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The Disruptive Nature of Digitization:

The Case of the Recorded Music Industry

François Moreau

GREG / Laboratoire d6économétrie (EA CNRS n° 2430) Conservatoire National des Arts et Métiers Case 153 H 2 rue Conté H 75003 Paris H France francois.moreau@cnam.fr

This version : january 2009

Abstract. This article draws on the theory of disruption to analyze the impact of digital technology on the recorded music industry. It shows that: (i) digitization matches the characteristics of disruptive innovation as described in the literature. Thus, established firms initially paid little heed to an innovation leading to a product (digital music files) that is cheaper and lower quality than their existing product (CDs) and ill suited to their mainstream consumers. (ii) The reaction of these firms has been typical of the behavior adopted by firms facing disruptive innovation. Confronted with an innovation that they see as more of a threat than an opportunity, incumbent firms have found it extremely difficult to accept the need for a radical rethinking of their business model, which could, it is true, significantly diminish their position in the industry6s value chain.

KeyWords: Recorded Music Industry; Digitization; Disruption

. Introduction

The CD industry is an oligopoly with a competitive fringe. Four companies, often referred to as the ]majors_, (Universal Music, Warner Music, Sony BMG and EMI) produce three quarters of world turnover, while a cloud of independent producers orbits round them. This market structure is the result of important economies of scale at two key stages in the value chain: distribution and promotion. Supplying a large number of wholesalers and retailers with CDs requires the settingup of a huge distribution network, the source of substantial fixed costs that only the majors can afford. So distributors, who control an essential link in the access to end consumers, can extract a rent from this activity by imposing their tariffs and conditions on the independent labels, the vast majority of which are now distributed by the majors. Thus, the majors can charge up to 40% of the wholesale price for the distribution of a CD. What is more, distribution costs must be paid even in the event of commercial failure (Passman, 2003). Vertical integration towards distribution then represents a


source of economy of transaction costs and an instrument for excluding competitors or raising their costs (Rothenbuhler and Streck, 1998). The activity of promotion also generates economies of scale. Most marketing is carried out when an album is released. Further, the dynamics of success is cumulative. Growth in sales, intensification of radio and television broadcasts and word of mouth amongst consumers are mutual causes and effects. High initial expenditure on marketing allows to reduce the variable costs of promotion considerably, with a proportional reduction in promotion costs per unit sold, thus creating obvious economies of scale in marketing. Furthermore, promotional opportunities are rare in comparison to the number of new products that need to be promoted (Bourreau and Gensollen, 2006). The majors therefore seek to pre empt these promotional channels, particularly the two main ones that are radio and television. The dominant economic model of the majors is the ]star system_, in which spending on the search for new talent is sacrificed to promotion, and the aim is to concentrate demand on a few stars, to maximize economies of scale. A small number of successes is then more than enough to make up for the losses incurred with the rest of the catalogue. The huge economies of scale achieved at the levels of distribution and promotion therefore constitute an undeniable entry barrier to the recorded music industry (Alexander, 1994a). At the same time, the low cost of recording and producing CDs explains the survival of several hundred small labels, often positioned in niche markets, such as Reggae or Rap during their emergence. Here, the narrowness of the market is compensated for by intimate knowledge of its characteristics, in terms of both demand (consumers6 tastes) and supply (the most talented groups and artists). The distribution of roles between independent and major labels is therefore quite clearly defined (Burnett, 1996; Burke, 1997). The independent labels, with the reputation of treating their artists better, enjoy a competitive advantage in the search for new talents. They play the role of talent scouts. The majors, on the other hand, are considered more capable of managing the careers of stars, thanks to their control over distribution networks and the scale of their marketing resources. Thus, it is common for artists to follow a career path where they start with an independent label and then sign with one of the majors if they meet with commercial success. This organization, relatively stable since the 1970s, has been challenged since the late 1990s by the appearance of digital technology, particularly the emblematic MP3 1 . The possibility of ]dematerializing_ music has led not only to the development of peer to peer networks and the free downloading of digital music files (Napster, then Kazaa, eMule, Bit Torrent, etc.) but also to the emergence of legal platforms for the online sale of music (like Apple6s iTunes Music Store). At present, however, the boom in online sales is not sufficient to compensate for the decline in CD sales. The recorded music industry is in crisis: sales in the US H the biggest market in the world H fell by 29% between 1999 and 2007. On several occasions in the past, admittedly, the industry has succeeded in accommodating discontinuities that could have been disastrous for the leading firms (Huygens et al., 2002): the appearance of radio in the 1920s, rock6n6roll in the 1950s or cassettes in the 1970s 2 . Will the same thing happen in the case of digital technology? It certainly

1 MP3 technology, or more precisely MPEG 1 Layer Three, was developed at the beginning of the 1990s and originally designed for transforming videos into smallsize digital files. It very quickly became apparent that this technology could also be used to compress music, enabling a simple CDRom to contain up to 12 CDs6 worth of music.

