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
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