Newly Vulnerable Markets in an Age of Pure Information Products:An Analysis of Online Music and Online News

Eric K. Clemons§ • Bin Gu§,¶ • Karl R. Lang§,±

§The Wharton School, University of Pennsylvania, Philadelphia, PA 19104¶ McComb School of Business, University of Texas at Austin, Austin, TX 78712

±Baruch College, City University of New York, New York, NY, 10010

clemons@wharton.upenn.edu • bin.gu@mail.utexas.edu • klang@ust.hk

Last Update: August 26, 2002

Submitted for publicationTo the Journal of Management Information Systems

Newly Vulnerable Markets in an Age of Pure Information

Products:

An Analysis of Online Music and Online News

Eric K. Clemons, Bin Gu and Karl R. Lang

ABSTRACT: We describe the emerging competition between music companies and their star acts, and the

role of online distribution in this industry. We then contrast this with the lack of competition newspapers

will face from their reporters, writers, and photographers, but do identify other possible competitors for

newspaper publishers. We examine what resources have previously enabled record companies to lock in

their star acts and ways in which technology has altered artists’ ability to reach the market independently

and thus their dependency upon record companies. We examine which resources have seen their value

eroded in the newspaper industry and the remaining value that the newspaper company does still create,

other than bundling stories, adding advertising, and printing and selling the papers. We consider what part

of the newspaper business is vulnerable, if any, and where threats may arise. We combine the resource-

based view of competitive advantage to examine which industry may have become newly easy to enter,

and the theory of newly vulnerable markets to assess which industry may actually have become vulnerable

as a result. Our analyses are then used to create a computer simulation model to make the implications

more explicit under a range of assumptions.

KEY WORDS AND PHRASES: newly vulnerable markets, resourced-based competition, electronic

commerce, music industry, newspaper industry.

ACKNOWLEDGEMENTS: The authors thank Robert J. Kauffman, Alina M. Chircu and the three

anonymous referees for their useful comments and suggestions. We also benefited from the comments and

criticism of the participants of the Organizational Systems and Technology Track at the 35 rd Hawaii

International Conference on Systems Science (HICSS) in Big Island, Hawaii in January 2002. Finally, we

thank the Reginald H. Jones Center for Management Policy, Strategy and Organization for ongoing

sponsorship of our research on electronic commerce. Special thanks are due to Saul Hansel at the New

York Times for his inputs and ideas. Any errors of fact and interpretation are the sole responsibility of the

authors.

Author Biographies

Eric K. Clemons is Professor of Operations and Information Management at The Wharton School of theUniversity of Pennsylvania. He has been a pioneer in the systematic study of the transformationalimpacts of information on the strategy and practice of business. His research and teaching interests includestrategic uses of information systems, information economics, the changes that information technologyenables in the competitive balance between new entrants and established industry participants,transformation of distribution channels, and the impact of information technology on the risks andbenefits of outsourcing and strategic alliances. Industries of focus include international securities marketsand financial services firms, consumer packaged goods retailing, telecommunications, and travel. Hespecializes in assessing the competitive implications of information technology and in managing the risksof large-scale implementation efforts. Additionally, Dr. Clemons is the founder and Project Director forthe Reginald H. Jones Center’s Sponsored Research Project on Information: Strategy and Economics,founder and area coordinator of the School’s new major in Information: Strategy, Systems, andEconomics, director of the School’s new MBA e-commerce major, an active participant in the School’seCommerce Forum research program, and member of the Faculty Council of the SEI Center for AdvancedStudies in Management. Dr. Clemons is currently a member of the editorial board of the Journal ofManagement Information Systems and the International Journal of Electronic Commerce. He has servedon the Congressional Office of Technology Assessment study of securities markets and on the Quality ofMarkets Advisory Board of the London Stock Exchange.

Bin Gu is an Assistant Professor in Management Science and Information Systems at the University ofTexas at Austin. His research interests include value of online information, impact of online informationon consumer choices, firm strategies and market competition, and modeling of information-based businessstrategies. He was an active participant in the Project on Information: Economics and Strategy, a multi-company research partnership conducted by Wharton’s Reginald H. Jones Center. His research has beenpresented at the Federal Reserve Bank of New York’s Financial E-Commerce Conference, theInternational Conference on Information Systems, the Workshop on Information Systems Economics,and the Hawaii International Conference on Systems Sciences.

Karl Reiner Lang is an Associate Professor in Information Systems at Baruch College, City University ofNew York (CUNY). He received his MBA from the Free University of Berlin, Germany (1988), and holdsa Ph.D. in Management Science from The University of Texas at Austin, USA (1993). Before joiningBaruch in 2002, he was on the faculty of the Business School at the Free University of Berlin and theHong Kong University of Science & Technology (HKUST). Dr. Lang’s has been teaching courses onInformation Technology and Electronic Commerce at the undergraduate, postgraduate, and executiveeducation level. His research interests include management of digital businesses, decision technologies,knowledge-based products and services, and issues related to the newly arising informational society. Dr.Lang's recent publications have appeared in leading research journals such as Annals of OperationsResearch, Computational Economics, Journal of Organizational Computing and Electronic Commerce, andDecision Support Systems. He has professional experience in Germany, the USA, and Hong Kong.

Author Addresses

Eric K. Clemons (contact author)Operations and Information Management DepartmentThe Wharton School, University of Pennsylvania3620 Locust Walk 1300 SH-DHPhiladelphia, PA 19104Phone: 215-898-7747Email: clemons@wharton.upenn.edu

Bin GuManagement Science and Information Systems DepartmentMcComb School of BusinessUniversity of Texas at AustinCBA 5.202Austin, TX 78712Phone: 512-471-3322Email: bin.gu@mail.utexas.edu

Karl R LangDepartment of Computer Information Systems (CIS)The Zicklin School of BusinessBaruch CollegeCity University of New York (CUNY)One Bernard Baruch WayNew York City, NY 10010Phone: 646-312-1000Email: klang@baruch.cuny.edu

1. Introduction

The advent of digitization of pure information products has created turmoil and uncertainty in most

markets for information goods. Travel agents and stock brokers are facing disintermediation. The music

industry is suing Napster even while some labels are seeking strategic alliances with it. At the same time,

recording artists are threatening to break with the record companies that have historically produced their

material, while some are fighting Napster and others are seeking to work directly through it, bypassing

record companies and the traditional retail channel. Newspapers have embraced online distribution of the

news with different degrees of enthusiasm, and with very different strategies. The only thing that has been

said with certainty is that for information products some markets will undergo more change in industry

structure than others, resulting in rapid evolution of strategies for some markets and significant changes in

the future prospects of some currently dominant industry participants.