2 This last case is particularly interesting in that, like digital technology today, the cassette was initially perceived as a source of piracy. Thus, at the beginning of the 1980s, faced with falling sales of vinyl records, the RIAA was quick to blame blank

tapes, launching a campaign with the slogan ]Home taping is killing music

Copyright Royalty Tribunal had shown that the consumers who copied onto cassettes were also the biggest buyers of

And yet an independent study conducted by the


presents attractive possibilities for the recorded music industry. Firstly, digital technology offers new opportunities for promotion. So, for example, consumer to consumer promotion, much less developed than classic media promotion in the current organization of the recorded music industry, but also much cheaper, could become dominant for online music (Peitz and Waelbroeck, 2005). Secondly, the possibility of distributing music digitally through dedicated platforms or mobile phones considerably reduces the costs incurred by the recording label. However, the recorded music industry can only benefit from this technology at the price of a radical transformation of its business model. The aim of this paper is to demonstrate the validity of this thesis, and to examine the capacity of the four leading firms in the recorded music industry to adapt to this digital revolution without losing their dominant position. To do so, we shall draw on works devoted to technological discontinuities and their consequences on industrial structures. Several authors (Tushman and Anderson, 1986; Utterback, 1994; Christensen and Rosenbloom, 1995; Christensen, 1997, to cite just the pioneers) have shown that technological change can generate modifications in sector hierarchy and lead to the disappearance or take over of previously dominant firms. The article is organized as follows. Section 2 gives an overview of the literature on the theory of disruption. Section 3 shows that digital technology can be considered a disruptive innovation in the recorded music industry. Section 4 explores the appropriateness of the incumbent firms6 response and their capacity to avoid disruption. Section 5 provides a brief conclusion.

2. The theory of disruption

A technological discontinuity is defined as an innovation producing a critical advance (a leap) in the price performance frontier of an industry and a significant change in the form of products or processes (Tushman and Anderson, 1986). Based on case studies in various different industries H cement, microcomputers, (container and flat) glass (Tushman and Anderson, 1986), semiconductor alignment equipment (Henderson and Clark, 1990), etc. H the literature devoted to technological discontinuities has investigated the conditions under which such discontinuities could bring about changes in sector hierarchy (leadership turnover), bringing to light notably the crucial role of radical architectural innovations (Henderson and Clark, 1990) 3 or competency destroying innovations (Tushman and Anderson, 1986) 4 . However, Christensen and Rosenbloom (1995) and Christensen

records. Moreover, between 1980 and 1986, total sales of albums and prerecorded cassettes increased in volume by 13% (Coleman, 2003).

3 For Henderson and Clark (1990), a technological discontinuity can generate a change in the hierarchy of a sector if it is of an architectural nature, that is to say if it leads to a reconfiguration of the relations between the components of a product without actually modifying those components. Such an innovation may then lead to cognitive biases for established firms, because their existing organizational routines do not allow them to identify the technological change taking place. The firm is incapable of reinventing itself, even if it is theoretically in a position to adopt the new technology, because it is focused on what made it successful in the pretransitional environment, and cognitive constraints prevent it from seeking a solution elsewhere (Levitt and March, 1988). Christensen and Rosenbloom (1995), for example, cite the case of RCA and Ampex, which, at the end of the 1970s, had access to all the competencies needed to become leaders in the tape recorder industry, but which were prevented by deeprooted beliefs and unsuitable organizational structures.

4 Tushman and Anderson (1986) draw a distinction between technological changes that strengthen the core competencies of established firms (competency enhancing) and those that make them obsolete (competency destroying). The competencies possessed by the manufacturers of mechanical calculators, for example, (creating precision arithmetical machinery made of cogs, gears, levers, and springs) proved to be of no use whatsoever for producing calculators with electronic components. Such major changes in the know how required, in specific competencies and in production


(1997), studying the industry of the hard disk drive, subject to numerous and frequent changes in sector hierarchy, observed that none of the traditional explanations appeared to be relevant. In the industry of the hard disk drive, incumbent firms have carried out both incremental and radical innovations, architectural innovations and competency destroying innovations. An alternative explanation has been proposed, based on the concept of value network, itself based on the concept of technological paradigm (Dosi, 1982). This has led to a distinction between disruptive innovations, likely to result in leadership turnover to the detriment of the established leaders, and sustaining innovations, which, on the contrary, simply strengthen existing firms, even when they are radical, architectural and competency destroying.

The characterization of disruptive technologies

The value network is defined as the context within which the firm meets consumer demands (Christensen, 1997). In particular, it expresses the needs of the firm6s main consumer group or groups. As a general rule, the more a firm grows and improves its competitiveness in a given value network, by better meeting the needs of the consumers concerned, the less able it becomes to meet needs in other segments of the market. This leads to an atrophy of its capacity and desire to develop new applications, and therefore new value networks. Likewise, if the existing firms become more and more efficient in gathering and processing information about the value networks in which they are active, they will encounter growing difficulties in doing the same with information about other value networks. The key question for an established firm is then to determine whether the new innovation can be exploited within its current value networks, or if other value networks need to be targeted, or even created, to exploit the full potential of this innovation. So incumbent firms are capable of being leaders in all sorts of radical innovations H whether they involve the components or the architecture of the product H from the moment that those innovations meet needs expressed within their value networks, when their importance and applications are obvious. Conversely, incumbent firms are likely to lag behind in the development of technologies, even when they appear intrinsically simple, that meet the needs of consumers within newly emerging value networks. On the basis of works pioneered by Clayton Christensen (Christensen and Rosenbloom, 1995; Christensen, 1997, 2006; Christensen et al., 2001; Christensen and Raynor, 2003) and the critical responses they have provoked H see notably Danneels (2004), Henderson (2006), Govindarajan and Kopalle (2006), Tellis (2006) or Schmidt and Druehl (2008) H we can define a disruptive innovation as follows:

