Digital Audio Insider -- the economics of music and other digital content

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Digital Audio Insider is David Harrell's blog about the economics of music and other digital content. I write from the perspective of a musican who has self-released four albums with the indie rock band the Layaways.

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April 01, 2010

Of Course the Demand for Music is Elastic: The P2P Numbers Prove It
by David Harrell
In a recent blog post, former eMusic CEO David Pakman notes that the new CD pricing strategy from Universal Music means that the music industry (or at least one major label group), is finally acknowledging that the demand for music is elastic. That is, lower prices will increase unit sales enough to boost the total amount spent on music.

Pakman has long believed that music is elastic, and I tend to agree. In previous blog posts he has cited eMusic sales figures as evidence of the price elasticity of demand for music, but I believe there's another set of data that also makes a strong, albeit incomplete, case for elasticity: peer-to-peer file sharing.

According to the International Federation of the Phonographic Industry, for every track that is purchased from a legal download service, 19 are acquired via file sharing networks. No doubt a percentage of illegal download activity comes at the expense of legal sales, and P2P sharing and other forms of piracy are generally blamed for the decline of music sales over the past decade. (Check out the most recent IFPI Digital Music Report.) But a larger portion of this activity simply represents the increased demand for music when the price is zero. We know this because the sheer volume of music acquired outweighs the amount that was purchased before the advent of P2P sharing.

Think of it this way -- if all of the tracks now acquired via P2P sharing were instead purchased legally via iTunes or other download stores, it'd represent an annual digital music market of approximately $84 billion, 20X the total digital sales of $4.2 billion in 2009. Yet the total market for recorded music peaked in 1999 with worldwide sales of $38.6 billion and U.S. sales of $14.6 billion. And when you consider that the P2P crowd only represents a subset of music listeners -- those with both the basic technical skills to acquire music this way and no qualms about the legality/ethics of doing so -- the total demand for recorded music is obviously much greater than that reflected by total music purchases under traditional pricing models.

So it's undeniable that the demand for music is extremely elastic, at least as the price approaches zero. But you can't make money from $0 per unit, no matter how many are moved. What we don't know for certain is the shape and slope of the demand curve. Does demand only skyrocket as the price approaches zero, or is there some point between zero and current music prices where demand will increase to a level that produces total revenues that exceed the current dwindling numbers?

Keep in mind that -- because of fixed costs such as mechanical royalties -- the increase in demand must be significantly greater than the decrease in prices. Double the sales at half the price is a net loss for music labels. That is, due to mechanical royalties totaling 91 cents, if you drop the retail price of a 10-track album from $10 to $5, you need to sell 2.22 units at $5 to equal the revenue from 1 unit sold at $10, ignoring all other costs. (Physical CDs, of course, have manufacturing costs and shipping costs as well, but even digital albums have additional costs such as credit card transaction fees, though those tend to be percentage amounts.) The demand for music has to be elastic enough to offset the fixed costs that increase as a percentage amount as the selling price decreases.

I've long been convinced that, with its daily and monthly mp3 album deals, has been conducting an ongoing experiment in music pricing and demand, and that it will eventually use (or is already using) its sales data to try to convince labels to agree to a permanent restructuring of the pricing of digital albums. I'd love to see those sales figures, as well as those for Universal CDs under its new pricing model.

Can the music industry somehow adjust its prices to increase the sales of recorded music? Given the trend over the last decade, it seems like it'd be silly not to try. If nothing else, just halting or slowing the ongoing decline would be something of a victory.


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