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Newly Vulnerable Markets in an Age of Pure Information Products:An Analysis of Online Music and Online News
Eric K. Clemons§ • Bin Gu§,¶ • Karl R. Lang§,±
§The Wharton School, University of Pennsylvania, Philadelphia, PA 19104¶ McComb School of Business, University of Texas at Austin, Austin, TX 78712
±Baruch College, City University of New York, New York, NY, 10010
[email protected] • [email protected] • [email protected]
Last Update: August 26, 2002
Submitted for publicationTo the Journal of Management Information Systems
Newly Vulnerable Markets in an Age of Pure Information
Products:
An Analysis of Online Music and Online News
Eric K. Clemons, Bin Gu and Karl R. Lang
ABSTRACT: We describe the emerging competition between music companies and their star acts, and the
role of online distribution in this industry. We then contrast this with the lack of competition newspapers
will face from their reporters, writers, and photographers, but do identify other possible competitors for
newspaper publishers. We examine what resources have previously enabled record companies to lock in
their star acts and ways in which technology has altered artists’ ability to reach the market independently
and thus their dependency upon record companies. We examine which resources have seen their value
eroded in the newspaper industry and the remaining value that the newspaper company does still create,
other than bundling stories, adding advertising, and printing and selling the papers. We consider what part
of the newspaper business is vulnerable, if any, and where threats may arise. We combine the resource-
based view of competitive advantage to examine which industry may have become newly easy to enter,
and the theory of newly vulnerable markets to assess which industry may actually have become vulnerable
as a result. Our analyses are then used to create a computer simulation model to make the implications
more explicit under a range of assumptions.
KEY WORDS AND PHRASES: newly vulnerable markets, resourced-based competition, electronic
commerce, music industry, newspaper industry.
ACKNOWLEDGEMENTS: The authors thank Robert J. Kauffman, Alina M. Chircu and the three
anonymous referees for their useful comments and suggestions. We also benefited from the comments and
criticism of the participants of the Organizational Systems and Technology Track at the 35 rd Hawaii
International Conference on Systems Science (HICSS) in Big Island, Hawaii in January 2002. Finally, we
thank the Reginald H. Jones Center for Management Policy, Strategy and Organization for ongoing
sponsorship of our research on electronic commerce. Special thanks are due to Saul Hansel at the New
York Times for his inputs and ideas. Any errors of fact and interpretation are the sole responsibility of the
authors.
Author Biographies
Eric K. Clemons is Professor of Operations and Information Management at The Wharton School of theUniversity of Pennsylvania. He has been a pioneer in the systematic study of the transformationalimpacts of information on the strategy and practice of business. His research and teaching interests includestrategic uses of information systems, information economics, the changes that information technologyenables in the competitive balance between new entrants and established industry participants,transformation of distribution channels, and the impact of information technology on the risks andbenefits of outsourcing and strategic alliances. Industries of focus include international securities marketsand financial services firms, consumer packaged goods retailing, telecommunications, and travel. Hespecializes in assessing the competitive implications of information technology and in managing the risksof large-scale implementation efforts. Additionally, Dr. Clemons is the founder and Project Director forthe Reginald H. Jones Center’s Sponsored Research Project on Information: Strategy and Economics,founder and area coordinator of the School’s new major in Information: Strategy, Systems, andEconomics, director of the School’s new MBA e-commerce major, an active participant in the School’seCommerce Forum research program, and member of the Faculty Council of the SEI Center for AdvancedStudies in Management. Dr. Clemons is currently a member of the editorial board of the Journal ofManagement Information Systems and the International Journal of Electronic Commerce. He has servedon the Congressional Office of Technology Assessment study of securities markets and on the Quality ofMarkets Advisory Board of the London Stock Exchange.
Bin Gu is an Assistant Professor in Management Science and Information Systems at the University ofTexas at Austin. His research interests include value of online information, impact of online informationon consumer choices, firm strategies and market competition, and modeling of information-based businessstrategies. He was an active participant in the Project on Information: Economics and Strategy, a multi-company research partnership conducted by Wharton’s Reginald H. Jones Center. His research has beenpresented at the Federal Reserve Bank of New York’s Financial E-Commerce Conference, theInternational Conference on Information Systems, the Workshop on Information Systems Economics,and the Hawaii International Conference on Systems Sciences.
Karl Reiner Lang is an Associate Professor in Information Systems at Baruch College, City University ofNew York (CUNY). He received his MBA from the Free University of Berlin, Germany (1988), and holdsa Ph.D. in Management Science from The University of Texas at Austin, USA (1993). Before joiningBaruch in 2002, he was on the faculty of the Business School at the Free University of Berlin and theHong Kong University of Science & Technology (HKUST). Dr. Lang’s has been teaching courses onInformation Technology and Electronic Commerce at the undergraduate, postgraduate, and executiveeducation level. His research interests include management of digital businesses, decision technologies,knowledge-based products and services, and issues related to the newly arising informational society. Dr.Lang's recent publications have appeared in leading research journals such as Annals of OperationsResearch, Computational Economics, Journal of Organizational Computing and Electronic Commerce, andDecision Support Systems. He has professional experience in Germany, the USA, and Hong Kong.
Author Addresses
Eric K. Clemons (contact author)Operations and Information Management DepartmentThe Wharton School, University of Pennsylvania3620 Locust Walk 1300 SH-DHPhiladelphia, PA 19104Phone: 215-898-7747Email: [email protected]
Bin GuManagement Science and Information Systems DepartmentMcComb School of BusinessUniversity of Texas at AustinCBA 5.202Austin, TX 78712Phone: 512-471-3322Email: [email protected]
Karl R LangDepartment of Computer Information Systems (CIS)The Zicklin School of BusinessBaruch CollegeCity University of New York (CUNY)One Bernard Baruch WayNew York City, NY 10010Phone: 646-312-1000Email: [email protected]
1. Introduction
The advent of digitization of pure information products has created turmoil and uncertainty in most
markets for information goods. Travel agents and stock brokers are facing disintermediation. The music
industry is suing Napster even while some labels are seeking strategic alliances with it. At the same time,
recording artists are threatening to break with the record companies that have historically produced their
material, while some are fighting Napster and others are seeking to work directly through it, bypassing
record companies and the traditional retail channel. Newspapers have embraced online distribution of the
news with different degrees of enthusiasm, and with very different strategies. The only thing that has been
said with certainty is that for information products some markets will undergo more change in industry
structure than others, resulting in rapid evolution of strategies for some markets and significant changes in
the future prospects of some currently dominant industry participants.
