Making Use of File-Sharing in Music Distribution

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1 Making Use of File-Sharing in Music Distribution Martin Peitz University of Mannheim Patrick Waelbroeck ECARES, Université Libre de Bruxelles this version: February 2004 Abstract The use of file-sharing technologies, so-called Peer-to-Peer (P2P) networks, to copy music files has become common since the arrival of Napster. P2P networks may actually improve the matching between products and buyers we call this the matching effect. For a label the downside of P2P networks is that consumers receive a copy which, although it is an imperfect substitute to the original, may reduce their willingness-to-pay we call this the competition effect. We show that the matching effect may dominate so that a label s profits are higher with P2P networks than without. Furthermore, we show that the existence of P2P networks may alter the standard business model: sampling may replace costly marketing and promotion. This may allow labels to increase profits in spite of lower sales. Keywords: filesharing, P2P, sampling, information transmission, piracy, music JEL-Classification: L11, L82 Martin Peitz gratefully acknowledges financial support from the Deutsche Forschungsgemeinschaft (Heisenberg Fellowship). Address: Department of Economics, University of Mannheim, Mannheim, Germany, peitz@rumms.uni-mannheim.de Address: ECARES, Université Libre de Bruxelles, CP 114, 50 av. Roosevelt, 1050 Bruxelles, Belgium, pwaelbro@ulb.ac.be.

2 1. Introduction Digital music files (mostly in MP3 format) have become widespread on the internet. File-sharing systems pioneered by Napster and nowadays dominated by Kazaa have become popular among certain online communities and a target for legal prosecution by record companies. Industry representatives partly attribute the recent drop in CD sales to a rise in online file-sharing, which, from the point of view of the record companies simply reads as piracy of copyrighted material. In the US alone an estimated number of 30 to 40 million people have downloaded MP3 files. Since the vast majority of material on file-sharing systems is copyrighted material this means that almost the same number has downloaded copyrighted material. In some cases, downloading files may be within fair use, namely if a consumer who downloads an MP3-file already owns a CD containing the same song (even this use is contested by the Recording Industry Association of America, short RIAA). However, in most cases consumers download files which they do not already own in some other format. 1 The surge in downloading has taken the music industry by surprise. It is still trying to find viable business models for online music distribution. At the same time it is trying to restrict the use of file-sharing systems with legal actions (as in the Napster case) and what they call educational measures, which also contain threats to consumers and firms (for a survey of the technological, legal, and business aspects see Peitz and Waelbroeck, 2003c, for a partisan view see the IFPI online music report 2004, published in January 2004). As a recent illustration, in September 2003 the Recording Industry Association of America (RIAA) started to file lawsuits charging music uploaders with copyright infringement. The industry also reacted by implementing technological measures of protection, such as Digital Rights Managements (DRM). These actions are based on the strong belief that music downloads are causing a substantial damage to the music industry. While the music industry is experiencing falling revenues there exists some evidence that file-sharing networks have hurt the music industry. Liebowitz (2003) reaches this conclusion by looking at longitudinal CD sales data in the US. In Peitz and Waelbroeck (2003b), we find that online file-sharing and internet piracy played a significant role in the decline in CD sales in 2001, although they can hardly account for the subsequent drop in 1 In a survey, 28% of all downloaders responded that they downloaded music they already own in a different format (PEW Internet tracking July-August 2000, see Peitz and Waelbroeck, 2003c, for details). 2

3 2002. Advocates of online file-sharing, however, believe that file-sharing should be free and unrestricted. One argument goes that downloaders use the downloaded files for sampling in order to make more informed purchasing decisions. Hence, the argument continues, the music industry may actually benefit from file-sharing networks. This view is to some extent supported by survey data that show that a large share of internet users downloads files for sampling: A share of 69% of downloaders listen to new music and 31% to music by artists never heard before according to PEW internet tracking, July-August A share of 30% of respondents to an IPSOS survey of 2002 acknowledged that the genre that they typically listen to/purchase has changed since they started downloading (over a brief period of time), mainly because they were able to experiment with new genres and new artists; for more details see Peitz and Waelbroeck (2003c). We believe that these numbers understate the potential of file-sharing systems for sampling purposes because cross-recommendations and profiling of downloaders can largely be improved so that sampling becomes much more attractive. We claim that the argument of sampling fits well many types of music individually acquired information is very important for music because of the nature of the good (an experience good where horizontal product differentiation and taste heterogeneity are important). This implies that an MP3 download and a CD are complements because the former gives relevant information on the value of the latter. Of course, this is a partial view as consumers will download and listen to much more music than they will actually purchase so that some substitution will take place. This substitution may lead to a fall in the number of units sold or a lower price. The important question is whether record companies can actually benefit from free file-sharing although some substitution takes place. To address this question we analyze a simple multi-product monopoly environment in which the original and the copy are imperfect substitutes. We make the extreme point that sampling may actually increase the label s profits. Currently, data do not confirm this possibility. However, this could be due to the fact that current file-sharing systems are not very helpful as a sampling device and that the music industry may find a profitable business model by embracing file-sharing networks and responding to consumers demand for online music and CDs on demand (this is what Bertelsmann claimed to do with the attempted purchase of Napster and what Apple s itunes is partially offering). Possibly, fee-based systems can still be introduced successfully. This would give the music industry an 3

