The Impact of Music Downloads and P2P File-Sharing: Hypotheses

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Theoretical Focus and Empirical Review

When estimating the effects of music downloading and P2P file-sharing on music purchases there are many influences that ought to be taken into account. Demand theory provides an appropriate framework for investigation. The variables in this framework address some key concepts related to our analysis. As highlighted in economic textbooks (e.g. Begg, Fischer and Dornbusch 1994, chapter 3) the demand for a particular good is directly related to four key concepts: (i) price of the good, (ii) price of related goods (whether substitutes or complements), (iii) consumer income, and (iv) consumer taste.

This section aims to integrate these four determinants into the design of our analysis. The discussion is supported by the literature on P2P file sharing behaviour, adding to the design and arguments in this paper. We also identify and make a case for taking into account determinants in addition to those identified above. These include the role of demographic factors such as Internet skills, age, gender, occupation and education.

The determinants of demand

In this section, we introduce several hypotheses about the determinants of music consumption. We discuss the impact of prices, income and taste in music.

When measuring the direct effect of the price of music on CD consumption some hypotheses can be developed, based upon theoretical economic assumptions. The relationship between the price of goods and the demand for goods is well established within the economic literature (e.g., Begg, Fischer and Dornbusch, 1994). Therefore, our Hypothesis 1 states:

H1. The price of CD albums is negatively associated with CD purchases. Likewise, the price of paid electronically-delivered music is negatively associated with purchases.

However, Liebowitz (2004) illustrated that prices for CD albums have been almost constant over a 30-year period (1973-2002) suggesting that changes in record sales would seem to be, of statistical necessity, due to other factors.

We also have to consider the price of related goods, whether they are substitutes or complements.

H2a. There is a positive relationship between the price of CDs and (i) purchases of electronically-delivered music, as well as (ii) music downloading activities and P2P file-sharing.

This hypothesis can be tested in several ways.

'Cross-price elasticity':

• It can be tested if an increase in CD price will increase purchasing of paid electronically-delivered music tracks.

'Album too expensive':

• Individuals may engage in music downloading or P2P file-sharing if they feel that the price of purchased music is too high. Respondents who engaged in P2P file-sharing were asked about their motivations for doing so.

The substitution effect

The substitution effect occurs when the downloaded copy directly substitutes for the purchased original (Liebowitz, 2005b). Important issues regarding perfect substitution include whether (i) the quality of music between the original and the substituted copy is the same, (ii) the information attached to the original and the downloaded file is the same, and (iii) the ability to listen to the downloaded file should be available in as many locations as the original.

In general, some substitution is expected since the marginal cost of P2P file-sharing is essentially zero. It can be tested whether there is a negative association between P2P file-sharing or music downloading and music purchasing.

This direct substitution effect is due to the unwillingness to pay for authorized copies. Liebowitz (2004, 2005b) argued that P2P file-sharing decreased music CD sales by 20-25%. He also states that file-sharing is the cause of the entire decline in record sales that has occurred and also appears to have vitiated what otherwise would have been a fairly robust growth in the industry.

Such evidence is supported by Zentner (2004), who analyzed survey data from 15,000 European respondents and found that file-sharing may reduce the probability of music purchases by up to 30%. Sundararajan (2004) argues that the free alternatives are attractive, so we need a new pricing schedule enforced by digital rights management. Evidence from Rob and Waldfogel (2004) in an analysis of 500 US college students suggests that each downloaded album reduces music purchases by 0.2. Finally, using data from the Global Market Information Data base (CMID), Hui (2003) finds that the demand for CDs decreases with (physical) CD piracy. He finds that each pirated album reduces music purchases by 0.42, and he suggests that such 'theft' outweighs the possible positive effects of CD piracy and that the music industry has lost up to 6.6% of its revenues to piracy, although this is much lower than the industry estimates which he also refers to.

In an analysis of 200 US college students, Gopal, Bhattacharjee and Sanders (2006) found a strong positive association between downloading from free MP3 sites and the intention to subsequently purchase those same songs as part of a CD or as electronically-delivered music tracks. They refer to a sampling effect of 'awareness and increased popularity' as sampling provides exposure to unknown artists. Thus, they argue that free sampling may have major benefits for the music industry, provided that their works are offered for purchase on-line. That is, although Gopal, Bhattacharjee and Sanders (2006) recognize that P2P file-sharing may sometimes lead to reduced music purchasing, they suggest that the phenomenon is a complex one. Their views resemble those of Blackburn (2004), who used microeconomic data from 14,000 US retail outlets to analyze the effect of file-sharing on CD sales.

