Michel’s working paper is based on 4 chapters of his dissertation thesis entitled “A Theoretical and Empirical Analysis of the Impact of the Digital Age on the Music Industry”. In addition two articles in the Review of Economic Research on Copyright Issues are also based on the findings of the dissertation thesis. Michel constructed a model of interactions between artists, record labels, and consumers, which suggests that file sharing may have been undertaken by consumers who were previously not in the market for music. In order to test his model, Michel provided evidence, based on Consumer Expenditure Survey (CEX) data, that “(…) file sharing decreased CD sales by about 4 percent, though the estimate is statistically insignificant” (Michel 2005: 30).
In his model, Michel imagined a three stage process in which the record label bargains with an artist to obtain permission to reproduce the original work. Then the label picks a profit maximising price for a CD before the consumers decide whether to copy or purchase the music, or to stay out of the market altogether. The consumers’ choice, therefore, depends on the transaction costs consumers are faced with each option. “As the transaction cost of copying falls and the relative quality of copies rises, the model predicts that more consumers will enter the market through copying” (Michel 2005: 3). Therefore, the model predicts that file sharing has been undertaken by consumers who previously did not buy any or merely an insignificant amount of music.
The model provides a formalisation for the bargaining arrangement between record label and artist. Therefore, a Nash bargaining solution was employed from which the impact of the arrangement for the pricing of music was derived. Then, a Hotelling-type model of spatial differentiation was applied to illustrate the consumer decision problem and to derive a demand function.
The demand function suggests that the consumer buys the CD if the perceived quality of the CD, according to the consumer’s taste preferences, is higher than the price. The consumer will copy if the perceived quality of the copy is higher than the cost of copying. Finally, the consumer does neither if she/he does not like the music at all. Hence, if the quality difference between the CD and the copy diminishes, the consumer’s choice will largely depend on the price of the CD and cost of copying. When the taste parameter is greater than a critical value, the consumer will buy the CD rather than copy. However, “(…) consumers will copy, unless their taste for music is so low they forgo consumption altogether” (Michel 2005: 9). This leads to the key hypothesis of the paper “(…) that Internet file sharing, with its lower transaction costs and higher copy quality, could have induced from the ‘neither’ region [no buying, no copying] (…) to move into the ‘copy’ region” (Michel 2005: 9).
In the following, Michel adds a profit function for the music label assuming that it is a profit maximising monopolist, viewing the CD as a homogeneous product without any reference to a particular genre. Each label, then, has always the monopoly on a particular version of an album/song.
Furthermore, Michel applies a Nash cooperative bargaining model to analyze the profit sharing arrangement between record label and artist. It is assumed that the firm is considered risk neutral, but the artist is risk averse. The artist’s optimal share in profits is positively related to her/his bargaining power and negatively related to her/his level of risk aversion. The model indicates that if the quality difference of CD and copy decreases, the artist’s profit share also decreases. However, since the production and distribution costs of music have declined over the years, there are efficiency gains. “For a given level of profit, the model predicts that the income gains from these lower costs will be captured by the artist” (Michel 2005: 23), since the digital age increases the artist’s bargaining power and disagreement utility.
In order to test the model predictions, Michel conducted a study based on Consumer Expenditure Survey (CEX) data. CEX reported expenditures up to 95% of the U.S. households. Michel assumed that computer ownership is correlated with file sharing and that it can therefore be used as an instrument to measure the impact of record sales. The regression results support the model hypothesis that some file sharing was undertaken by consumers that were formerly not in the market for music – neither buying, nor copying. Further, “this estimate suggests that file sharing decreases CD sales by about 4 percent, though the estimate is statistically insignificant” (Michel 2005: 30).
Michel, Norbert J., 2003, A Theoretical and Empirical Analysis of the Impact of the Digital Age on the Music Industry. Ph.D. dissertation, University of New Orleans.
In part 18 Seung-Hyun Hong’s working paper “Measuring the Effect of Napster on Recorded Music Sales”, in which he tried to measure the effect of file sharing on recorded music sales, will be reviewed.