Fixing the price of music

Elastic Music Demand could have been the name of a Jefferson Airplane album (yes, I’m that old), but it’s becoming a hot topic of debate in the music industry.

On Wednesday, Pandora announced on its corporate blog that it is raising the subscription price for its ad-free Pandora One service starting in May from $3.99 a month to $4.99 a month and is ending its annual subscription plan — moves it claimed are necessary because “the costs of delivering this service have grown considerably due to higher royalty rates. The move came just days after Pandora lost a bid in court to role back the royalty rate it pays to songwriters and publishers through ASCAP, although the royalties at stake in that case are far smaller than what Pandora pays record labels and performers through SoundExchange.

Over at Re/Code, Venrock partner David Pakman, formerly CEO of eMusic spells out an interesting case for why the price hike might be a bad idea (albeit without addressing Pandora specifically). Pakman runs through the last couple decades of the business and shows that per capita spending on recorded music among active music buyers has been fairly stable over that time despite multiple format shifts, in a range of $45 -$65 per year, and that the larger any one music service gets the lower in the range that spending number goes. Apple’s iTunes music ARPU, for instance, fell from $42 in Q4 2007 to $12 in Q4 2012 while the number of iTunes users went from less than 10 million to nearly 600 million.

If the music industry wants to grow the industry overall, therefore, it needs to target a lower ARPU for subscription streaming services than current pricing permits. Pakman is particularly skeptical of on-demand streaming services like Spotify, Beats Music and Rdio, all of which are priced at roughly the same $10 a month ($120 a year) because they are all working from the same minimum prices established by the record labels in their licensing deals:

The data shows that $120 per year is far beyond what the overwhelming majority of consumers will pay for music, and instead shows that a price closer to $48 per year is likely much closer to a sweet spot to attract a large number of subscribers.

For this reason, I believe the market size for these services is limited to a subset of music buyers, which in turn is a subset of the population. This means that there will be fewer subscribers to these services than there are purchasers of digital downloads unless one of two things happens:

  • (a) Consumers decide to spend more than two times their historical spend on recorded music, or
  • (b) major record labels allow the price of subscription music services to fall to $3–$4 per month.

Pakman is doubtful that either will happen. And the reason he offers for such self-defeating behavior is that the music labels erroneously believe that demand for music is non-elastic. That is, it is not much affected, one way or the other, by price:

My experience with the major labels when I was CEO of eMusic was that they largely did not believe that music was an elastic good. They were unwilling to lower unit economics, especially for hit music, to see if more people would buy. Our experience at eMusic taught us that music is, in fact, elastic, and that lower prices lead to increased sales. If the major labels want to see the recorded music business grow again, I believe the price of music must fall.

The non-elasticity of demand for media and entertainment content is one of the great un-tested hypothesis of business history, and is certainly not limited to the music industry.

The movie studios stuck stubbornly to high unit prices for DVDs and Blu-ray Discs, even as they watched consumer purchases steadily erode in favor of streaming and kiosk rentals, which produce much lower margins. If the studios had instead lowered the purchase price of new release DVDs to $9.99, and let grocery stores discount them to $8.99, how many of those grocery stores would have made space available for Redbox kiosks? I suspect far fewer, but we don’t know because the idea was never tested in the real world.

Assumptions about the non-elasticity of demand also keeps the studios locked into a system of exclusive, format-specific release windows despite consumers’ manifest preference for seamless availability across devices and platforms.

Book publishers resisted lower unit economics for ebooks to the point where it landed them on the wrong end of a price-fixing case. Only now, after getting slapped by the Justice Department, are they starting to experiment with strategies like subscription pricing for ebooks, through Scribd, Oyster and Entitlebooks, to see if they can grow the market.

Media businesses have long operated from the premise of inherent value — that each media property has some fixed and immutable appeal based on its particular inputs: Who’s in the movie? Who wrote the book? Who put out the album? Managing ROI, therefore, comes down to managing the cost of the inputs, not to responding effectively to elastic demand.

That premise more or less held so long as distribution options were limited and supply could be effectively rationed. It doesn’t hold in digital markets, however, where supply cannot easily be rationed.