The Knockoff Economy

by Kal Raustiala

  A VERY BRIEF HISTORY OF THE MUSIC INDUSTRY’S DECLINE

  Music and the music industry are not the same. The “music industry” is often just shorthand for the interests of the major record labels, such as the Warner Music Group and Sony Music Entertainment. When people say that Internet piracy is killing “the music industry,” they are really talking about the major labels. And, in a sense, they are right. The labels have been deeply harmed by illegal downloading.

  Yet music itself is very much alive. As we described in the conclusion to this book, musicians once had to rely on expensive studios and highly trained engineers to record their music, and big companies to manufacture and distribute it. Retail stores—even the biggest of them, like Tower Records—could only carry a small amount of stock. The result was an expensive distribution scheme that excluded most artists and restricted consumer choice.

  All of this has now changed—for the better. With a laptop, artists can produce high-quality recordings on their own, and distribute them easily via the Internet. In this more wide-open world, even virtual unknowns can make a living while bypassing the traditional industry players. And because online retailers like Amazon are reachable by anyone with an Internet connection, have unlimited virtual shelf space, and much lower costs than physical retailers, consumers now enjoy much greater choice in what music to buy.* The result is a great flowering of music of all kinds. In fact, judged in terms of the diversity and quality of music available today, the ease of obtaining it, its low price, and the amount of information available to guide consumers to the music they want, we are living in a musical golden age.

  This is better not only for consumers. It is also better for many musicians. When success meant distribution through a major label, the market produced a few very rich superstars and a large number of broke nobodies. Today, a wide range of musicians use technologies like home studios, blogs, YouTube, MySpace, Facebook, and Twitter to carve out decent careers on their own. Music, in short, is thriving—even in the face of vast amounts of copying.

  Still, it is undeniable that the fortunes of the major labels are declining. This decline is driven by technology, but technology is not the only factor. The labels themselves made some strategic missteps, and they failed to recognize the opportunities, not just the harm, inherent in these technological transformations. We elaborate on this point here because it is underscores an important element: it is often not copying per se that is a problem, but how copying is understood and addressed.

  To begin, take a look at the following chart, which we have constructed from the industry’s own data.2

  In 1999, total record company revenues hit an all-time peak of $14.5 billion. This followed a decade of vigorous growth in which revenues increased from $6.5 billion to $14.5 billion between 1989 and 1999, a 220% increase (or 170% adjusted for inflation). Yet this growth was deceptive, for it was driven primarily by a one-time event: the format shift from LPs to CDs. CDs, first introduced in 1982, outsold vinyl records by 1988, and in subsequent years consumers spent huge sums replacing their old vinyl records.

  FIGURE 6.1 Recorded Music Industry Revenues (1999-2010) (RIAA data]

  But the good times did not last. By the end of 2009, total revenues were down to just over $7.6 billion—a fall of almost 50% over 10 years. And that figure doesn’t capture the full extent of the decline. Adjusted for inflation, record company revenues fell by approximately 60% over the last decade. That trend continued in 2010: as the Recording Industry Association of America’s (RIAA) latest figures show, total revenues dropped by another 11%, to just under $7 billion. And there’s no end in sight.

  ENTER NAPSTER

  What happened? Napster happened. The creation of Shawn Fanning, then a 19-year-old college student, Napster was the first music filesharing service to gain a huge following. Napster attracted almost 50 million users within months of its release. It was appealing because it was so easy to use: Fanning’s elegant design made it simple to go online and find exactly the song you wanted. But by far the biggest reason for Napster’s viral growth was that it had everything: pretty much any song you wanted, instantly and free.

  The huge amount of music available on Napster was, in turn, due mostly to the system’s “peer-to-peer” architecture. Napster didn’t collect music on a server. Instead, it used the Internet to connect the computers of millions of users. When a user asked for a song, Napster consulted its constantly updated list of music files and then connected the requesting user with another user’s computer that had the relevant file.

  The music industry’s reaction was unsurprising and, given the scale of the copying Napster was enabling, understandable. In 1999, the RIAA sued Napster, asking for $100,000 for each song downloaded—billions of dollars in total—and a court order directing Napster to shut down. In 2001, a federal court agreed, ordering the company to remove all unlicensed content from its network—which quickly led to Napster’s shutdown. Facing extinction, Napster offered the major labels a deal worth about $1 billion to license their catalogs. The envisioned “Napster 2.0” service would charge users between $2.95 and $9.95 per month and use the revenue to fund yearly payments to the record companies of $200 million.3

  The labels turned down Napster’s offer. And in retrospect, this looks like a major mistake. If Napster had become a pay service, some of its users would certainly have left to find new sources of free music. But the runaway success, years later, of Apple’s iTunes shows that a lot of people are perfectly willing to pay for music, at least if they are getting what they want conveniently (and safely) at a fair price. A Napster pay service would have enjoyed a significant head start. So many people were using Napster in 2001—especially young people, the biggest consumers—that the labels would have at least been able to make a case that paying a reasonable price for convenient online music was better than stealing it. That case would have been more powerful if the labels had embraced the new technology, and trumpeted a Napster settlement as the beginning of a new and better deal for consumers.