News stories are increasingly written on laptops and filed electronically. Photographs are increasingly

taken with digital cameras, or are readily converted into digital files. With html files combining formatted

text and digital photographs, news stories can easily and rapidly be communicated over the net, either

through publishers’ websites or directly via email or pointcast distribution to interested subscribers.

Timeliness, reliability and accuracy matter most when it comes to the delivery of news. Established

publishers with reputable brand names have been best positioned to go online. Different from other

information goods, consumer valuation for news depreciates quickly. Yesterday’s news may already be

worthless today. This is one reason that illegal copying and distribution have not happened often in the

news industry. Hence, the big papers generally feel less inhibited about making their content available

online.

Similarly, music is increasingly frequently recorded using digital technology, mixed and mastered using

digital technology, and distributed on digital media such as compact disks (CDs). Indeed, with digital

performance on synthesizers (at one end of the value chain) and digital distribution over the net as MP3

files (at the other end of the value chain) some music can be created, distributed, and enjoyed without ever

requiring a physical recording or hard copy.

Protecting digital content from unauthorized distribution has been the industry’s main concern regarding

online music. Fear of losing sales combined with some degree of organizational inertia may explain the

industry’s initial indifference to the net as a new business infrastructure and distribution channel. But after

start-ups like Napster, Gnutella, and MP3.com began to successfully service massive consumer demand for

online music – largely bypassing the record companies - the incumbents had to accept the new business

reality and change their behavior. Rather than introducing competitive online alternatives, the answer

most commonly chosen at present appears to be a dual approach of experimenting with new technologies

like digital rights management and digital watermarking in order to stop large-scale piracy, while

simultaneously launching litigation suits against the new Net-based competitors over copyright

infringements. While the former approach, attempting to develop and deploy reliable and effective

technology to support secure digital music, has not been successful, the latter has.

As noted, a wide range of strategies is being pursued. The online delivery of The New York Times is free to

all who register with the Times, and includes online access and email distribution of topics selected by the

user, or of late-breaking news; in contrast, the Wall Street Journal has chosen not to make its online

services available without charge to non-subscribers to their paper editions. In the music industry, Warner

Brothers and Sony initially chose to sue Napster, while Bertelsmann initially pursued forging a business

alliance with them [10, 11]. Ultimately, legal action won out — over the short-term at least — forcing

Napster into bankruptcy; however, there is no indication that this represents a permanent solution to the

problem faced by record labels1, nor is there any reason to believe that the issues raised here will decrease

in significance for this or other industries.

The strategies that will be pursued, the effectiveness of these strategies, and outcomes that will result are as

yet not clear, but a theoretically sound analysis should enable us to make both predictions and strategic

recommendations. In section 2 we will present two relevant theories of competition that have proven

valuable in predicting the outcome of competition during and immediately after innovation:

• The theory of resource-based value retention; that is, the degree to which the ownership of

distinct yet related assets confers value upon the owners when innovation and change occur in an

industry

1 Napster Inc. filed for Chapter 11 bankrupt on June 3 after battling with the music industry's copyrightinfringement lawsuit for more than three years [8]. It had more than 60 million users at its peak andclaimed to herald the arrival of new era of music distribution. While Napster has been shut down, onlinemusic piracy continues. Numerous new music sharing software (e.g. Gnutella, MusicCity) have replacedNapster with better technology. Unlike Napster, their decentralized structure makes it impossible to shutdown. Moreover, illegal music distribution servers hosted in other countries create an even bigger problemfor the music industry. The legal environment in foreign countries is often dramatically different from theUS. Reuters reports that US record labels brought lawsuit against US internet providers for their assistancein routing illegal digital music from a server hosted in China. Ironically, the company running the server isnot listed as a defendant. The music industry explains that it is not able to identify the owner of the server[1].

• The theory of newly vulnerable markets, that is, of markets that have been rendered easier to

attack as a result of technological innovation or other change

In sections 3 and 4 we will exploit these theories to examine two very different industries, popular music

and daily newspapers. Our analyses demonstrate that music labels are vulnerable, and that the increase in

power that technological changes have given to the most popular musical groups and artists will slash the

profit of these labels, despite their currently dominant position. However, our analyses also demonstrate

that newspapers are much less vulnerable to attack by their writers, although there is a separate, different

form of vulnerability that must be considered, that of alternative distribution of the advertisements that

currently, at least in the United States, provide the bulk of the newspapers’ profits. Conclusions and

suggestions for future research are presented in section 5.

2. Theoretical Underpinnings

This is of course not the first paper that has addressed channel conflict. Byers and Lederer [3], for

example, study the conflict between online and traditional provision of banking services, and model

consumer behavior to show that the banks’ ability to preempt new entrants is robust under a wide range of

assumptions about consumer behavior. While the problem we address here is fundamentally different — a

shortening of the distribution channel for producers of existing products, rather than competing new

entrant providers using a different channel — the need for a dynamic model that emerges over time and

depends upon consumer behavior is common to their work and ours.

There are two theories of competitive strategy that will help structure and inform our analyses:

• Resource-based value retention and the role of critical resources in creating and sustaining competitive

advantage

• Newly vulnerable markets, and the conditions that encourage new entrants and facilitate their success

in competition with large, well established, and apparently well positioned incumbents

These theories deal with different issues. The theory of resource based value retention describes conditions

under which an innovator can expect to retain much of the value created by his or her innovation; that is,

it describes when the innovator can expect to retain economic rents, and when those rents must be shared

with other parties. The theory of newly vulnerable markets deals with a confluence of factors that, when

combined, makes a firm or an industry extremely vulnerable to new entrants. We combine the two of

them in this paper by showing how a change in the cost of resources or the availability of resources may

erode barriers to entry, creating significant vulnerability to previously invulnerable incumbents.

2.1. Resource-Based Value Retention

The theory of resource-based value retention is largely due to David Teece [12] and accurately predicts

how value will be distributed after innovation. To take some simple but illustrative examples:

• If an idea is readily replicated and requires no special resources to exploit (soft-batch home-style

cookies, introduced in the mid-1980s and now available from Keebler, Nabisco, Procter & Gamble,

among others) the consumer receives the bulk of any gain from innovation. There is no reason to

expect super-normal profits to any industry participant as a result of the innovation.

• If an idea is readily replicated but requires special resources to exploit, then the idea will be replicated,

eroding profits from the innovation itself, but providing significant profits to the owners of the

resources needed to exploit the innovation. Microsoft and Intel were the major winners from the

introduction of the largely standardized IBM PC architecture, and not IBM itself. These special

resources are called co-specialized assets.

