Online Royalty Rates

The New York Times has an interesting article of the recent debate over online music royalty rates.  Currently music royalty rates are set by the Copyright Royalty Board - a group of three judges - as opposed to the marketplace.  Online music firms (such as Pandora) are asking for a lower royalty rate and the music industry are advocating higher royalty rates.  So the question is:  what is the best royalty rate?  This is an important question and one that lies at the heart of industrial economics.

As always, to make things easier, let's make some assumptions to get to the heart of the matter.  We can always come back to the assumptions and discard those that are too restrictive and adjust the analysis given the change in the underlying assumptions.  First, let's suppose the music industry is trying to make the most amount of money from music royalties, which I will think of as profit maximization.  Second, let's suppose that the marginal cost of streaming music over the internet is zero.  This may not be the case, but as for now let's use this assumption.  Third, let's suppose that the market demand for online music is inversely related to the royalty rate (or price).  By this what I mean is that in terms of the market overall, as the royalty rate rises, some consumers of online music will drop out of the market due to higher subscription fees that would be passed on by higher royalty rates and/or online music firms will eventually drop out of the market, resulting in a decline in the amount of music streamed over the internet.  Conversely, as the royalty rate decreases the amount of music streamed over the internet increases as the number of firms or subscribers increases.  Finally, let's suppose the online royalty rate is set independently of terrestrial radio stations.

So what royalty rate should the music industry advocate?  Well, as stated in the article linked at the beginning of this blog, “[i]t’s not so much about rates as about how much dollars you spend,” Mr. Pittman said. “The amount of dollars to artists is rate times volume. If the rate suppresses the volume, there’s less money. If it encourages volume, there’s more money.”  Converting to economic terminology, rate is price and volume is quantity.  Hence, Mr. Pittman is talking about the price elasticity of demand.  If the price (royalty rate) increases and demand is price inelastic, this will increase the revenues received by the music industry, but if the demand for online music is price elastic, then an increase in the royalty rate will lead to a decrease in royalty revenues.

For the music industry, they should be focusing on lobbying for a royalty rate that maximizes their profit (or royalty revenues from online music companies) and this would be the case where the royalty rate is set where the price elasticity of demand is unit elastic.  By doing so, the music industry would maximize the revenues from online music firms such as Pandora.