4 additional source of revenues. 2 Our starting point is the hypothesis that the consumers sampling technology exhibits increasing returns to scale. This is formalized by introducing a fixed sampling cost and zero marginal costs for sampling an additional song. Sampling allows consumers to find out about their favorite music so that they can make informed purchases. A consumer who likes a particular song or album is assumed to have a higher willingness to pay for the CD (he wants the real thing, including lyrics and other complementary material). Hence, sampling relaxes the participation constraint of consumers. However, after sampling, the outside option of a consumer is different because he now owns a digital copy that he can use whether he purchases the original or not. This effect reduces the willingness to pay for the original CD ceteris paribus. In the simplest version of the model, we postulate that consumers make uninformed purchasing decisions in the absence of sampling. If the information acquired through sampling sufficiently increases the willingness-to-pay then consumers are willing to spend more on a favorite song or album than if they had to make an uninformed choice, even though copies are available. Extending the argument, labels may transmit information on product characteristics to consumers by marketing and promotion. 3 In the music industry, these marketing and promotion costs constitute an important part of the average cost of a CD. 4 Sampling then provides an alternative channel of information transmission, which allows labels to save on marketing and promotion. In other words, the optimal business model in the music industry may change and a significant part of the marketing and promotion efforts may no longer be needed with P2P. We find that copying and sampling may reduce revenues but at the same time increase profits. Hence, although the claim by the music industry that revenues fall holds for certain specifications of our model, online file-sharing, if properly designed, has the potential to reduce the costs of marketing and promotion in our simple model the need to spend on marketing and promotion is completely 2 According to the Digital Millenium Copyright Act, copyrigh owners already collect royalties on content that is streamed online. 3 The view that a firm can transmit information on product characteristics is also expressed in the industrial organization literature on informative advertising, see e.g. Rosen (1978) and Meurer and Stahl (1994). 4 According to the RIAA, promotion costs are perhaps the most expensive part of the music business today (see Chuck Philips ( Record Label Chorus: High Risk, Low Margin, L.A. Times, May 31, 2001) reports that marketing costs can run from $3 per hit CD to more than $10 for failed projects. 4

5 eliminated. That is, copying, which is an information-pull technology, substitutes for an information-push technology. There exists a growing literature on end-user copying (for a review see Peitz and Waelbroeck, 2003a). However, most of the literature does not address copying as a means of information transmission. Exceptions are Duchene and Waelbroeck (2002), Takeyama (2002), and Zhang (2002). Duchene and Waelbroeck (2002) analyze the effect of extended copyright protection on a firm s distribution and protection strategies, when digital copies available through P2P play an informational role. They consider a single-product firm that decides how much costly technological protection to implement in different legal enforcement regimes. Technological protection increases the consumers disutility of consumers of a copy but at the same reduces the fair use value of the original product (although they assume that the first effect dominates the second). A strengthening of legal protection reduces the surplus of copiers through the increase in the expected penalty if caught copying. In this framework, they show that increasing copyright protection has both a direct effectoncopiersbutalsoan indirect effect on buyers as technological protection and prices increase with legal protection, unambiguously reducing consumers surplus. Moreover, increasing copyright protection hurts artists distributing their albums on P2P networks. Zhang (2002) argues that sticking to the traditional distribution technology is wasteful from a social point of view when P2P technologies are available. He considers an asymmetric environment in which a star performer can distort demand in its favor using the traditional distribution channel. Niche performers can partly compensate this disadvantage by using P2P that gives them the opportunity to expose a share of consumers to its music, increasing consumers willingness-to-pay. Thus P2P may be beneficial for the niche performer. Takeyama (2002) analyzes how copies that provide information on the quality of a product can solve an adverse selection in a two-period durable good monopoly. In particular, if a consumer copies the product in the first period, she learns its quality and can decide whether to purchase in the second period. However, there are some consumers, call them captive consumers, who never copy. Takeyama shows that there exists a pooling equilibrium in which the monopolist intertemporally price-discriminates, selling to the captive consumers in the first period and charging the price equal to the difference in valuation between the original and the copy to the other consumers in the second period. Takeyama then makes the availability or non-availability of copies part of the firm s strategy. She shows that the absence of copies (in other words, the enforcement of copyright) is a (cheap) 5