News stories are increasingly written on laptops and filed electronically. Photographs are increasingly
taken with digital cameras, or are readily converted into digital files. With html files combining formatted
text and digital photographs, news stories can easily and rapidly be communicated over the net, either
through publishers’ websites or directly via email or pointcast distribution to interested subscribers.
Timeliness, reliability and accuracy matter most when it comes to the delivery of news. Established
publishers with reputable brand names have been best positioned to go online. Different from other
information goods, consumer valuation for news depreciates quickly. Yesterday’s news may already be
worthless today. This is one reason that illegal copying and distribution have not happened often in the
news industry. Hence, the big papers generally feel less inhibited about making their content available
online.
Similarly, music is increasingly frequently recorded using digital technology, mixed and mastered using
digital technology, and distributed on digital media such as compact disks (CDs). Indeed, with digital
performance on synthesizers (at one end of the value chain) and digital distribution over the net as MP3
files (at the other end of the value chain) some music can be created, distributed, and enjoyed without ever
requiring a physical recording or hard copy.
Protecting digital content from unauthorized distribution has been the industry’s main concern regarding
online music. Fear of losing sales combined with some degree of organizational inertia may explain the
industry’s initial indifference to the net as a new business infrastructure and distribution channel. But after
start-ups like Napster, Gnutella, and MP3.com began to successfully service massive consumer demand for
online music – largely bypassing the record companies - the incumbents had to accept the new business
reality and change their behavior. Rather than introducing competitive online alternatives, the answer
most commonly chosen at present appears to be a dual approach of experimenting with new technologies
like digital rights management and digital watermarking in order to stop large-scale piracy, while
simultaneously launching litigation suits against the new Net-based competitors over copyright
infringements. While the former approach, attempting to develop and deploy reliable and effective
technology to support secure digital music, has not been successful, the latter has.
As noted, a wide range of strategies is being pursued. The online delivery of The New York Times is free to
all who register with the Times, and includes online access and email distribution of topics selected by the
user, or of late-breaking news; in contrast, the Wall Street Journal has chosen not to make its online
services available without charge to non-subscribers to their paper editions. In the music industry, Warner
Brothers and Sony initially chose to sue Napster, while Bertelsmann initially pursued forging a business
alliance with them [10, 11]. Ultimately, legal action won out — over the short-term at least — forcing
Napster into bankruptcy; however, there is no indication that this represents a permanent solution to the
problem faced by record labels1, nor is there any reason to believe that the issues raised here will decrease
in significance for this or other industries.
The strategies that will be pursued, the effectiveness of these strategies, and outcomes that will result are as
yet not clear, but a theoretically sound analysis should enable us to make both predictions and strategic
recommendations. In section 2 we will present two relevant theories of competition that have proven
valuable in predicting the outcome of competition during and immediately after innovation:
• The theory of resource-based value retention; that is, the degree to which the ownership of
distinct yet related assets confers value upon the owners when innovation and change occur in an
industry
1 Napster Inc. filed for Chapter 11 bankrupt on June 3 after battling with the music industry's copyrightinfringement lawsuit for more than three years [8]. It had more than 60 million users at its peak andclaimed to herald the arrival of new era of music distribution. While Napster has been shut down, onlinemusic piracy continues. Numerous new music sharing software (e.g. Gnutella, MusicCity) have replacedNapster with better technology. Unlike Napster, their decentralized structure makes it impossible to shutdown. Moreover, illegal music distribution servers hosted in other countries create an even bigger problemfor the music industry. The legal environment in foreign countries is often dramatically different from theUS. Reuters reports that US record labels brought lawsuit against US internet providers for their assistancein routing illegal digital music from a server hosted in China. Ironically, the company running the server isnot listed as a defendant. The music industry explains that it is not able to identify the owner of the server[1].
• The theory of newly vulnerable markets, that is, of markets that have been rendered easier to
attack as a result of technological innovation or other change
In sections 3 and 4 we will exploit these theories to examine two very different industries, popular music
and daily newspapers. Our analyses demonstrate that music labels are vulnerable, and that the increase in
power that technological changes have given to the most popular musical groups and artists will slash the
profit of these labels, despite their currently dominant position. However, our analyses also demonstrate
that newspapers are much less vulnerable to attack by their writers, although there is a separate, different
form of vulnerability that must be considered, that of alternative distribution of the advertisements that
currently, at least in the United States, provide the bulk of the newspapers’ profits. Conclusions and
suggestions for future research are presented in section 5.
2. Theoretical Underpinnings
This is of course not the first paper that has addressed channel conflict. Byers and Lederer [3], for
example, study the conflict between online and traditional provision of banking services, and model
consumer behavior to show that the banks’ ability to preempt new entrants is robust under a wide range of
assumptions about consumer behavior. While the problem we address here is fundamentally different — a
shortening of the distribution channel for producers of existing products, rather than competing new
entrant providers using a different channel — the need for a dynamic model that emerges over time and
depends upon consumer behavior is common to their work and ours.
There are two theories of competitive strategy that will help structure and inform our analyses:
• Resource-based value retention and the role of critical resources in creating and sustaining competitive
advantage
• Newly vulnerable markets, and the conditions that encourage new entrants and facilitate their success
in competition with large, well established, and apparently well positioned incumbents
These theories deal with different issues. The theory of resource based value retention describes conditions
under which an innovator can expect to retain much of the value created by his or her innovation; that is,
it describes when the innovator can expect to retain economic rents, and when those rents must be shared
with other parties. The theory of newly vulnerable markets deals with a confluence of factors that, when
combined, makes a firm or an industry extremely vulnerable to new entrants. We combine the two of
them in this paper by showing how a change in the cost of resources or the availability of resources may
erode barriers to entry, creating significant vulnerability to previously invulnerable incumbents.
2.1. Resource-Based Value Retention
The theory of resource-based value retention is largely due to David Teece [12] and accurately predicts
how value will be distributed after innovation. To take some simple but illustrative examples:
• If an idea is readily replicated and requires no special resources to exploit (soft-batch home-style
cookies, introduced in the mid-1980s and now available from Keebler, Nabisco, Procter & Gamble,
among others) the consumer receives the bulk of any gain from innovation. There is no reason to
expect super-normal profits to any industry participant as a result of the innovation.