(1) The product resulting from the innovation under performs compared to the existing product, as far as the attributes appreciated by mainstream consumers are concerned. Conversely, innovations targeting the segment of highend consumers, i.e. those who are the most willing to pay, are sustaining, because their impact on the continuity of the current business model of established firms is obvious (Schmidt and Druehl, 2008). Christensen and Raynor (2003) draw a distinction between new market disruption and low end disruption. The former corresponds to innovations that introduce a new dimension of performance and so create a new market for new consumers. The

processes generally generate a profound upheaval in the distribution of control and power to the detriment of established firms, which, prisoners of their tradition, possible sunk costs and internal political constraints, remain faithful to an outmoded technology. Thus, while competency enhancing technological discontinuities are initiated by established firms, it is the new entrants H not constrained by their existing competencies or history H that initiate competency destroying technological discontinuities.


latter correspond to innovations that enable firms to supply a less expensive solution H often in a trade off for reduced performance H targeting customers who do not value the extra features/high performance of the existing product or simply cannot afford it. (2) The product resulting from the innovation is usually simpler, cheaper to produce and sold at a lower price than the existing products 5 , but the new possibilities or characteristics that it offers are not appreciated by mainstream consumers unless it attains a minimum performance level in terms of historical attributes 6 . This is true to such an extent that when the innovation is introduced, the most profitable consumers of the incumbent firms generally do not want to and very often are not able to use the products resulting from the disruptive technology. (3) These products are therefore usually introduced into niche markets, where the new technology can mature and improve in a protected competitive environment. This sort of niche may be either an emerging market or a segment of a mainstream market composed of ]overserved_ consumers receptive to a low cost offer 7 . (4) From points (1), (2) and (3), incumbent firms draw the conclusion that investing in the disruptive technology is not a financially rational decision. Even if the disruptive technology can offer a better unit margin, the small size of the market reduces profit prospects. (5) Over time, the performance of the product of disruptive innovation improves sufficiently, in terms of the attributes valued by mainstream consumers, for these latter to start taking it up. ]Disruptive innovations do not necessarily improve to surpass the performance of the prior technology. They generally do not, and need not [m]. The trajectories of technological progress are parallel. They do not intersect. The salient question is whether the disruptive technology will improve to the point that it becomes good enough to be used in a given tier of the market_ (Christensen, 2006). For Henderson (2006), it is not necessarily the performance of the disruptive technology that improves but consumer preferences that evolve. Many disruptive innovations tend to redefine the pattern of preferences in a market.

A technological problem or a problem in perceiving and understanding demand?

Christensen6s approach to the modification of sector hierarchy differs from previous ones in its focus on the demand side rather than on supply side and technology. Thus, radicality is a technological

5 Schmidt and Druehl (2008) call this the ]fringe market scenario

market scenario_, in which a firm ]initially targets a market segment with needs quite different from the existing market.

This gives the entrant firm the potential to sell the new product at a high price without necessarily breeding an immediate

In this case, the targeted segment corresponds to low end

consumers in the existing market. Traveling salespeople, for example, who were not important customers for fixed telephone operators, were the first to adopt the cell phone. Thus, a disruptive innovation always encroaches from the low end, possibly after first opening up a new fringe market or detached market. We shall not explore the ]detachedmarket scenario_ any further, because it does not match the characteristics of the recorded music industry.

6 For Danneels (2004), for example, in the field of disk drives, once drive capacity exceeded the requirement of a certain market segment, the size of the drive became a basis of competition.

7 This is in line with an observation by Malerba et al. (1999), for whom a competency destroying discontinuity that is not accompanied by a significant extension of the market has no decisive competitive impact. Firstly, established firms are encouraged to invest massively in the new technology, drawing on the profits from their existing products. Secondly, these same firms can use their commercial assets both to protect themselves efficiently and to market new products. A competency destroying discontinuity accompanied by the creation of new market segments, on the contrary, encourages big established firms to ]wait and see_, giving new firms the opportunity to exploit the advantages provided by the position of first mover.