Blackburn distinguishes between two separate effects, the substitution effect (where some consumers may substitute free music downloads for purchases) and the penetration effect (where increased exposure through P2P file-sharing leads to increased purchasing of those works). The substitution effect is found to be strongest for well-known artists, while the penetration effect is strongest for the unknown artists. The overall negative impact of file-sharing is mainly due to the fact that the industry is dominated by a few well-known artists. Consequently, P2P file-sharing not only provides exposure for some new artists, but also results in some income redistribution within the music industry. For this reason, many superstars oppose P2P file-sharing.

Bounie (2005) separates the P2P file-sharing population into two groups: "explorers" who discover new music and increase their CD purchasing, and "pirates" who substitute P2P downloads for CD purchases. Furthermore, Madden (2004) also confirms in a report on the Pew Internet & American Life Project that artists are divided with regard to their view on whether the Internet has made it possible for them to make more money from their work, or whether it has made it harder to protect their work from piracy and unlawful use. Still, many of the artists do not view the Internet and file-sharing as a great threat. 52% of all artists and 55% of all paid artists believe that it should be legal for Internet users to share unauthorized copies of music and movies over P2P file-sharing networks, compared to 37% of all artists and 35% of all paid artists who say it should be illegal.

However, in his analysis of CD sales and P2P file-sharing data from Japan, Tanaka (2004) shows that there is little evidence that file-sharing reduces CD sales.

The following hypothesis can be tested in this context:

H2b. People who engage in music downloading and P2P file-sharing do so partly because they wish to hear a soundtrack or an artist before buying. Thus, there is a positive relationship between P2P file-sharing and music purchasing.

Liebowitz (2005b) attacks the possibility of a positive P2P sampling effect by arguing that although consumers may learn more about the music and make superior choices, record companies are not necessarily better off. Liebowitz sees two opposite effects of sampling, which are both about 'tolerance':

• Free music exploration online may increase demand for music purchases: basically when you have found what you like you want more, i.e. the music consumption (or tolerance) is not yet saturated.
• Free music exploration online may decrease music purchases: when you have explored and found the music you like, the exploration phase has surpassed your tolerance to music. You will move on to things other than music (Liebowitz 2005). Liebowitz draws the analogy to beer or wine tasting. When you are done with such tasting activities you may be full and do not want any more.

Liebowitz found that people generally belong to the latter category which decreases music sales, as highlighted in the above section on the 'substitution effect' between free music downloads and CD purchases.

A survey of 2,002 Canadian respondents conducted by Decima Research (2005) investigated the means by which new music is discovered. The results showed that radio is by far the most important medium for discovering new music. Still, about one quarter of the younger population (age 15 to 34), particularly males, also discovers new music via the Internet. Younger people and especially women discover new music through television and word-of-mouth. Other ways of discovering new music (such as concerts, stores, movies, etc.) are relatively unimportant. The extent to which the discovery of new music via the Internet occurred through free sites or pay-sites was not investigated.

We believe that the decision to engage in music downloading or P2P file-sharing is not only a response to the price of music; it is also a response to the availability of musical works. For example, rare songs, music from bands that have not signed with a record label, or private recordings from live concerts may be available through P2P networks but may not be available for sale. However, whether such new markets are so similar to the existing markets that they in fact substitute in practice is difficult to guess. We would marginally anticipate the creation of competing new markets to have a negative impact on music purchases in the existing markets.

Hypothesis 2c states the following:

H2c. People who engage in P2P file-sharing or music downloading are less likely to purchase music in traditional markets.

In order to consider the relative importance of the 'sampling' and 'substitution' effects associated with P2P file-sharing and music downloading, the two effects ought to be considered together. Moreover, in our analysis we divide the 'sampling effect' into a 'market creation effect' and a 'market segmentation effect'. The two effects are distinct, but tend to be mixed in the existing literature. More specifically, the market creation effect refers to situations where the individual engages in P2P file-sharing in order to hear a particular song before buying it and where such activity increases that individual's music purchasing. The relevant variable is 'hear before buying', one of several possible motives behind P2P file-sharing identified by respondents. Another market creation effect refers to the situations where the music is not available in stores or from pay sites. The relevant variable is called 'not available elsewhere', another motive identified by respondents. The market segmentation effect refers to situations where the respondent does not want to buy a whole album, that is the whole bundle of songs. The relevant variable is called 'not whole album'. Finally, the market substitution effect refers to situations where the respondent engages in music downloading or P2P file-sharing activities because the song or album price is considered to be too high. This variable is called 'album too expensive'.

We now consider the effect of the prices of related entertainment goods on demand for music. We develop a double-sided hypothesis:

If an entertainment good is a direct complement to music (such as MP3 players in relation to paid electronically-delivered music), a negative relationship is expected, in the sense that a fall in the price of MP3 players will result in increased purchases of paid electronically-delivered music; if the good is a substitute (such as a film/movie) then a positive relationship is expected, such that an increase in the price of a CD or electronically-delivered music track will result in increased purchases of films.

