Fixing the Business Model

What we’ve discovered so far are two critical things: First, the implicit contract between the principals and the agents in the music market, far from creating the right incentives, in fact produces a moral hazard – because it doesn’t take into account problems in monitoring the record industry. Second, technology has allowed music listeners to take matter into their own hands, creating a double moral hazard.

Does understanding this help solve the record industry’s problems? Yes – in a major way. If the record labels can’t resolve the information asymmetries that let it operate under extreme moral hazard, and that cause listeners to retaliate with their own moral hazard, it should do exactly what these economics suggest: provide listeners with insurance. Of course, it would be better if the industry could resolve these information asymmetries, but I’ll leave that for another time.

How can the record industry offer insurance without creating a double moral hazard? The surest way is to offer a subscription service instead of charging for discrete bits of music. Otherwise, it might offer limited guarantees – the opportunity, for example, to sample any song in it’s catalogue an unlimited number of times, but to only download it once. It’s important to note that low quality 30-second snippets don’t really cut it – they most likely don’t provide enough information to ensure to consumers that the industry is doing it’s job.

But the simplest way might be to actually offer insurance – just like the standard model of the insurance industry. That is, for a fee (the deductible), offer consumers the ability to sell their risk of buying music they don’t prefer. For example, users might pay $20 a year, for the ability to return a certain amount of music.

Another way is to offer listeners a contingent contract. Contingent contracts are where payment is dependent on some property of a good, like quality. You sell a contingent contract every time you order from Domino’s: if it’s not there in 30 minutes, your pizza’s free. The points is that these contracts offer another form of insurance, by matching quality to price – and so create the incentive for agents that are also good for principals. Because they make up for quality slip-ups, contingent contracts help sell goods when quality is uncertain, by reducing risk. It’s difficult to see how this can apply to information goods like music – since the price is paid before the quality is discovered. But there are innovative ways to do so. For example, shipping companies offer rebates when they deliver late. Similarly, the music industry might offer rebates when the aggregate sales of a top singer’s latest album are less than expected.

A third way is to offer multilateral contracts, which offer the potential for risk-sharing among listeners. Multilateral contracts are made by one party, with many parties – but, crucially, whose terms to any one consumer depend on the acceptance of the contract by other consumers. For instance, labels might offer downloads from a given artist at a discount – but only if enough people offer to buy the good. Alternatively, they might try a pricing scheme where the industry offers steeper discounts the more people offer to buy an artists’ goods. The point is that schemes like this make private information and expectations public, allowing people to pool and share their risk.

All of these are essentially ways to let consumers hedge the extra risk they take selling a broken contract to agents they know are operating under conditions of extreme moral hazard. Right now, consumers only have one viable way to hedge that risk, and eliminate the moral hazard – by parceling it out, and sharing it with other listeners, via file-sharing.

So we’ve helped explain three crucial things. First, why many music listeners feel so much antipathy to the music industry – because they understand the moral hazard and large agency costs implicit in the risky broken contract they’re being offered. Second, why many feel morally conflicted about file-sharing, but continue to do so anyways – because they have no other risk-mitigating mechanism. Third, crucially, what the music industry can do in the face of these kinds of contract dynamics to revolutionize it’s business model.

Current Models

We can now take a look at what’s wrong with the latest efforts to market music over the net. Immediately, we can see that the most successful business model over the net will utilize prices to convey information rather than price everything at exactly the same value, and crucially, provide a mechanism for consumers to hedge their music risk. Sadly, all the major new services provide none of these things. They’re essentially the same old business model, minus physical distribution costs. Not a surprise from an industry that’s more afraid of change than death.

Itunes, for example, standardizes prices across most of its products – providing consumers no information about future value or risk. It also entirely ignores the role of the positive consumption externalities users produce, because it provides no mechanism to share playlists or file directories. Finally, and most importantly, the only mechanism that iTunes provides consumers to mitigate risk is 30 second sound samples. It’s unlikely that this is enough to eliminate the moral hazard labels operate under. But that’s besides the point: what it really means is that iTunes can be outcompeted easily by any service which provides everything iTunes does, as well as a more efficient risk-mitigation mechanism, such as more complete insurance, contingent contracts, or a limited and rights-protected file-sharing scheme.

Whatever the mechanism the industry decides to help listeners hedge risk, it’s important to note that it should be one that makes strategic sense. There is one simple risk reduction mechanism that would be even more destructive to the industry than file-sharing, and that the industry should avoid at all costs: price competition. If prices drop low enough – singles cost $0.99 on iTunes – listeners’ risk effectively disappears. But so do industry margins and the industry’s business architecture. It would be more strategically effective to construct a mechanism that creates value by hedging risk, eliminating the double moral hazard – and one that the industry can then trade for additional profits.