• If an idea is tightly protected (by copyright or patent, for example) but requires co-specialized assets to

exploit effectively, then the owner of these assets will be able to retain a share, perhaps a significant

share, of economic gains.

• If an idea is tightly protected (again, by copyright or patent, or other mechanisms), but there are no

critical resources required to exploit it, then it is the innovator himself (or herself) that can expect to

gain.

Additional research has shown that critical resource differences may play an even more important role in

gaining advantage from investments in information technology. This is because the innovation itself

—online shopping for golf clubs, for example — is rarely protectable. If the innovator is to harvest

significant advantage it must be a result of something else and that something is usually a strong ownership

position in critical resources needed to exploit the innovation fully [4, 6].

2.2. Newly Vulnerable Markets

The theory of newly vulnerable markets has three essential components [5]. The market should be:

• Newly easy to enter

• Attractive to attack

• Difficult to Defend

We explore the roles of each of these factors in turn.

2.2.1. Newly easy to enter

A market can become vulnerable if it is newly easy to enter, as a result of regulatory change (regulatory

change in Europe increased the vulnerability of financial institutions previously protected by national

borders), technological change (cellular telephony increased the pressure on Bell operating companies by

offering alternatives to their local service based upon traditional land lines), or consumer preferences (as

consumers become more net-savvy online shopping may threaten established mall operators and the

owners of large physical stores).

It is important not to overlook the importance of the word “newly.” That is, a market whose entry

barriers have not recently changed can be assumed to be more or less in steady state or competitive

equilibrium. If it were vulnerable to attack someone would have already attacked it. However, when entry

barriers suddenly drop we can expect rapid and massive changes in corporate populations — much as when

land bridges end the isolation of islands during low sea levels associated with ice ages, producing massive

changes in populations of flora and fauna.

2.2.2. Attractive to attack

We have found two conditions that are associated with markets that are vulnerable to successful attack.

The first is the presence of a strong customer profitability gradient, that is, the presence of extreme

differences in profitability between the best and the worst customers in a market. This is most frequently

due to uniform pricing in the presence of great differences in customers’ cost to serve, although other

forms of simplistic pricing can produce similar effects. This difference in profitability, due to simplistic

pricing, is equivalent to massive cross-subsidies of the worst (least profitable, or “kill you”) accounts by the

best (most profitable, “love ‘em”) accounts, which we have described as a money pump between different

customer segments. The most publicized example of an industry vulnerable to attack due to simplistic

pricing has been credit cards [8].

Such cross-subsidies do indeed create vulnerabilities, related to opportunistic pickoff of the best accounts,

also called cream skimming or cherry-picking. A new entrant that targets profitable accounts and forgoes

the kill yous and the losses that they produce can successfully attack, even in the presence of higher unit

operating expenses. That is, a new entrant can have higher costs, capture market share by offering lower

prices to its intended customer base, and still be profitable. Again, this is because it is operating without

subsidizing losses from unattractive customers. We view these cross-subsidies as indicative of a vulnerable

market, much as Baumol viewed the presence of cross-subsidies as indicative that a market was not

contestable, but rather was operating under conditions that allowed it to earn monopoly profits [2].

Additionally, cross-subsidies can come from one product line being used to subsidize another, rather than

one customer group. Thus, in the UK, where all customers are entitled to no-minimum-balance free

checking accounts, these accounts must be subsidized somehow; the necessary funds are provided by banks

that historically over-charge customers for bank credit cards. This makes opportunistic pickoff even

easier; a new entrant that does not need to subsidize bad accounts and does not need to subsidize additional

lines of business is ideally positioned to make better offers to the customers it does want to attract, in the

product markets it does want to enter. When the UK banks’ simplistic pricing for credit cards (resulting in

a first cross-subsidy) is augmented by overcharging all customers to offset losses from free checking (a

second cross-subsidy) the combination created even greater incentives for Capital One and other UK card

issuers to attack.

2.2.3. Difficult to defend

Of course, without some barrier to prevent incumbents from immediately replicating the strategy of the

attackers, there would over the long term be no profits for the attackers to capture. The profits would be

competed away as market efficiency and more accurate pricing eliminate transfers and cross-subsidies.

New entrants would be spoilers, but not profitable, and with foresight one might expect them to conclude

that the market was not really worth attacking, reducing incumbents’ vulnerability. There is a wide range

of potential barriers to rapid replication, including regulatory restrictions on incumbents, fixed

commitments to existing customers to maintain current prices, and investments in inappropriate systems

or physical infrastructure.

3. The Recording Industry

3.1 Current Structure of the Industry

The major players in the industry include the following:

• The artists, who create the works of music (compose, write, and perform)

• The record companies, also called labels, who sign the groups, promote the groups, produce master

recordings for most of the groups, produce copies or arrange for their production, and sell copies to

retailers

• Various production facilities, including recording studios and factories to produce copies of records,

tapes, and CDs, most of which are owned by the labels

• Retailers, who do most of the actual selling to consumers

The essential activities performed by these players can be summarized as follows:

• creation (by the artists)

• creation management (selection and promotion, generally by the labels)

• production (recording, mastering, and production of physical copies, generally by facilities owned by

the labels)

• retailing (by traditional stores, the labels themselves, online sellers of physical copies, and to some

extent online sellers of pure digital products)

3.2. Potential Sources of Record Company Vulnerability

The analysis of section 2 suggests that the following are potential vulnerabilities of the labels. However,

for each there has historically been an effective source of defense against these vulnerabilities.

3.2.1. Cross-subsidies of Talent and Opportunistic Pickoff

The principal source of vulnerability will come from the threat of opportunistic pickoff, as described in

section 2.2. In a real sense the artists are captive “customers” of the labels, buying promotion and

production services in exchange for giving up their copyrights and accepting royalty payments as

compensation. There is a strong customer profitability gradient (CPG) among these groups; some acts

desperately require the promotional services that the labels can offer, while others have little need for

these services, or to obtain them from their record companies. Thus, one of the marks of strategic

vulnerability is present: the best, most popular, and most profitable groups under any labels control are

being forced to subsidize their less popular and less profitable stable-mates.

Historically, record companies were able to protect themselves from opportunistic defection, a form of

opportunistic pickoff in which the most profitable groups leave the label at the end of the contract and

begin to promote themselves and record and sell their own works. The labels’ defenses came from the

following sources:

• In the beginning of the performing careers, artists had limited reputations, limited funding, and thus

limited access to the promotional process other than through the labels, with their talent scouts and

development system. Groups initially needed contracts with labels simply to “break into” the business.

• Even established groups had limited access to recording studios, mixing technology, and mass

production except through the labels, and thus needed contracts to remain in business.

