Economics of File-Sharing

Umair writes "The Red Herring's got an article by me about the economics of file-sharing, which argues that the music industry should provide insurance...against itself. This is because the contract listeners sign with labels is risky - it lets labels shirk on their end of the bargain. That's why file-sharing isn't just 'theft', it's risk-sharing. The original, longer, version of the paper is here, which argues that this a situation economists call double moral hazard."

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Text of article

[Anonymous Coward]

Music Industry: Stop Shirking

Don't say theft when you mean rational avoidance of moral hazard.

By Umairis Kwir

Every major label is drooling over the money-making prospects of having its own iTunes or Musicmatch. But they are all, in the immortal words of Johnny Cash, "born to lose, and destined to fail." Why? The music industry's problem is fundamental: the implicit contract between music companies and listeners is no longer viable.

The music industry fails to understand that a primary reason that consumers illegally share music files is that they want insurance against the music industry itself. File sharing is as much about risk sharing as it is about the theft of value. Technology makes file swapping possible - but the music industry's business model, which is at odds with the implicit contract it signs with listeners, is what makes it probable.

The contract between record labels and music listeners follows basic economics: The labels assume market risk in exchange for value. They take on the risk of talent search, artist development, and distribution costs, in exchange for profits.

Alternatively, we can say that labels are agents hired by music listeners, or principals, to perform a function they do not have the time to do: find interesting and entertaining musical artists. In every such transaction, there are always additional costs incurred. Economists call these costs agency costs.

The problem with such a simple contract is that it creates massive information asymmetries. There is no monitoring mechanism, so listeners cannot tell what the labels are doing; conversely, labels cannot really tell what listeners' preferences are. Even worse, listeners cannot influence labels unless they can coordinate amongst themselves.

Furthermore, the labels' biggest buyers - the big music and electronics retailers - have forced them to standardize prices. In most markets, prices convey meaningful information about value and risk. This point is intuitive: think of the price of blue-chip stock, for example. But because every CD costs roughly the same, prices do not serve their usual function of providing an informational feedback loop between labels and listeners.

So what if, under such a contract, the interests of the record labels (the agent) diverge from the interests of the listeners (the principal)? What if, for business reasons, the labels are more interested in their own economies of scale and brand identity than providing listeners with music they value?

In an extreme case, the labels might begin to impose costs beyond the actual search and production costs for which listeners are actually interesting in paying just to feed the bottom line. That is exactly what the recording industry did well before file sharing existed. The result? Alienated and disgruntled customers.

With the rise of peer-to-peer services, consumers found it more efficient to take on their own search costs and avoid the inefficient middleman, the record company. Many people were more happy to spend time searching for new music on the Net and compiling their own collections - a service previously performed by recording companies - than they were simply buying the goods the industry selected and promoted by the record labels.

Economists have a name for this problem: moral hazard. Moral hazard happens when the actions of agents can be hidden from principals, creating "agency costs" because agents are able to shirk and not deliver on their end of the bargain. In this case, the moral hazard is the shirking behavior of the record industry. It chooses artists and music collections not based on listeners' preferences, but based on production, marketing, and distribution efficiencies - adding massive agency costs and no longer offering the search value it is supposed to provide. The problem is compounded because music is an experience good - its value is not directly knowable to buyers until they have begun to consume it.

The way to change the incentives implic

of course ...

[Alien54]

Of course, no one wants to by an albume only to get access to one hit tune, never listening to the rest of the junk.

But the music companies want to have all the benefits as long as possible, and argue that all efforts to get out of their little trap are illegal

Re:The RIAA

[Anonymous Coward]

How on EARTH is this flainbait. Its a simple, straigh foreward opinion which doesnt insult ANYONE.

Re:THESE ARE TEH FACTS.

[PetWolverine]

Haven't you seen Die Hard?