competitive reaction from the firm selling the old product

They also point out another possibility, the ]detached


dimension of innovations, whereas disruptiveness is a market based dimension (Govindarajan and Kopalle, 2006). Likewise, for Adner (2002) and Adner and Zemsky (2005), the structure of demand H combined with technological progress H certainly explains a large part of the phenomenon of disruption. On this point, it is interesting to note that whereas Christensen and Rosenbloom (1995) or Christensen (1997) used the term disruptive technology, more recent works (Christensen and Raynor 2003; Christensen, 2006) prefer the term disruptive innovation. Indeed, the technology in itself is not necessarily disruptive. Many established firms, when faced with disruptive technology, have proved capable of developing prototypes that exploit it, showing that they possess the necessary R&D skills. Where they have failed is in trying to sell the disruptive technology to their regular consumers and in not building up relations with other consumers, hitherto unserved but who appreciate the attributes of this new technology (Danneels, 2002). It is therefore not the technology in itself that causes difficulties for the established firm, but the fact that a disruptive innovation renders obsolete the business model on which the firm has based its development. This explains why an innovation can be disruptive for certain firms but sustaining for others 8 . This thesis that disruption results from incumbent firms concentrating too narrowly on the needs of their existing consumers can be extended to firms focusing on the needs of their value networks in a broader sense. The inability of dominant firms to implement disruptive innovation can also be related to the fact that it would render obsolete the resources and skills not only of its consumers, but also of its suppliers, distributors, ]complementors_ and more widely all the actors in its value chain (Afuah, 2000; Rosenbloom and Christensen, 1994). Moreover, in the face of disruptive innovation, vertical integration constitutes a strategic handicap. When the disruptive nature of an innovation stems from the modification of a product6s value chain, firms that are vertically integrated in the new technology succeed better than those that are not. Likewise, firms that are vertically integrated in the old technology succeed less well than those that are not (Afuah, 2001). Thus, the explanations of leadership turnover in terms of the theory of disruption go beyond a lack of strategic vision among managers (Tellis, 2006) or the cognitive, political or organizational obstacles they face (Henderson, 2006). The management of a disruptive innovation is complex, because its value and potential applications are highly uncertain in terms of the usual criteria applied by the established firm. It is tricky for an incumbent firm to dedicate resources to innovations that do not meet the needs of today6s main consumers. Established firms are the victims of rational inertia (Robertson and Langlois, 1994).

3. The disruptive nature of digital technology in the recorded music industry

Digital technology impacts on several key steps in the value chain of the recorded music industry. Firstly, it drastically reduces production and distribution costs. In the case of online music, these costs almost completely disappear, whence a reduction of up to 50% in the retail price (Vogel, 2001).

8 ]While an innovation may be disruptive to one incumbent, it could prove sustaining to another. For example, while Internet retailing could be deemed as highly disruptive relative to a personal service oriented bricks and mortar retailer, it was not disruptive to catalog retailers. Catalog retailers6 established processes facilitated using the Internet as a complementary new channel and their values allowed them to prioritize and allocate resources to its development. Thus, if a technology is disruptive relative to a company6s business model, we would expect the firm to be paralyzed; if the

(Christensen et

technology is sustaining relative to a company6s business model, we would expect the firm to continue on al., 2001).


Moreover, digital distribution provides the opportunity for world wide diffusion to any and every artist, whether or not they have a contract with a major company. Secondly, digital technology radically changes the mode of promotion of artists, their possibilities of getting themselves known to the public. Alongside the traditional model of centralized promotion, based on the media, we are witnessing the gradual emergence of an innovative model of decentralized promotion and recommendation, based on online wordofmouth between consumers and founded on a community oriented approach (Chevalier and Mayzlin, 2006). Here again, the potential reduction in costs is far from negligible, as promotion accounts for a large share of CD costs: as much as 50% of the sale price, net of taxes and retailers6 margins (Peitz and Waelbroeck, 2005). In addition, social networks like MySpace or Facebook enable obscure artists to become known throughout the world, whereas their reputations would probably never have spread beyond national frontiers in the physical world, for lack of sufficient investment in promotion and distribution. Digital technology therefore constitutes a radical innovation for the recorded music industry and is indeed competency destroying in the sense of Tushman and Anderson, because control of distribution and promotion was one of the key elements in the majors6 strategy, enabling them to erect powerful entry barriers to the market (see above). Nevertheless, as Christensen (1997) pointed out, this is not sufficient to make the innovation of digital technology a source of leadership turnover. The majors knew about this technology very early on in its development. The German Fraunhofer laboratories presented the MP3 format to the major record labels, as early as the mid1990s, but the majors were quite simply not interested. Moreover, the transition to digital distribution did not present any technological problem. In December 1999, for example, Sony was already proposing a service of downloading of online music, limited to its own catalogue. Likewise, the major companies were quick to use the new tools of online promotion, for example to test the success of new artists or songs before launching a massive promotion in the traditional media. Thus, in the music industry, and in keeping with the theory of disruption (see above), the problem that digital technology posed for established firms was not of a technological nature H the competencedestroying aspect could be overcome H but rather, as we shall see, related to a profound challenge to the industry6s business model.

Is digital technology disruptive in the recorded music industry?