• And, likewise, even established groups had limited access to distribution through record stores without

endorsement of a major label.

3.2.2. Cross-subsidies of Activities and Opportunistic Pickoff

The value creation comes from the artists and the revenue comes from producing and selling physical

copies, which may no longer be necessary for distribution and consumption of music. This decoupling of

value creation and revenue production creates a second cross-subsidy between these two activities, which

are presently linked only because physical production and distribution capability historically were co-

specialized assets needed to capture value from creation of the work of art. This creates a second force

towards opportunistic pickoff as groups can distribute their works at much lower cost if they neither

subsidize other acts nor subsidies the labels’ other activities. A typical record company contract offers a

mere 10%-15% royalty to the artists, while the labels and the retailers divide the rest. That means the

artists receive less than $2 for each CD sold, even those have an average retail price of about $15.

Clearly, the artists could expect to receive a bigger portion of the revenue if they could deliver the music

directly online2. Just as clearly, super-star artists could earn more simply by taking back control over

production and promotion, and paying for these with some sort of fee-for-services contracts with

independent recording studios and independent promoters, rather than allowing the record labels to retain

35% or more of the revenues received from retailers. This was technically infeasible for all but the largest

groups in the past, but as we will explore in the following section, this has become far easier today.

3.3. Changes that Exacerbate Vulnerability

Recent changes in the cost or value of assets owned by the labels have undercut the labels’ defenses. The

ease with which groups can now produce their own master recordings with inexpensive digital recording

studios, and the ease with which these recordings can be copied with inexpensive CD-burners, is sufficient

to erode the value of the co-specialized assets owned by the studios. An elementary comparative statics

argument based on the theory of resource-based value retention suggests that whatever the power of the

labels before the value of some critical co-specialized assets changed, anything that reduces the value of

these assets should reduce the share of value that the labels are able to retain.

2 Referees have noted that this division of profits implies a lack of perfect competition within the recording industry,which is of course correct. We note that when baseball owners were protected from prosecution for collusion by explicitexemption from prosecution under the Sherman Anti-Trust Act they retained a far larger share of the value created byplayers. With the end of this exemption and with the advent of free-agency increasing competition for star athletes, theshare of value (e.g., ticket receipts and revenue from the sale of television rights) retained by the players has greatlyincreased.

A complementary analysis based on the theory of newly vulnerable markets leads us in the same direction;

we can choose to view musical groups as potential new entrants in the music distribution business3. The

technological changes in music recording, mastering, production, and distribution do indeed make this

industry newly vulnerable, and these changes make it newly easy for groups to defect and enter the music

business without labels. As we have already seen, these markets are also attractive to attack, creating the

first two necessary conditions for newly vulnerable markets. If artists were to gain access to production

and distribution they would no longer need to forfeit roughly 85% of the sale price of their music to the

labels and the distribution channel4. In the past the costs of independent production and distribution were

so high that this option was available only to the most wealthy and powerful artists. Perhaps the only

group to clear this high hurdle and operate their own label in the age of vinyl records was the Beatles, with

their creation of the Apple label in the late 1960s. However, digital recording and mastering, to produce

the original recording of the performance, and net-based online distribution in purely digital form,

dramatically lower this hurdle and make self production available to a far wider range of artists.

Both arguments lead us to the same conclusion. As a result of technological innovation, the best groups

will be able to opt out of the record companies’ promotional activities, which offer them little, and will be

able to record and distribute directly to consumers online.

We have created a computer simulation model to allow us to examine the implications of our analyses

more concretely, using a range of assumptions. The assumptions of these simulations are included in the

appendix. Our simulation results illustrate the following:

• A base case run in which the studios are profitable, on average groups are profitable, but the bulk of

the profits comes from the best groups.

• Rapid defection / self promotion in which many of the best groups choose to defect from their

labels soon after the end of their contract periods. Record companies soon become much less

profitable. The groups that self promote do indeed enjoy an increase in profitability.

3 A similar analysis of airlines’ potential for direct distribution of reservations and ticket sales led to our early predictionof a loss of travel agency profitability [7].4 Of course, the phrase “gain access” does not mean that the groups need to perform these services themselves. It merelymeans that a third party provider can offer these services, much as third parties now provide more than 80% of the serviceand maintenance on GM cars. Indeed, promotion has always been available through publicity agencies; it was the need foraccess to recording, mastering, and production that kept groups dependent upon record labels.

• Rapid and broad defection / self promotion, in which many groups, across a broader spectrum,

choose to leave their labels and self promote. Record companies cease to be profitable. The earnings

of successful groups do indeed increase, but as record companies cease to promote, fewer bands enter

the industry and consumer choice actually declines.

• Slower defection/ self promotion, in which the top groups leave, but less rapidly. Record

companies earn less, groups earn more.

• Rapid adoption of piracy in which about 75% of the top acts’ sales are stolen, and about 25% of the

remaining acts’ sales are stolen. Record companies lose money, artists earn less, and fewer groups

choose to enter the recording industry. Consequently, consumer choice is reduced.

3.3.1. The Music Industry — Base Case

As can be seen in figure 1, initially the recording studios are quite profitable. Recording artists consistently

earn money as well. Since there is initially no self-promotion (that is, no groups are attempting to engage

in recording, promotion, and sales, without relying upon a contract with a studio), there is no profit

associated with self-promotion. The number of groups recording music available to consumers remains

roughly constant. The various curves in the graph depict the following:

• Record Co’s Profit — This is the total net revenue of the recording company, that is, total receipts

from sales of albums to music wholesalers and retailers, less promotional expenses, recording expenses,

and royalties.

• Groups’ Profit — This is the total net revenue received by the recording groups under contract to the

recording company (that is, royalties), less expenses that the recording company deducts from those

royalties.

• Self-Promoters’ Profit — This is the total income earned by groups that bypass the traditional

distribution system, less the costs of production and distribution incurred by those groups.

• Number of Groups — This is the total number of groups whose music is available to the public, that is,

the total number both of groups under contract and groups managing their own production and

distribution.

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INSERT FIGURE 1 ABOUT HERE

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3.3.2. The Music Industry — Rapid and Broad-Based Defection

As can be seen in figure 2, rapid and broad based defection of recording artists is devastating for the

recording industry. As the most profitable 10% of recording artists defect and do so at a rate of 50%

annually, producing and distributing their own music using alternative technology and alternative channels,

the profitability of traditional record labels is destroyed. In contrast, the money that was previously

earned by the studios is now earned by the artists themselves, as a result of their adoption of self-

production and self-distribution. However, it becomes quite difficult for most new groups to achieve

sufficient profitability for the record companies and many are dropped relatively quickly. Thus, the

number of groups recording and the amount of music available for consumers to purchase declines

dramatically over time.

