Disruptive Innovation and the Death of the Recording Industry

Last week I quoted a Wired article that discusses the rise of the MP3 format as a disruptive threat to the recording industry. The story of the recording industry’s decline is complicated because there are actually two different factors at work. The recording industry likes to focus on “piracy” as the main cause of its declining fortunes. But although copyright infringement has certainly done some short-term damage to the recording industry’s bottom line, I think the long-run problem facing the recording industry is a structural problem that has little to do with copyright infringement.

I’ve argued before that the recording industry and the newspaper industry are facing the same basic problem. Both industries are fundamentally in the content-distribution business. Newspapers are in the business of shipping newsprint to consumers. Record labels are in the business of shipping discs (first vinyl, then plastic) to consumers. These content-distribution technologies are to the Internet what the horse and buggy was to the internal combustion engine.

2170846681_97ea8fdef2The recording industry, like the newspaper industry, likes to think of itself as being in the content-creation business. But that’s largely wishful thinking. Musicians don’t sign on to record labels because they need their help to make music—typically, musicians have been making music for years before they get their first record contract. Rather, they sign onto a label because before the Internet a record deal was the only way to distribute their music to a national audience.

It’s true that when an artist signs a recording contract, she gets some financial assistance from the labels. Some of that money often goes to pay for studio time, but a lot of it is usually spent on promotional activities. And although musicians obviously benefit from a label’s effort to promote their work, the primary beneficiary of money spent on promotion is the label itself. Here’s why: publishing a CD involves high fixed costs, so a label needs to sell thousands of copies just to break even. Hence, once the decision was made to publish a given album, the label needs to ensure that it will sell well. From a label’s perspective, publishing an album that sold 500 copies is much worse than not publishing at all.

The Internet changed that. Today, releasing an album is a virtually risk-free decision, so the lavish promotional campaigns that typified major-label album releases are no longer needed. Musicians can simply release music on their websites, or through online services like iTunes and Amazon. Musicians don’t need to do a lot of promotion if they don’t want to, but the Internet helps here, too, giving bands a number of tools to promote organic, viral growth in their fan bases.

353462946_0460bb2fb4So the investments labels make in their musicians aren’t investments that are required for music publication, they’re investments that are required for the capital-intensive process of releasing music in CD format. Now that CD distribution is being rendered obsolete, there just isn’t any need for enormous music-publishing companies. We know from Coase that large firms exist only when there are benefits (such as economies of scale) to large size that exceed the inherent inefficiencies of bureaucratic management. Distributing a CD to a national audience is an activity where size is an advantage. Recording an album and releasing it on the Internet just isn’t.

It’s true that the prevalence of copyright infringement has accelerated the decline of the recording industry. If we could somehow outlaw peer-to-peer file sharing, it would probably postpone the recording industry’s demise by a few years. But the long-run trend has little to do with copyright infringement, and everything to do with technological change. The core competence of the labels has always been shipping plastic discs across the country. The Internet is rapidly rendering that music distribution method obsolete. And so there’s every reason to expect that the firms built around that technology will themselves go out of business.

As Mike Masnick has pointed out before, the CD business is not the same thing as the music industry. The vast majority of music has always been made by people who didn’t have recording contracts, and there’s no reason to think people will stop making music in a post-CD world. Being a rock star may become somewhat less lucrative in a post-CD world, but it will still be a tremendously high-status achievement. It seems implausible that we’ll ever have a shortage of people making and publishing music.

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3 Responses to Disruptive Innovation and the Death of the Recording Industry

  1. Ed Felten says:

    Another function of the recording industry is financial. This is not only about financing the cost of making a record — it’s also about providing artists income while they write and practice their songs. A record label can act as a kind of venture capitalist, giving artists advance payments in exchange for a share of the eventual revenue. This can benefit artists by improving their cash flow and reducing their risk: the proverbial starving artist might be quite happy to trade away uncertain future revenue for an immediate cash advance.

    This doesn’t necessarily contradict your main point, though, because there are other ways to finance artists’ careers. When the distribution channel was narrow, as in the past, it was efficient to provide financing through the same firm that handled distribution. In the future, financing might come from a separate firm, or might be provided by shrunken versions of today’s record labels.

  2. Kaleberg says:

    I wouldn’t be so hard on P2P. The big sharing that had a real impact on CD sales involved mix disks. In my niece’s circle every birthday or other party gave out a mix CD of the music played. That’s maybe 20 or 30 parties with 20 songs each. Why buy the latest CD to get the song you liked at someone’s party when you went home with the song in your goody bag? This type of sharing was so accepted that Ladies Home Journal suggested teaching kids the value of home made Christmas presents as opposed to commercial, store bought presents by making mix CDs as gifts. I wonder what the RIAA made of that heart warming message?

    The P2P stuff was just easier to track than CDs passed out at parties, hand to hand and so on.

  3. Ed,

    It’s a good point. But I’d make a stronger version of the point you make in your second paragraph: not only can musicians find other ways of financing their recording careers, most of them already have at the time they get their first major label recording contract. It’s extremely common for bands to tour and sell homebrew CDs for several years before they get noticed and signed onto a major label. So at worst, a world with no major record labels is a world in which the most talented musicians have to stay at their day jobs for an additional year or two while they build a fan base large enough to support full-time touring, iTunes sales, etc. Obviously, it’s nice to have financial backers, and some kind of music venture capital may emerge as a replacement for this aspect of the recording business, but if it doesn’t I think the impact on musicians careers will be relatively minor.

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