International Journal of Industrial Organization 24 (2006) 907 913 www.elsevier.

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Why the music industry may gain from free downloading The role of samplingB
Martin Peitz a,*, Patrick Waelbroeck b
b

International University in Germany, 76646 Bruchsal, Germany ECARES, Universite Libre de Bruxelles, CP 114, 50 av. Roosevelt, 1050 Bruxelles

Received 25 February 2004; received in revised form 17 December 2004; accepted 11 October 2005 Available online 13 December 2005

Abstract Downloading digital products for free may harm creators and intermediaries because consumers may no longer buy the version for sale. However, as we show in this paper, this negative effect may be overcompensated by a positive effect due to sampling: consumers are willing to pay more because the match between product characteristics and buyers tastes is improved. This indeed holds under sufficient taste heterogeneity and product diversity. D 2005 Elsevier B.V. All rights reserved.
JEL classification: L11; L82 Keywords: File-sharing; P2P; Sampling; Information transmission; Piracy; Music

1. Introduction Digital music files (mostly in MP3 format) have become widespread on the Internet. Filesharing technologies pioneered by Napster and for a while dominated by Kazaa have become popular among certain online communities and a target for legal prosecution by record companies. Industry representatives largely attribute the recent drop in music sales (in Dollars and in units) to a rise in online file-sharing, which, from their point of view, simply reads as

B We received helpful comments from various seminar and conference audiences. We are, in particular, grateful for comments by two anonymous referees. * Corresponding author. E-mail addresses: Martin.Peitz@i-u.de (M. Peitz), Belgium.pwaelbro@ulb.ac.be (P. Waelbroeck).

0167-7187/$ - see front matter D 2005 Elsevier B.V. All rights reserved. doi:10.1016/j.ijindorg.2005.10.006

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piracy of copyrighted material.1 Advocates of online file-sharing, however, believe that filesharing should be free and unrestricted. One argument goes that downloaders use the downloaded files for sampling in order to make more informed purchasing decisions.2 Hence, the argument continues, the music industry may actually benefit from file-sharing networks. In this paper, we formalize this argument. Sampling appears to be important in the market for recorded music music is an experience good where horizontal product differentiation and taste heterogeneity are important. Due to sampling, music labels may actually gain from P2P networks (and other ways to listen to recorded music for free) and use them to solve a two-sided asymmetric information problem between seller and buyers. We present a simple multi-product monopoly model in which products are located on the Salop circle and in which consumers regard each original as superior to its copy. We first consider a model with unit demand and full participation so that any increase in revenues stems from higher prices. The property that sampling allows consumers to find a better match to their tastes, tends to lead to higher profits under file-sharing. However, there is a countervailing effect: consumers have the option to download and listen to music without paying for it. In other words, consumers have the option to simply keep the download but not to buy the song or album. This tends to make not buying a more attractive option and tends to reduce the willingness-to-pay for music. We show that the former effect dominates the latter and that the introduction of file-sharing technologies leads to higher profits if there is sufficient taste heterogeneity and sufficient product diversity. We then extend the model to allow for variable demand and show that file-sharing can lead to lower prices, higher unit sales and higher profits. 1.1. Related literature A growing theoretical literature analyzes end-user copying see the survey by Peitz and Waelbroeck (2003). In this literature, the general result is that a free copy leads to lower firm profits since some consumers use the free copy as a substitute to the original. However, in the context of computer software, it has then been shown that the result no longer necessarily holds if there are network effects (see Conner and Rumelt, 1991; Takeyama, 1994; Shy and Thisse, 1999). Our contribution to this literature is to introduce

1 Recent empirical analyses lead to ambiguous results. Some studies show a negative effect of downloads on music sales (see e.g. Peitz and Waelbroeck, 2004; Zentner, 2004), whereas others find a negligible or even slightly positive effect (see Oberholzer and Strumpf, 2004; Boorstin, 2004). Liebowitz (2005) comes to the conclusion that the overall evidence supports the view that file-sharing has hurt music sales. However, this finding does not invalidate our argument that the music industry may gain from file-sharing, in particular because current P2P networks are not well-designed for sampling purposes. 2 This view is to some extent supported by survey data. A share of 69% of downloaders listen to new music and 31% to music by artists never heard before according to PEW internet tracking, JulyAugust 2000. A share of 30% of respondents to an Ipsos survey in 2002 state that the genre that they typically listen to/purchase has changed since they started downloading (over a brief period of time), mainly because they were able to experiment with new genres and new artists; for more details see Peitz and Waelbroeck (2005). Bounie et al. (2005) provide survey evidence on French university students according to which 90% of the students said to have discovered new artists by listening to MP3 files and that around 70% of them stated that this made them purchase CDs which they would not have purchased otherwise. Whereas 30% of the surveyed students said that MP3 has a negative effect on their purchases of music, 18% claimed to purchase on average a much larger number of CDs so that the aggregate effect is ambiguous.