Let us return to the five criteria of disruptive innovation defined in section 2. (1) Firstly, from the established firms6 point of view, digital technology under performs compared to the traditional CD. The absence of sleeves, booklets, lyrics, and photos and the inferior quality of MP3 files make the digital product undeniably of a lower quality than the CD. (2) Secondly, digital files are much easier and cheaper to produce than CDs, and are offered for sale to the consumer at a much lower price. This price varies from zero, when the digital files comprising an album are pirated, to $9.99 when they are bought from an online site (or less in the case of certain subscriptions). Initially, however, digital technology was considered a low end innovation, unsuitable for the mainstream market. Indeed, in 2001, less than 10% of American households had broadband internet access. Digital files were therefore only of interest to a small segment of the market: technophiles already equipped with broadband and MP3 players exchanging files on P2P networks (notably students). As purchases of recorded music are positively correlated with income (Liebowitz, 2004), the potential public for digital music was constituted rather of low end consumers of the CD market. Indeed, when MP3 and with it the exchange of files via P2P networks became widespread at the end of the 1990s, CD sales were still growing. Thus, for the


majors, digital files were simply an instrument of piracy through P2P networks, and not the support for a real market of online sales. (3) The development of online music has been favored by the existence of niche markets. One notable example is that of new artists putting their music online for free as a sort of ]loss leader_ to increase their reputation and possibly get signed up or to intensify their live activity (this was, on its creation in 1998, the objective of the web site MP3.com). Another niche market is composed of consumers who are ]over served_ by the mainstream market. From 2003, the strong growth in online sales of singles on iTunes MusicStore revealed the existence of consumer needs that were not satisfied by the majors6 strategy of favoring album sales. Thus, in the United States in 2007, singles represented 95% of units sold online, the figure being 1% for physical sales (source: RIAA). It is true that online, a single costs ten times less than an album, whereas the ratio is only one to six for physical CDs 9 . According to Coleman (2003, p. 175), ]CDs have stretched the album concept out of shape. In short, CDs hold too many songs. [m] Simply put, seventy four minutes and forty two seconds are far better suited to a symphony than a collection of popular songs (4) So at the end of the 1990s, the recorded music industry, and particularly the majors, concluded that it was not financially rational to invest wholeheartedly in online music. Even if the unit margin can be higher for the sale of a song in the form of a digital file than in CD form 10 , the fact of only selling one or two songs at 99 cents rather than an album at about $15 was clearly not financially attractive. In addition, the majors were afraid of encouraging piracy by putting digital files on line (Krasilovsky and Shemel, 2003). So although many labels were positioned on the internet at the end of the 1990s, they preferred to offer low quality samples online rather than MP3 files that might compete with their own CDs (Easley et al., 2003). (5) However, the fast growth in broadband internet access has transformed online music from a niche market to a market of interest to mainstream consumers. In the United States, for example, the proportion of households with broadband internet access at home reached 55% in 2008. In parallel, the market share of online music (via internet or mobile phones) as a percentage of total sales of recorded music rose from 1.5% in 2004 to 23% in 2007 (source: RIAA).

A radical challenge to the traditional business model

As pointed out above, the disruptive character of an innovation derives from the challenge it represents to the usual business model. Thus, in the past, the majors survived the appearance of the pre recorded cassette and then the CD without harm, because these were sustaining innovations. There was no challenge to the business model: the distribution network remained unchanged, promotion through the media remained essential, etc. Digital technology, on the other hand, calls for a profound rethinking of the business model of the recorded music industry. Digital content possesses the two characteristics of a pure collective good (Samuelson, 1954):

nonrivalry and non excludability. The possibility of reproducing a digital file at almost zero cost does away with the property of rivalry possessed by the physical support. As for excludability, although it can still theoretically be achieved ex post by the strict application of intellectual property rights

9 The calculations are based on data provided by the RIAA for physical CDs (taking into account the fact that a single contains two songs) and on the base price of iTunes Music Store for online music ($0.99 per song compared with $9.99 usually for an album). 10 With a payment of about 70 cents out of the 99 cents, the margin paid to record labels by iTunes Music Store is higher than that obtained from the sale of physical CDs.


and/or ex ante by technological systems of protection (Digital Rights Management H DRM), in practice the sheer scale of traffic on peerto peer networks shows that digital content potentially possesses the property of non excludability. In these conditions, unlimited access with marginal gratuity and flat rate payments proves to be the model that maximizes the collective surplus (ensuring that the marginal selling price is equal to the marginal cost, i.e. zero). Furthermore, this mode of selling is akin to bundling, which turns out to be the most appropriate model for selling information goods in general (Bakos and Brynjolfsson, 1999) and online music in particular (Zhu and MacQuarrie, 2003). Not only does bundling enable firms to increase their profits, by smoothing the willingness to pay of consumers with heterogeneous preferences and so capturing more of their surplus, but it can also help to reduce the number of individuals excluded from consumption, compared to separate sales, and so augment collective welfare. Thus, other strategies can be envisaged to valorize content in a digital environment (Varian, 2005; Liebowitz and Watt, 2006; Curien and Moreau, 2007; Bourreau et al., 2008), besides the direct protection of digital content by means of DRM and legal tools, the efficacy of which appears to be relative, at the very best (Bhattacharjee et al., 2006; Maffioletti and Ramello, 2004; Liebowitz and Watt, 2006). In particular, it is possible to exploit a shift in value from content to linked consumptions. This strategy of shifting value may focus, to begin with, on rival goods that are useful, or even essential, for wholly satisfying consumption. The main rival goods are broadband internet access and different forms of players (digital players, mobile phones, etc.) 11 . Using advertising revenue to finance the broadcasting of content (along the lines of the television model) is another means of shifting value from content. A third strategy consists in shifting value onto meta information. A digital music service with unlimited access is all the more appreciated by consumers when it offers the means to increase the utility that can be derived from this abundance. Otherwise, by generating a situation of overchoice or scarcity of attention among consumers (Simon, 1971), an increase in supply can paradoxically result in a fall in consumption (see, for example, Gourville and Soman, 2005).

