Analysis and Recommendations

1. Introduction

In recent years, advances in the speed and functionality of the communications infrastructure have made information more accessible to the non-professional user. In particular, the Internet as we know it today is regarded as a cheap and quick way to distribute multimedia information. The hype has been that very soon music, video, and all sort of services would be provided via the Internet and that disintermediation would have a large impact on businesses as we know them today. Perhaps this hype is not very far from the truth. Although bandwidth constraints do not make it very practical to distribute massive quantities of information on a large scale, new infrastructures like Internet II are being built and small, but innovative companies are leading the way with data compression tools that address these problems.

Among these tools, data compression algorithms for data transmission, (revitalized by the explosion of the Internet) have been the core of many technologies for sound and video transmission. Products like RealAudio, InternetPhone or VivoActive use lossy data compression ("lossy" means the compression algorithm deteriorates the quality of the data to achieve higher compression rates) to broadcast real time data over the Internet.

One of these standards, the 2nd generation algorithm for data compression from the Motion Picture Experts Group or MP3, is gaining increased support from the Internet community. It was quickly adopted by a large number of hackers that posted copyrighted works of many music artists on their web sites. The small size of MP3 compressed files (1/12 of the original size), the playback quality (indistinguishable from a CD for a normal listener) and the fact that a few companies plan to release their first portable player during this year, sent the major players in the music industry into red-alert.

Our purpose in this paper is to analyze the reasons why the MP3 standard was so quickly adopted, to speculate on the impact it might have in the music industry, and to give some recommendations to the music industry concerning how to take advantage of these new developments.

2. What is MP3?

Background

MPEG Layer-3 (or MP3), is a compression technique that is capable of shrinking audio information by losing’some of the audio data imperceptible to the human ear. Its name is derived from the Motion Picture Experts Group, a committee that meets under ISO (the International Standards Organization) and the International Electro-Technical Commission (IEC) to generate standards for digital video and audio compression. MPEG Layer-3 was originally designed to reduce the size of high-definition TV broadcasts so more channels could be crammed into the broadcast spectrum. Its development was outsourced to the Fraunhofer Gesellschaft Research Institute in Germany. Today, Layer-3 is already in use in various telecommunication networks (ISDN, satellite links) and speech announcement systems.

Using MP3 compression, digital music takes up one-twelfth of the original space without any discernible loss in audio quality, and therefore, becomes viable for Internet download. For example, a five-minute song uncompressed would take about 50 megabytes in the original format but when applying MP3 compression, the size reduces to approximately 4 megabytes. Therefore, downloading a song would only take a few minutes even on a 28.8 modem.

In order to record and listen to information using this format you need an encoder and a decoder. The encoder analyses and compresses the data by removing the irrelevant and the redundant parts of the signal (parts of the sound that we do not hear). The player or decoder reads this streamlined file and converts it back into audio data. An MP3 file can be broken up into pieces, and each piece is still playable which means that MP3 files can be made to stream across the net real-time (assuming the speed of the Internet connection is compatible).

The Future of the Standard

For each Layer, the standard specifies the bitstream format and the decoder. It does not specify the encoder to allow for future improvements like the MPEG-2 AAC. MPEG-2 Advanced Audio Coding is based on the MPEG standard and represents the current state-of-the-art in audio coding. It is able to include up to 48 audio channels, 15 low frequency enhancement channels, and 15 embedded data streams and has multi-language capability. It also offers files half the size of MP3 with the same quality.

The MPEG group continues to control the standard and keeps it widely accepted by inviting major companies like AT&T, Dolby, the Fraunhofer Institute, Lucent Technologies, Sony and others to contribute to the development of new generations of algorithms. Currently, these companies are holding several meetings and seminars concerning the future standard, MPEG-7.

Participation in setting the standard can be very important and profitable. For example, the recognition that the Franhuser Institute got from developing the first generation of MPEG enables them to licenses a proprietary algorithm for compression (used by most professional products) for $70,000. However the standard is open and free to anyone who wants to implement it.

3. Analysis

The Music Industry

Music is one the most complex and profitable industries. With an estimated $3 billion profit in 1998, high entry costs, and economies of scale, it might not seem the ideal industry for a small entrepreneur with few connections. Authors (of music and lyrics), producers, studios, agents, manufacturers, distributors, graphic artists, engineers, lawyers and touring agencies are just some of the elements involved that want a piece of the pie. However, with all these people involved, only the top 15 percent of the music industry makes money, while the other 85 percent loses money. In fact six major companies dominate the music industry, largely controlling distribution and marketing channels (Bertelsmann, EMI-Capitol, Universal, PolyGram, Sony Music, and Warner Music). Sony and Warner together accounted for 36% of the US market sales last year. These companies either intentionally or unintentionally control distribution and marketing channels (such as radio) making it difficult for smaller labels to survive.

