Digital Immigrants

Technology is changing fast. Any business that wants to have a future has to keep up, and the music industry is no different. You don’t need to be an old man to remember how cassettes took the place of vinyl, only to be replaced later by the CD. Nowadays we’re witnessing its own slow disappearance, making room for the new digital music. The process is visualized nicely in Chart 3, made from Recording Industry Association of America (RIAA) data[1].

Chart 3 teaches us that the record labels decided not to cooperate with the new digital technology. Commercial Cassettes and CDs emerged while their predecessors were still popular; and had a gradual, healthy growth, taking the lead in the market. But since the compact disc became dominant, the record companies enjoyed such a massive growth that they, presumably, didn’t want to move on to the new lightweight MP3 music files. The launch of Napster at 1999 brought the MP3 music to the public before the industry was ready. The labels lost control over the development of the music market. And then, a war between the natives and the immigrants broke out.

It’s not Native Americans or European immigrants we’re dealing with, of course. In 2001, Marc Prensky coined the expression Digital Natives to represent the generation of people who were born into the digital world. He describes the Natives as people who are always online, used to receiving information fast, to multi-tasking, to networking. The Digital Immigrants, on the other hand, weren’t born into the digital world but had to adapt. Prensky describes the Immigrants as having an “accent”, trying to force their old habits on a new world (like printing out e-mails, struggling to find a piece of information instead of looking it up on Wikipedia, or calling someone to your screen to see a website instead of just sending the URL).

The Digital Natives see copyrights fundamentally different than how the record labels see them. In 2010, Palfrey and Gasser wrote that the Digital Natives “believe that virtually all forms of private, noncommercial copying of copyrighted works either is or should be allowed.” This obviously conflicted with the Digital Immigrants view of things – they just see copying as theft, a crime. Instead of trying to adapt to the new world, the music industry declared war against the Digital Natives, filing lawsuits against the file sharing developers and their users (even little kids and school teachers, which proved to be a PR disaster).

It’s amazing (and somewhat satisfying) to see how the aggressive measures taken by the labels have done nothing to mend the music industry, while they let four whole years pass by without a proper alternative that would appeal to the Digital Natives. And then Steve Jobs came along, and created the iTunes store.

In late 2003 Apple launched an online music store, iTunes, and gave birth to a new fast-growing digital music market (clearly visible in Chart 3). While the labels were investing their time and money in litigation, unsuccessfully trying to force people back into buying physical CDs, iTunes “moved the industry far more than the industry was willing to move on its own” (Palfrey and Gasser, 2010). It was a wake up call for the record companies, one that got there too late.

Old-school piracy always came when the industry was already prepared for it: high quality cassette recorders hit the market as late as 1985; affordable CD burners only in 1995. However, the illegal market for MP3 developed long before the legitimate one was conceived, due to the record companies’ reluctance to move on to the new technology. Therefore, it is no wonder that the digital market’s growth is much slower than that of the CD in its first years (Chart 4[2]). For years, the music industry failed to supply music the way the consumers wanted it. Now it’s paying the price.

Where Do We Go From Here

Things nowadays are starting to change within the music industry. The gap between the Natives and the Immigrants is starting to close. Ironically, or perhaps finally, the labels are starting to rely on online sharing to promote their business. Three of the world’s biggest labels – SME, UMG and EMI – started a YouTube channel called VEVO where they promote new music from their artists, and encourage people to share the free music with their friends on social networks. Instead of fighting the freedom of information, they started to cooperate with it, using it as a marketing tool.

New services like Spotify, first introduced in 2009, allow streaming of the labels’ entire portfolio to PCs and mobile devices, for a small monthly fee. It has been amazingly effective in increasing revenue from digital music: out of the 20 largest music markets in the world, countries where streaming services were available showed average growth of 43% in digital revenues in 2010 – compared with 13.5% growth where streaming wasn’t available[3].

An online music market has also started to develop, one that is completely independent of the “old” industry. The declining prices of production equipment allow musicians to produce their own music, distribute it on YouTube or MySpace, and sell it on iTunes and other online music stores – without a need for a label. The two markets are open to each other, and thus the big labels sometimes sign online stars, such as Lily Allen and Justin Bieber (minimizing their risk, since the talent of these artists isn’t hidden); while big names like Radiohead and Cher put their new albums for free download on the Internet.

Conclusion

Although it’s traditionally considered that the recorded music industry is failing because of piracy, and there is some empirical evidence to support that claim, we’ve seen that it’s not necessarily the case. Piracy might be responsible for some of the decline in sales, but as we already know, sales are affected by both demand and supply – and piracy only explains one side. The big labels have negatively affected the supply side of the market by inefficient management of artists and a very late response to the change in technology and generations.