  Instead, Napster was shut down. But the genie could not be put back in the bottle. New services arose in Napster’s wake, including Grokster, Kazaa, and BitTorrent, and millions of Napster users migrated to the newer networks. The music industry again went to court. In 2005, in a major decision, the Supreme Court held that Grokster could be held liable for “inducing” copyright infringement. Here too, however, the victory was more apparent than real. Grokster was not found guilty of directly infringing copyrights—unlike Napster, when Grokster users shared digital files, they did so without any direct assistance from Grokster. Instead, Grokster was found guilty of essentially provoking piracy. The Supreme Court held that the company had induced copyright infringement by intentionally choosing a name that sounded like Napster, and then encouraging Napster users to use Grokster to download free music.

  These acts amounted, in the Court’s view, to an open invitation to break the law. They are also unlikely to be repeated. Unsurprisingly, the decision in Grokster had little lasting impact. Grokster shut down, but new platforms quickly emerged, and filesharers migrated again. The RIAA’s litigation strategy, in short, was like playing Whack-a-Mole, only in this version new and faster moles kept appearing.

  A current example is BitTorrent. By some accounts, files shared over Bit-Torrent comprise as much as one-third of current Web traffic. Users can search BitTorrent using public search engines like the Pirate Bay. However, an increasing amount of BitTorrent filesharing occurs via “closed” search engines that are accessible only by invitation—basically, clubs that share files among their members. New technological tools make detection of file-sharing much less likely and more expensive.

  And even newer technologies are coming online, such as the file-hosting and “cyberlocker” sites. To distribute music via a file-hosting site, a user uploads a file to a site like Rapidshare, and then distributes a Web address that permits visitors to download the file. The large number of file-hosting sites, their
independence, and the fact that many are located in foreign jurisdictions with weak legal systems makes cracking down on them very difficult.

  The music industry, in short, has remained one step behind the technologies used for illegal downloading. And while it has won many court victories, these have been largely Pyhrric. The copying of music is more prevalent today than when Napster was invented.

  IF YOU CAN’T BEAT THEM, JOIN THEM

  The major labels likely would have done better had they struck a deal with Napster when they had the chance. Providing an attractive legal alternative to copying would not have stopped piracy altogether. Yet the market for paid online music is very big indeed: as we noted in the Conclusion, iTunes has provided well over 16 billion paid song downloads. Perhaps if the labels had co-opted the Napster model, as Napster proposed in its settlement offer, that would have helped to reduce piracy to a level that would no longer be a fundamental threat.

  Such a system implies a different business model, of course: one much more like iTunes than A&M Records. Consumers would buy their music one song at a time rather than in higher priced bundles of a dozen or so songs. And they would pay less. These changes would mostly benefit consumers.

  In the longer term, however, the labels likely would have benefited as well—certainly relative to the disastrous losses they’ve suffered over the past decade. Not least, the industry’s costs of distribution would have fallen dramatically. Napster would have functioned, in effect, as an efficient and scalable retailer. There was another, perhaps even more important, potential gain—information. Napster’s network was based around a central server that could have been used to store customer identification information and transactions. Millions of music fans had gathered in one place, Napster’s central server knew how to find them, and the labels could have used this to target products and services to the Napster user base. In one stroke, a deal with Napster would have allowed the record labels to adjust their business model to account for the rise of the Internet.*

  Instead Napster was shuttered. The technologies that rose up to take its place were much less promising as potential business partners. These networks were decentralized, and so were much harder to control or coopt.4 The simple fact is that Napster made music incredibly easy to find, and it was the first example of filesharing to really hit it big. That made Napster the perfect partner.

  FROM P2P TO PERSONAL

  As it became clear that downloading technologies would not disappear, the record labels tried a second strategy. Beginning in 2003, the labels filed suit against 261 individuals who had shared music illegally. Under US law, those defendants were liable for damages of up to $150,000 per song shared. Ultimately, the labels would file or threaten suits against more than 30,000 people, including a dead person and a 13-year-old girl.

  Most of these suits never reached a courtroom, because the very stiff damages available led the defendants to settle. And yet this strategy too failed to pay off. The cases that did go to trial cost millions in lawyers’ fees and generated a significant popular backlash. Nor did the individual lawsuits discourage much filesharing. Filesharers numbered in the tens of millions in the United States alone, so any individual’s chance of getting sued was minuscule. Like a lion attacking a huge herd of gazelles, most simply got away. By late 2008, the labels announced that the consumer lawsuits would stop.

  APPLE’S RISE TO MUSIC DOMINANCE

  The labels have little to show for their frontal attack on copying. But the real long-term damage is not just about money, but control. While the industry was locked in a futile struggle against ever-easier copying, the late CEO of Apple, Steve Jobs, was quietly positioning his company to be the next kingmaker in the music business.