• If an idea is readily replicated but requires special resources to exploit, then the idea will be replicated,
eroding profits from the innovation itself, but providing significant profits to the owners of the
resources needed to exploit the innovation. Microsoft and Intel were the major winners from the
introduction of the largely standardized IBM PC architecture, and not IBM itself. These special
resources are called co-specialized assets.
• If an idea is tightly protected (by copyright or patent, for example) but requires co-specialized assets to
exploit effectively, then the owner of these assets will be able to retain a share, perhaps a significant
share, of economic gains.
• If an idea is tightly protected (again, by copyright or patent, or other mechanisms), but there are no
critical resources required to exploit it, then it is the innovator himself (or herself) that can expect to
gain.
Additional research has shown that critical resource differences may play an even more important role in
gaining advantage from investments in information technology. This is because the innovation itself
—online shopping for golf clubs, for example — is rarely protectable. If the innovator is to harvest
significant advantage it must be a result of something else and that something is usually a strong ownership
position in critical resources needed to exploit the innovation fully [4, 6].
2.2. Newly Vulnerable Markets
The theory of newly vulnerable markets has three essential components [5]. The market should be:
• Newly easy to enter
• Attractive to attack
• Difficult to Defend
We explore the roles of each of these factors in turn.
2.2.1. Newly easy to enter
A market can become vulnerable if it is newly easy to enter, as a result of regulatory change (regulatory
change in Europe increased the vulnerability of financial institutions previously protected by national
borders), technological change (cellular telephony increased the pressure on Bell operating companies by
offering alternatives to their local service based upon traditional land lines), or consumer preferences (as
consumers become more net-savvy online shopping may threaten established mall operators and the
owners of large physical stores).
It is important not to overlook the importance of the word “newly.” That is, a market whose entry
barriers have not recently changed can be assumed to be more or less in steady state or competitive
equilibrium. If it were vulnerable to attack someone would have already attacked it. However, when entry
barriers suddenly drop we can expect rapid and massive changes in corporate populations — much as when
land bridges end the isolation of islands during low sea levels associated with ice ages, producing massive
changes in populations of flora and fauna.
2.2.2. Attractive to attack
We have found two conditions that are associated with markets that are vulnerable to successful attack.
The first is the presence of a strong customer profitability gradient, that is, the presence of extreme
differences in profitability between the best and the worst customers in a market. This is most frequently
due to uniform pricing in the presence of great differences in customers’ cost to serve, although other
forms of simplistic pricing can produce similar effects. This difference in profitability, due to simplistic
pricing, is equivalent to massive cross-subsidies of the worst (least profitable, or “kill you”) accounts by the
best (most profitable, “love ‘em”) accounts, which we have described as a money pump between different
customer segments. The most publicized example of an industry vulnerable to attack due to simplistic
pricing has been credit cards [8].
Such cross-subsidies do indeed create vulnerabilities, related to opportunistic pickoff of the best accounts,
also called cream skimming or cherry-picking. A new entrant that targets profitable accounts and forgoes
the kill yous and the losses that they produce can successfully attack, even in the presence of higher unit
operating expenses. That is, a new entrant can have higher costs, capture market share by offering lower
prices to its intended customer base, and still be profitable. Again, this is because it is operating without
subsidizing losses from unattractive customers. We view these cross-subsidies as indicative of a vulnerable
market, much as Baumol viewed the presence of cross-subsidies as indicative that a market was not
contestable, but rather was operating under conditions that allowed it to earn monopoly profits [2].
Additionally, cross-subsidies can come from one product line being used to subsidize another, rather than
one customer group. Thus, in the UK, where all customers are entitled to no-minimum-balance free
checking accounts, these accounts must be subsidized somehow; the necessary funds are provided by banks
that historically over-charge customers for bank credit cards. This makes opportunistic pickoff even
easier; a new entrant that does not need to subsidize bad accounts and does not need to subsidize additional
lines of business is ideally positioned to make better offers to the customers it does want to attract, in the
product markets it does want to enter. When the UK banks’ simplistic pricing for credit cards (resulting in
a first cross-subsidy) is augmented by overcharging all customers to offset losses from free checking (a
second cross-subsidy) the combination created even greater incentives for Capital One and other UK card
issuers to attack.
2.2.3. Difficult to defend
Of course, without some barrier to prevent incumbents from immediately replicating the strategy of the
attackers, there would over the long term be no profits for the attackers to capture. The profits would be
competed away as market efficiency and more accurate pricing eliminate transfers and cross-subsidies.
New entrants would be spoilers, but not profitable, and with foresight one might expect them to conclude
that the market was not really worth attacking, reducing incumbents’ vulnerability. There is a wide range
of potential barriers to rapid replication, including regulatory restrictions on incumbents, fixed
commitments to existing customers to maintain current prices, and investments in inappropriate systems
or physical infrastructure.
3. The Recording Industry
3.1 Current Structure of the Industry
The major players in the industry include the following:
• The artists, who create the works of music (compose, write, and perform)
• The record companies, also called labels, who sign the groups, promote the groups, produce master
recordings for most of the groups, produce copies or arrange for their production, and sell copies to
retailers
• Various production facilities, including recording studios and factories to produce copies of records,
tapes, and CDs, most of which are owned by the labels
• Retailers, who do most of the actual selling to consumers
The essential activities performed by these players can be summarized as follows:
• creation (by the artists)
• creation management (selection and promotion, generally by the labels)
• production (recording, mastering, and production of physical copies, generally by facilities owned by
the labels)
• retailing (by traditional stores, the labels themselves, online sellers of physical copies, and to some
extent online sellers of pure digital products)
3.2. Potential Sources of Record Company Vulnerability
The analysis of section 2 suggests that the following are potential vulnerabilities of the labels. However,
for each there has historically been an effective source of defense against these vulnerabilities.