The recorded music industry might seem like it’s slowly disappearing, but as the Digital Natives are slowly allowed to take part in shaping the future of the market, it seems like perhaps there’s still growth to see in the future. Not only for the industry, but also for any of us: we all might be just a YouTube video away from being the next best superstars.

It’s the Supply, Stupid

The true effect of music piracy is very hard to measure, especially with the financial interests of multinational multi-billion-dollar corporations involved. A conspiratory mind would immediately imagine dark forces moving things around in the background, so that we only hear about the research results that are in favor of the record companies. And indeed, there are experts who contradict the ones quoted above.

Oberholzer-Gee and Strumpf are two American economists who set out to challenge the conventional wisdom. Instead of trying to find correlations between general, huge things like Internet bandwidth and decreasing sales, they looked into specific albums and artists, comparing downloads with purchases. Their conclusion? In their paper from 2005, they wrote: “Downloads have an effect on sales which is statistically indistinguishable from zero”. In a more recent publication from 2010, they mentioned some empirical work suggesting that file sharing is to blame for no more than 20% of the decline in sales.

The decline is real: we saw it with our own eyes back in Chart 1. But if Oberholzer-Gee and Strumpf’s claims are true, as well as others’, then we can’t blame piracy for the decline – at least not for all of it. This is where economics comes in. The economic theory demonstrates that the balance in any market is determined by supply and demand. The music industry is a market like any other, and file sharing has certainly affected its balance from the demand side. However, the supply side has seldom been discussed. Is it possible that the record labels should have some of the blame?

We’re going to explore two factors that might be holding the industry back from the supply side: one has to do with the artists and the other with the media of distribution.

When Business and Art Meet

Let’s do a little imagination exercise. When you think about a big record label executive, what do you see? How about when you think of the lifestyle of a typical pop star, say, Lady Gaga or Madonna? Try to keep those images in mind while we explain a phenomenon called the principal-agent problem.

Lady Gaga

A simple example would look like this: suppose you had a plumbing problem at home, a small flood maybe, and hired a plumber to fix it. At this point, a familiar conflict of interest starts: while you want your plumbing fixed at a minimum cost, the plumber wants to maximize his own profits. It might be that you just have one loose pipe – but the plumber can just as well tell you that you need to replace the whole system. He knows you don’t have a clue in plumbing, you don’t know what it takes to fix the problem and how much time is really necessary. You don’t even know if he’s a good plumber.

That is called the agency dilemma. It always involves two sides: a principal and an agent. The principal hires the agent to perform a task. The principal then faces two risks: the agent might be holding out information about himself; or he can be opportunistic, benefit himself on the expense of the principal -  just like an employee demanding a pay raise for his “hard work”, when he actually spends half his day playing Facebook poker. This problem was studied thoroughly by economists and describes many real-life situations.

Gundel, Hecker and Muthmann (2006) suggested that the agency dilemma could be used to describe the relationship between the record labels and the artists. Let’s go back for a moment to the images you were asked to imagine. When you thought about the label executive, you probably imagined a rich businessman in a suit, sitting in his office, signing fat record deals, turning music into a profitable business. When you thought about the pop star, chances are you thought about a glamorous life style of partying and drinking, waiting for the muse to come for another song. Since the artists are usually signed with the labels, and in order to make money the labels need hard-working, creative artists, what we have here is a conflict of interest, a classic principal-agent problem – the labels being the principals, and the artists are the agents.

Record labels want to make money. In order to do that, they have to sign artists, preferably ones that have the potential of becoming superstars. But in order to become a star you need a ton of talent and motivation, and these are very hard to measure. This poses a problem for the labels, since setting the ground for a hit song costs over US$1 million[1], and even then the success of the song isn’t guaranteed. It is obvious that only a handful of the new-signed artists will become as successful as Britney Spears or Rihanna, and therefore the labels are facing a great risk. This risk pushes the labels to invest more in their current stars, reducing the quantity and diversity of music by new artists (Chart 2) – hence, reducing the overall music supply.

Chart 2: Global Album Sales, Millions of Units

The problem above isn’t necessarily an agent problem – since the artists themselves might not be aware of their own talents. But signing the artist is just the first step. After an artist has been signed, the label would usually fund him, either by some sort of front payment or a salary. At that point the artist might lose his (or her, or their) motivation to work and create high quality music. Even without being paid, just being signed with a label might make the artist believe that his path to stardom is set, and that he doesn’t need to work that hard anymore. The labels usually solve these problems by assigning a producer on their behalf to produce the artist’s album – but that solution is expensive and results in music that is more generic and is not loyal to the true artistic aspiration of the talent. This problem could possibly prove to be even worse with older talents. A rich, well known artist, whose contract alone cost millions to the record companies, might prove to be very unmotivated to keep being creative or work hard to create value for the label.