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INSERT FIGURE 2 ABOUT HERE

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3.3.3. The Music Industry — Less Rapid and More Focused Defection

As can be seen in figure 3, slower and more narrowly focused defection of recording artists is still

extremely damaging but less immediately devastating for the recording industry than more broad-based

defection shown in figure 2. As the most profitable 5% of recording artists defect and do so at a rate of

25% annually, producing and distributing their own music using alternative technology and alternative

channels, the profitability of traditional record labels is rapidly eroded, though not quite to the levels

caused by more broad based defection. However, given the significant skew in profitability, and the high

percentage reflected by the top deciles of the labels’ artists, the loss of even 5% is quite damaging. Once

again, much of the money that was previously earned by the studios is now earned by the artists

themselves, as a result of their adoption of self-production and self-distribution. Additionally, as with

more broadly based defection, it becomes quite difficult for new groups to achieve the profitability that

record companies require, and thus difficult for them to enter the industry. As a consequence of this, once

again the number of groups recording and the amount of music available for consumers to purchase declines

over time.

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INSERT FIGURE 3 ABOUT HERE

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3.3.4. The Music Industry — Slower and More Focused Defection

As can be seen in figure 4, slower and more narrowly focused defection of recording artists is only

moderately damaging for the recording industry, and significantly less so than the more rapid defection

shown in figures 2 and 3. As the most profitable 2% of recording artists defect, but at a slower rate of 25%

annually, the profitability of traditional record labels is somewhat eroded. However, given the degree of

natural turnover that would have removed many of these groups from their labels collection of recording

artists, this is much less damaging than the rapid reduction of groups that would have otherwise remained

profitable for their studios. Once again, the money that the studios no longer earn is now earned by the

artists themselves, as a result of their adoption of self-production and self-distribution. However, since the

profits of the studios are no longer under as extreme pressure the studios are no longer cutting back quite as

extensively on their support of new groups, and thus the impact on the music available to consumers is less

severe than in figures 2 and 3.

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INSERT FIGURE 4 ABOUT HERE

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3.3.5. The Music Industry — Online Piracy without Payment for Production or Intellectual

Property

As can be seen in figure 5, an online piracy rate of 50% has a dramatic impact on the profitability of the

recording studios. However, the money being lost by the studios is no longer captured by the recording

artists. Consumer advocates might argue that although this may appear unfair to both artists and

shareholders in record companies, it is at least producing significant consumer surplus: the money that had

previously been earned by artists and record companies is retained by consumers who now have access to

music free. However, this issue now appears more complex; an examination of the number of new groups

being promoted by record companies is significantly reduced, and hence the selection of music available

ultimately is reduced as well. <<At last, here we really do have reduction in the number of groups. Why

should piracy be more damaging to the record companies’ ability to produce new music than defections?

Indeed, defections at least save the record companies money, while piracy reduces their earnings but not

their promotional expenses. Is this because we are having piracy affect all groups? Is this 50% of all

music, rather than skewed towards more popular music, unlike self promotion? No. The 50% is skewed

towards more popular music. I think that’s why the impact is significant>>

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INSERT FIGURE 5 ABOUT HERE

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3.4. Defensive Strategies Available to Labels

We see a range of strategies available to record companies. The first, of course, is the one that is almost

always recommended in the presence of newly vulnerable markets: end the practice of uniform pricing and

the implicit cross-subsidies of different populations in the presence of extreme heterogeneity among

customers; that is, since different musical groups are different, offer them pricing structures or other

incentives that would induce them to remain5. A second is to attempt to exploit the initial vulnerability

of new groups, and to attempt to capture them for a longer period of time by signing all new prospects up

to longer term contracts. A third is to broaden the set of activities they perform for their best groups by

bundling in more services. Large cash advances or large pre-payments for future albums represent a form

of risk sharing: the artist’s risk is reduced because a certain minimum payment is assured and the

company’s large portfolio of good acts reduces the risk from any one group’s future failure. This form of

risk pooling is of course the basis of all insurance. Without exploring risk avoidance and actuarial fair

prices it is simple to note that this form of insurance is not new (Marlene Dietrich’s legs were insured with

Lloyds in the 1940s) and that if the price (implicit or explicit) of this insurance is set high enough to fund

the cross-subsidies that have created the recording company’s problems alternative coverage will be

available from other parties. The final, most difficult, but most robust recommendation is for the record

companies to attempt a profound transformation of their basic value proposition, much as travel agencies

5 Paying more to the owners of ideas when losing the bargaining power that comes with co-specialized assets is, ofcourse, the default outcome, in the sense that it is predicted by theory and in a sense is always available: if your talent canleave without greater compensation you will need to increase compensation. We see this occurring as recording studiosoffer their best talent better contracts and even renegotiate existing contracts before their expiration. However, this is bothcostly and complex, in that it would require a change to the labels’ existing, albeit overly simplistic, business models andstrategies for dealing with their artists.

were forced to do by capitation of ticket prices and the threat by airlines to opt out of the agency-based

distribution system for corporate travel. This could entail some combination of the following activities:

• The record labels could provide promotional management and production management services, for

competitive fees. They might choose to do this for all groups, or they might choose to offer all new

groups the current promotional program and offer fee-for-services contracts to groups at the

completion of their initial contracts.

• They could attempt to lock up Napster and Gnutella and other online distribution channels and lock

out independent distribution by groups. (However, this appears unlikely to succeed, due to restraint of

trade implications and difficulty in preventing new entry by websites without such restrictions)

• They could make stamping out piracy and protecting the intellectual property rights of their artists an

essential part of the service that they provide to their groups as part of their contract. (Technically,

this has always been one of the services that labels have provided for their groups. However, with the

ease of online piracy, this service has become far more valuable, and should be more explicitly stressed

by the labels.) They could work with Napster and Gnutella and other online distribution channels, to

assure (for a fee) that they and their artists receive compensation every time a copy of their work is

exchanged. This may indeed be what Bertelsmann has planned.6

4. The Newspaper Industry

4.1. Current Industry Structure

The major industry players, ignoring, for now, online editions, include the following:

• The writers and photographers, who cover and report on the news

• The newspapers, which hire or contract with writers and photographers, edit their works, sell

advertising space, bundle their works with advertising, print the paper copies, and distribute them to

subscribers and to other retailers

6 We have a draft manuscript completed on this topic and anticipate continuing research in this area.

• The various forms of retailers, who do most of the actual selling to consumers not handled directly

by the newspapers’ subscription service

The essential activities performed by these players can be summarized as follows:

• creation (by reporters and photographers)

• creation management (selection of stories, editing of stories, and certification of correctness, accuracy,

timeliness, and suitability)

• production (bundling with advertising, printing and distributing copies)

• retailing (by subscription services, news agencies, news stands, convenience stores, and other retail

outlets)

4.2. Potential Sources of Newspaper Vulnerability

The analysis of section 2 suggests that the following is the principal potential vulnerability of the

newspapers. In contrast with the music industry, bypass, defection, and self-distribution of their work by

the creative staff itself does not appear to be a significant threat. There is a major threat to existing

players in the newspaper industry created by their persistent cross-subsidy of different activities. We note

that, as in the recording industry, there has historically been a defense against this threat and, as we did

with the recording industry, we will use resource-based value retention as a framework for analysis.

