Unchained Melody: A Price Discrimination-Based Policy Proposal for Addressing the MP3 Revolution
Kinnear, Douglas, Gallaway, Terrel, Journal of Economic Issues
Recent innovations allow Internet users to access and trade digital music files without paying those who have produced the music. MP3 and other data compression algorithms allow digital files to easily fit on hard drives or portable discs, and software such as Napster and Gnutella allow music fans to trade files on the Internet. These new technologies are turning recorded music into a public good, since no one can be prevented from enjoying an inexhaustible supply of digital copies.
We may expect private markets to provide less-than-optimal quantities of music as a public good. Indeed, foes of Napster claim that downloads are hurting sales of prerecorded CDs (Stem 2000, A03). Others, such as Napster attorney David Boies, argue that Internet music trading does not hurt sales of prerecorded CDs and may actually enhance them by whetting consumers' appetites for new music (E03). Recent congressional inquiries and civil lawsuits have heightened interest in this question: What effect does Internet music trading have on sales of prerecorded CDs?
Controversy aside, Internet music trading demands study because it is a more efficient distribution system than the industry's traditional model.  With no costs of manufacturing, packaging, shipping, or retailing CDs, downloads can be offered at a marginal cost of virtually zero and can be enjoyed by music fans at the cost of just a few minutes of computer time. Internet music trading thus represents a tremendous potential efficiency gain in music distribution. To realize these gains, the recording industry must find a way to harness reasonable profits from the new technology.
We have surveyed almost a thousand college students to determine how the availability of digital music files has altered their music consumption habits, allowing us to estimate the effect of MP3s on their purchases of prerecorded CDs. The survey also allows us to evaluate the efficacy, for recording companies, of using intertemporal price discrimination to capture profits from Internet music downloads. Our goal is to find distribution and pricing schemes that allow recording companies to survive while taking advantage of new distribution technologies.
The Music Industry
It is important to distinguish between art and industry when examining music and searching for business models that will be responsive to new technologies. Ensuring a continued supply of music that reflects diverse consumer preferences is not identical to protecting those with interests vested in the status quo. In current rhetoric, there is a good deal of equivocation linking corporate and artistic vitality. The call to protect music by protecting a highly concentrated industry suggests ceremonial encapsulation, wherein "a new discovery in the arts or sciences will be incorporated only to the extent that the community believes that the previously existing degree of ceremonial dominance can be maintained" (Bush 1987, 1093). Bush noted "ceremonial encapsulation, to the extent that it is successful, denies to the community those technological innovations that the existing knowledge fund is capable of generating, thereby depriving the community of higher levels of instrumental efficiency" (1093).
A brief overview of the music industry will identify areas where certain pecuniary and instrumental interests diverge. The music industry is highly concentrated-dominated by five media conglomerates.  Not surprisingly, market power has helped elevate prices. In fact, the recording industry recently settled with the Federal Trade Commission, and is currently being sued by thirty states, over price-fixing charges (Oestricher 2000). This market concentration belies the broad array of aesthetic and business sensibilities that mark music as a profession. For example, many artists, especially those whose work does not conform to the constructs of mass marketing, have welcomed the free exchange of MP3s. …