An article published by Forbes shows how the music industry is the quintessential illustration of the middleman. Less then $1 on average of a $16 CD makes it back to the artist. A special issue of Guitar World (July 1996) profiled a hypothetical band, which sold 500,000 copies of an album. Their share was $78,900--less than $.16 cents per CD.

Disintermediation and the Restructuring of the Value Chain

The explosive growth of the PC and the Internet penetration to non-professional users changed the status quo of this industry. The advances in speed in the communications infrastructure have made information more accessible and created some of the most compelling strategic decision points. Some of these decisions will eventually restructure the value chain and reconfigure the way value is created across a broad spectrum of industries.

One of the implications of this restructuring is the disintermediation of information industries (we should probably say re-intermediation). The Internet provides an inexpensive and immediate way to distribute information goods and to create new ways of adding value to the final consumer.

Unfortunately, with such high profits and so many intermediaries involved, the industry has little motivation to change. Until innovative companies start taking advantage of this new distribution medium or piracy begins to substantially eat into that profit, there will be no incentive to risk changing the way the industry works now.

The major music companies are aware of the possibilities and technologies, but are waiting to embrace a digital system, which they believe will protect the current retail model and will not drastically displace their existing business. Security concerns and reluctance to upset the retail channel are the justifications the major labels have for not embracing commercial downloads of music. However, by waiting they risk missing an opportunity similar to the one missed by film studios that resisted VCRs only to lose valuable distribution to companies like Blockbuster. One provocative quote was from Tom McPartland, CEO of TCI Music saying, "The major labels have taken their heads out of the sand, but still have their feet in concrete." An example of the forces involved was outlined in a recent Business Week article which referred to the Capitol Records attempt to sell a Duran Duran single on the net for $.99 cents last year. The article claimed it was a "nightmare" as retailers revolted and the piracy concerns dominated the ensuing discussions.

One of the companies that started breaking this pattern is AT&T's a2b. This wholly owned subsidiary of AT&T uses the MPEG AAC algorithm that AT&T helped to develop to deliver the highest quality sound available for digital music distribution. The a2b music platform is based on three core technologies from AT&T Labs: AT&T proprietary compression algorithms that deliver music over the Internet at CD-quality; the CryptoLib Security Library, which encrypts compressed music for secure transmission via the Internet; and PolicyMaker, an electronic licensing system which controls how music is distributed and used across the network. Starting in November of 1997, a2b music was the first to promote a major label artist (RCA's The Verve Pipe) through both online and traditional outlets and this might be one of the steps necessary to break the inertia of the industry.

Why is MP3 Winning the Standard War?

In our opinion there are a few reasons why MP3 is being increasingly adopted as a de facto standard:

Reputation of the companies involved. These companies are known not only for their expertise in the technical, musical and marketing fields, but they also are the ‘influential buyers’needed to get the industry attention and to get them to adopt this technology. Selecting this powerful group of strategic partners was a wise choice and should create the critical mass necessary to get the standard adopted.

Availability of the standard. – Although the MP3 standard is controlled by ISO, any company can use it in its products for free (no royalties involved). This has been a critical factor for the creation and dissemination of MPEG tools (encoders and decoders), and many of them (like WinAmp, WinDac and Mp3 compressor) are available for free.

Network effects on the supply and demand sides. –An increasing number of companies are implementing products based on MP3. Multimedia companies like Macromedia (Shockwave), Telos (Audioactive), museArc and many game developers are incorporating Layer-3 into their audio products. Even Microsoft has recently awakened to the possibilities of streaming compression/decompression algorithms (codecs), including Layer-3. With this industry support for the standard, there are also an increasing number of customers that are starting to create their own MP3 music libraries. This availability of both software and hardware and a growing installed base has caused users, by positive feedback effects, to find the adoption of the standard worthwhile.

Double lock-in. Once using a standard for encoded information, there is a considerable switching cost to move to another standard and this means that both the customer and the music company are locked in this format.

Intellectual Property Issues

While the Internet provides an excellent vehicle for mass customized distribution of music, it also opens doors to easy piracy. The commoditization of digital recording tools like CD-R started to bring down the marginal cost of digital media. A few years ago a CD-R was available only to professionals for prices starting at $6000 with media at $50. Today a CD-R costs around $200 and and the media $2. The Internet lowered these costs and if the costs associated with download time and storage are excluded, the marginal cost of copying a piece of music is zero.

It is not difficult to see that this started a holy war between the recording industry and thousands of pirates over the issue of MP3 encoding, usage, and distribution. The latest craze on the World Wide Web, IRC, FTP, and Hotline, is to download and/or trade copy-written MP3 songs or albums, entirely for free. The number of these trading sites grows daily. There are MP3 search engines that let you select a song name or artist, then direct you to the corresponding Web site or FTP archive. The media also helped to project the standard by publishing numerous articles and debates about MP3 issues in high circulation publications like Business Week, Forbes, Wall Street Journal and CNN.

