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What’s the Future of the Music Industry? A Freakonomics Quorum

Before I was in the writing industry, I was in the music industry.

While the economics of journalism have changed a lot over the past 20 years — witness the demise of Times Select and the potential demise of the Wall Street Journal‘s pay site — many other aspects of the writing industry haven’t changed much at all. If you are a non-fiction writer who writes books, for instance, the economic setup is pretty much the same as it was, in large part because book publishers still primarily offer hard copies of books to people who pay money for them.

But the music industry of today looks almost nothing like the music industry of 20 years ago. There are a ton of reasons, most of them having to do with digital technology. If you are a young journalist starting out today, you may still aspire to get a big publisher to give you an advance and widely publish your book; but if you are a young musician starting out today, do you want to get a big record advance or do you want to sell the music yourself, like these folks do, and like Jane Siberry does? If you are a record label, what do you do about illegal downloads, and do you keep putting out “albums” that nobody buys or do you instead try to release only individual songs, as many people seem to prefer?

It strikes me as ironic that a new technology (digital music) may have accidentally forced record labels to abandon the status quo (releasing albums) and return to the past (selling singles). I sometimes think that the biggest mistake the record industry ever made was abandoning the pop single in the first place. Customers were forced to buy albums to get the one or two songs they loved; how many albums can you say that you truly love, or love even 50% of the songs — 10? 20? But now the people have spoken: they want one song at a time, digitally please, maybe even free (yikes: big can of worms, which is addressed ably below).

So what really happened to the music industry, and what will it look like in five or ten years?

That’s the question we put to five smart people in our latest Freakonomics Quorum. I found their answers to be incredibly interesting, full of real information and clear-eyed thinking. (If you haven’t already done so, you should also read Lynn Hirschberg‘s really good recent profile of Rick Rubin in the Times Magazine.) Huge thanks to all our participants.

Koleman Strumpf, professor of business economics at the University of Kansas Business School whose papers include “The Effect of File Sharing on Record Sales”:

Many dire assessments have been made about the record business. Unfortunately, these claims are rarely supported with data. As such, I will provide specific numbers about the industry’s health, put those numbers in perspective, and discuss several factors that might explain recent trends.

Let me begin by discussing the current state of the U.S. record industry. As has been widely reported, sales are down. According to Nielsen SoundScan, album sales fell 18 percent between 2000 and 2006, after accounting for paid digital downloads from online stores like iTunes. While these numbers are not good, other industries have experienced similar downturns. For example, new car sales are down 22 percent for U.S. automakers.

It is important to remember that sales downturns are not atypical in the music business, and that investors remain interested in selling records. The current situation closely mirrors the post-disco bust in the early 1980s. Specifically, real revenues fell by the same percentage during the years 1979 to 1985 and 1999 to 2006. The record industry also continues to generate profits and attract interest from investors. For example, a private equity firm just last month completed a £3 billion takeover of EMI, and an investment group purchased the Warner Music Group in 2004 for $2.6 billion.

Investors seek out high returns, and these large investments suggest that many believe that they can make money in the record business. It also implies that the industry is still profitable. While profit data can be hard to come by, we get a small window from Warner, the only publicly traded standalone record company in the U.S., which enjoyed operating margins of 7 percent and 10 percent from its recorded music segments in 2005 and 2006.

Putting profitability aside for now, what is the explanation for the sales reduction that has occurred? The most obvious culprit is illicit file-sharing on networks such as Napster, KaZaA, eDonkey, and BitTorrent. While linking the two seems tantalizing — file sharing rose to prominence at roughly the same time that record sales started to fall — there is surprisingly little evidence to support the claim that file sharing has significantly hurt record sales. I co-authored a paper with Felix Oberholzer-Gee of the Harvard Business School in which we studied this link using download data from file-sharing networks. If file sharing hurts record sales, then albums that are more heavily downloaded should experience lower sales than comparable albums that are less downloaded. But, after controlling for the role of popularity, we found that downloads had little effect on album sales.

There are several other factors that might explain recent sales trends. First, recall the industry’s similar problems in the early 1980s. Then, as now, sales were down as consumers stopped purchasing albums from a previously popular genre (in the ’80s it was disco; now it’s teen-pop). So one explanation is that the industry has failed to find genres that capture the interests of consumers.

Second, much of the reduction in sales is the direct result of industry cost-cutting. The major record labels have cut large numbers of staff and severed ties with many artists. Such moves are not necessarily bad business choices, but they suggest that less attention should be given to revenues and more to profits.

