The Music Industry Is Playing a New Tune

Reprinted with permission from Knowledge@Wharton.

From Confrontation to Experimentation

EMI Music backs a label that turns the traditional economics of the recording industry on its head. Vivendi's Universal Music Group creates multiple pricing schemes for CDs. Sony BMG Music Entertainment and Yahoo decide to sell a single without digital rights restrictions.

These moves typify a flurry of experimentation by major record labels in recent weeks, and stand in stark contrast to earlier behavior by an industry that six years ago was best known for launching anti-piracy lawsuits against Napster — a network that originally swapped music files for free — and individual users. This experimentation has been preceded by a series of court victories that favored entertainment companies, including record labels and moviemakers. The most significant was the Supreme Court's June 2005 ruling against file sharing networks Grokster and Streamcast Networks. In that lawsuit, brought by the Motion Picture Industry of America and the Recording Industry Association of America (RIAA), the Court ruled that Grokster and Streamcast Networks could be held liable for copyright infringement by people using their software.

Even as the courts have made it clear that that downloading music files without paying for them is illegal, the recording industry has been searching for new business models. "The music industry is showing a greater willingness to experiment," says Wharton marketing professor Peter Fader. Other observers point out that the music industry has all the tools to navigate a new Internet-enabled landscape. "I think we are over the hump in our transition to the digital world and respect for property rights," said RIAA CEO Mitch Bainwol in a June 16 webcast with Inside Digital Media senior analyst Phil Leigh, posted on the firm's site. "We are in a transition and this is a journey."

Wharton business and public policy professor Joel Waldfogel notes that the music industry's journey isn't as easy as it seems. The biggest task, he says, is still convincing young consumers that they can't share their tunes at will. And to do that, the industry has to walk the fine line between wooing consumers and protecting copyright. "Part of the challenge here is cultural. The industry's strategy has to change values about music."

It remains to be seen if the recording industry has what it takes to thrive amid Internet distribution, but it is clearly on the right track, says former musician Jeffrey Babin, India global country manager for the Wharton Global Consulting Practicum. "The recording industry is doing what it should." A few examples:

• EMI Music announced on July 6 that it would back a yet-to-be-named record label, started by a management company called The Firm, that abandons the recording industry's traditional royalty payment system for what EMI terms a more "artist-friendly" profit sharing scheme. Instead of paying artists upfront and taking the bulk of the profits later, The Firm will split profits with artists signed to the venture. In theory, this arrangement should lower the risk and upfront costs of finding new talent and encourage more innovative promotion. "You have to give the recording industry credit for realizing that the barriers to entry are lower," says Kendall Whitehouse, senior director of information technology at Wharton. "The industry no longer has a chokehold on distribution. Indie bands promoting their music on [websites like] MySpace are changing the rules."
• Vivendi's Universal Music Group on July 5 announced a three-tiered pricing system for CDs that targets everyone from consumers who want no-frills music to those willing to pay more for fancy extras included with the music tracks. While on the surface, such actions may be seen as an attempt to squeeze more revenue from the slow-growth CD market, Whitehouse says the move makes sense. "CDs mean different things to different people. Some people only want the music while others will pay more for extras" like dual-disc media with audio on one side and DVD video on the other.
• On July 19, Sony BMG and Yahoo began offering a new Jessica Simpson single for $1.99 without digital rights management (DRM) software restricting how and where the music can be played. Instead, the song will be distributed as an "open" MP3 file and is available personalized with the buyer's name in the song (assuming the purchaser's name is among the pre-set list of several hundred names available). As a previous Knowledge @ Wharton story noted, most DRM schemes have been widely criticized by industry analysts. Indeed, Yahoo Music's blog noted that "DRM doesn't add any value for the artist, the label … or the consumer. The only people it adds value to are the technology companies interested in locking consumers into a particular technology platform."

What has sparked this rash of experimentation in the music industry? Most observers suggest it was inspired by the launch of Apple Computer's iTunes, which has quickly become a key means of distributing legal music for 99 cents a song. "It seems that Apple's iTunes has opened the music industry's eyes to the opportunity, rather than the threat, of the Internet," says Whitehouse. "In the early days there were no alternatives. iTunes changed all that."

And so far, so good. The RIAA is projecting $1 billion in legal digital music downloads for 2006. That figure is likely to increase given that 36 million Americans — roughly 27% of Internet users — download music, according to the Pew Internet & American Life Project.

Multiple Business Channels

Fader also notes another factor behind the music industry's willingness to try new approaches: It has no choice but to embrace the Internet. Like other media such as print, movies and television, the Internet is revamping the way entertainment is shared. Fortunately for the recording industry, it has strong assets, says Fader. "If you wipe the slate clean regarding past mistakes, the recording industry has a wonderful opportunity and is in a better position than any other industry wrestling with digital media. The industry enjoys multiple business channels, such as selling CDs, offering downloads and collecting fees for music rights."

According to Fader, the Internet can accentuate the music industry's core strengths which include: an ability to find artists and generate audiences for them; multiple promotion vehicles such as the Internet and live concerts; technologies such as dual CDs and DVDs to boost older music sales; and multiple distribution channels such as satellite, the Internet and cell phone networks. "No other content has as many ways to be distributed."