4. The recorded music industryIs reaction to this potential disruption.

The potentially disruptive character of digital technology provoked a =wait andsee? attitude among the majors

Faced with the appearance of a potentially disruptive innovation, the first reaction of established firms may be to try to stop the innovation from penetrating the market (Christensen et al., 2001). And this is indeed what the majors first sought to do, by refusing to open up their catalogues to the new players of digital distribution, developing tools of protection against copying and taking legal action to discourage the exchange of musical files on peerto peer networks. Thus, before even proposing legal downloading, the majors won their legal battles against the two emblematic sites of free downloading: MP3.com and Napster. These two were both bought out by majors after their legal misfortunes, respectively by BMG at the end of 2000 and by Universal Music in May 2001. Subsequently, they were neither developed nor valorized. In reality, the majors have

11 But we could also cite ancillary products and live shows in the case of the music industry. Many record labels consider concerts as a means of growth to make up for the decline in record sales. On this question, see Gayer and Shy (2006) or Curien and Moreau (2005) for a theoretical approach and IFPI (2008) for an empirical view.


been more than reluctant H unlike the independent labels H to deal with firms whose business model is based on a rationale of unlimited access or bundling 12 . This reluctance should be compared with their swiftness in signing with Apple, in 2003, to make their music available on iTunes Music Store (which incidentally, unlike the above sites, did not initially include the catalogues of the independent labels). And indeed the form of pricing practiced on iTunes Music Store H $0.99 per song or $9.99 per album H was no different from the traditional business model of the recorded music industry, where

value is captured on a support that is rival (initially, the possibilities of copying or transferring the files bought were restricted). This unwillingness of the majors to ]ride the wave_ of the disruptive technology is consistent with the theoretical analyses. Of course, the inertia of the major record labels, faced with the emergence of digital music, could be interpreted as the result of strategic myopia. In December 1995, for example, Nick Garnett, directorgeneral of the IFPI (International Federation of the Phonographic Industry), declared in Billboard magazine: ]Nobody is expecting the impact from the Internet over the next 10 years to be as great as the one we have had over the last

10 years. The Internet has a very long way to go before it has an impact like that of CD

interpretation is contradicted by the relatively innovative nature of Sony6s experiments in 1999 (see

section 3) and of MusicNet and Press Play in 2001. At the end of 2001, two online music platforms were opened at the same time: MusicNet, launched by EMI, AOL/Time Warner and BMG in collaboration with RealNetworks, and Press Play, created by Sony and Universal with Microsoft. So the majors have indeed tried to ride the wave of the disruptive innovation, to use the term coined by Christensen et al. (2001), but without really giving themselves the means to succeed, and neither of these platforms has managed to impose itself 13 . Like Christensen (1997), who pointed out that a disruptive technology can cause a ]good and well managed company to fail_, one may wonder whether the majors6 weak reaction to the development of digital technology should not, therefore, be ascribed to the fact that they considered it as a threat rather than an opportunity (Challis, 2005). When a disruption is seen as a threat, managers and firms tend to respond not just aggressively, but also rigidly (Gilbert and Bower, 2002):

But this

by trying to defend the existing business model (e.g. the majors6 preference for iTunes), by committing resources heavily and hastily instead of investing them with prudence to avoid heading irreversibly down the wrong track (e.g. the joint failure of MusicNet and Press Play, largely because

12 Wippit, for example, launched in 2000 in the United Kingdom, was a subscription service (£30 per year) for file exchange via peerto peer networks which paid back a share of receipts to rights holders. To begin with, only the independent labels were prepared to make their catalogues available to Wippit. And when the majors did eventually join them in 2004, they insisted that songs from their catalogues should be sold individually, thus completely perverting the whole principle of Wippit. Likewise, Playlouder, launched in 2003, also had a catalogue composed solely of independents and a business model based on a monthly subscription of £18 for a bundle combining an internet access service with a system of peerto peer file exchange and payment of royalties. Of the majors, only EMI and Sony, in 2005, authorized Playlouder to use their music catalogues. Another example, eMusic, launched in 1998, has become the biggest seller of online music for the independent labels, and the second biggest for all record labels taken together (behind iTunes). It operates on the principle of a monthly subscription of up to $20.99 for 75 songs ($0.28 per song, i.e. much lower than the $0.99 charged by iTunes). The majors have never agreed to make their content available on eMusic.