4.2.1. The Advertising Business and Cross-subsidy between News and Advertising

The newspaper industry has for much of its existence consisted of two separate and distinct industries —

selling news and selling advertising — that have been coupled together for historical reasons:

• Combining news with advertising yields lower cost distribution of advertisements (economies of scope

on delivery costs)

• Consumers are willing to accept advertisements in their newspapers but seldom have been willing to

pay for them, justifying bundling ads with the content that consumers desire and charging advertisers

for reaching consumers that advertisers would not otherwise have been able to reach at expense

comparable to the cost of advertising space

• Consumers, at least in the US, are often not willing to pay full cost of newspapers, justifying bundling

advertisements to subsidize providing newspapers to consumers and thus lowering the price that must

be charged to the newspapers’ readers

4.2.2. The News Reporting Business

There does not appear to be a strong customer profitability gradient in the existing news reporting

business. That is, when newspaper sales are compared with credit card issuance or health insurance there

are not consumers who are significantly more profitable on any individual sale than other consumers.

However, we do observe a decoupling of value creation and revenue production, largely analogous with the

music industry:

• Value comes from creation of the news story

• Revenue comes from creating and selling physical copies

Although there is no cross-subsidy of some customers by others, created by a strong CPG, there is a cross-

subsidy between the two activities of creation and selling. These activities are linked today only because

physical production and distribution capability historically were co-specialized assets, which were needed to

capture value from the creation of news stories; moreover, capturing value from the creation of news

stories came not from selling these stories to consumers but from selling space around these stories to

advertisers. Based on the data from Newspaper Association of America, advertising accounts for 81.5%

of the total newspaper revenue. Their sale of subscriptions accounts for only 18.5% of revenues. This

cross-subsidy of activities does suggest vulnerability, and may, indeed, suggest that sale of advertising space

has long been less than a fully competitive market. Ease of entry to the advertising market should, in the

manner described by Baumol, reduce the earnings of newspapers from advertising below the levels that

would permit cross-subsidies of other activities7.

4.3. Changes that Exacerbate Vulnerability:

Exploring Direct Distribution of Journalists’ Stories

7 While this statement is only fully true absent strong economies of scope such as consumer preference for print ads thatcome bundled with newspaper stories, there is no evidence at present that would suggest such preferences exist.

Have newspaper publishers faced changes that undercut their defenses and render them participants in

newly vulnerable markets, analogous to the situation faced by music labels? We do not see publishers as

vulnerable in the same way, or to the same set of threats; that is, we do not see threats posed by the writers

and content production staff of newspapers. Even if reporters could gain access to direct distribution of

daily newsletters (Floyd Norris on the Market, Saul Hansell on eCommerce, John Markoff on technology

companies) it is not clear that consumers would purchase them:

• Very few reporters are, indeed, consumer brands to the extent that ‘Nsync, Wings, the Grateful Dead,

or even Smashing Pumpkins or Dead Milkmen are to the public that listens to pop music

• News stories need some form of authentication or certification — a story I read in the Times online

has a very different level of credibility than something I read in alt.conspiracy.middle-east, and acting

on an unsubstantiated rumor can be dangerous or expensive. Reputation and brand name have been

recognized as the main corporate assets in the media industry, and especially in the online news

market. Papers like The New York Times or the Wall Street Journal have therefore invested heavily

in efforts to carry over their reputation for accuracy, timeliness, and relevance of their print versions

to their online editions. In contrast, a piece of music that I like is enjoyable to me, regardless of who

wrote it or who played it. We have been surprised on occasion when a concerto we heard on the radio

was by Bach when we were sure it was by Vivaldi, or a symphony was by Haydn when we thought it was

by Mozart; we like it either way, and there is no need for certification comparable to that which exists

with news stories.

There has been a change in the difficulty of obtaining assets needed to produce and distribute a news story

or photograph, so we might initially suspect that using the resource-based theory of value retention

reporters and photojournalists might be able to retain a greater share of the value they create by directly

selling their stories to their readers. However, this does not seem to have occurred, and therefore it has

not resulted in a change in competitive position of the newspaper, in its most obvious business of covering

the news. Perhaps the following offers at least a partial explanation:

• Reporters and photographers do indeed have access to low-cost production of their digital stories and

photographs, and low cost access to consumers of the news via online direct distribution

• However, the certification and authentication role of the editorial function remains intact. This is in

sharp distinction with online distribution of digital music: if we enjoy a performance we may not care

whether or not it is an authorized recording; indeed, many teenagers take a real joy in purchasing a

bootleg recording of a concert that was never commercially released. However, we cannot invest

wisely or make other plans based on a story whose accuracy we can neither trust nor confirm.

As long as the certification role remains intact, and as long as it remains an essential role of the newspaper

editorial staff rather than the individual news story creator, then it will be difficult for individual content

producers to compete effectively with their newspapers8. Thus we may conclude that the industry is

neither easy to enter, either by reporters themselves or by new entrants who do not yet enjoy a strong

reputation for reliability and timeliness, nor attractive to attack, based on the absence of a strong customer

profitability gradient among readers of most daily news stories.

What can we say about the attractiveness of supporting journalists who work for newspapers, viewed as

customers of editorial services? Clearly, some journalists are more attractive than others, and therefore

some have more attractive contracts than others. However, nowhere in the industry of print journalism

do we note journalists implicitly being charged exorbitant rates for services that could readily be provided

by an independent service provider. When a musical group pays a double-digit percentage of the net

receipts of its recordings for promotional services and recording and production when these could be

purchased for a much smaller fee, then serving musicians becomes attractive. If super-star reporters were

charged comparable fees for services that could be provided by an independent service provider

this might suggest that the analysis of the previous section, on music groups’ bypass of record companies,

was more directly applicable.

