. Millions will choose free downloads of ripped files rather than purchase expensive, restricted songs from recording companies because the pricing mechanism is misapplied.
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