3.2.1. Cross-subsidies of Talent and Opportunistic Pickoff
The principal source of vulnerability will come from the threat of opportunistic pickoff, as described in
section 2.2. In a real sense the artists are captive “customers” of the labels, buying promotion and
production services in exchange for giving up their copyrights and accepting royalty payments as
compensation. There is a strong customer profitability gradient (CPG) among these groups; some acts
desperately require the promotional services that the labels can offer, while others have little need for
these services, or to obtain them from their record companies. Thus, one of the marks of strategic
vulnerability is present: the best, most popular, and most profitable groups under any labels control are
being forced to subsidize their less popular and less profitable stable-mates.
Historically, record companies were able to protect themselves from opportunistic defection, a form of
opportunistic pickoff in which the most profitable groups leave the label at the end of the contract and
begin to promote themselves and record and sell their own works. The labels’ defenses came from the
following sources:
• In the beginning of the performing careers, artists had limited reputations, limited funding, and thus
limited access to the promotional process other than through the labels, with their talent scouts and
development system. Groups initially needed contracts with labels simply to “break into” the business.
• Even established groups had limited access to recording studios, mixing technology, and mass
production except through the labels, and thus needed contracts to remain in business.
• And, likewise, even established groups had limited access to distribution through record stores without
endorsement of a major label.
3.2.2. Cross-subsidies of Activities and Opportunistic Pickoff
The value creation comes from the artists and the revenue comes from producing and selling physical
copies, which may no longer be necessary for distribution and consumption of music. This decoupling of
value creation and revenue production creates a second cross-subsidy between these two activities, which
are presently linked only because physical production and distribution capability historically were co-
specialized assets needed to capture value from creation of the work of art. This creates a second force
towards opportunistic pickoff as groups can distribute their works at much lower cost if they neither
subsidize other acts nor subsidies the labels’ other activities. A typical record company contract offers a
mere 10%-15% royalty to the artists, while the labels and the retailers divide the rest. That means the
artists receive less than $2 for each CD sold, even those have an average retail price of about $15.
Clearly, the artists could expect to receive a bigger portion of the revenue if they could deliver the music
directly online2. Just as clearly, super-star artists could earn more simply by taking back control over
production and promotion, and paying for these with some sort of fee-for-services contracts with
independent recording studios and independent promoters, rather than allowing the record labels to retain
35% or more of the revenues received from retailers. This was technically infeasible for all but the largest
groups in the past, but as we will explore in the following section, this has become far easier today.
3.3. Changes that Exacerbate Vulnerability
Recent changes in the cost or value of assets owned by the labels have undercut the labels’ defenses. The
ease with which groups can now produce their own master recordings with inexpensive digital recording
studios, and the ease with which these recordings can be copied with inexpensive CD-burners, is sufficient
to erode the value of the co-specialized assets owned by the studios. An elementary comparative statics
argument based on the theory of resource-based value retention suggests that whatever the power of the
labels before the value of some critical co-specialized assets changed, anything that reduces the value of
these assets should reduce the share of value that the labels are able to retain.
2 Referees have noted that this division of profits implies a lack of perfect competition within the recording industry,which is of course correct. We note that when baseball owners were protected from prosecution for collusion by explicitexemption from prosecution under the Sherman Anti-Trust Act they retained a far larger share of the value created byplayers. With the end of this exemption and with the advent of free-agency increasing competition for star athletes, theshare of value (e.g., ticket receipts and revenue from the sale of television rights) retained by the players has greatlyincreased.
A complementary analysis based on the theory of newly vulnerable markets leads us in the same direction;
we can choose to view musical groups as potential new entrants in the music distribution business3. The
technological changes in music recording, mastering, production, and distribution do indeed make this
industry newly vulnerable, and these changes make it newly easy for groups to defect and enter the music
business without labels. As we have already seen, these markets are also attractive to attack, creating the
first two necessary conditions for newly vulnerable markets. If artists were to gain access to production
and distribution they would no longer need to forfeit roughly 85% of the sale price of their music to the
labels and the distribution channel4. In the past the costs of independent production and distribution were
so high that this option was available only to the most wealthy and powerful artists. Perhaps the only
group to clear this high hurdle and operate their own label in the age of vinyl records was the Beatles, with
their creation of the Apple label in the late 1960s. However, digital recording and mastering, to produce
the original recording of the performance, and net-based online distribution in purely digital form,
dramatically lower this hurdle and make self production available to a far wider range of artists.
Both arguments lead us to the same conclusion. As a result of technological innovation, the best groups
will be able to opt out of the record companies’ promotional activities, which offer them little, and will be
able to record and distribute directly to consumers online.
We have created a computer simulation model to allow us to examine the implications of our analyses
more concretely, using a range of assumptions. The assumptions of these simulations are included in the
appendix. Our simulation results illustrate the following:
• A base case run in which the studios are profitable, on average groups are profitable, but the bulk of
the profits comes from the best groups.
• Rapid defection / self promotion in which many of the best groups choose to defect from their
labels soon after the end of their contract periods. Record companies soon become much less
profitable. The groups that self promote do indeed enjoy an increase in profitability.
3 A similar analysis of airlines’ potential for direct distribution of reservations and ticket sales led to our early predictionof a loss of travel agency profitability [7].4 Of course, the phrase “gain access” does not mean that the groups need to perform these services themselves. It merelymeans that a third party provider can offer these services, much as third parties now provide more than 80% of the serviceand maintenance on GM cars. Indeed, promotion has always been available through publicity agencies; it was the need foraccess to recording, mastering, and production that kept groups dependent upon record labels.
• Rapid and broad defection / self promotion, in which many groups, across a broader spectrum,
choose to leave their labels and self promote. Record companies cease to be profitable. The earnings
of successful groups do indeed increase, but as record companies cease to promote, fewer bands enter
the industry and consumer choice actually declines.
• Slower defection/ self promotion, in which the top groups leave, but less rapidly. Record
companies earn less, groups earn more.
• Rapid adoption of piracy in which about 75% of the top acts’ sales are stolen, and about 25% of the
remaining acts’ sales are stolen. Record companies lose money, artists earn less, and fewer groups
choose to enter the recording industry. Consequently, consumer choice is reduced.
3.3.1. The Music Industry — Base Case
As can be seen in figure 1, initially the recording studios are quite profitable. Recording artists consistently
earn money as well. Since there is initially no self-promotion (that is, no groups are attempting to engage
in recording, promotion, and sales, without relying upon a contract with a studio), there is no profit
associated with self-promotion. The number of groups recording music available to consumers remains
roughly constant. The various curves in the graph depict the following:
• Record Co’s Profit — This is the total net revenue of the recording company, that is, total receipts
from sales of albums to music wholesalers and retailers, less promotional expenses, recording expenses,
and royalties.