  Apple’s first move was the iPod. Introduced in 2001, it was a runaway hit. Then, in 2003, Apple struck a deal to license music from the major labels. The labels thought that they could control Apple, which seemed at the time like a failing company with a tiny share of the personal computer market. Less than a decade after its iTunes Store opened for business, however, Apple controls almost 75% of the US market for paid downloads. Indeed, Apple’s business is so large that it controls more than a quarter of all sales in the total US music market. That’s more than the combined share of the #2 and #3 players, Walmart and Amazon.

  iTunes had another trick up its sleeve, and the labels another fumble. Consumers who purchased music from iTunes became effectively locked into Apple’s platform. If a consumer wanted to move to a rival portable music player, his music would no longer be playable. He could work around this by burning his music to a CD and then transferring it, but this is a very labor-intensive process. So once consumers start to use Apple’s platform, they are almost certain to stay with it.

  The labels had an opportunity to break Apple’s lock-in when, in 2006, Microsoft introduced its competing music player, the Zune. If they had vigorously supported Zune, that might have put into play a company with the resources to challenge Apple’s dominance. But Zune faced a serious problem—consumers who had built iTunes libraries could play these only on their iPods. Why switch to the Zune if doing so meant walking away from their music collections?

  The labels could have helped Microsoft solve the music lock-in problem by offering to license to Zune users, for perhaps a penny a song, replacement copies of all of the music they had bought on iTunes. This did not happen, with the predictable result that the Zune—have you ever seen one?—never caught on.* Apple’s dominance remained secure.

  Where does this story lead? To a critical point about the respective roles of copying and copyright. Copying certainly hurt the labels. But copyright is also to blame. Instead of being a tool the labels used as part of their overall business strategy, strengthening rules against copying became the principal focus of their business strategy. That strategy won a few battles but largely lost the war. It created bad publicity and proved a distraction from the task of reforming the industry’s business model to survive in a world that had been changed irreversibly by the Internet. And in the end, it delivered up the music business not to the pirates, but to Apple.

  What happens next? Copying is not going away. Indeed, it seems to be getting easier by the day. The entire music industry is increasingly living—whether they like it or not—in the copy-friendly environment that characterizes the other creative industries we’ve examined in this book. Understanding how creativity thrives in these industries can point toward a future in which the music industry might adapt and even prosper.

  LOOKING AHEAD

  There was nothing inevitable about this tale of decline. Hollywood, for example, has fared better. To be sure, Hollywood worries a lot about piracy. But while there is plenty of it, especially overseas,* piracy has yet to threaten the existence of the major film studios. Box office revenues have increased steadily for years, and even given some ups and downs are now almost double what they were in 1992, when the Internet first began to take off as a social phenomenon.5 These figures also don’t account for DVD releases, a major income stream over the past two decades, though decreasingly important today.

  Why has the movie industry’s fate been different? For one, technology gave them a few years’ reprieve. Video files are much larger than music files. As a result they were, until recently, relatively difficult to download and upload. More important, Hollywood learned some lessons from the music industry’s straits. Hollywood fought copying, but as a part of a broader overall strategy aimed at capitalizing on the opportunities the Internet offered, while blunting the effect of piracy. We will examine some of the details of Hollywood’s thus-far more successful strategy as we consider music’s future.

  That future is bound to be different from music’s past. Copying music is easy and the risk of getting caught minimal, and this is unlikely to change. But easy piracy does not mean the death of creativity in music. Nor does it mean the end of profits from music. Here are some ways that the music industry could adapt—and in some cases alrea
dy is adapting—that mimic strategies we’ve seen deployed by other copy-prone creative industries.

  MUSIC AS AN EXPERIENCE

  The most obvious adaptation is changing what the music industry sells from product to performance. We argued in the Conclusion that products often are easy to copy, but performances are not. One of the reasons chefs remain so creative is that competitors can copy a restaurant’s signature recipe but they cannot so easily copy the quality of the preparation or the restaurant’s ambience or service.

  We won’t repeat the discussion here, but we do want to underscore the centrality of performance. Millions of people every year already attend concerts. A greater shift to performance will never replace all the revenues that currently flow from recording. But shifting the business model away from the easily copied product (the song or album) and toward the hard-to-replicate performance (the concert) can help to stabilize the fortunes of musicians.

  In many ways, this is simply a return to the reality of the last two centuries of popular music. As Mick Jagger rightly noted, the era of making riches off of recording was really just a brief window in the history of music. The past was, and the future is going to be, much more about performance. In this new world, recordings often function more as ads for concerts than as money-makers themselves. (And sometimes they are bundled with concert tickets, as Madonna’s latest album was.) As a result, copying looks a lot less fearsome. An illegally copied ad is just as effective—and maybe much more so—than the original.6

  MUSIC AS A SOCIAL NETWORK

  As the cost of producing and distributing a product falls, basic economics predicts that more of it will be produced and consumed. This axiom certainly applies to music: as digital technologies have slashed the cost of producing and distributing music, we see an unprecedented amount and variety of music on offer. But there’s another change. Digital technologies also change how the rewards of the music industry are distributed. In the heyday of the labels, a lot of revenues unsurprisingly went to them. This system produced some very successful stars, but a lot of musicians—even very talented ones—made little or nothing.