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consumer sampling. This can make end-user copying beneficial to a (multi-product) label even without network effects. Independent of our work, Gopal et al. (2004) show that, for certain parameter constellations of their model, a firm increases its revenues in the presence of P2P. In particular, some consumers with an intermediate interest in music first download and then buy the corresponding song or album if they like what they downloaded. These consumers would not buy if P2P were not available. A limitation of their analysis is that the price for the version that is for sale is not determined in the model but taken as a parameter. Also, they only consider a single-product environment and thus do not explicitly model sampling.3 2. A simple model in which file-sharing may increase profits 2.1. Model setup Consider the problem of a multi-product monopolist that offers N products. We use the simple structure of the Salop circle to formalize product differentiation: products are equidistantly located on a circle of unit length. Product i is located at S i on the circle and the distance between two neighboring products is 1 / N. The firm (or label) maximizes at stage 0 its profit p with respect to the prices of the products it sells. Because products are located equidistantly, the profit-maximizing firm will always charge the same price p across products.4 The firm incurs zero marginal costs of production. In the case of CDs and other physical copies, this means that we consider the price net of any marginal costs of production. Since the number of products is given, we do not need to consider any fixed costs. Hence, in our setting, the profit is equal to revenues. Consumers with a total mass of 1 are uniformly distributed on the circle and have an ideal variety x. They buy at most one product. Suppose that a product is located at S . Then choosing this product gives a consumer located at S a gross surplus of r s|x S |, where r is the surplus of a product located at the ideal location and s is the btransport costQ parameter. Parameter s measures the degree of substitutability between products: if s is large, then products are strongly differentiated and, therefore, are bad substitutes for one another. If a consumer purchases the original product he obtains an added benefit a / 2.5 Consumers do not initially know the location of the N products. Without downloading consumers do not have any information and therefore can only buy at random. Consumers who have downloaded learn the exact location of the product on the circle that provides the best fit among all available products.

3 Other papers that also address sampling but have a different focus include Duchene and Waelbroeck (2005) and Takeyama (2003). 4 In reality, we observe uniform prices across titles and labels. Clearly, in the real world, there are winners and losers in the market for CDs and the market is asymmetric. However, since list prices are rather uniform across albums, these asymmetries are not reflected in the pricing decision. Also note that we abstract from strategic interaction between labels. To the extent that the big labels collude in prices, it does not really matter whether we consider a single label, as in this paper, or several labels, as observed in reality. Indeed, the music industry has a history of alleged price collusion. For example, in 2003, the music industry reached an out-of-court settlement in the US on charges of price fixing that facilitates collusion. 5 This added benefit reflects the value of the original over the copy (such as additional songs unavailable on P2P networks, lyrics, booklet, pictures, song information, feel-good factor to have indirectly paid the artist).