4.4. Changes that Exacerbate Vulnerability:

Exploring Competition from Alternative Advertising Media

The industry based on selling of advertising space within newspapers will need to be analyzed separately.

Selling physical copies of the story does indeed cross-subsidize the creation of the story, and online

distribution does indeed appear to offer lower cost ways of reaching readers, but at the moment the

8 It is not necessary for this analysis that the role of certification remains the only role performed by the newspaper andnot by the individual content providers. For example, it is also true that few newspaper reporters work alone. A starreporter like the Times’ Saul Hansell can employ a photojournalist as needed for an individual story. A columnist likeNewsweek’s Jane Bryant Quinn can employ her own research assistant rather than relying upon those available through herpublisher, and, indeed, she may well do so. Those newspaper professionals who work alone and who do not requirecertification — such as cartoonists and editorial columnists — often are able to retain a greater share of the value createdby their work. However, most reporters’ stories are the result of collaboration among staffers from many locations. Thismay alter the value of parameters we use in our model and may change our story line slightly, but the basic idea — thatfew reporters can consider bypassing their employers and reaching their readers directly — remains intact.

bundling of advertising is simply too important, and bundling of advertising into online editions is simply

too uncertain to encourage entry by online competitors. Can we conclude, therefore, that newspapers are

safe from erosion of their profitability due to innovations in information technology and online

communications?

Perhaps the newspapers business of selling advertising space may yet prove vulnerable. There may indeed

be an untapped and unexploited customer profitability gradient, and possibly a strong one. Online

advertisers might be able to locate it and find ways to exploit it. Two of the authors of this paper are

upper-middle income professionals who have recently taken up golf. Both need clubs. Both can afford to

pay a bit more for clubs that promise — rightly or wrongly! — to deliver longer and straighter shots, and

both actually would be willing do so. This information would make them much more valuable consumers of

golf product advertisements, and would enable a well-informed online advertising company to create and

exploit a customer profitability gradient. Moreover, we have agreed that, as in the music industry, the

physical distribution of the paper and its ads is cross-subsidizing other activities; this cross-subsidy may

indicate that advertisers are being over-charged by newspapers, now that alternative means of distribution

may be available to advertisers. This in turn creates significant vulnerabilities for newspapers.

We do observe changes that undercut defenses of newspapers, creating a newly vulnerable market for the

sale of advertising. In particular:

• The direct distribution of paperless advertisements makes the advertising portion of the newspapers’

business easy to enter.

• Technology facilitates exploiting the customer profitability gradient among consumers who respond to

advertising, terminating cross-subsidies of consumers who read the news but do not respond to

advertising, focusing on point-casting advertising to consumers who will respond, and terminating

support of other activities that do not add value to advertisers. All these combine to make the

industry attractive to attack.

• For reasons that we will explore below, it will be difficult for newspapers to respond to this threat,

making the industry difficult to defend.

Hence we conclude that the three conditions required for newly vulnerable industries are indeed present.

The news side of the business will not be attacked. However, the advertising revenue base will come under

increasingly intense assault.

But why do we believe that it will be difficult for industry participants to defend themselves? Most

importantly, their core competence is in producing engaging and reliable news, producing and distributing

paper-based copies of news and advertising to the widest readership in a cost effective and timely fashion,

day after day. However, these are the skills needed to support precisely the activities that the advertiser-

based services will terminate. They are not ideally situated to compete in any way against pure, targeted

distribution of advertisements.

Qualitative Results:

Competitors’ lower cost distribution of advertising places significant revenue pressure on newspapers.

Reducing the news content leads to death spiral, with fewer readers, reduced interest from advertisers,

reduced revenue, and increased revenue pressure. Increasing the price charged to readers may result in

reduced readership as well, but may result in retention of higher quality readership if the experience of

Le Monde or the Financial Times were to translate to the US environment. However, if the

readership decline results in reduced advertising revenue then, indeed, death spiral will result again.

4.5. Defensive Strategies Available to Newspapers

A limited set of defensive strategies may be available to newspaper publishers.

Firstly, but implausibly, they can exit the news business and focus on advertising, although for

reasons of core competence, and fixed investments in infrastructure, and commitments to union

employees, this appears unlikely.

Alternatively, they can create a changed value proposition:

• They can focus on audience willing to pay for the news

• They can provide a news service that does not require subsidies from advertising

• Perhaps they can develop an advertising business as well, though no reason not to spin this off if it is

not heavily synergistic with the news business

• They can use online distribution as an essential adjunct, not a competitor or alternative to, to paper-

based business

We notice in passing that Bloomberg has successfully located a market that will pay thousands of dollars a

month for information that is accurate, timely, and in some sense certified as correct.

5. Conclusions

We have used the theory of resource-based advantage to examine two markets for information goods,

within the context of the theory of newly vulnerable markets. We have concluded that the music industry

is vulnerable to attack by the artists and musicians it employs. In contrast, we have shown that

newspapers are not vulnerable to attack by content staff but are vulnerable to pickoff from targeted

distributors of advertising. Preliminary quantification is provided by simple simulations and computational

techniques.

We believe that the managerial implications of our work are clear and important:

• Cross-subsidies of activities require near-monopoly power and cross-subsidies of different classes of

accounts likewise requires near-monopoly power. Technological innovation reduces the value of co-

specialized assets and the economic power that they conferred upon their owners.

• Industries that enjoyed near-monopoly power in the past will be newly vulnerable. Those that cross-

subsidized some participants at the expense of others may find that they lose their most profitable

accounts. Those that subsidized some lines of business at the expense of others may find that the lose

their most profitable businesses.

Planned extensions and future research includes the following:

• calibrating our computational results via actual data from the music recording and newspaper industries.

• using our analytical techniques to study additional industries within the collection of markets for pure

information products; specific examples that we have considered include publishing of novels,

production of television and movies, and of course our own “industry”, higher education.

• performing more detailed analysis of alternatives available to record companies, in particular the use of

prevention of piracy as a value-adding service that they can provide for their recording artists

References

1. Appleson, G. "Record Labels Sue Internet Providers over Site" Reuter News, August 16, 2002.2. Baumol,W. J. and Willig, R. D. "Fixed Costs, Sunk Costs, Entry Barriers, and Sustainability of Monopoly."Quarterly Journal of Economics, 96, 3 (August 1981): 405-431.

3. Byers, Reynold E., Lederer, Phillip J. Retail Bank Services Strategy: A Model of Traditional, Electronic,and Mixed Distribution Choices”, Journal of Management Information Systems, Fall 2001, Vol. 18 Issue 2,p133,

4. Clemons, E. K. “Corporate Strategies for Information Technology - A Resource-based Approach.”Computer, 24, 11 (November 1991): 23-32.