• Groups’ Profit — This is the total net revenue received by the recording groups under contract to the
recording company (that is, royalties), less expenses that the recording company deducts from those
royalties.
• Self-Promoters’ Profit — This is the total income earned by groups that bypass the traditional
distribution system, less the costs of production and distribution incurred by those groups.
• Number of Groups — This is the total number of groups whose music is available to the public, that is,
the total number both of groups under contract and groups managing their own production and
distribution.
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INSERT FIGURE 1 ABOUT HERE
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3.3.2. The Music Industry — Rapid and Broad-Based Defection
As can be seen in figure 2, rapid and broad based defection of recording artists is devastating for the
recording industry. As the most profitable 10% of recording artists defect and do so at a rate of 50%
annually, producing and distributing their own music using alternative technology and alternative channels,
the profitability of traditional record labels is destroyed. In contrast, the money that was previously
earned by the studios is now earned by the artists themselves, as a result of their adoption of self-
production and self-distribution. However, it becomes quite difficult for most new groups to achieve
sufficient profitability for the record companies and many are dropped relatively quickly. Thus, the
number of groups recording and the amount of music available for consumers to purchase declines
dramatically over time.
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INSERT FIGURE 2 ABOUT HERE
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3.3.3. The Music Industry — Less Rapid and More Focused Defection
As can be seen in figure 3, slower and more narrowly focused defection of recording artists is still
extremely damaging but less immediately devastating for the recording industry than more broad-based
defection shown in figure 2. As the most profitable 5% of recording artists defect and do so at a rate of
25% annually, producing and distributing their own music using alternative technology and alternative
channels, the profitability of traditional record labels is rapidly eroded, though not quite to the levels
caused by more broad based defection. However, given the significant skew in profitability, and the high
percentage reflected by the top deciles of the labels’ artists, the loss of even 5% is quite damaging. Once
again, much of the money that was previously earned by the studios is now earned by the artists
themselves, as a result of their adoption of self-production and self-distribution. Additionally, as with
more broadly based defection, it becomes quite difficult for new groups to achieve the profitability that
record companies require, and thus difficult for them to enter the industry. As a consequence of this, once
again the number of groups recording and the amount of music available for consumers to purchase declines
over time.
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INSERT FIGURE 3 ABOUT HERE
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3.3.4. The Music Industry — Slower and More Focused Defection
As can be seen in figure 4, slower and more narrowly focused defection of recording artists is only
moderately damaging for the recording industry, and significantly less so than the more rapid defection
shown in figures 2 and 3. As the most profitable 2% of recording artists defect, but at a slower rate of 25%
annually, the profitability of traditional record labels is somewhat eroded. However, given the degree of
natural turnover that would have removed many of these groups from their labels collection of recording
artists, this is much less damaging than the rapid reduction of groups that would have otherwise remained
profitable for their studios. Once again, the money that the studios no longer earn is now earned by the
artists themselves, as a result of their adoption of self-production and self-distribution. However, since the
profits of the studios are no longer under as extreme pressure the studios are no longer cutting back quite as
extensively on their support of new groups, and thus the impact on the music available to consumers is less
severe than in figures 2 and 3.
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INSERT FIGURE 4 ABOUT HERE
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3.3.5. The Music Industry — Online Piracy without Payment for Production or Intellectual
Property
As can be seen in figure 5, an online piracy rate of 50% has a dramatic impact on the profitability of the
recording studios. However, the money being lost by the studios is no longer captured by the recording
artists. Consumer advocates might argue that although this may appear unfair to both artists and
shareholders in record companies, it is at least producing significant consumer surplus: the money that had
previously been earned by artists and record companies is retained by consumers who now have access to
music free. However, this issue now appears more complex; an examination of the number of new groups
being promoted by record companies is significantly reduced, and hence the selection of music available
ultimately is reduced as well. <<At last, here we really do have reduction in the number of groups. Why
should piracy be more damaging to the record companies’ ability to produce new music than defections?
Indeed, defections at least save the record companies money, while piracy reduces their earnings but not
their promotional expenses. Is this because we are having piracy affect all groups? Is this 50% of all
music, rather than skewed towards more popular music, unlike self promotion? No. The 50% is skewed
towards more popular music. I think that’s why the impact is significant>>
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INSERT FIGURE 5 ABOUT HERE
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3.4. Defensive Strategies Available to Labels
We see a range of strategies available to record companies. The first, of course, is the one that is almost
always recommended in the presence of newly vulnerable markets: end the practice of uniform pricing and
the implicit cross-subsidies of different populations in the presence of extreme heterogeneity among
customers; that is, since different musical groups are different, offer them pricing structures or other
incentives that would induce them to remain5. A second is to attempt to exploit the initial vulnerability
of new groups, and to attempt to capture them for a longer period of time by signing all new prospects up
to longer term contracts. A third is to broaden the set of activities they perform for their best groups by
bundling in more services. Large cash advances or large pre-payments for future albums represent a form
of risk sharing: the artist’s risk is reduced because a certain minimum payment is assured and the
company’s large portfolio of good acts reduces the risk from any one group’s future failure. This form of
risk pooling is of course the basis of all insurance. Without exploring risk avoidance and actuarial fair
prices it is simple to note that this form of insurance is not new (Marlene Dietrich’s legs were insured with
Lloyds in the 1940s) and that if the price (implicit or explicit) of this insurance is set high enough to fund
the cross-subsidies that have created the recording company’s problems alternative coverage will be
available from other parties. The final, most difficult, but most robust recommendation is for the record
companies to attempt a profound transformation of their basic value proposition, much as travel agencies
5 Paying more to the owners of ideas when losing the bargaining power that comes with co-specialized assets is, ofcourse, the default outcome, in the sense that it is predicted by theory and in a sense is always available: if your talent canleave without greater compensation you will need to increase compensation. We see this occurring as recording studiosoffer their best talent better contracts and even renegotiate existing contracts before their expiration. However, this is bothcostly and complex, in that it would require a change to the labels’ existing, albeit overly simplistic, business models andstrategies for dealing with their artists.
were forced to do by capitation of ticket prices and the threat by airlines to opt out of the agency-based
distribution system for corporate travel. This could entail some combination of the following activities:
• The record labels could provide promotional management and production management services, for
competitive fees. They might choose to do this for all groups, or they might choose to offer all new
groups the current promotional program and offer fee-for-services contracts to groups at the
completion of their initial contracts.