6 signal for low quality. Our contribution to this promising literature is to show that copying increases the fit between the purchased product and the tastes of a particular consumer, an aspect which can make sampling by consumers beneficial to a (multi-product) label. Our plan of the paper is as follows. In section 2, we shortly present facts on the music industry that motivate our modeling strategy. In section 3, we present the model. Section 4 contains the analysis: subsection 4.1 analyzes sampling in isolation, subsection 4.2 analyzes sampling as a possible substitute to marketing and promotion efforts by the label. Section 5 concludes. 2. Three facts about the music industry and digital copies In this paper we present an information-based story for the usefulness of P2P as part of a label s strategy. There are several reasons to believe that file-sharing can have an important impact on the music industry. First, there is a large number of new releases every year that make up for a majority of CD sales during the year, and information on new artists and new albums is an important component of the purchasing decision. Second, survey data show that downloading is strong among the youth. The young cohorts of consumers has a high propensity to listen to music but a low willingness-to pay for music so that the choice of the right distribution technology can lead to large potential benefits or losses for record companies. Finally, survey data indicate that consumers who stream online or download music the most also purchase more CDs than the average (Arbitron/Medison 2002 and Forrester 2002 discussed in Peitz and Waelbroeck 2003c). As a consequence, filesharing and other means of acquiring information on new music can potentially have an important positive or negative impact on the music industry. Central to our analysis will be the assumption that there is a large variety of different titles and albums available. Therefore, we work in a multi-product environment in which the substitutability between products is explicitly taken into account. Our modeling strategy is guided by a number of stylized facts. 1. List prices are rather uniform across albums. The uniformity of prices has two implications: (i) labels mostly do not use prices as a discrimination device at least for new titles and albums within its repertoire and (ii) big labels do not follow different pricing strategies. Our analysis focuses on a symmetric environment. Clearly, in the real world there are winners and losers in the market for CDs. However, our fact 1 suggests that these 6

7 asymmetries are not reflected at the pricing stage and can therefore be ignored. We will also abstract from strategic interaction between labels. To the extent that the big labels collude in prices, it does not really matter for the analysis whether we consider a single label, as in this paper, or several labels, as observed in reality An important share of consumers use P2P for sampling. As documented in the introduction, survey data support the view that an important number of downloaders gathers information on previously unknown music. This means that copying and downloading may be a complement to purchasing CDs. Listening to downloaded files enables consumers to make more informed purchasing decisions. As we will show, this may actually be beneficial for the label. 3. While sampling seems an important reason for downloading, a share of consumers uses copies as substitutes for originals. We will present a framework in which consumers can use downloads as a substitute to the original: sampling increases the willingness-to-pay for the original of the favorite album, whereas the availability of free copies makes the no purchase option more valuable. 3. The model We consider the problem of a multi-product monopolist facing the decision to advertise and price its products. In Section 4.1, we suppose that the firm can not advertise its products and highlight the matching effect of digital copies. In section 4.2, we introduce expenditures for marketing and promotion and we compare the situation of traditional marketing and promotion to the situation in which free digital copies of an original product are available on a P2P distribution technology. For simplicity, we place our analysis within a discrete-choice setting. Products in the market. Suppose that the monopolist offers N symmetric products. For the sake of simplicity we do not distinguish here between a single track and the album which contains this track. We use the simple structure of the Salop circle: products are equidistantly positioned on a circle of unit length. Good i is located at l i on the circle. This particular structure makes the analytical 5 The music industry has a history of alleged price collusion. For example, in 2003 the music industry reached an out-of-court settlement in the US on charges of price collusion. 7

8 problem easy to solve. 6 Music experience. Consumers are uniformly distributed on the circle and have an ideal variety ω. The specific location of the product closest to their ideal variety, l, is unknown. We assume that the location is uniformly distributed on a circle segment the length of which depends on consumer s information, as we will describe below. A consumer experiences a disutility τ ω l when consuming the good at location l. Consumers at their ideal point obtain a certain value of listening to music which is denoted by r>0, regardless of whether they purchase the original product or downloaded the digital copy. If they purchase the original product and like the good, they obtain an additional utility γ(1/2 ω l ) that corresponds to the value of the original over the copy (such as additional songs unavailable on P2P networks, lyrics, booklet, pictures, song information,...) at apricep. The parameter γ reflects the value added for an original at the ideal location. This value added is assumed to increase linearly with the attractiveness of a product. The underlying motivation for this assumption is that original cover with lyrics and other bundled services are very valuable for somebody s favorite band or album, whereas they are of little value if the music is not much appreciated. 7 Note that the maximal distance is 1/2 in which case the original does not give any value added. Denote the buying decision by b {0, 1} and the downloading decision by d {0, 1}. If consumers neither download nor purchase the product they obtain an indirect utility v(0, 0) = 0 where the first argument of the utility function corresponds to the decision to purchase the original or not and the second argument to the decision to download the digital copy or not. When consumers purchase the original product they obtain a surplus v(1, 0) = r + γ(1/2 ω l ) τ ω l p Consumers can connect to a file-sharing network to download digital copies of available albums. P2P users spend time to go on-line and use file-sharing 6 Other models (such as the multinomial logit) may be chosen alternatively. In particular, the one-dimensional spatial structure is merely assumed for convenience. 7 For instance, classical music lovers typically do not care much about lyrics and pictures or additional video files of Metallica. 8