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Consumers follow a two-stage decision process ! Stage 1: Download yes/no, denoted by d = 1 for downloading and d = 0 for not downloading. After downloading, consumers learn the location of their preferred product. ! Stage 2: Buy one unit yes/no, denoted by b = 1 for buying and b = 0 for not buying. At Stage 1, a consumer either downloads to learn the location of the product which is closest to his ideal point x or does not download at all. For this, we assume that a consumer incurs an opportunity costs for finding out about his favorite product on the Internet (for instance on a P2P network).6 In the case of sampling, the consumer selects the most attractive product available in the market. We denote a consumers actions as (b,d). The realized utility, denoted by v, that a consumer receives then depends on his actions (b,d), his ideal variety x, location S of the product and price p, which is charged uniformly for all products. Expected utility at stage 1 is denoted by u. 2.2. The market when downloading is not possible We first analyze the market when, through protective measures by the firm or legal actions, downloading is prohibitively costly to consumers so that it is not an option. In this case, only actions (0,0) and (1,0) need to be considered. The (expected) utility of a consumer who neither buys nor downloads is normalized to zero, u(0,0) = 0. If a consumer buys the original at location S , he obtains utility v(1,0) = r + a / 2 s|x S | p. When deciding whether to buy, the consumer does not know S . Since he does not collect information prior to purchase, the expected distance to his ideal variety is E x j 1 and his expected utility is 4 u1;0 Ev1;0 r a=2 s=4 p Given that a consumer cannot download, he buys a product at stage 2 if u(1,0) z u(0,0). Hence, when downloading is not possible, the monopolist sets its price to extract the full expected surplus from consumers and u(1,0) = u(0,0). We assume throughout this paper that the firm can make positive profit in an environment in which downloading is not possible, i.e. r + a / 2 s / 4 z 0. Lemma 1. If downloading is not possible, the profit-maximizing firm sets p 0 = r + a / 2 s / 4 and makes profit p 0 * = r + a / 2 s / 4. 2.3. The market when downloading is possible When downloading is possible, consumers can also choose actions (0,1) and (1,1). Consider, therefore, the situation in which a consumer has downloaded at stage 1. If he does not buy, his realized utility from consuming product S is v(0,1) = r s|x S |s. If he downloads and purchases the original version of a product, he obtains in addition a / 2 but has to pay p and his realized utility is v(1,1) = r + a / 2 s|x S | p s. Hence, independent of the location of his preferred product, a consumer buys if v(1,1) z v(0,1) which is equivalent to p V a / 2. Denote the

6 Note that a consumer typically has to sample more than one product to find his favorite product. However, through directed search, the consumer may find out about his favorite product in the market without sampling all products but by sampling only a number of them. We simply assume that s is the opportunity cost for this search process.

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critical price by p 1 = a / 2 at which all consumers are indifferent between buying and not buying at Stage 2. Denote the corresponding profit as p 1* = a / 2. Before the consumer has downloaded, he does not know the exact distance between the characteristic of the album and his ideal location. He knows that there are N equidistantly spaced products on the circle. After sampling, the product that best fits his taste is located at a distance |x S | equal to zero in the best case and to 1 / (2N) in the worst. On the interval [0,1 / (2N)] all distances are equally likely. Hence, when a consumer downloads, the expected distance to the product closest to his ideal product is 1 / (4N). At Stage 1, before a consumer downloads, his expected utilities are u0;1 r s= 4N s and u1;1 r a=2 s= 4N p s: Consider then consumer decision making at Stage 1. A consumer downloads if max{u(1,1), u(0,1)} z max{u(1,0), u(0,0)}. Then all consumers download at Stage 1 and buy at Stage 2 if u(1,1) z max{u(0,0), u(1,0)} and v(1,1) z v(0,1) for all consumers (because the latter implies u(1,1) z u(0,1)). At any price p, all consumers have u(1,1) z u(1,0) if and only if s / 4 z s + s / (4N). If this inequality is satisfied, consumers download before buying a product. Lemma 2. If downloading is possible, the firm sets its price such that all consumers sample and buy if and only if s / 4 z s + s / (4N). To prove Lemma 2, it remains to be shown that the firm sets its price sufficiently low but positive such that consumers buy. In particular, since v(1,1) z v(0,1) must hold, the firm has to set a price less or equal to p 1 = a / 2. The firm sets its price equal to p 1 if, evaluated at this price, u(1,1) z u(0,0) = 0. This is equivalent to r z s + s / (4N). Otherwise, the firm has to lower its price to p 2 such that u(1,1) = u(0,0), i.e. p 2 = r + a / 2 s / (4N) s, which can be shown to be positive.7 2.4. Profits and sampling The main point of this paper is to show that a firm can obtain higher profits if downloading is possible. This can only be the case if a profit-maximizing firm decides to set a price such that consumers sample, i.e. s / 4 z s + s / (4N).8 First, suppose that, in addition, r z s + s / (4N). As shown above, the firm sets p 1. It gains from the possibility of downloading if p 1* z p 0* which is equivalent to s / 4 z r. Note that if taste heterogeneity is insufficient such that s / 4 b r but still s / 4 z s + s/(4N), the firm also sets the price p 1 and all consumers sample and buy. However, in this case, the possibility of downloading leads to lower profits. Second, suppose that s / 4 z s + s/(4N) z r so that the firm lowers its price to p 2. Then the firm gains from the