• They could attempt to lock up Napster and Gnutella and other online distribution channels and lock
out independent distribution by groups. (However, this appears unlikely to succeed, due to restraint of
trade implications and difficulty in preventing new entry by websites without such restrictions)
• They could make stamping out piracy and protecting the intellectual property rights of their artists an
essential part of the service that they provide to their groups as part of their contract. (Technically,
this has always been one of the services that labels have provided for their groups. However, with the
ease of online piracy, this service has become far more valuable, and should be more explicitly stressed
by the labels.) They could work with Napster and Gnutella and other online distribution channels, to
assure (for a fee) that they and their artists receive compensation every time a copy of their work is
exchanged. This may indeed be what Bertelsmann has planned.6
4. The Newspaper Industry
4.1. Current Industry Structure
The major industry players, ignoring, for now, online editions, include the following:
• The writers and photographers, who cover and report on the news
• The newspapers, which hire or contract with writers and photographers, edit their works, sell
advertising space, bundle their works with advertising, print the paper copies, and distribute them to
subscribers and to other retailers
6 We have a draft manuscript completed on this topic and anticipate continuing research in this area.
• The various forms of retailers, who do most of the actual selling to consumers not handled directly
by the newspapers’ subscription service
The essential activities performed by these players can be summarized as follows:
• creation (by reporters and photographers)
• creation management (selection of stories, editing of stories, and certification of correctness, accuracy,
timeliness, and suitability)
• production (bundling with advertising, printing and distributing copies)
• retailing (by subscription services, news agencies, news stands, convenience stores, and other retail
outlets)
4.2. Potential Sources of Newspaper Vulnerability
The analysis of section 2 suggests that the following is the principal potential vulnerability of the
newspapers. In contrast with the music industry, bypass, defection, and self-distribution of their work by
the creative staff itself does not appear to be a significant threat. There is a major threat to existing
players in the newspaper industry created by their persistent cross-subsidy of different activities. We note
that, as in the recording industry, there has historically been a defense against this threat and, as we did
with the recording industry, we will use resource-based value retention as a framework for analysis.
4.2.1. The Advertising Business and Cross-subsidy between News and Advertising
The newspaper industry has for much of its existence consisted of two separate and distinct industries —
selling news and selling advertising — that have been coupled together for historical reasons:
• Combining news with advertising yields lower cost distribution of advertisements (economies of scope
on delivery costs)
• Consumers are willing to accept advertisements in their newspapers but seldom have been willing to
pay for them, justifying bundling ads with the content that consumers desire and charging advertisers
for reaching consumers that advertisers would not otherwise have been able to reach at expense
comparable to the cost of advertising space
• Consumers, at least in the US, are often not willing to pay full cost of newspapers, justifying bundling
advertisements to subsidize providing newspapers to consumers and thus lowering the price that must
be charged to the newspapers’ readers
4.2.2. The News Reporting Business
There does not appear to be a strong customer profitability gradient in the existing news reporting
business. That is, when newspaper sales are compared with credit card issuance or health insurance there
are not consumers who are significantly more profitable on any individual sale than other consumers.
However, we do observe a decoupling of value creation and revenue production, largely analogous with the
music industry:
• Value comes from creation of the news story
• Revenue comes from creating and selling physical copies
Although there is no cross-subsidy of some customers by others, created by a strong CPG, there is a cross-
subsidy between the two activities of creation and selling. These activities are linked today only because
physical production and distribution capability historically were co-specialized assets, which were needed to
capture value from the creation of news stories; moreover, capturing value from the creation of news
stories came not from selling these stories to consumers but from selling space around these stories to
advertisers. Based on the data from Newspaper Association of America, advertising accounts for 81.5%
of the total newspaper revenue. Their sale of subscriptions accounts for only 18.5% of revenues. This
cross-subsidy of activities does suggest vulnerability, and may, indeed, suggest that sale of advertising space
has long been less than a fully competitive market. Ease of entry to the advertising market should, in the
manner described by Baumol, reduce the earnings of newspapers from advertising below the levels that
would permit cross-subsidies of other activities7.
4.3. Changes that Exacerbate Vulnerability:
Exploring Direct Distribution of Journalists’ Stories
7 While this statement is only fully true absent strong economies of scope such as consumer preference for print ads thatcome bundled with newspaper stories, there is no evidence at present that would suggest such preferences exist.
Have newspaper publishers faced changes that undercut their defenses and render them participants in
newly vulnerable markets, analogous to the situation faced by music labels? We do not see publishers as
vulnerable in the same way, or to the same set of threats; that is, we do not see threats posed by the writers
and content production staff of newspapers. Even if reporters could gain access to direct distribution of
daily newsletters (Floyd Norris on the Market, Saul Hansell on eCommerce, John Markoff on technology
companies) it is not clear that consumers would purchase them:
• Very few reporters are, indeed, consumer brands to the extent that ‘Nsync, Wings, the Grateful Dead,
or even Smashing Pumpkins or Dead Milkmen are to the public that listens to pop music
• News stories need some form of authentication or certification — a story I read in the Times online
has a very different level of credibility than something I read in alt.conspiracy.middle-east, and acting
on an unsubstantiated rumor can be dangerous or expensive. Reputation and brand name have been
recognized as the main corporate assets in the media industry, and especially in the online news
market. Papers like The New York Times or the Wall Street Journal have therefore invested heavily
in efforts to carry over their reputation for accuracy, timeliness, and relevance of their print versions
to their online editions. In contrast, a piece of music that I like is enjoyable to me, regardless of who
wrote it or who played it. We have been surprised on occasion when a concerto we heard on the radio
was by Bach when we were sure it was by Vivaldi, or a symphony was by Haydn when we thought it was
by Mozart; we like it either way, and there is no need for certification comparable to that which exists
with news stories.