13 The subscription charged, about $10 per month, proved to be too expensive in relation to the very mediocre quality of the offer: restrictions on the use of downloaded music, especially the impossibility of burning the songs onto CDs or transferring them onto digital players. In addition, the absence of any cooperative strategy among the established firms contributed to this double failure. MusicNet and Press Play were unattractive because their catalogues were so incomplete. And yet standardized formats H it should be possible to play a song on any type of player, whatever the platform it was bought from H is an indispensable condition for the development of online music, as various examples from the history of the record industry demonstrate (Coleman, 2003).


of the failure to adopt a cooperative solution), and by strengthening the authority of the existing organization, rather than giving independence to a new entity. A new organization makes it much easier to divert resources from dominant consumer segments and to dedicate them to niche markets of uncertain potential. Moreover, adapting the size of the organization to the size of the new market

makes it possible to motivate employees and managers about projects that would appear to be minor when judged by the criteria of the established firm (Danneels, 2004). Finally, an independent firm makes it much easier to implement a business model that may end up cannibalizing the assets and markets of the established firm (Tellis, 2006). Now, at the end of the 1990s, the majors had several reasons for finding the digital market unattractive. They did not want to nurture a business that they considered to be more favorable to the hardware and ISP industries than to themselves, with lower profit margins 14 and with high risks of cannibalization of physical sales (physical sales only started to fall in 2000 in the United States, and even later in many OECD countries). But above all, the digital revolution in the record industry called into question the whole value chain and vertical organization of the industry. According to the OECD (2005): ]The dominance by the music majors of the physical distribution system and the promotional

value chain has significantly delayed a move to digital distribution

The majors clearly feared an

organizational shake up that would result in the under use of their distribution network and harm their traditional retailers (Krasilovsky and Shemel, 2003). This leads us back to Afuah6s argument (2001) that vertically integrated firms have greater difficulty in adapting to an innovation that radically transforms the value chain. Even for those who considered digital distribution to be the future of the record industry, the objective was clearly to minimize the upheaval. So even if the majors knew that ]at some time in the future, recorded music will be widely available online [ ] [their] challenge, in terms of developing rights for producers, is how to get from here to there, with an industry intact Thus, the dominant models of fee charging online music platforms were born out of the record industry6s desire to integrate digital technology into its traditional business model, instead of adapting this latter to the digital revolution.


Towards a modification of the sector hierarchy in the recorded music industry?

The majors could have been the pioneers, and above all the leaders, in online music for the online distribution of music has all the attributes of a winner take all activity, as demonstrated by the hegemonic market share held by Apple in the United States in this market. They could have held onto their leadership in physical distribution at the same time. In this way, they could have made the technological leap and used the financial resources provided by their dominant position in the old technology to overcome their handicap in competencies, as suggested by Malerba et al. (1999). But their inertia left the field open for other actors to take control of distribution (Apple and the mobile telephone operators, essentially). If music becomes a loss leader used to further the sales of related rival goods or services (digital players, mobile phones handsets, advertising, broadband internet access, mobile phone subscriptions, etc.), we can observe the actors in these markets moving up the value chain. The main problem for the majors is almost certainly not that the others will supplant

14 As a percentage, the majors6 share of the receipts from online music is high (about 70% of the 99 cents for the publisher who then pays the label and the artist), but it remains lower in value when compared to physical sales.

15 In IFPI in 1995, For the Record, p. 1, quoted by Burnett (1996) and underlined by us.


them in their core business H producing music or try to take control 16 , but that bargaining over prices will be tougher than it is in the physical world. On its own, a corporation like Apple, for example, has a turnover roughly equivalent to the worldwide recorded music industry. Of course, the majors are beginning to envisage a major recasting of their standard business model. Thus, the International Federation of the Phonographic Industry recognizes that ]the potential for subscription models is enormous_ (IFPI, 2008). Similarly, the majors are at last favoring H by agreeing to open up their catalogues of rights H the development of a ]new subscription model based on the concept of tbundling6 music with other services or devices H be it an ISP subscription, a mobile phone or a portable player. While the music comes virtually tfree6 to consumers under this model, record companies and artists get paid out of the sale of services or devices_ (IFPI, 2008). Finally, 2008 marked the beginning of the abandonment of DRM, solving the problem of interoperability between the different digital music services and playing systems (computer, mobile phone, digital player). And yet this has been eMusic6s model from the very beginning! (see note 12). The development of decentralized promotion, notably by electronic word ofmouth, in place of promotion by the classic media (radio and television), represents another threat to the leadership of the majors. Talent spotting, rather than control of channels of promotion, will once again become the key competency of record labels. According to the Long Tail theory (Anderson 2006), the fall in production and storage costs leads to an increase in the number of different items supplied to consumers, thus extending the tail of the very asymmetrical distribution of sales by item. And then the greater possibilities offered by decentralized promotion and online distribution for discovering and accessing niche products make the tail fatter, to the detriment of star products 17 . This then disrupts the traditional complementarity between innovative SMEs and big companies capable of transforming small emerging markets into large markets of mass consumption a complementarity observed both in recorded music and in many other industries (Markides and Geroski, 2005) 18 . With the undermining of centralized promotion and the disappearance of physical distribution, both sources of high entry barriers to the industry, the small firms no longer need the big ones. Thus, the Long Tail model seems to be made to measure for the independent labels and their talent spotting skills rather than the majors, who have based their domination on centralized promotion and control of physical distribution networks. In France, for example, between 2003 and 2008, the market share of independent labels in the recorded music market grew by 9 percent 19 , even though several important independent labels were bought by one of the majors during the same period. Even the

16 Before launching iTunes, however, and faced with the majors6 reluctance to accept its pricing model (they considered that $0.99 per song was too cheap), Apple had envisaged acquiring one of the majors to ensure it possessed the critical mass of available songs at the moment of launching the platform; it had even considered buying Universal Music for 5 to 6 billion dollars.