Third, recorded music has had trouble competing against other products that vie for consumers’ entertainment spending. Consider home video products like the DVD. It does not seem implausible that a good chunk of the $11 billion rise in spending on home video products since 1999 represents foregone CD sales. (Music industry revenues only fell $2 billion over this period.) Entertainment spending was also likely channeled into cell phones and video games, both of which experienced large sales growth and have been particularly popular with the key teen demographic.

A fourth and final factor to consider is the rise of paid digital downloads made popular by iTunes. While this model is often described as a competitor of illicit downloading, there is little evidence that file-sharing users also use iTunes (plus genres like classical music, which are largely ignored on file-sharing networks, are very popular on iTunes). More problematic is the likelihood that music consumers who used to purchase whole albums now download only one or two songs, so rather than getting $15 for an album sale, the industry gets two downloads at $2. While there is no direct evidence that cannibalization is occurring, the growing size of paid downloads makes this factor an important one to consider.

As for the future, I am dubious about making forecasts. Much will depend on the choices the major labels make on key issues (will they run experiments to determine the optimal pricing of digital downloads?) and the arrival of still-unforeseen technologies (which could allow labels to more cheaply distribute music, or lead to new forms of piracy). At the same time, I reject the argument that recorded music is close to death, simply because the financial incentives to create music have never been particularly high. In 2005, less than one in five albums were released on a major label, and even among those releases, fewer than one in fifteen went gold (the usual measure of record success). With such daunting odds, recording an album may have seemed like a pointless task. But in that year, nearly 44,000 albums were released — enough to provide almost three consecutive years of listening. Regardless of what happens to companies that produce and distribute music, I am sure that recorded music will continue to be made.

Fredric Dannen, author of Hit Men: Power Brokers and Fast Money Inside the Music Business:

Two decades ago, I was interviewing David Geffen for Hit Men, and he offered a warning about what he saw as a grave threat to the record industry: digital audio tape. If record companies started issuing albums on D.A.T., Geffen said, they would effectively be distributing their master tapes, “obviating the need for catalog.” At the time, Geffen’s admonition made sense; but D.A.T. never caught on with the consumer. The failure of D.A.T. got me thinking, and before long I believed I had discerned something about the consumption of recorded music — something startlingly obvious that has somehow eluded the record industry throughout its history, and led to the industry’s irreversible decline.

My epiphany, if you want to call it that, was simply this: consumers of recorded music will always embrace the format that provides the greatest convenience. No other factor — certainly not high fidelity — will move consumers substantially to change their listening and buying habits. The single exception to this rule was the introduction of two-channel stereo in the late fifties.

Let me state this more clearly, by example. When the long-playing record (LP) format was introduced by Columbia Records back in the late 1940s, the industry as a whole resisted it, and many predicted it would never take off because 78s sounded better. Without question, early LPs did not sound nearly as good as 78s. But given the choice of listening to all of Beethoven’s Ninth Symphony on two sides of one record versus sixteen sides of eight records, the consumer opted for convenience and simplicity (not to mention less shelf space).

The industry also resisted the audio cassette. Who in their right mind would prefer a format with an ever-present hiss over the pristine sound of an LP? The answer: nearly everybody. Cassettes were much easier to handle than records; they didn’t scratch, and you could listen to them in your car, or while walking or jogging.

Starting about twenty years ago, the CD took off like a rocket, burying both the LP and the audio cassette in a few short years. At that time, the CD was the last word in simplicity and convenience. I remember meeting an audiophile at a record-industry convention in the late 1980s. The popularity of the CD appalled and befuddled him. Couldn’t people hear that digital sound was cold and harsh compared to the warm, luxurious sound of an LP? Sure. But most consumers of music are not high-end audiophiles. Now you could hear all 74 minutes of Beethoven’s Ninth Symphony on one side of one disk.

I myself am something of a music nut. I cannot get through a day without listening to music, and my personal collection of recordings is enormous. By the early 1990s, I longed for a format even more convenient than the CD. And, based on my own listening habits, I was pretty sure I knew where we were headed. In short, I wanted to be able to run my music library from my home computer, and dispense with disks altogether. What I did not foresee was the advent of MP3 compression. As soon as MP3s hit the scene, I embraced them ecstatically. I was the first person I knew to own a Diamond Rio, the first portable MP3 player.

In 1999, I wrote an editorial for the New York Times predicting that MP3 was an unstoppable force that would destroy the oligopolistic power of the record industry. This paper did not believe me; the editorial ran instead in the Los Angeles Times.