However, as the price of related entertainment goods is not available for most observations (see Section 3), this paper simply considers the effect of the ownership of MP3 players, as well as the number of purchased entertainment goods. These factors are addressed below in the new double-sided hypothesis that we now propose:

H2d. If a good is complementary to, or compatible with, paid electronically-delivered music (e.g. MP3 player) but not complementary to CDs, then the ownership of this good leads to a preference for purchasing music in electronic format over (physical) CDs and vice versa. If a good can be regarded as a substitute for music (e.g. a film/movie), then purchases of this good are negatively associated with music purchases.

This hypothesis can be addressed by considering the following factors:

MP3 player ownership as a complementary good:

One would expect that ownership of an MP3 player tends to (i) be associated with a relatively large volume of electronic music purchases and to (ii) be associated with a greater likelihood of engaging in music downloading and P2P file-sharing activites, compared with not owning an MP3 player. However, it should be noted that to some extent, the direct effect of MP3 player ownership on CD markets is uncertain, as the relative magnitudes of the complementary and substitution effects cannot be known a priori.

Substitute entertainment goods and the issue of time:

Assuming people not only have limited money (i.e. they are constrained by income) but also limited time, other entertainment goods can be assumed to be in direct substitution with music purchasing with respect to both CD and MP3 purchasing. As put forward by Liebowitz (2004), "There is another element involved in listening to music, and that is the constraint of time. Listening to music requires time, and higher income does not necessarily lead to a great amount of free time". In this context, Liebowitz (2005a) considered the effect of substitute entertainment goods, and found that movie revenue per capita, video game revenue per capita and units of pre-recorded videos per capita grew hand in hand with record sales for most of the period 1990-2003, and he discussed whether the positive correlations between the variables suggested that the goods were complements (e.g. movies spur sales of a soundtrack or playing video games while listening to music). He found that after accounting for time constraints (assuming the movies and music CDs are substitutes), the observed increase in per capita sales of VHS and DVDs could only explain half of the drop in per capita sales of sound recordings.

In an analysis of music downloads in 16 countries, Peitz and Waelbroeck (2004) argue that 'Internet piracy' played a significant role in the decline in CD sales in 2001. However, they suggest that the later and continued drop in record sales needs to be attributed to something quite different. Today people are doing different things with the Internet, such as listening to radio and audio clips, viewing video clips, creating picture albums, and using it more generally. Thus, the Internet offers new forms of entertainment, effectively replacing old forms of entertainment. In this line of argument the pertinent issue is the advent of changes in lifestyle rather than P2P file-sharing and music downloading substituting for music purchases.

To this end, a 2001 Canadian survey of 5,682 youth aged nine to 17 (i.e. 13 to 21 years of age in 2005 when the survey for this paper was conducted) demonstrated that children used the Internet for different purposes and at different locations: 57% of children downloaded music (which is important in light of the results of the survey conducted for this paper, as only 15% of children had ever purchased something on the Internet), 56% used the Internet for sending Email, 50% surfed the web, 48% played and downloaded games, 41% obtained information unrelated to school work (e.g. health related information or to look up things related to their hobbies), 40% engaged in chat-rooms and used the Internet for homework. As discussed below, the survey also showed that girls tend to use the Internet more for social communication and chatting, and boys used it more for music, games and schoolwork (Environics Research Group 2001).

A consumer survey by McKie (2006) of 1,229 Canadian consumers aged 13 and above found that 83% of young people aged 18-24 considered music played on the radio to be repetitive (tracks were "played to death" so they did not find a need to purchase the track or the album). This suggests that music on the radio displaces music purchases. The survey results also suggested that in order to increase music choice Canadian consumers turned to (or were pushed to) self-programming, especially from the P2P file-sharing sources.

Thus, a decline (or lack of growth) in purchasing in CD markets may not only be attributable to increases in price or the emergence of free music downloads and P2P file-sharing, but also to other entertainment goods. We have data on the following: number and price of purchased DVDs, number and price of purchased video games, number and price of movie tickets bought and the number and price of live concerts attended. This information is used to test Hypothesis 2d.

Then there is the effect of consumer income:

H3. In accordance with economic theory, a higher income is associated with increased purchasing, so we expect a positive relationship between income and music purchasing.

Whereas a positive relationship between income and purchasing is relatively simple to understand with respect to CDs, one does not, at first glance, expect purchasing of electronic music files to be related to income, as they are relatively inexpensive. However, other factors may come into play here. As higher income groups are also at the 'upper end of the digital divide' having better Internet access and/or Internet skills (see hypothesis H5 and associated text for discussion), a positive relationship between income and purchases of paid electronically-delivered music can also be expected.