9 technologies. This opportunity cost is denoted s and includes time spent searching and downloading files with the P2P technology. When consumers download digital files using the P2P technology, they can decide to only copy the product or after downloading they can purchase the original product. When a consumer only downloads a digital copy without purchasing the original product, she obtains a utility v(0, 1) = r τ ω l s where s is the opportunity cost for sampling. We observe that for r > s there exists a number of products beyond which v(0, 1) >v(0, 0) for each consumer s preferred product as the maximum distance to the closest ideal product is 1/2N for users of P2P networks. If we see the choice not to buy as the outside option, then downloading increases the value of the outside option. We refer to this negative effect as the competition effect because the original enters into competition with thedownload,whichis priced ats. If she downloads and purchases the original version of a product she gets v(1, 1) = r + γ(1/2 ω l ) τ ω l p s Here, downloading enable consumers to buy the music they like. 8 In this sense, there is a better match between a user of P2P and the purchased product, which increases his willingness-to-pay. This can lead to a situation in which a consumer prefers to purchase after downloading a digital copy from a P2P network rather than to directly purchase from a record store. We refer to this positive effect as the matching effect. We can then write the (random) indirect utility as v(b, d) =max{b, d}r + bγ(1/2 ω l ) max{b, d}τ ω l bp ds. Precision of information and likelihood to buy. Without any information (no marketing, no uses of P2P technology), consumers would just choose any of the N product at random and the probability to buy a particular product is 1/N. There are two ways, consumers can acquire more information about their most preferred product. On the one hand, the firm can spend resources on advertisement and 8 Although v(1, 0) > v(1, 1), the information structures changes and as a matter of fact, without P2P, consumers have less information as discussed in section 4. 9

10 promotion to transmit information to consumers. On the other hand, consumers can use file-sharing networks to find out about their ideal product. Consumer sampling. We have already assumed that consumers can acquire information on their most favorite product by using file-sharing networks and that consumers incur an opportunity cost s for sampling. We further assume that, given his previous information, a consumer either downloads all or none of the relevant files. In other words, copying entails a fixed part but a negligible marginal component. 9 With this simplifying assumption, we do not need to develop a model of consumer choice from which to derive the optimal number of sample. Downloading all digital files, which are potentially of interest to the consumers, is assumed to give perfect information on the type of products. Hence, the consumer selects the most attractive brand available, which we assume to give a positive utility net of the download cost, i.e. r>s, to the consumer. Thus if the consumer has sampled all relevant products and selected the one closest to her ideal location, then this good is purchased with probability 1. Marketing technology. The firm can also transmit information to the consumer on the location of the products closest to her ideal product through marketing and promotion. The marketing technology is the following. The monopolist uses marketing which reaches all consumers. In particular, we think of informative advertising. These efforts provide information about the existence of a product and partial information on the horizontal characteristic of the product. The degree of informativeness is captured by the precision 1 µ, which we treat as a choice variable. Parameter µ = m/n reduces the set of potential ideal products to m out of N. We formalize this by assuming that advertising (or, more generally, marketing and promotion) with precision 1 µ reduces the length of the circle segment where the ideal product could be located to a length of µ<1. 10 Advertising all products with precision µ leads to advertising costs A(µ), which is assumed to 9 We discuss the implications of this assumption on business models at the end of the article. 10 The marketing technology can be understood as follows. Without information, consumers enter a record store and see the N different CDs (with unknown faces or names on the cover) and the product closest to the ideal product could sit anywhere on the circle of length 1. With a precision of m/n, the consumer knows from advertising that only m out of a total N of CDs can potentially match the ideal product when he enters the store. It is as if the relevent circle where the product closest to the ideal product lies has length m/n and thus this product can not be further than m/2n. Note that if a product is element of the set of possible ideal varieties, then the probability to buy this particular product is 1/(µN) where µ = m/n and m {1, 2,...N} is the number of products that are potentially closest to the ideal product. 10