It was an easy prediction to make. You can always count on the record industry to cling to the past, and to fight innovation. (Apart from resisting the LP, the cassette, and the CD, the industry also fought MTV.) The industry could have adopted and embraced MP3 as the new dominant format, had it understood why it was unstoppable. But the business’ failure to understand has been striking for its persistence. By the time Napster hit the scene, the industry had a Hobson’s choice: accept MP3, or die.

We all know what happened next.

George Drakoulias, music producer, artists & repertoire executive at American Recordings, and veteran of Def Jam Recordings:

There are many factors contributing to the industry’s current decline. The biggest ones include the inability of record companies to take advantage of new resources like Napster and American Idol, the continuous churning out of bad music, and, of course, greed, greed, and more greed. I think it is clear how we got here; but where we’re going remains very uncertain.

For starters, while we’re still in agreement as a society that people want music, I’d say music is not as important now as it once was. Instant gratification has removed some of the the demand. Music feels like it has become more disposable and cheap, with less staying power. As a result, it becomes a lot harder to commit to newer acts knowing they may not be around a year from now. I don’t see many kids nowadays wearing the T-shirts of the latest fad bands, but I do see a hell of a lot of AC/DC, Led Zeppelin, and Pink Floyd shirts out there.

In a way, the blogosphere has removed all sense of mystery from the entertainment industry as a whole. For example, everyone knows what Heath Ledger looks like as the Joker in the the new installment of Batman, which won’t be in theaters for almost a year. We see previews of magazine covers weeks before they hit the stands. The Christmas Eve-type excitement and anticipation that used to accompany entertainment seems to have disappeared.

As far as how the music industry fits into this scheme, the old business model is dead. In five years, the CD should be over. Someone will take a stab at a subscription service — though the right way to make that work is a mystery to me. Maybe it will involve several like-minded acts getting together and starting a co-op, such as the bands of Ozzfest, etc. Meanwhile, music executives still need some sort of filter to help them navigate the new playing field.

Without stating the obvious, the future is really in the hands of the consumer. The public will dictate to whatever is left of the record industry (it’s funny that we still call it that — long live vinyl!) the way in which it wants its music delivered. The final product will most likely involve computers, and will give you the ability to take your music with you in your phone, car, bathtub, skydiving parachute, etc.

What am I going to do in the midst of all this? It may sound simple, but my plan is to work as hard as I can to make the best music possible and try to educate the listener. A few years ago, I worked on a record called The Last DJ by Tom Petty. The songs on the album addressed the problems we are currently dealing with in the industry. I thought the record would be a wakeup call for consumers; but it’s hard to tell kids, “Eat your broccoli, it’s good for you.” I’ll try to nurture new talent and make records that sound exciting, emotional, and timeless, and to bring some level of craft back into record-making, ensuring that the artists I work with have the ability to play live and move an audience.

One option that doesn’t seem feasible is making everything free and eliminating copyrights. Hopefully, someone smarter than I am will come up with the right formula to get music to consumers in the way that they want it, and to collect fees that are distributed accordingly. I hope that person shows up soon.

Peter Rojas, founder of Engadget and co-founder of RCRD LBL, a free, online-only music label launched by Downtown Records.

The short answer is that the Internet happened.

I never thought studying Adorno and Horkheimer in college would come in handy (much as I loved them), but they did a good job of identifying how the rise of mechanical reproduction went hand-in-hand with the birth of mass culture. Whether it was television, radio, newspapers, or records, huge media companies were able to take advantage of a curious sweet spot in history — mechanical reproduction made it possible to churn out cheap, identical copies of a book, newspaper, record, etc., but creating and distributing those cheap, identical copies required the sort of capital to which very few individuals had access. In the case of music, a handful of major labels could more or less monopolize the creation and distribution of music.

The Internet changed all that. We’d already been slowly shifting from analog to digital reproduction, but it was digital reproduction combined with the a ridiculously cheap distribution channel (the Internet) that really mucked it up for the major labels. The emergence of Napster (the original one) was the wake-up call, but the record industry would be in trouble now even if no one had invented peer-to-peer file sharing.

The fact of the matter is that the majors thrived in an era of inefficiency, when there was value in physically producing and distributing music. There isn’t any value in that any more (or at least, it’s very quickly declining), and there’s no good way for labels to compete given that the cost structure of the business was designed around physical releases. Major labels need blockbusters, because the costs inherent with producing, distributing, and marketing each physical release means it’s easier to make money from one mega-hit that sells 10 million records than 100 small hits that each sell 100,000 records. In a digital world, you could make money from those 100 small hits almost as easily as you could from that one mega-hit. (See Chris Anderson‘s theory of the Long Tail).