These two issues – finding the artist’s true worth and creative laziness – are problems that can be fixed, and possible solutions are described in detail in Gundel, Hecker and Muthmann (2006). But as long as they’re not treated, the supply of music will be less diverse and of less quality.

Click here for part III…

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Of Pirates, Agents and Immigrants:

The Demise of the Music Industry

Why is the Recorded Music Industry Failing?

It is common knowledge that the music industry is falling apart. It’s also pretty obvious whose fault this is: all them disrespectful youngsters, downloading MP3 files illegally, causing labels to crumble and forcing struggling artists to quit. Millions of unaware thieves, even little kids, have managed to bring that industry down to its knees in the past decade. Everyone knows it’s the online piracy that’s to blame for the slow but steady shrinking of revenues from selling music. But if you know something about economics, you know that more often than not, conventional wisdom might hold only part of the truth.

Before we dive deep into the roots of the problem and try to find if piracy is indeed its sole cause, let’s have a quick look at the state of the global recorded music industry. In order to do that we’ll use some data provided by IFPI[1], a non-profit organization that represents the recording music industry worldwide. A quick look at Chart 1 [2] emphasizes how grim the situation of the music industry is. Since 1999, the global recorded music sales declined by about 45%, and seem to keep this trend. The steady growth in sales of digital music since 2004 hasn’t been able to make up for the waning physical sales.

Chart 1: Global Recorded Music Sales ($US Billions)

The record companies have it all against them. They have to fight piracy, to keep up with ever-changing crowd tastes and capricious artists, the rapidly changing technology, and the need to finance risky projects. Despite the complicated environment, which obviously makes it difficult to make profits for a variety of reasons, the big record labels seem to be devoting much of their energy and public relations specially on fighting piracy[3].

How big really is the piracy problem?

Pirates Aboard

In June 1999 a file sharing application called Napster was launched, and everything changed. The music industry was used to amazing growth rates during the 1990’s: according to IFPI, global music sales grew from US$24.1 billion in 1990 to US$39.4 billion in 1996. But since Napster’s launch the tables have started to turn. The effect was immediate, as could be seen in Chart 1: the growth of the industry had stopped and reversed. Following a lawsuit by the RIAA, Napster was closed in 2001. But it was too late: the file-sharing genie was out of its bottle. Its successors, apps like KaZaA and eMule, managed to surpass Napster’s success and some of them are still very popular today, almost a decade later.

The scale of the piracy problem is quite huge. The IFPI Digital Music Report for 2011 shows that even today, with many legal music distribution services, still 76% of all music obtained online in the relatively conservative British music market was from illegal sources.

It’s clear that music piracy is a widespread phenomenon. But how is it affecting sales? Napster executives, at the time, claimed that it didn’t harm sales; that people were just “trying out” songs before purchase[4]. Napster’s opinion was obviously biased, and back then there was insufficient knowledge as to the real effect of piracy on sales. Some research has been done in the following years to try and find a statistical connection between the two. Surprisingly, preliminary results showed that people who download more illegal music also buy more legal music[5]. How could that be? Does piracy actually encourage sales?

Well, if you ask an economist he will tell you it’s just a simple case of simultaneity. Simply put, it means that even though it seems like people who download more also buy more, both are actually affected by something else entirely: passion for collecting music. Those who like music more than others will naturally tend to both buy and download more music. It does not mean that file sharing made them buy more tracks, which is what anyone might accidentally think of the results. They’re just naturally more fond of music.

To avoid the problem, instead of measuring downloading habits, economists used a person’s connectivity to broadband. Connection to high speed Internet implies that a person downloads music online (the researches quoted here took place circa 2003, when broadband was a more expensive form of connection), but it’s not affected by his or hers obsession with music. This is what economists call an instrumental variable. When using the connection speed as an instrumental variable, the results were different: less flattering for Napster.

Different papers show different results: one found that file sharing decreases the tendency to buy music by 13% (Michel, 2006); another used different techniques and found an amazing 30% decrease (Zentner, 2006). A recent research estimates the commercial value of illegal music files available online at about US$40 billion (Frontier Economics, 2011). In Sweden, it was measured that for every 1% decrease in piracy, the sales increase by 0.7% (Adermon & Liang, 2011), suggesting that without the file sharing, record labels could have made a lot more money. It seems like the hysteria from the big labels is justified – piracy is indeed eating up the industry.

All this is not news for you: it has simply been a confirmation to what you already knew. It’s considered conventional wisdom that piracy is the cause for the record companies’ diminishing sales. At this point, if you ever read Levitt & Dubner’s Freakonomics books, you should immediately ask yourself, is it really the only cause? And if there are others, might piracy not be the leading one?