11 Length 1 Length m/n = µ ω µ Figure 3.1: Marketing and information transmission take the form (a/2)(1 µ) 2. This implies that advertising costs are convex in the precision. The marketing technology can be represented by selecting all products within a distance of µ/2 generating a smaller circle with circumference µ on which m products are equidistantly located this is illustrated by figure 3.1. The monopolist s decision problem. We consider unit demand so that total potential demand is insensitive to the monopolist s marketing strategy. However, as we have described above the consumers willingness-to-pay is influenced by the label s marketing strategy that can shift the demand curve. The monopolist has to choose the amount of marketing and the prices of its products under two different scenarios: (1) only the original good is available; that is, there do not exist digital copies; (2) a digital copy is available for free online and consumers can decide whether to download the digital copy and whether to purchase (possibly in addition to the download) the original product. These scenarios are exogenous or part of the marketing strategy. The latter is the case if the download of illegal digital copies can be effectively made impossible. The firm charges a price p for the original products; this price is uniform across products. The digital copy can 11

12 be obtained free of charge if the P2P distribution technology is available. The production technology is the following. The marginal cost of production of the original and the digital copy is set to zero because the goods are information goods. Since we consider a particular project as given we do not need to include the fixed costs of creating it. 4. Peer-to-peer technology as a profit enhancer 4.1. Free downloads and consumer information: sources for profits To highlight the basic trade-off between availability and non-availability of P2P we analyze the model under the assumption that a firm cannot use advertising. This implies that the only way to transmit information about the characteristics of a particular album to consumers is P2P. No P2P. Without P2P consumers cannot distinguish ex ante between the different albums and buy at random. The expected distance to the ideal variety is E ω l =2 R ldl = 1. Their expected utility is therefore 4 u n (1, 0) = Ev(1, 0) = r + γ/2 γ/4 τ/4 p = r +(γ τ)/4 p. Since all consumers are identical ex ante (because they do not know where albums are located) the monopolist s profits are ½ p if p r +(γ τ)/4 π n (p) = 0 if p>r+(γ τ)/4 Hence, a profit maximizing monopolist sets p n = r +(γ τ)/4 and makes profits π n π n (p n )=r +(γ τ)/4. (4.1) P2P. Consider the other extreme scenario in which all consumers use P2P, download all albums, and consider buying their favorite album. Consumers now make their decision in a perfect information environment. If all consumers buy the album then the maximal distance between the characteristic of the album and the ideal location of any consumer is 1/(2N). Suppose that it is optimal for the monopolist to serve all consumers. Then a consumer with ω l =1/(2N) who only downloads a digital copy has utility u w (0, 1) = r τ 1 2N s 12

13 Alternatively, he may decide to buy the album after downloading. This gives utility µ 1 u w (1, 1) = r + γ 2 1 τ 1 2N 2N p s. Aconsumerwith ω l =1/(2N) is weakly better off with decision (1, 1) than with decision (0, 1) if u w (1, 1) u w (0, 1) which is equivalent to µ 1 p γ 2 1 (4.2) 2N If inequality (4.2) holds, all consumers find that buying their most preferred album after sampling is worthwhile. To see that a multi-product monopolist does indeed want to serve the whole market, note that to obtain demand x for a particular album the participation constraint u w (1, 1) u w (0, 1) has to be satisfied for all consumers in a neighborhood x/2 of that album. Profit maximization for that album gives x =1/2. This implies that for N 2 the monopolist will cover the whole market. The above participation constraint is the relevant one if u w (0, 1) v(0, 0) for all consumers. This holds if r s + τ/(2n). (4.3) Furthermore, we have to check that consumers want to download, i.e. u w (1, 1) u n (1, 0). We referred to this condition as the matching effect in section 3. For this condition to hold, the opportunity cost of sampling has to be sufficiently low, namely s γ + τ 2 µ N (4.4) Then, under P2P the profit-maximizing price (assuming full market coverage) is µ 1 p w = γ 2 1 (4.5) 2N Comparison. We can now compare profits. Since all consumers buy one unit profits with P2P are greater than without P2P if p w >p n.thisisequivalentto r< γ µ τ (4.6) N 4 13