If this was merely the extent of the problem, the record industry might be doing okay right now. The majors could have adjusted and reinvented themselves for the digital era. Instead, they took too long to start selling music online (and even when they did agree to start selling digital downloads, they screwed it up by insisting on digital rights management). The lack of legal, paid-for downloads created a vacuum in the pre-iTunes era, one that numerous peer-to-peer file-sharing networks were happy to fill. A generation of kids got used to the idea that music was free, and given the infinite amount of freely — if illegally — available music out there, it was hard to argue with the facts on the ground. Music seemed free, so it was free. It didn’t help that the industry had been gouging consumers for years with high CD prices; prices rose even as the cost of producing CDs plummeted. Digital downloads should have made it possible to slash prices for recorded music, but the majors have done their best to keep prices at around a dollar a track — an artificially high price point that makes piracy more attractive than it should be.

I don’t pretend to know what the industry will look like in ten years, but the funny thing about all of this is that music itself is healthier than ever. The Internet, combined with low-cost (or even no-cost) digital tools, has led to an explosion of creativity, with millions of amateurs making music for every conceivable genre, sub-genre, and microgenre, and then sharing their creations online. Andrew Keen might look down on these results, and no doubt 99.9 percent of the music being created today is terrible; but that’s besides the point. Even that one-tenth of one percent means that there is more great music being created than any of us will have time to listen to — and that’s not even taking into account all of the “professional” music that still manages to get made. Many professional artists are discovering that, regardless of how well their music sells, they’re still able to make a healthy living from live appearances, merchandise, and licensing — and the Internet only makes it easier for them to build a fan base. It’s the Britney Spearses of the world that are hit hardest by all of this change. Manufactured pop doesn’t do quite so well when consumers have better options to choose from.

The majors thrived in an era of artificial scarcity when they were able to control the production and distribution of music. Today, we have an infinite number of choices available to us, and when content is infinitely abundant, the only scarce commodities are convenience, taste, and trust. The music companies that are successfully shaping the Internet era are recognizing that the real value is in making it easier to buy music than to steal it, helping consumers find other people who share their music tastes, and serving as a trusted source for discovering new music.

Steve Gottlieb, president of TVT Records:

The decline in record sales over the past year was entirely predictable. The technology that has wreaked havoc on the industry was developed 8 or 9 years ago, and, while certain features of it have improved, the individual elements that comprise it — an institutionalized standard for non-protected music files like MP3s, music search and swapping protocols, and rip/burn hardware — are not new. Combining these elements allowed CDs to go from a storage medium to a broadcast medium. As such, the passing along of burned CDs now constitutes the primary means of music acquisition. The cycle of reduced demand causing retail channels to reduce distribution pipelines in advance of the marketplace began in earnest last year, when not a single retailer saw enough value in Tower Record to outbid liquidators.

This tale of technology leveling the record industry demonstrates its unique character. Record companies seem unable to digest change, redefine their businesses, and, perhaps most importantly, resist the temptation to seek unfair competitive advantages over one another. The failure of record labels to take collaborative action against piracy has led to the industry’s current bizarre circumstances — in a world of skyrocketing demand for music, the development and sale of recorded music offers ever-decreasing economic returns.

This set of circumstances was entirely avoidable. Many of the blunders that created the current mess were heavily anticipated, as was the recent decline in sales. Major industry mistakes included shutting down Napster after its commitment to begin paying rights holders, suing consumers without clarifying to the public what constituted personal use, and failing to squarely address CD burners and iPods as strategies to sell hardware by bundling them with unlimited access to freely-copied music.

For as long as the woes of MP3s, file sharing and CD burning have existed, solutions to them have existed as well, although their attractiveness and cost of implementation may have changed. These solutions include combining advertising with free consumption, subscription services, and transactional unit-based sales of secure formats. Given the fact that the public has gotten used to sharing music for free, getting people to abandon this notion will be extremely difficult.

Regardless of what created this mess, if we accept that free music has become the model for consumption, then we have little choice but to invest in advertising-supported free services that will make this type of consumption profitable. This step will require patience, leadership and a long-term view. After formulating a way to recapture the revenue it’s losing, the industry can then address the development of a new, secure file format that offers audio, meta-data, and other digital features superior to those of MP3s. This should be an easy task, and will give the industry access to both ad-supported free “iPod quality” MP3s, and higher-quality digital products that can be sold directly.

Unless the labels actively reinvent themselves and embrace change, they will continue to find themselves in an expanding music marketplace that rewards their efforts less and less.