The Record Industry in an Era of File Sharing: Lessons from Vertical Differentiation

The record industry is undergoing substantial change from Internet-enabled file sharing. There is a heated debate surrounding how record labels should react to file sharing. This paper provides a rigorous economic analysis to identify the profit-maximization behavior for record labels. Using two widely accepted economic models of vertical differentiation, where competing products are priced according to their relative quality, this paper investigates the record labels’ profit-maximizing behavior under the current industry structure. It is assumed that the quality of the music experience using a file sharing service is inferior to that of purchased music. This methodology provides valuable insight into current practices, as well as recommendations for the record industry. The most surprising result is that, consistent with the labels’ behavior, introducing a fee-based, downloadable, music service usually does not increase profits. In addition, closing music sharing services, suing ISPs and universities who are complacent about sharing, and “polluting” the pool of available music are all in the labels’ best interest. However, a number of results also contradict current practices. On the one hand, prices for CDs should decline with the introduction of music sharing services, recognizing that users have an alternative to purchasing CDs. On the other hand, the record labels should aggressively introduce content exclusively for CD purchasers to increase the quality of CDs. Sound economic analysis is key for companies evaluating how to respond to the challenges of the Internet.