14 This means the larger the number of products the more likely that condition (4.6) is satisfied. We also observe that a higher transportation cost and a higher value of the original (for N>2) favor P2P. This is explained by the advantage of P2P: consumers obtain the good which better fits their tastes; this results in a lower transportation cost and a higher willingness to pay for the original. We can now state our first result. Proposition 1. Installing P2P increases the label s profits if inequalities (4.3), (4.4), and (4.6) are satisfied. If r<γ/4+τ/2 and s γ/4 +τ/4 then there exists a critical number of albums Ñ offered by the label such that for all N Ñ the monopolist makes higher profits in the presence of P2P-technology than in its absence. The intuition behind Proposition 1 is the following. By assumption, the original has two advantages: it provides added value and not using P2P avoids the negative downloading experience. The added value is relevant if the number of albums offered is greater than 2. Note that there is a disadvantage for a single album offered by the label. The reason is that with P2P the added value for the marginal consumer determines the price whereas without P2P consumers have to take expectations so that the average added value determines the price with a single product the average added value is greater than the added value at the margin. If there are more than two albums available the sampling of albums allows consumers to pick an album which come quite close to their ideal album. In the absence of P2P an increase in the number of albums does not lead to better choices on average. While this is an extreme formulation we believe that it captures the sampling aspect of free downloads in its pure form. Our result also highlights the role of labels offering a large number of products under P2P: it provides consumers the possibility to make more informed choices. Effectively, the corresponding matching effect may dominate the competition effect. Downloads and loyal CD buyers. Proposition 1 was derived under the assumption that all consumers download. A straightforward extension is to consider a population mix in which a share λ of the population never downloads. We call consumer belonging to this group loyal CD buyers because they do not consider substituting CDs for downloaded files. If these consumers are informed about the different albums (perfect precision) then, if λ is not too large, the label s maximization problem has the solution that both groups buy the original. The price is determined by the incentive constraint of the downloaders. If loyal CD buyers are less informed about the albums then, for certain parameter values, the price 14

15 is determined by the participation constraint of the loyal CD buyers. Even if loyal CD buyers have the same ex ante information as downloaders profits may be higher with P2P (a necessary condition is that λ is not too large). However, in this case loyal CD buyers do not buy at all when P2P are available A Comparison of two channels to Transmit Information to Consumers In this subsection we introduce marketing and promotion (in particular, advertising) as an alternative way to transmit information to consumers. The idea here is that the label can transmit information on the desirability of its products to consumers. The label can incur large marketing and promotion expenditures such that the information is so precise that all consumers make the optimal choice (extreme marketing). The label may alternatively engage in moderate marketing expenditures which leads consumers to improved choices ex ante compared to a situation without marketing efforts (moderate marketing). However, under prefect information they would have chosen a different product with positive probability. With respect to P2P we implicitly assume that inequalities (4.2), (4.3), and (4.4) are satisfied. No P2P with positive marketing and promotion efforts. The label can choose the level of precision 1 µ where µ = m/n and m {1,..., N}. This means that, if the precision is 1 µ then each consumer can rule out all products which are in a distance of more than µ/2. Here,1 µ =0represents no precision and 1 µ = 1/N maximal precision in the consumers purchasing decision. Note that maximal precision does not mean that consumers know the exact location of the most preferred product but that they know which is the most preferred product modelling information this way makes the analysis very simple. The associated marketing expenditure is A(µ) =(a/2)(1 µ) 2. The expected utility of consumers receiving information with precision 1 µ can then be calculated as u (µ) (1, 0) = Ev(1, 0 µ) =r + γ(1/2 µ/4) τµ/4 p. This is the same expected utility independent of the location of the consumer on the circle. We make a couple of observations: u (1) (1, 0) = u n (1, 0) as defined in the previous section. This means that A(1) = 0 does indeed give the same expected utility as the model without marketing expenditures. 15

16 u (2/N ) (1, 0) = u w (1, 1) + s for a consumer located in the middle of two products. With precision 1 2/N almost all consumers learn that exactly two products cannot be excluded to be the most attractive; the expected distance is 1/(2N). 11 All consumers buy a product if Ev(1, 0 µ) 0. Thisisequivalentto p r + γ(1/2 µ/4) τµ/4. Hence, for a given precision level 1 µ the label sets its price equal to r + γ(1/2 µ/4) τµ/4. To solve the maximization problem of the label using the first-order condition, we will treat µ as a continuous variable. The maximization problem is the following: max r + γ(1/2 µ/4) τµ/4 (a/2)(1 µ)2 µ [0,1] where the price is replaced by its profit-maximizing value. From this follows the optimal precision of the unconstrained problem as µ =1 1 (γ + τ). (4.7) 4a The optimal precision 1 µ is thus increasing in the transportation cost. Consequently, we have the following result: Proposition 2. Without P2P the following marketing strategy is chosen: extreme marketing if moderate marketing if 1 1 4a (γ + τ) 1 N 1 1 4a (γ + τ) > 1 N 11 This implies that transmitting information with precision 1 2/N is as attractive on average as perfect revelation of the products positions for the perfectly informed marginal consumer (net of the downloading cost), located at distance 1 2/N. If the precision is 1 1/N the expected distance is (1/4N). 16

