Bayaan (2004) not only theoretically investigated the impact P2P file sharing on record sales but also examined how technological advances in the recording of music affected the music industry. He assumed therefore that firms exercise monopoly power over artists and examined the effects of technological change on profits and the number of artists signed. He then attempted to model various steps that a firm can take dealing with file sharing technology – either investing in higher quality product or pursuing legal remedies. Finally, Bayaan focused on the artists’ decision and their ability to produce and distribute their own music on the Internet. The author came to the conclusion that technological advances “(…) leads to more artists and more variety within the music industry” (Bayaan 2004: 1) and increases social welfare.
In his model, Bayaan attributed a specific value to each artist, which reflects the type of music she/he makes. This parameter is known for both artist and record label. “This means that firms can make decisions regarding the signing of artists with full information on how successful a particular artist will be with consumers” (Bayaan 2004: 4). Demand, therefore, is depended on the popularity of the artist and the price, assuming marginal costs to be zero for each CD.
In the next step, the author modelled the firm’s behavior under a regime of no-file sharing. The label is assumed to have monopoly power over the artist it signed. Each firm in the music industry, thus, faces a two-stage game: first, the firm has to decide whether or not to sign an artist; second, if the label decided to sign the artist, the firm has to choose a profit maximizing price for a CD, assuming certain fixed promotion and artist development costs. The model implies that the more popular the artist, the higher the price for the CD and the more CDs can be sold. However, labels are only interested in signing an artist if they expect to make enough revenue to recoup fixed costs invested into the artist. Hence, there is a break-even value for a specific popularity level. The break-even value would represent, therefore, the least popular arist that would be signed by a record label. Industry profits are the sum of all artists’ profits.
In the following, Bayaan differentiated two scenarios for labels to respond to file sharing: (1) a quality response or a (2) legal response by the labels. The quality response could be to add bonus DVDs, as well as to offer autographed CDs or higher quality CDs (e.g. SACDs). The purpose is to stimulate demand for orginals by increasing the quality differential between orginal and copy. In this case, the label has to incur additional costs. However, Bayaan shows that the profit maximizing price is exactly the same as in the no-file sharing regime, but with lower overall profits for the artist, because the demand is only a fraction of what it was before and because of higher fixed costs. This leads also to lower overall profits for the label. On the other hand, the break-even level is higher now than it was without file sharing. The model indicates that under a file sharing regime combined with a quality response of the labels “(…) [f]ewer artists are signed by firms and the profit is smaller than it was before” (Bayaan 2004: 10).
In the following, the author compared the quality response scenario with a legal response scenario, e.g. to sue individual file sharers. In this way, the labels get back a portion of the demand that is lost when file sharing becomes widespread. However, all firms have to pay a certain fixed cost of legal prosecution, which changes the profit function. The model shows that break-even level of popularity is not only higher than it is under a situation with no-file sharing but also higher than in the quality response scenario, which means that there is less variety in the industry in the legal response scenario than in the quality scenario. Therefore, the profits are also lower than with the quality response.
For artists, the technological improvements dramatically reduce music production costs and make it easier for them to distribute their music to the consumers at marginal costs close to zero. Hence, artists that are not popular enough to be signed can still produce and distribute CDs by themselves.
Although labels and signed artists are worse off if file sharing is widespread under consumers, artists who are not popular enough to be signed have the ability to produce and distribute CDs using the new technology. Thus, they are better off. However, if the labels decide to invest in higher quality for the same CD price, this increases consumers’ welfare. Since previously unsigned artists are enabled by the new technology to produce and distribute their music by themselves, consumers enjoy a higher variety of music. In constrast, if the labels decide to use legal methods, consumers also enjoy a greater variety due to the increase of CDs by previously unsigned artists. However, the legal costs incurred by the labels are a deadweight loss to the industry. If these costs are too high, the benefit gained by consumers may not be enough to offset the profit losses by labels and signed artists. “The worst scenario for consumers and society as a whole is where firms use legal methods to combat file-sharing and artists who were not previously signed have no incentive to produce and distribute” (Bayaan 2004: 17).
Bayaan, Ibrahiim, 2004, Technology and the Music Industry. Effects on Profits, Variety and Welfare. Working Paper, Emory University.
In part 7 of the series “How Bad Is Music File Sharing” I will summarize the article of Nicolas Curien and François Moreau entitled “The Music Industry in the Digital Era: Towards New Business Frontiers?”