There has been a change in the difficulty of obtaining assets needed to produce and distribute a news story
or photograph, so we might initially suspect that using the resource-based theory of value retention
reporters and photojournalists might be able to retain a greater share of the value they create by directly
selling their stories to their readers. However, this does not seem to have occurred, and therefore it has
not resulted in a change in competitive position of the newspaper, in its most obvious business of covering
the news. Perhaps the following offers at least a partial explanation:
• Reporters and photographers do indeed have access to low-cost production of their digital stories and
photographs, and low cost access to consumers of the news via online direct distribution
• However, the certification and authentication role of the editorial function remains intact. This is in
sharp distinction with online distribution of digital music: if we enjoy a performance we may not care
whether or not it is an authorized recording; indeed, many teenagers take a real joy in purchasing a
bootleg recording of a concert that was never commercially released. However, we cannot invest
wisely or make other plans based on a story whose accuracy we can neither trust nor confirm.
As long as the certification role remains intact, and as long as it remains an essential role of the newspaper
editorial staff rather than the individual news story creator, then it will be difficult for individual content
producers to compete effectively with their newspapers8. Thus we may conclude that the industry is
neither easy to enter, either by reporters themselves or by new entrants who do not yet enjoy a strong
reputation for reliability and timeliness, nor attractive to attack, based on the absence of a strong customer
profitability gradient among readers of most daily news stories.
What can we say about the attractiveness of supporting journalists who work for newspapers, viewed as
customers of editorial services? Clearly, some journalists are more attractive than others, and therefore
some have more attractive contracts than others. However, nowhere in the industry of print journalism
do we note journalists implicitly being charged exorbitant rates for services that could readily be provided
by an independent service provider. When a musical group pays a double-digit percentage of the net
receipts of its recordings for promotional services and recording and production when these could be
purchased for a much smaller fee, then serving musicians becomes attractive. If super-star reporters were
charged comparable fees for services that could be provided by an independent service provider
this might suggest that the analysis of the previous section, on music groups’ bypass of record companies,
was more directly applicable.
4.4. Changes that Exacerbate Vulnerability:
Exploring Competition from Alternative Advertising Media
The industry based on selling of advertising space within newspapers will need to be analyzed separately.
Selling physical copies of the story does indeed cross-subsidize the creation of the story, and online
distribution does indeed appear to offer lower cost ways of reaching readers, but at the moment the
8 It is not necessary for this analysis that the role of certification remains the only role performed by the newspaper andnot by the individual content providers. For example, it is also true that few newspaper reporters work alone. A starreporter like the Times’ Saul Hansell can employ a photojournalist as needed for an individual story. A columnist likeNewsweek’s Jane Bryant Quinn can employ her own research assistant rather than relying upon those available through herpublisher, and, indeed, she may well do so. Those newspaper professionals who work alone and who do not requirecertification — such as cartoonists and editorial columnists — often are able to retain a greater share of the value createdby their work. However, most reporters’ stories are the result of collaboration among staffers from many locations. Thismay alter the value of parameters we use in our model and may change our story line slightly, but the basic idea — thatfew reporters can consider bypassing their employers and reaching their readers directly — remains intact.
bundling of advertising is simply too important, and bundling of advertising into online editions is simply
too uncertain to encourage entry by online competitors. Can we conclude, therefore, that newspapers are
safe from erosion of their profitability due to innovations in information technology and online
communications?
Perhaps the newspapers business of selling advertising space may yet prove vulnerable. There may indeed
be an untapped and unexploited customer profitability gradient, and possibly a strong one. Online
advertisers might be able to locate it and find ways to exploit it. Two of the authors of this paper are
upper-middle income professionals who have recently taken up golf. Both need clubs. Both can afford to
pay a bit more for clubs that promise — rightly or wrongly! — to deliver longer and straighter shots, and
both actually would be willing do so. This information would make them much more valuable consumers of
golf product advertisements, and would enable a well-informed online advertising company to create and
exploit a customer profitability gradient. Moreover, we have agreed that, as in the music industry, the
physical distribution of the paper and its ads is cross-subsidizing other activities; this cross-subsidy may
indicate that advertisers are being over-charged by newspapers, now that alternative means of distribution
may be available to advertisers. This in turn creates significant vulnerabilities for newspapers.
We do observe changes that undercut defenses of newspapers, creating a newly vulnerable market for the
sale of advertising. In particular:
• The direct distribution of paperless advertisements makes the advertising portion of the newspapers’
business easy to enter.
• Technology facilitates exploiting the customer profitability gradient among consumers who respond to
advertising, terminating cross-subsidies of consumers who read the news but do not respond to
advertising, focusing on point-casting advertising to consumers who will respond, and terminating
support of other activities that do not add value to advertisers. All these combine to make the
industry attractive to attack.
• For reasons that we will explore below, it will be difficult for newspapers to respond to this threat,
making the industry difficult to defend.
Hence we conclude that the three conditions required for newly vulnerable industries are indeed present.
The news side of the business will not be attacked. However, the advertising revenue base will come under
increasingly intense assault.
But why do we believe that it will be difficult for industry participants to defend themselves? Most
importantly, their core competence is in producing engaging and reliable news, producing and distributing
paper-based copies of news and advertising to the widest readership in a cost effective and timely fashion,
day after day. However, these are the skills needed to support precisely the activities that the advertiser-
based services will terminate. They are not ideally situated to compete in any way against pure, targeted
distribution of advertisements.
Qualitative Results:
Competitors’ lower cost distribution of advertising places significant revenue pressure on newspapers.
Reducing the news content leads to death spiral, with fewer readers, reduced interest from advertisers,
reduced revenue, and increased revenue pressure. Increasing the price charged to readers may result in
reduced readership as well, but may result in retention of higher quality readership if the experience of
Le Monde or the Financial Times were to translate to the US environment. However, if the
readership decline results in reduced advertising revenue then, indeed, death spiral will result again.
4.5. Defensive Strategies Available to Newspapers
A limited set of defensive strategies may be available to newspaper publishers.
Firstly, but implausibly, they can exit the news business and focus on advertising, although for
reasons of core competence, and fixed investments in infrastructure, and commitments to union
employees, this appears unlikely.
Alternatively, they can create a changed value proposition:
• They can focus on audience willing to pay for the news
• They can provide a news service that does not require subsidies from advertising
• Perhaps they can develop an advertising business as well, though no reason not to spin this off if it is
not heavily synergistic with the news business
• They can use online distribution as an essential adjunct, not a competitor or alternative to, to paper-
based business
We notice in passing that Bloomberg has successfully located a market that will pay thousands of dollars a
month for information that is accurate, timely, and in some sense certified as correct.