5. Clemons, E. K., Croson, D. C., and Weber, B. W., "Market Dominance as a Precursor of a Firm’sFailure: Emerging Technologies and the Competitive Advantage of New Entrants", Journal ofManagement Information Systems, Vol. 13, No. 2, Fall 1996 pp. 59-75

6. Clemons, E. K., and Row, M. C. “Sustaining IT Advantage – The Role of Structural Differences.” MISQuarterly, 15, 3 (September 1991): 275-292.

7. Clemons, E. K. and Row, M. C. "Electronic Consumer Interaction, Technology Enabled Encroachmentand Channel Power: The Changing Balance Between Manufacturers' Electronic Distribution and EstablishedRetailers." Proceedings of the Thirty-first Hawaii International Conference on System Sciences, 6 (January1998): 321-328.

8. Clemons, E. K. and Thatcher, M. E. "Capital One: Exploiting an Information-based Strategy."Proceedings of the Thirty-first Hawaii International Conference on System Sciences, 6 (January 1998):311-320.

9. Gowan, M. "Requiem for Napster - Analysis: Outlaw music site composed new tune for digital music,broadening listeners' expectations forever." PCWorld, Friday, May 17, 2002

10. Kirstner, S. “All the News That's Fit to Pixel.” Wired Magazine , 8, 2 (February 2000): 126-40.

11. Steinbock, D. “Building Dynamic Capabilities, The Wall Street Journal Interactive Edition: ASuccessful Online Subscription Model (1993-2000).” The International Journal on Media Management, 2,3/4, (Autumn/Winter 2000): 178-194.

12. Teece, D. The Competitive Challenge: Strategies for Industrial Innovation and Renewal (ed). NewYork: Harper & Row, Ballinger Division, 1987.

Appendix: Modeling Assumptions

Common Assumptions

We assume that record companies compete efficiently with each other to sign the best acts and that acts

compete efficiently with each other to sell their recordings. We assume that, as at present, record

companies use standardized contracts and that all are therefore equally vulnerable both to piracy (illicit

copying) and disintermediation (production and direct distribution by recording artists, without the need for

a record contract or the technical and promotional support of a record label). Therefore, without loss of

generality, we model the profitability of a single record company.

Maintenance of a Stable of Acts: We assume that the record company seeks to employ a constant stable of

50 signed acts. Each year any and all unprofitable acts are dropped. Moreover, for a variety of reasons,

20% of the profitable acts retire each year; this can be a result of anything from a bass player dying from a

drug overdose, a fight between the drummer and the lead singer, or an accurate assumption that their

listeners are no longer interested in their work. Replacement acts are auditioned and a sufficient number

are added to replace those that drop out. However, while groups arrive with a predetermined quality, which

will be maintained throughout their recording careers, this quality can only be observed with uncertainty.

Thus, if the record company wants to replace R acts it auditions 4R and takes those that it ranks as the

top, but these are likely to be randomly selected from the top 2R ranked by true (but unobservable) quality.

Operations: The record company cuts a master disk for each act each year at cost M and promotes the

disk at cost P. These costs are subtracted from the act’s royalties, to determine the act’s own profits. If

M and P are not fully covered by royalties, and if the record company’s operation of the act is

unprofitable, then the act is dropped. (Our parameters were set so that at least some new groups passed

this profitability screen at the end of their first year. It is easy enough to modify the simulation and to

apply a lag, allowing groups to remain with the record company into their second year even if they were

not profitable, and to apply this screen only after a group’s second year. Likewise, we assumed that M and

P were constant for all acts and constant over time; clearly these assumptions are not fully realistic. Often

a super-star group will receive more production support and more promotional support than a mature act

with only moderate popularity; however, this increase in the expense of support will seldom if ever

approach the enormous revenues that these super-star acts earn for their labels, thus reducing the validity

of our model only slightly. Likewise, a promising first-year act may receive more support than mature

acts of only moderate popularity; far from reducing the validity of our model, this would only strengthen

our confidence in our findings.

Sales: The record company sells N recordings a year at $5.00 / disk wholesale. Royalties are calculated at

10% of these sales, less production and promotional expenses.

Base Case

Using the assumptions listed under common assumptions above, the model is run until profitability reaches

steady state, and then data are captured and displayed for as many periods as desired.

Direct Distribution Cases

The assumptions listed under common assumptions are used once again. However, in each of the direct

distribution scenarios we assume that a fraction of the company’s top acts will choose to produce and

distribute their own recordings. The acts need to fund their own production and promotion, which the tops

acts are now able to do. The principal impact of this disintermediation on the record company is that it

loses the revenues from these acts. The principal impact on the acts themselves is that they retain the full

wholesale price of their recordings. We are able to vary which deciles are liable to engage in direct

distribution, and what fraction of these deciles actually chose direct distribution. We have not assumed

uniformity of behavior of all acts within either the deciles that are attracted by bypass; we have however

assumed that their behavior is unknown except in probabilistic terms. We could have used more complex

distributions, where the likelihood of being attracted to bypass was greatest for the most profitable groups

within the population and was lowest among the least profitable groups. Indeed, we could have used some

form of negative exponential, where the likelihood of bypass asymptotically approached zero as

profitability declined, rather than having a uniform distribution within a segment of the population.

Clearly a negative distribution with a mean loss of L% each year, with mass shifted strongly towards the

most profitable groups, would be more damaging than the uniform distribution we employed, and thus

would only strengthen our confidence in the results that we have reported.

Piracy Case

The assumptions listed under common assumptions are used once again. However, in each of the piracy

scenarios we assume that a fraction of the company’s sales are lost due to piracy, the illicit coping and

distribution of music, either through sales of forged copies or, increasingly, through online swapping of

digital recordings. The principal impact of this piracy on the record company is that it loses the revenues

that would have come from the sale of legitimate copies of their acts’ recordings. The principal impact on

the acts themselves is that they too now lose their share of the revenue from sales lost to piracy.

Figure 1: Base case for recording industry

Time (in quarters)

Pro

fits

(in

$K

)

NumberofGroups

Figure 2: Rapid and broad-based self-promotion

Time (in quarters)

Pro

fits

(in

$K

)

NumberofGroups

Figure 3: Rapid but more focused self-promotion

Time (in quarters)

Pro

fits

(in

$K

)

NumberofGroups

Figure 4: Slower and more focused self-promotion

Time (in quarters)

Pro

fits

(in

$K

)

NumberofGroups

Figure 5: The introduction of online piracy

Time (in quarters)

Pro

fits

(in

$K

)

NumberofGroups