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Intellectual Property in the Music Industry

[I wrote this for my excellent class on Open Innovation.  With mere weeks to go until I finish my MBA, I haven’t found much time to write original stuff for this blog, so I’m recycling a bit.]

The music recording industry is in trouble.  Disruptive changes in music playback technology have seriously reduced demand for their mainstay business, physical CD sales.  CD sales comprise 80% of the industry’s total revenue, but have dropped sharply in recent years.  Last year sales dropped by 19%, and the channel is in danger of freefall as retailers start to re-allocate store space currently assigned to CDs.  The industry’s hopeful replacement revenue stream, digital downloads, looks like it will only replace a fraction of the loss.  What went wrong?  How did an entire industry fail to keep up with technological innovation?

The recording industry’s value in the economy comes from providing consumers access to great music.  The value chain includes discovering talent, developing the talent to create and record great music, and distribution of that music to consumers.  The early stages of the pipeline have remained about the same for decades.  But technology has permanently changed how music is distributed to consumers.  This fact was driven home to EMI management when a group of teenagers were invited to take as many free CDs as they wanted after participating in a focus group, and they didn’t take a single one!  The recording industry has acted as a manufacturer of physical goods.  But really their business is in licensing Intellectual Property (IP).  When it was inconvenient for consumers to reproduce high-quality recordings the distinction was unimportant.  But today physical distribution of recorded media provides a tiny fraction of the value in the music value chain.

Music IP is legally controlled by copyright.  Digital Rights Management (DRM) technology has been used to enforce licensing agreements on digital recordings files.  Until 2007, the recording industry only sold digital music with DRM, in an attempt to control copyright violations.  The great irony of DRM that has prevented its acceptance by consumers is that by restricting the use of the legally distributed digital music, DRM makes the legal product lower quality than the illegal product.  The lack of consumer incentive to use a lower quality product, combined with the impracticality of enforcing copyright agreements on individual consumers makes the appropriability regime in the distribution of music to consumers very weak.

We can think of innovation in this content space as the creation of compelling new music.  A hot young band with a new album or style of music has an innovation they want to commercialize.  As discussed earlier, the appropriability regime with consumers is quite weak.  The value of the labels’ distribution assets are waning, putting the band in the position of the attacker’s advantage according to Gans’ and Sterns’ innovation framework.  The band should go it alone and seek novel distribution techniques, ignoring the incumbent labels.  The appropriability regime is less clear with respect to incumbent labels – the album itself is well protected by copyright law since the legal recourse is straightforward against a large recording company, but a novel style of music is unprotectable.  So a promising band considering partnering with an incumbent label should consider how easily the value of their art could be expropriated.

The recording industry has focused too long on a part of the value chain that is no longer economically relevant.  They should look to other industries for inspiration as to how to create value in an environment where content and innovation are created more openly.

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