17 We observe that it is always optimal to engage in some marketing activity (using the continuous approximation). The reason is that improving the precision is relatively cheap when the precision is low. Extreme Marketing and Promotion Efforts. Profits under extreme marketing and no P2P are µ 1 π x = r + γ 2 1 τ 1 4N 4N a µ N We can first compare profits with extreme marketing to profits in the presence of P2P, given by π w = γ(1/2 1/(2N)) (as follows from equation (4.5)). If the label optimally uses extreme marketing, introducing P2P increases the labels profits if (τ γ) 1 4N + a µ >r. (4.8) 2 N We state this result as our next proposition. Proposition 3. Suppose it is optimal for a label to use extreme marketing in case P2P is not available. Installing P2P increases the label s profits if inequality (4.8) is satisfied. Remark 1. Inequality (4.8) is more likely to hold the larger the label, that is, the larger N. Ifa/2 >r there exists a number Ñ such that, for all N Ñ, P2P increases the label s profits. Because a firm that engages in marketing and promotion efforts incurs a cost is no longer sufficient to compare prices. In particular the situation can arise in which p w <p x but π w >π x. In this case the availability of P2P leads to higher profits although the firm has lower sales. This suggests that the music industry may find a business model which avoids part of the marketing and promotion efforts and passes part of the savings on to consumers who themselves engage in the search process. In other words, an information-push technology is replaced by an information-pull technology. Furthermore, note that in such a case (where p w <p x but π w >π x ) the use of P2P leads to a Pareto-improvement if the opportunity cost of sampling s is sufficiently small. Moderate marketing and promotion. If marketing and promotion are very costly at the margin, the label prefers moderate to extreme marketing, Using 17

18 equation (4.7) the labels profits in case P2P is not available are then given by µ 1 π m = r + γ 2 µ τ µ 4 4 a 2 (1 µ ) 2 = r + γ τ 4 = r + γ τ a (γ + τ)2 1 (γ + τ)2 32a + 1 (γ + τ)2 32a Compared to pricing in the presence of P2P, moderate marketing without P2P leads to lower profits if γ + τ 1 32a (γ + τ)2 >r (4.9) 4 A necessary condition for this inequality to hold is that marketing is sufficiently costly, 8a >γ+ τ. Proposition 4. Suppose it is optimal for a label to use moderate marketing in case P2P is not available. Installing P2P increases the label s profits if inequality (4.9) is satisfied. Remark 2. Inequality (4.9) is more likely to hold the more expensive is marketing, that is, the larger a. If (γ + τ)/4 >r, i.e., P2P is more profitable than no P2P without marketing efforts, there exists a parameter for marketing costs, a, sufficiently large such that P2P increases the label s profits. Recall that if moderate advertising is used when P2P is not available, installing P2P makes consumers better informed. Note that also in the presence of moderate marketing, sales with P2P may be lower than without P2P whereas net profits are higher. Hence, this specification shows that the following observations are compatible: the introduction of P2P leads to better informed consumers, lower sales in dollars, lower expenditures for marketing and promotion, and higher profits for the label. 5. Discussion and Conclusion We have presented a multi-product monopoly model in which there exist two channels of information transmission: information push via promotion and marketing and information pull via sampling on P2P networks. Although the use of P2P networks gives consumers an imperfect copy which may reduce their demand for the 18

19 original, P2P networks may actually improve the matching between products and buyers and in some cases can be used as a channel for information transmission which increases profits. In particular, we show that if there are many varieties in the market, the potential gains from information transmission can be large. The cost of information transmission. A critical assumption was that marketing and promotion are costly channels of information transmission. As pointed out in the introduction, a large share of the labels costs are indeed expenses for marketing and promotion. We also made the simplifying assumption that the owner of the original does not incur a cost when information is transmitted via a P2P network. This gives a cost advantage to the use of P2P over promotion and advertising as a channel of information transmission. When consumers download music that they have no interest in and they do not discover what they really like, P2P networks become informationally less efficient. It thus depends on whether information-push or information-pull is more efficient. 12 We have shown that the cost advantage of P2P in transmitting information may overcompensate the competition effect that arises from the introduction of pirated products that can be used as substitutes for the original. Furthermore, we have shown that if promotion and advertising costs are significant at the margin, less information may be transmitted in a traditional distribution system than under the use of P2P. This is an admittedly simplifying picture: even a P2P network that works with cross recommendations and individual recommendations based on past downloads is unlikely to provide perfect information. However, we do believe that personalized information available through P2P networks is likely to generate better recommendations than blind marketing and promotion. We would therefore argue that our model is a bit simplistic but a reasonable approximation for a start, in particular if we include recent fee-based business models (see below). Market coverage. In our simple model we assumed that the market is always covered. For a different set of parameters the market is not fully covered so that some consumers do not buy originals at all. Even in this case P2P may be profit enhancing because a label s markup can be drastically improved which may overcompensate the loss in units sold. This means that in our model, the profitability of P2P is compatible with lower sales both in units and in dollars. 12 Even in a world in which information is acquired via P2P or, more indirectly, through internet service providers, marketing and promotion still plays a role. In particular, targeted online advertising seems a way to combine the active role of labels and the posibilities of targeted information transmission. 19