With these assets, Fader argues that the recording industry can place its chips on multiple business models. Those favored by experts include:

• Music by subscription: Despite Apple's contention that consumers want to download songs rather than play music online, Fader and Babin expect most consumers will ultimately subscribe to catalogs of music. These songs would then be "streamed" to various devices such as a personal computer, networked music player or cell phone. Babin, who subscribes to four different music services, says he is surprised the subscription model hasn't gained more traction, but acknowledges that both technological and cultural issues remain.

  On the technology front, Babin notes that his subscription services don't share well among various devices. Meanwhile, there are quirks with various DRM systems. For instance, Babin's music collection disappeared once when he wasn't connected to the Internet at the turn of a new billing cycle. The problem: The songs expired because the services couldn't verify he paid the bill. "If you're not connected to the Internet when the new billing cycle turns, your music is gone."

  But the bigger hurdle may be cultural, says Babin, who adds that people like to own their music. "It makes sense to have a subscription to music, but it's a hurdle to get consumers to adopt it." Meanwhile, it doesn't help that Apple, which dominates digital music distribution, doesn't support a subscription model. And without Apple, it is unlikely subscriptions will gain momentum.

• New labels: According to Fader, it would be better if each music label developed its own model and conducted its own experiments. If each label came up with a different business model, the industry as a whole would find a winning approach quickly. "They tend to follow each other in lockstep, but we need to see more variation." During his interview with Inside Digital Media's Leigh, RIAA's Bainwol said that the labels are in the process of developing those models. "The labels are doing more than people realize. The switch went off about digital distribution and they are embracing change and experimenting."
• Hybrid models: Leigh suggests that business models in the music industry don't necessarily have to fall into any single category. And Waldfogel points out that experimentation needs to become ingrained into the way the music industry operates. Free music services that are ad supported may be one avenue worth pursuing. Adds Fader: The main thing is to have the music industry play to all of its assets. "For instance, you could have a subscription service where members can buy CDs for $4."

  Fader is also an advocate of combining satellite radio with music services. One such effort — a partnership between XM Satellite Radio and Napster, which is now a legal online music service — has been panned by the RIAA. The RIAA has sued XM for copyright infringement over a device called the Pioneer "Inno" that combines the ability to store music played over satellite radio. "The industry needs to find ways to integrate multiple channels," says Fader. "It's troubling that [the industry] hasn't embraced a device like that."

• DRM-free music sales: Leigh suggests that many technology hurdles with subscription music services could be resolved if digital music could be sold without DRM restrictions. "If labels would sell music without DRM protection it would eliminate a lot of the interoperability issues," says Leigh, who notes that one service — eMusic — has already found a following by not deploying DRM. "The industry needs to experiment by releasing music without DRM. If there was a serious effort to sell without DRM for popular releases, you could look at the impact of piracy versus the added distribution and publicity. You may discover benefits."

Assuming these issues with DRM and playing music on multiple devices can be overcome, Babin says the music industry could discover its Holy Grail — digital distribution via cell phones. In his view, music over cell phones would boost sales and open up new markets since there are more cell phones than music players globally. "The more cell phone networks are upgraded, the larger the potential."

Apple: Friend or Foe?

As new models develop for the music industry, it could increasingly find itself at odds with Apple, which arguably brought the RIAA and its members into the digital age, says Fader. Indeed, the music industry's relationship with Apple gets more curious as the music industry branches out.

The paradox: Currently Apple doesn't buy into the subscription music model, which would provide the industry recurring revenue. In that light, Apple, whose main goal is to sell iPods, could hamper the industry. While Bainwol says the RIAA is "thankful for the vision of [Apple CEO Steve] Jobs," other analysts have doubts. Whitehouse, for example, notes that the industry's failed efforts to get Apple to change its iTunes pricing to reflect different levels based on demand illustrates the tension between the two parties. Then again, the music industry has little choice, says Whitehouse, who notes that Apple controls pricing power because the industry failed to create its own digital distribution effort earlier. "Apple helped start legitimate music distribution with its simple 99 cent-per-song model. While the industry has pushed for variable pricing (say $1.99 for a hit song and 50 cents for an older tune), the fact that Apple hasn't budged shows who has the upper hand."

Others, including Babin, Leigh and Waldfogel, downplay any tension between Apple and the music industry. While acknowledging an "interesting symbiosis" with Apple and the music industry, they claim it's in both parties' interest to maintain long-term ties.

Fader, however, doesn't buy it. He maintains that Apple is a foe — or at least will become one. Apple's dominance in the music industry means that one model — downloading music — rules the roost when there may be better options, such as subscription-based businesses. "Apple gave the industry a wake up call, but it has taken away the flexibility on pricing and promotion," says Fader. "The iPod is a killer device in more ways than one."

Leigh says that if the music industry is truly worried about Apple, it should help Microsoft become a stronger competitor. Microsoft could offer a counterbalance to Apple and boost alternative business models. That day may be coming. On July 21, Microsoft confirmed that it had plans to develop a new digital music and entertainment brand, called Zune, that could compete with the iPod.

Given that it's not clear what online music formula ultimately wins, it only makes sense for all involved with the music industry to try a little bit of everything, says Waldfogel. "Since we don't know how [things] will play out, this is a good time to experiment."

Reprinted with permission from Knowledge@Wharton, the online research and business analysis journal of the Wharton School of the University of Pennsylvania."