5. Conclusions
We have used the theory of resource-based advantage to examine two markets for information goods,
within the context of the theory of newly vulnerable markets. We have concluded that the music industry
is vulnerable to attack by the artists and musicians it employs. In contrast, we have shown that
newspapers are not vulnerable to attack by content staff but are vulnerable to pickoff from targeted
distributors of advertising. Preliminary quantification is provided by simple simulations and computational
techniques.
We believe that the managerial implications of our work are clear and important:
• Cross-subsidies of activities require near-monopoly power and cross-subsidies of different classes of
accounts likewise requires near-monopoly power. Technological innovation reduces the value of co-
specialized assets and the economic power that they conferred upon their owners.
• Industries that enjoyed near-monopoly power in the past will be newly vulnerable. Those that cross-
subsidized some participants at the expense of others may find that they lose their most profitable
accounts. Those that subsidized some lines of business at the expense of others may find that the lose
their most profitable businesses.
Planned extensions and future research includes the following:
• calibrating our computational results via actual data from the music recording and newspaper industries.
• using our analytical techniques to study additional industries within the collection of markets for pure
information products; specific examples that we have considered include publishing of novels,
production of television and movies, and of course our own “industry”, higher education.
• performing more detailed analysis of alternatives available to record companies, in particular the use of
prevention of piracy as a value-adding service that they can provide for their recording artists
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Appendix: Modeling Assumptions
Common Assumptions
We assume that record companies compete efficiently with each other to sign the best acts and that acts
compete efficiently with each other to sell their recordings. We assume that, as at present, record
companies use standardized contracts and that all are therefore equally vulnerable both to piracy (illicit
copying) and disintermediation (production and direct distribution by recording artists, without the need for
a record contract or the technical and promotional support of a record label). Therefore, without loss of
generality, we model the profitability of a single record company.
Maintenance of a Stable of Acts: We assume that the record company seeks to employ a constant stable of
50 signed acts. Each year any and all unprofitable acts are dropped. Moreover, for a variety of reasons,
20% of the profitable acts retire each year; this can be a result of anything from a bass player dying from a
drug overdose, a fight between the drummer and the lead singer, or an accurate assumption that their
listeners are no longer interested in their work. Replacement acts are auditioned and a sufficient number
are added to replace those that drop out. However, while groups arrive with a predetermined quality, which
will be maintained throughout their recording careers, this quality can only be observed with uncertainty.
Thus, if the record company wants to replace R acts it auditions 4R and takes those that it ranks as the
top, but these are likely to be randomly selected from the top 2R ranked by true (but unobservable) quality.
Operations: The record company cuts a master disk for each act each year at cost M and promotes the
disk at cost P. These costs are subtracted from the act’s royalties, to determine the act’s own profits. If
M and P are not fully covered by royalties, and if the record company’s operation of the act is
unprofitable, then the act is dropped. (Our parameters were set so that at least some new groups passed
this profitability screen at the end of their first year. It is easy enough to modify the simulation and to
apply a lag, allowing groups to remain with the record company into their second year even if they were
not profitable, and to apply this screen only after a group’s second year. Likewise, we assumed that M and
P were constant for all acts and constant over time; clearly these assumptions are not fully realistic. Often
a super-star group will receive more production support and more promotional support than a mature act
with only moderate popularity; however, this increase in the expense of support will seldom if ever
approach the enormous revenues that these super-star acts earn for their labels, thus reducing the validity
of our model only slightly. Likewise, a promising first-year act may receive more support than mature
acts of only moderate popularity; far from reducing the validity of our model, this would only strengthen
our confidence in our findings.
Sales: The record company sells N recordings a year at $5.00 / disk wholesale. Royalties are calculated at
10% of these sales, less production and promotional expenses.
Base Case
Using the assumptions listed under common assumptions above, the model is run until profitability reaches
steady state, and then data are captured and displayed for as many periods as desired.
Direct Distribution Cases
The assumptions listed under common assumptions are used once again. However, in each of the direct
distribution scenarios we assume that a fraction of the company’s top acts will choose to produce and
distribute their own recordings. The acts need to fund their own production and promotion, which the tops
acts are now able to do. The principal impact of this disintermediation on the record company is that it
loses the revenues from these acts. The principal impact on the acts themselves is that they retain the full
wholesale price of their recordings. We are able to vary which deciles are liable to engage in direct
distribution, and what fraction of these deciles actually chose direct distribution. We have not assumed
uniformity of behavior of all acts within either the deciles that are attracted by bypass; we have however
assumed that their behavior is unknown except in probabilistic terms. We could have used more complex
distributions, where the likelihood of being attracted to bypass was greatest for the most profitable groups
within the population and was lowest among the least profitable groups. Indeed, we could have used some
form of negative exponential, where the likelihood of bypass asymptotically approached zero as
profitability declined, rather than having a uniform distribution within a segment of the population.
Clearly a negative distribution with a mean loss of L% each year, with mass shifted strongly towards the
most profitable groups, would be more damaging than the uniform distribution we employed, and thus
would only strengthen our confidence in the results that we have reported.
Piracy Case
The assumptions listed under common assumptions are used once again. However, in each of the piracy
scenarios we assume that a fraction of the company’s sales are lost due to piracy, the illicit coping and
distribution of music, either through sales of forged copies or, increasingly, through online swapping of
digital recordings. The principal impact of this piracy on the record company is that it loses the revenues
that would have come from the sale of legitimate copies of their acts’ recordings. The principal impact on
the acts themselves is that they too now lose their share of the revenue from sales lost to piracy.
Figure 1: Base case for recording industry
Time (in quarters)
Pro
fits
(in
$K
)
NumberofGroups
Figure 2: Rapid and broad-based self-promotion
Time (in quarters)
Pro
fits
(in
$K
)
NumberofGroups
Figure 3: Rapid but more focused self-promotion
Time (in quarters)
Pro
fits
(in
$K
)
NumberofGroups
Figure 4: Slower and more focused self-promotion
Time (in quarters)
Pro
fits
(in
$K
)
NumberofGroups
Figure 5: The introduction of online piracy
Time (in quarters)
Pro
fits
(in
$K
)
NumberofGroups