20 The cost of downloads to consumers. If there is a price of downloading additional songs or if the opportunity cost of being sued as a user of P2P networks is heterogenous, some consumers may find P2P less attractive. In the extreme, if the opportunity cost is large for all users, P2P would not be a threat to standard business models. In particular, if recent campaigns by the RIAA and others were completely successful in deterring consumers from using Kazaa and the like, business could go on as usual. However, this is unlikely to be the case. The industry seems to have recognized that the only alternative to P2P networks on which copyrighted material is exchanged for free is the online sale of music in MP3 or other (better) compressed formats. Then as consumers pay a price for legal downloads, downloading becomes a positive source of revenue in itself. Recent experiences with itunes in the US and OD2 in Europe suggest that finally there may exist viable business models to sell downloads to consumers. 13 New business models for the music industry. Record companies together with intermediaries such as itunes and OD2 may benefit from the online sale of music. Informational inefficiencies in the traditional distribution system can be reduced by promoting and recommending new products online and targeting only consumers who have the highest likelihood to purchase (either a download or a traditional product such as a CD). Using smart software which tracks past purchases and streaming and which uses the behavior of similar consumers for recommendation (a crude system of this is already available on Amazon.com and similar internet sites), this would allow record companies to save on the large costs of marketing and promotion by transferring part of the cost of information transmission to consumers who are better informed about their own tastes (and may to some extent even enjoy sampling). One of the challenges for these business models to be successful seems to balance the desire of consumers to be unrestricted in the private use of a track and the desire of the labels that copyrights are not violated, in particular, that the track is not distributed to other consumers. This implies that labels or intermediaries are going to use a particular form of digital rights management (DRM), which makes illegal transfer of tracks more difficult. As technology advances, DRM may be seen as less intrusive by consumers and therefore may not reduce their willingness to pay. As the ease of use, availability of songs and unique offerings of these sites (labels and intermediaries) increase, the market for illegal copies may shrink 13 In the period from mid-october to mid-december 2003 itunes generated around 12 Mio. downloads in the US. Here itunes may partially substitute downloads on Kazaa and Grokster, which have seen a big drop of its use in the second half of

21 substantially. Let the music play. In this paper we treated the number of products, i.e., albums or titles, as given. The lobby of the music industry has painted the horror picture of a world without music as online piracy takes over and rips artists and record companies of their sources of revenues. This is clearly a caricature as musicians have other sources of revenues such as live concerts and do not only respond to monetary incentives. 14 Moreover, P2P networks allow new artists to enter the market with low distribution and marketing costs. The less drastic statement that the definition and enforcement of property rights affects the production of music certainly cannot be dismissed. Hence, it would be of interest to analyze how P2P affects the variety (and quality) of music. Since variety of artistic expression is often seen as a public good in itself, research in this direction would contribute to the public policy debate. Such an analysis would certainly be value-added but would in our opinion require a more elaborate model in which artists are an additional group of players in the market. 14 As Gayer and Shy (2004) have shown in a model with network effects, music labels and artists are likely to have conflicting interest over the availability of free downloads. The reason is that a larger number of downloads tends to increase the popularity of the artist. This in turn gives higher revenues to the artist (but typically not to the label) through live concerts. 21

22 References [1] Duchêne, A. and P. Waelbroeck (2002), Peer-to-Peer, Piracy and the Copyright Law: Implications for Consumers and Artists, mimeo. [2] Gayer, A. and O. Shy (2004), Publishers, Artists, and Copyright Enforcement, mimeo. [3] Liebowitz, S. (2003), Will MP3 Downloads Annihilate the Record Industry? The Evidence so Far, in G. Libecap (ed.), Advances in the Study of Entrepreneurship, Innovation, and Economic Growth, JAI Press. [4] Meurer, M. and D.O. Stahl II (1994), Informative Advertising and Product Mix, International Journal of Industrial Organization 12, [5] Peitz, M. and P. Waelbroeck (2003a), Piracy of Digital Products: A Critical Review of the Economics Literature, CESIfo Working Paper #1071. [6] Peitz, M. and P. Waelbroeck (2003b), The Effect of Internet Piracy on CD Sales Cross Section Evidence, mimeo. [7] Peitz, M. and P. Waelbroeck (2003c), An Economist s Guide to the Technology, Law, and Business of Music Distribution, mimeo. [8] Rosen, S. (1978), Advertising, Information, and Product Differentiation, in D.G. Tuerk (ed.), Issues in Advertising: The Economics of Persuasion, Washington, D.C.: American Enterprise Institute for Public Policy Research, [9] Takeyama, L.N. (2002), Piracy, Asymmetric Information and Product Quality Revelation, mimeo. [10] Zhang, M.X. (2002), Stardom, Peer-to-Peer and the Socially Optimal Distribution of Music, mimeo. 22

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