CD prices and piracy

Fellow Chicago GSB grad Jane Galt has a piece arguing that piracy will increase CD prices because, if people are getting unauthorized copies for free, labels will have to charge a higher average price to make up their upfront fixed costs. I don't think this is quite right.

Firstly, labels only need worry about making up their upfront fixed costs before deciding to launch a new CD. Once a CD is out, all that upfront stuff is sunk and shouldn't factor into pricing decisions. And since labels have a great amount of discretion over what those upfront fixed costs are (ie how much to spend on promotion, packaging etc.) they can simply change what kind of CD they support and how they market it (lowering upfront investment) instead of raising price.

So how do we know whether they will lower upfront investment or raise price? The answer has to do with the elasticity of demand for CDs. Elasticity is one of those jargon terms that represents such a useful concept, you wish everyone knew about it. It simply means "how will people respond to a change in price?" If demand is inelastic, people won't change how much they buy if the price changes. If demand is elastic, people will buy lots more if the price falls, and lots less if the price rises.

We know labels have the power to set prices (unlike onion farmers) because CDs are priced considerably above marginal cost. How much above marginal costs depends on the elasticity of demand -- if demand is very elastic, then the price will be lower, if demand is very inelastic, that means price will be higher. Think about it this way, if someone's going to buy something no matter what, why not jack the price up on them? So a record label's price response to unauthorized copying depends on whether mp3s increase or decrease the elasticity of demand for CDs.

This is actually a tricky question. You could say that mp3s make demand more elastic, because now a CD needs to be really good otherwise I'll just substitute an mp3 for a CD (we might see this happen with albums that feature a single good song). This means labels should lower price. Or you could say mp3s make demand less elastic, because the only people left buying CDs will be those who *really* *really* value buying CDs and by definition, they respond less to changes in price. Examples of these folk could be older jazz and classical buyers, who don't like computers. In this case, labels should raise price. Or you could say that everyone substitutes equally from CDs to mp3s, meaning the elasticity is the same. In this case, price stays the same but labels will sell less, and make less money overall. Or you could argue that since mp3s promote CD purchases, file trading increases CD sales, meaning price stays the same but labels sell more, and make more money overall.

So which is it? (Or more realistically, which of the four possibilities is happening more?) According to the RIAA, between 2000 and 2001, quantities shipped dropped 10% and expenditure dropped 4% (meaning prices rose around 7%). This suggests that demand is becoming less elastic (price rises, quantity falls) but I haven't controlled the data for larger macroeconomic factors--so this isn't a firm conclusion.