17 The idea that digital technology favors the entry of new artists and their sales, to the detriment of established artists, has been empirically verified by Gopal et al. (2006). Looking at artists entering the top 200 in the United States since 1991, they show that online music tends to erode the star system: for the stars, already known to the public, downloading very probably follows a rationale of substitution, detrimental to record sales; for less well known artists, on the contrary, downloading stems from a rationale of sampling (Peitz and Waelbroeck, 2006).

18 Markides and Geroski (2005) argue that instead of devoting precious resources and managerial talent to growing their own radically new business inside, established firms ]should aim to create, sustain, and nurture a network of feeder firmsv of young, entrepreneurial firms busy colonizing new niches. [m] Then, when it is time to consolidate the market, it could build a new massmarket business on the platform these feeder firms have provided. Since the younger firms do not have the resources, power, marketing, and distribution to scale up their creations, they should, in principle, be happy to subcontract this activity to the bigger firms, subject to a fair division of the spoils

19 Source: Observatoire de la Musique.


stars appear to be able to do without the majors. The British group Radiohead, for example, produced their last album themselves and made it available for digital download for whatever price each person chose to pay. The album was then released in CD format, no longer with their habitual major record label (EMI), but with an independent one (XL). Well known artists can also use their celebrity to help promote new or unknown performers in place of the record label (Halonen Akatwijuka and Regner, 2004). For Huygens et al. (2002), the majors have always proved to be capable of adapting ]by

shaking off old habits and routines, and renewing their search for novel capabilities through radical processes of organizational change, eventually resulting in new organization forms and business

Nevertheless, the two main crises of the past show that this organizational change has

often required a modification in the control of the majors. Record sales fell for the first time in the 1920s. According to the industry, this was due to the boom in the broadcasting of free music on the radio. This crisis led to the disappearance of many small firms and the takeover of the historic players by radio corporations (Victor by RCA and Columbia by CBS). Later, in the 1950s, the majors of the time (Columbia, Decca, RCA Victor and Capitol) were slow to catch on to the emerging market of rock6n6roll, and their market share in the US collapsed from 75% in 1955 to 25% in 1962 (Alexander, 1994b). When they eventually realized that rock6n6roll was more than just a passing craze, they reorganized and adapted their strategy; the importance of discovering and developing new talents

was recognized, leading to the creation of specialized departments (Peterson and Berger, 1975). However, although this reorganization was successful for Columbia and Capitol, it was a failure for both RCA, which fell from first to tenth place among US record labels, and Decca, despite having been one of the pioneers of the star system. Only the purchase of these two companies, by Bertelsmann and Matsushita respectively, enabled them to re establish their competitive position (Huygens et al., 2002). So, as in the past episodes of turbulence in the record industry, the question today is whether the established firms can re organize on their own, or will they need the exogenous shock of a takeover? More fundamentally, the issue is one of intrinsic contradiction between the business model of online music focused on talent spotting, and the current size and vertical integration of the majors.


5. Conclusion

As long as innovations are sustaining and do not challenge the standard business model, established firms often succeed in maintaining their advantage, because the innovations are financially attractive to them and they are therefore encouraged to adopt them. This article has shown that digital technology can, on the contrary, be considered disruptive in the recorded music industry, because it calls for profound changes in the dominant business model, changes that the established firms H the majors H have been and still are reluctant to accept. In the predigital world, the majors derived their competitive advantage from their control over the phases of distribution and promotion. A large number of artists were produced, but only a handful had any real chance of being widely promoted and distributed to consumers. With the arrival of digital music, we can witness a change in the surplus created in the music industry. Prices are falling, and the consumer surplus gains are probably being redistributed towards ancillary products of recorded music (concerts, merchandise, etc.) and above all hardware manufacturers (digital


players, mobile phones, etc.) and access providers (mobile phone operators, ISP). Furthermore, the position of the majors is weakening in relation to that of the independents, in several ways. Entry barriers to distribution, particularly international distribution, have disappeared. With digital music, the majors no longer control distribution. On the contrary, it is essentially dominated by hardware manufacturers, ISP and mobile phone operators. In the business models based on decentralized promotion, the star system so cherished by the majors is losing its effectiveness, to the benefit of a strategy of decentralized promotion based on the search for new talents which consumers will set their hearts on sharing with each other. Overall, however, the majors in the record industry satisfy the conditions for survival of incumbent firms in a market hit by a disruptive innovation, as defined, for example, by Malerba et al. (1999). They can use the financial resources obtained from their dominant position in the old technology, particularly to set up partnerships with external agents possessing the necessary competencies. This is something they already do with mobile phone manufacturers and operators and ISP (IFPI, 2008). Nevertheless, they will have to accept important organizational changes, for their survival appears to be conditional on profound modifications to their business model. Now, past experiences of radical transformations in the competitive conditions of the record industry show that the organizational changes required have often been brought about either by new entrants or by established firms, but only subsequent to their takeover or merger.

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