Playing music on your computer may not sound like a threat to record companies, but if you take into account that most computers have multimedia capabilities, and that many people work in front of a computer for extended periods of time, this becomes a major issue for record companies. Because of this, music labels have taken a stand by sending threatening letters to Webmasters of sites containing pirated MP3 material demanding immediate closure of their sites and in some cases, they have taken MP3 pirates to court and won.

The entity responsible for protecting the interests of the recording industry is the RIAA (Recording Industry Association of America). Supporting one side of the argument RIAA considers MP3 copyrights infringement a very serious crime that threatens the recording industry. "Downloading an MP3 is no different than walking into a record store, putting a CD in your pocket, and walking out without paying." The RIAA is one of the major supporters for the National Information Infrastructure (NII) bill now before Congress, that asks for support for a developing a global copyright management system that encodes copyright information and buries it in recorded music, using techniques that prevent it from being stripped. Such a system will allow authorities to precisely identify music no matter where or how it is stored. More importantly, it can be used to determine a customer's "privileges" for using a given piece of electronically obtained recorded music. For example, coded information might allow a user to hear a piece of recorded music just once for one fee, while allowing another user to store the piece indefinitely and listen to it repeatedly for another fee.

The "MP3 evangelists" support the other side of the argument, charging the music industry for over-inflating the price of retail CDs and for not creating alternatives. Another valid argument is that disintermediation is an excellent way to level the field by giving the chance of making a new artist's work known at a low cost.

Yet another important issue raised in the debates is the lack of bundling alternatives. Many users don’t want to buy a CD with 10 songs from which they want just one. They prefer to pay a premium for having just the songs they like and the Internet is a great way to achieve that.

In response to this, major consumer electronics companies want to prevent digital pirating of music and movies on the Internet. Intel, Sony, Hitachi, Matsushita and Toshiba just announced a joint encryption standard aimed at protecting digitally distributed music and videos.

4. Conclusions and Recommendations

Any recommendation to the music industry should focus on how to maximize the value of the intellectual property rights and not the protection itself. The music industry needs to understand that the Internet is restructuring the value chain and creating opportunities for new middleman, info-brokers, which facilitate commerce and services electronically. Some companies use the Internet to develop new markets, change the nature of customer interactions and provide previously unarticulated benefits. However, the main consequence of this restructuring is the disintermediation. The companies whose business models are built around old assumptions will find that the Internet puts their shareholder value at risk. At the same time, the same Internet provides opportunities to create new shareholder value for those who can develop new businesses that embrace the new realities.

Our recommendations are:

Continue the effort to protect the intellectual property of the artists. Although the changes in the information technology occur at faster pace than the changes in the legal environment, it is important to quickly pass this turmoil phase where there are no clear rules (or enforcement of those rules) in order to avoid the stagnation of innovation. The RIAA efforts to pass the NII bill and the strategic alliances to develop encryption methods that make copy piracy difficult are good examples of these efforts.

Consolidate the effort for high quality standard definition and implementation. The MPEG/ISO committee includes today members designated by national governments as the leaders in research and implementation of these techniques. It is important to emphasize the need to assure the high quality of these members because network effects make it very difficult to overcome even a bad standard once it is adopted.

Use value-pricing techniques to create new markets and segment existing ones. The Internet and its interaction bring new possibilities for companies to price discriminate in order to extract consumer surplus. An example of what can be done with differential pricing is to set 2 different prices for a low quality (mono or AM quality) version and a normal high quality version of a song (and including an upgrade path). Consumers will self-select according to their value and this also creates the chance of sampling from a larger quantity of music, which will stimulate demand. Also use promotional techniques such as lowering the price dynamically to get rid of a low turnover inventory or give away certain tracks in order to stimulate demand for other works of an artist.

Differentiate and exploit the value of the information. The web-based evolution of the music industry will bring the issue of how to avoid commoditization which will bring prices to marginal cost (zero).The key is to explore differentiation by using the value of information to add other products or services that are relevant to your buyer. For example a company might offer for download a CD cover file or a screen saver from the artist, it can offer a bonus track from another artist that you never heard of but you probably like (because of your browsing patterns). It can even offer you a customized, low quality (very small size), 1000 song sampler from which you will probably buy many songs. Another differentiating dimension is speed. For example some companies are already offering on-line recordings before they are available in stores. There are many ways companies can add value to their services to avoid commoditization. This is also key to building a reputation, which is ultimately a source of competitive advantage.

Original text by Pedro Ferreira, Jonathan Martin, Jun Yang, Han-Shen Yuan