Click here for Part II…

The source of the confusion is pretty much semantic. To understand it we need to be able to tell between what’s Positive and what’s Normative. A positive claim is one that describes a fact or makes a prediction; it has no ethical or moral value. It’s just an observation. ‘This car is going at 90 mph’ is a positive statement. I didn’t say if it was wrong to drive so fast, I wasn’t encouraging it either. ‘If it keeps going that fast, chances are it will cause an accident’ – is a positive phrase as well. I was just stating a fact, which does not in itself make ‘an accident’ good or bad. Just something that’s likely to happen.

Nevertheless, we all know that car accidents are bad. That’s a normative claim. As a society, we decided that car accidents are not a good thing. Car accidents cause human mortality. ‘Death of human beings by car accidents is bad’ is again a normative statement. It does not describe reality. It is a moral value adopted by modern civilization. ‘Death of human beings by accident is good because it prevents the overpopulation of the earth’ is a normative statement as well (admittedly, one that not many would happily agree with).

The science of economics makes things confusing. Is a free market good or bad? Freedom is good; therefore free markets are good as well, right? Not necessarily! A free market is a positive description. If a certain market fulfills a certain set of conditions we’d call it free. But it’s just an observation of what’s there. It’s neither good nor bad. How about efficiency? Is efficiency good? And growth? Isn’t growth a good thing? The answer is, as you probably already realized, is no. Efficiency, growth, equilibrium, and other economic keywords, are just positive descriptions. They have no moral value in themselves. It is up to society to decide what’s good and what isn’t. “Growth is desirable as long as it doesn’t increase the gaps in distribution of wealth” – that’s a normative decision that has to be made by the public, through elections and the media.

So here’s back to where I started. My economics BA taught me how to make positive claims – about inflation, taxes, inequality, growth. It’s no surprise, that’s the whole point of any science – describing what’s there, and predicting what’s going to happen next. But the normative aspect was neglected almost entirely. Why, for instance, were normative-oriented words like ‘efficiency’ selected to describe positive states? Did the people behind this economic theory (specially Keynes) have some sort of agenda? What was the social, economic, and political climate in which they wrote these theories? They were people, after all, and understanding their background is important when trying to understand their science.

Perhaps trying to decide what’s good and what’s bad is considered too vague for a ‘hard’ science like economics. Maybe it’s a question better left to the humanities and social sciences. I personally believe we should have been given the tools that would help us, as economists, make real normative claims. I want to be able to explain why I think communism is bad without using words like ‘it prevents growth’, since growth isn’t necessarily good. Reality is complicated. It cannot fit into a bunch of charts. Is that a bad thing? Who knows.

Last week I finally finished reading Neverwhere by Neil Gaiman. I love his writing, and in the past few years he’s really become one of my favorite authors. There’s something about Gaiman’s ability to blur out the border between what’s real and what isn’t, that makes his books so irresistible to me. I love fantasy literature and enjoy it a lot – yet I’m not a “believing” person. While science fiction keeps me wondering of what is and what isn’t possible, inspire my imagination to run wild, fantasy books usually don’t have that effect on me. As an atheist, I have a strong sense of reality and logic that allows thoughts such as “I wonder if that weird light in the sky is a spaceship” and not “I wonder if it could be a fairy”. I wasn’t always like that, and sometimes consider my realistic view of life as a bit of a handicap; like there’s things out there that are waiting for me to notice them, but I can’t see.

The beauty with Gaiman’s writing is that his fictitious world is weaved right into the everyday life. He identifies soft spots in our reality (dark allies, sealed-out tube stations and locked doors) and turns them into things that exist half here, half there; changes forever the way that you think about them. That, you might think, isn’t so special – and quite a common technique. Gaiman, nevertheless, uses it very skillfully, taking it a step further. The book includes numerous anecdotes about London’s history; facts I assume known mostly to the older locals. While reading one might be confused whether a certain description is of fact or fiction. I found myself looking up Wikipedia more than once throughout the book, trying to figure out if what I was reading was actually true. I was discovering things about the city of London I had never known, further confusing my sense of what’s real. I suppose that by letting my mind open for actual historical facts, some fantastical elements were able to sneak in. This, for me, is nothing short than brilliant.

Obviously, it’s not just the fantasy story that make this book so great: it’s the gripping plot, the beautifully crafted scenes, and the people and creatures that occupy them. The characters in Neverwhere’s world range from the plain normal to the utterly insane – all of them so likable, even the evil ones. I still find myself thinking of some of them, hoping to meet them again in a future novel (one that, regrettably, we would probably never see). I will definitely be looking for them in my next visit to London, hiding in between the shadows of old tube tunnels, forming the slightest crack in an overly-realistic world.