If the reverse inequality s / 4 b s + s / (4N) holds, the firm sets its price less or equal to p 0 such that no consumer samples but all buy. There are two subcases. (i) The firm sets its price equal to p 0 if, evaluated at this price, u(1,0) z u(0,1), which is equivalent to r V s + s / (4N). Hence, if s / 4 V r V s + s / (4N) the firm sets p 0, none of the consumers downloads and all buy a product. (ii) The firm has to lower its price such that u(1,0) = u(0,1), i.e., p = s + a / 2 s / 4 d (1 1 / N) and avoids downloading (note that this price is positive since s + s / (4N) N s / 4). 8 Otherwise, depending on the parameters the following holds: (i) downloading is too costly for consumers, i.e. s / 4 V r V s + s / (4N), and the outcome of Lemma 1 is realized; or (ii) the firm decides to deter downloading by setting a lower price (if s / 4 V s + s / (4N) V r) and obtains lower profits due to the possibility of downloading, see Footnote 7.

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possibility of downloading if p 2* = p 2 z p 0*, which is equivalent to p / 4 z s + s/(4N) and thus satisfied. We summarize our main findings in the following proposition. Proposition 1. The possibility of downloading leads to higher profits if and only if s / 4 z s + s / (4N) and s / 4 z r. These inequalities are satisfied if there is sufficient taste heterogeneity (measured by a large s) and sufficient product diversity (measured by a large N). Note that with downloading, a consumer derives a higher expected utility from not buying than without downloading, u(0,1) N u(0,0) this bpiracyQ effect is the concern of the music industry. However, because of sampling consumers find a better match to their tastes and are willing to pay more, u(1,1) N u(1,0). Proposition 1 provides the precise conditions such that the latter effect dominates the former. 2.4.1. Numerical example A particular numerical example may be helpful for illustration. Suppose that s = 1/2, r = 3/4, a = 2, and s = 4. Then u(1,0) = 3/4 p. Consequently, without the possibility of downloading, p 0* = p 0 = 3/4. Since v(1,1) v(0,1) = 1 p, the firm can set p 1 = 1 and consumers buy, provided that they have downloaded. Since, u(0,0) = 0 and u(1,0) = 1/4 when evaluated at p 1 consumers download as long as u(1,1) = 5/4 1/N p = 1/4 1/N z 0. Hence, the firm sets p 1 = 1 and makes profit p 1* = 1 if N N 4, i.e., if there is sufficient product diversity. This can also be seen directly by checking the inequality s / 4 z r z s + s / (4N), which reads 1 N 3/4 N 1/2 + 1/N. 2.4.2. Extension to variable demand Our simple model does not address a number of concerns. First, the unit demand assumption may be restrictive. Secondly, the price increase with sampling may be seen as a mere theoretical possibility. Therefore, we build on our previous example and postulate that consumers have variable demand, namely that they buy up to two products (one unit of each). For the first unit we take r 1 = 7/4 for the first product and r 2 = 3/4 for the second item. All other parameters are unchanged; consumers incur the sampling cost for each product. When downloading is not possible, p 0* = 7/4 because it is privately optimal to sell only one product to each consumer a price p 0 = 7/4. Suppose the firm sets p 1 = 1. Provided that consumers download, they buy two products and p 1* = 2 N p 0*. Note that at p 1 = 1, consumers net surplus is then 5/4 + 1/4 4 / N = 3/2 4 / N. If consumers did not download, they would buy only one product and their expected net surplus would be 7/4 p 1 = 3/4. Therefore, consumers strictly prefer to download if 3/2 4 / N N 3/4 or, equivalently, N N 16/3. Again, for sufficient product diversity the firm makes higher profit with the possibility of downloading than without. The novelty of the example with variable demand is that the possibility of downloading leads to lower prices p 1 b p 0, which are overcompensated by higher unit sales. 2.4.3. Concluding remark Do music labels necessarily suffer from downloading on P2P networks? Our analysis shows that the answer is dnoT. In our model, profits increase for a certain set of parameters because consumers can make more informed purchasing decisions because of sampling and are willing to spend for the original although they could consume the download for free. Our model can be applied to other digital products such as software and computer games.

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