Sunday, November 21, 2004

Downloading Music

The Times' Economic View has an article that talks about lost sales from music downloading. This is a more interesting problem than Daniel Gross has time to explore. How does standard micro theory respond to this problem? The cost of buying music has fallen, from $15 to whatever time it takes to download an album. So the price of music falls and rational agents consume more music.

Mitch Bainwol, chairman and chief executive of the Recording Industry Association of America, has this brilliant quote: "The most basic notion of economics is this notion of perfect substitution. You have two products that are in essence substitutes, so the market drives toward the freebies." But what's interesting is that people continue to buy CDs even after they can get them from free. The CD case and liner notes probably aren't valued at $15. What's important here are cultural values. It's not culturally acceptable to give a gift of a CD that is burned, for example.

In November 2002, Peter D. Hart Research Associates found that when 19- to 24-year-olds were asked about a song they liked, 32 percent said they would download it, while only 9 percent said they would buy it.
This can be integrated into the theory easily. We simply add a parameter to the utility function that is increasing in proportion of CDs purchases rather than downloaded, or something similar. But this is strange too. Let's estimate the cost of buying a CD at $15 and the cost of downloading a CD at $1. Then for a given CD, say worth $20 to our rational consumer, the net benefit from buying the CD is $20-$15=$5 and the net benefit from downloading the CD is $20-$1=$19. This means that a dollar estimation of the cultural value of buying CDs instead of stealing them is that it is at least $19-$5=$14!!! Seems a bit high, doesn't it? But this is what it costs when you buy a CD.

But what about the people who buy some CDs and download some CDs? Then it becomes harder and it is unclear whether this can be accounted for in a rational agent framework. If the cultural benefit of buying a CD is constant, we can think of this as raising the total cost of a downloaded CD. If this total cost is greater than $15, the agent only buys CDs; if it is less, the agent only downloads CDs. So in order to account for people who do both at different times, the cultural benefit of not stealing music must vary.

Perhaps it varies with time, whether they are with their friends or not, etc., But one interesting implication of this is that it varies with quality. If the agent really likes a CD the cost of stealing may increase. Intuitively, this seems accurate. People want to support bands they like and don't care about ripping off bands they don't. Then this is a mechanism for weeding out bad music or at least music people don't like as much, which is in my view a good thing.


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