Using per capita GDP and CD sales data, Liebowitz (2005a) found that income had a minor impact on album sales ($1,000 increase would alter per capita sales by only 0.28 units). However, based on household income, Liebowitz (2005b) demonstrates (counterintuitively) that higher household income is more likely to lower per capita sales of albums. Again, this could be explained by the digital-divide argument (discussed in relation to hypothesis H5 below). That is, higher income groups are more likely to use the Internet, and that such use leads to substitutions away from CD purchasing. However, contrary to Liebowitz (2004), Peitz and Waelbroeck (2004) find a strong positive effect of income (measured as GDP growth) on CD purchases.

As discussed previously in this section, the degree of purchasing and price tolerance in CD and MP3 markets is also expected to vary with consumer taste.

H4. In accordance with economic theory, a greater taste for music is expected to be associated with increased music purchasing.

However, as we have no direct data on consumer taste (see Section 3), this paper considers two proxies:

Perception of music quality:

Firstly, a respondent who answered that the 'quality' of music had increased between 2004 and 2005 is perceived to have a 'taste' for the music available during 2005. Similarly, respondents who answered that the quality had declined are considered not to have a taste for the music supplied in the market during 2005, and respondents who answered that they did not believe quality had changed between years are considered to have a neutral taste for music available during 2005. Taste for music available, or the perception of music quality can, for example, increase because a certain artist a consumer likes has been releasing albums.

Music interest:

Secondly, 'music interest' can also be related to music taste where a person with a strong interest can be perceived as having a taste for music. Thus, music interest is also expected to influence music purchasing and price tolerance in CD and paid electronically-delivered music markets. Thus:

1. A positive relationship is expected between the degree of experienced 'music quality' or 'music interest' and music purchasing.
2. Taste for music available is expected to be associated with a less price elastic music demand curve.
3. Taste for available music is also expected to be associated with increased music downloading and P2P file-sharing.

Liebowitz (2005a) used financial success of concerts (1990-2001) and time spent listening to the radio as proxies for change in music quality. However, he found that increased concert revenues (which should reflect an increase in music quality) were associated with a decrease in record industry revenues. He, therefore, discussed whether his estimated 9 percent decline in radio listening (indicating lowering of music quality) could explain the decrease in record industry revenues, although he concluded that the evidence was very weak and it depended on age and music genre.

The effect of demographic factors

Demographic factors such as Internet skills, age, gender, occupation and region may also have an influence on music purchasing. Some hypotheses can be suggested in this context, based upon the 'digital divide' discussion famously led by Castells (2001), where it is suggested that such demographic factors, and others, influence the participation in Internet-based activities. Although Castells (2001) mainly focused on Internet access in the USA, his research sought to explain why certain groups did not have, or did not choose to have, Internet access. In this context, we discuss the Internet as a means of acquiring music (both through P2P file-sharing and purchasing of electronic tracks), in contrast with traditional CD purchasing and CD copying.

According to Castells (2001), the people using the Internet (i.e. those at the upper-end of the digital-divide) are more likely to be high income earners (and the children of such high income families are advantaged in terms of both access from their bedroom and in high-quality teaching in computer and Internet skills), the educated, the younger generation, males, persons in the labour force, and inhabitants of urban areas. However, persons who do not use the Internet (i.e. those at the lower-end of the digital divide) are more likely to be low income earners (and the children of such low income families are particularly disadvantaged in terms of access from their bedroom and in terms of low quality teaching in computer and Internet skills), of lower education, elderly, female, outside the labour force, and outside urban areas.

The 2001 Canadian survey of 5,682 youth using the Internet, referred to above, demonstrated that youths acquire their Internet skills mainly from friends rather than parents. Thus, quality of friends in schools and neighbourhoods is very important in perpetuating the digital divide. The same survey also showed that girls tend to use it more for social communication and chatting, and boys use it more for music, games and school work (Environics Research Group 2001).

The 2005 survey by Decima Research found that the likelihood of having access to the Internet decreases with age (while only 2% of Canadians between 15 and 20 could not access the Internet, this increased to 14% among those aged 35 to 54 and spiked at 44% among those over 55 years old). Again, residents of urban areas are more likely than rural residents to have access both at home (74% vs. 64%) and at work (33% vs. 27%), while 26% of rural residents (compared to 17% among urban residents) do not have any Internet access at all.

H5. It follows that we expect that those at the 'upper end' of the digital-divide are more likely to engage in P2P file-sharing and to purchase paid electronically-delivered tracks than those at the 'lower end' of the digital-divide.

Thus,

1. A positive relationship is expected between Internet skills and P2P file-sharing and music downloading.
2. A negative relationship between Internet skills and purchasing of CDs and CD copying is expected.
3. A negative relationship between age and P2P file-sharing is expected.
4. A positive relationship between being male and P2P file-sharing is expected.
5. A positive relationship between being a student or working and P2P file-sharing is expected.
6. A positive relationship between degree of education and P2P file-sharing is expected.

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