Wade Armstrong

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The Recording Industry is Clearly Not Taking My Advice

Posted Monday March 12, 2007 in Business

A few weeks ago, I suggested that the recording and movie industries outsource their challenge to create a new business model. By having VCs and entrepreneurs attempt to implement industry group-approved business plans, it seemed to me that these industries could shift all of the risk of figuring out what was next onto other individuals while reaping all of the rewards from emerging distribution channels. The recording industry, at least, has made it clear that they have no intention of doing any such thing. They asked, and got, an increase in the royalties paid to artists by online radio stations, an increase to a level that will probably drive all of these radio stations — this entire emerging distribution channel — out of business.

What’s wrong with wanting high royalties?

Nothing! The recording industry should try to make as much money as it can. The only question is: does maximizing the price of playing a song on the radio maximize the revenue gained over the lifetime of that song? The answer to this question isn’t obvious, because music is consumed in so many ways — albums, tours, memorabilia, sheet music, sampling, to name a few — and whether or not a consumer wants one or more of these is probably related to their consumption patterns for all of the rest of these. If a song is too expensive to play, will the total number of albums sold containing that song decrease? What happens to concert revenue?

What high royalties mean

This is an important question because the effect of this new royalty structure on Internet radio is likely to be disastrous. The CEO of Pandora, a radio provider I listen to every day, says these rates will end internet radio, period.. In a short but complete analysis, the Radio and Internet Newsletter pegs the new rates as “about 100% of per-song revenue for an Internet radio station.” 100% of revenue is extraordinarily high, especially given that the royalty rate for terrestrial ad-supported radio is between 1 and 2 percent of revenue.

Now, both Westergren and Hanson are talking about ad-supported free-to-the-user Internet radio. That doesn’t say anything about how subscription-based services can survive, but, given that most sources suggest that all subscription-based services combined have less than 15% of the music market, the answer to that question probably is “the market doesn’t care.”

Why internet radio is a good thing for the recording industry

Internet radio is pretty much the embodiment of the business model I suggested — a bunch of technologists and VCs are running experiments, on their own dime, to figure out what the next distribution system is going to be. Will it be traditional DJd radio, online? Totally customized, shareable stations? Something in between? Guess what — the recording industry isn’t spending a penny to find out. Most people would pay money to have others absorb all of the risk of trying out next-generation business models for them; the recording industry is going to kill the companies that would do that for it.

It’s not just that the recording industry is getting business models tested for free; economics suggest that any company should keep selling its products, whatever the price, until marginal revenue — the money gained by selling one more unit — equals marginal cost — the additional cost required to produce one more unit. Since all of the costs of streaming Internet radio are borne by the radio stations, the marginal cost for recording companies of distributing their songs through Internet radio is pretty close to zero. So they should happily continue licensing for some relatively small price.

So then what could be wrong with online radio?

Of course, the marginal cost argument only holds true if online radio isn’t cannibalizing listeners from other distribution channels. If music consumers are switching from high-margin CDs to Pandora, then Internet radio can be costly and the music industry should rightly fear it. The common argument, that the low margin the industry gets off of Internet radio plays is better than the zero margin they get off of pirated music, is a bit of a red herring — no industry will ever voluntarily give up margin, so of course the recording industry will fight margin decreases. Unless, that is, these margin decreases come with volume increases. That’s why anybody does business with Wal-Mart.

Internet radio entrepreneurs will tell you that the people who consume their product are new customers — either people who weren’t consuming much new music in the past, or people who are now consuming more music than in the past.¹ If that’s true, then this channel really represents marginal revenue growth and is a desirable outlet for the music industry. Such a desirable outlet of course offers just the increase in volume that justifies lower margins.

Who’s right? The great thing about Internet radio is that we can figure out whose story is true. Each service requires a log-in, and each service has members who can be surveyed. Ask listeners about their older and more recent music consumption habits; gain demographic and psychographic detail; check claimed consumption habits against known buying patterns of people matching the demographic and psychographic profiles; then you have a pretty good idea of what money is new and what money is old.

What should the recording industry ask for instead?

If consumers are switching, they must view the product they’re switching to as having some advantage over the project they’re switching from. Entrepreneurs are trying to figure out what advantages consumers value and don’t value. The recording industry has given itself a set of big, powerful tools — it can kill entire business models through licensing (Internet radio) and lawsuits (Napster). But the industry doesn’t have any fine control. It can’t encourage certain patterns of growth, it can’t experiment, and it can’t gain data on its users. The industry is like the US President, with only a veto pen to kill the legislation he hates — but even Presidents have friends in Congress who will introduce the right bill. The music industry needs just such a friend

So I come back to my earlier plan. Licensing terms are a powerful tool, and they should be used delicately. The recording industry needs to step back and reduce its rates, letting the online broadcasters grow for a bit. In return, the recording industry should offer some discounts — reveal certain use patterns and get a discount on royalties. With that, the recording industry will start to get the information it needs about what the market will look like in the future, and that’s the first step to remaining viable for decades ahead.

¹ I certainly am consuming a lot more music — including buying new CDs — because of Pandora.