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For years now major labels and publishers have pointed at illegal file-sharing as the primary cause for plummeting record sales, and spend much of their time trying to eliminate this problem, expecting sales will bounce right back to pre-Napster days. But how likely is that scenario, if we look at the situation from a business point of view?

In a free market price and sales volume are determined by supply and demand. The more demand there is for a product, the higher the price will be, assuming there is a limited supply of that product. This is called scarcity. Superbowl tickets are low in volume, high in demand, and hence very expensive. They could easily raise the price even further, and the Superbowl will still sell out. With digital music, there is no scarcity. The supply is unlimited.

The reverse is also true: if demand for a product drops or the supply suddenly shoots up, the product’s price and/or quantity sold is likely to go down. Sellers will try harder to out-do each other in front of a group of potential consumers that is equally or less interested in what they are offering than before.

An implicit assumption behind the argument made by the record companies and publishers is that the market for recorded sales hasn’t fundamentally changed except for illegal downloading. In other words, it weren’t for downloads they would still be selling the same amount of albums and singles, at the same price, and with the same profit margins as before. This again seems unlikely, and we can see many other media companies also struggling with their digital alternatives. One example that comes to mind would be the newspaper industry and their online news alternatives. So what else could be going on?

The Supply Side: More Products, Better Access, So More Competition?

On the supply side, improvements in technology have increased both the amount of recorded music that is being produced, as well as consumer access. Hardware and software has become cheaper, smaller and easier to handle, bringing recording at acceptable quality within the reach of the masses. You no longer need an expensive studio with countless cables, knobs and buttons to record a decent track. For example, if you are a simple solo singer/songwriter, or even an indie rock band, more often than not you now can get by with a small laptop, a few microphones and Garageband, to record a decent sounding song. Also, recording equipment has become easier to use and the internet provides budding engineers with plenty of helpful instruction videos and message boards full of tips.

A second change on the supply-side is that the internet has greatly improved consumer access to recorded music and the artist’s ability to distribute their music. Amazon, MySpace and iTunes are not limited by shelf space or geographical proximity in the way your local record store is. Where record companies used to control what music was being distributed, this has now changed and nobody can prevent an artist from putting a few tracks on a website. There is more music available than we can possibly ever listen to and attention form consumers is more scattered than before. With more music being produced and better access to it, it is not surprising that artists and record companies are fighting harder to get their music noticed and that lowering prices is part of this. It’s even conceivable that some acts might start advertising to get people to listen to their music for free, hoping that they will “convert” to buying cds, concert tickets or merchandise later.

The Demand Side: Increasing Numbers Of Potential Customers, Decreasing Willingness To Pay

The good news can be found in demographics and economic development: as broadband penetration and middle-class incomes are increasing in various regions (e.g. urban areas in China) and hardware costs are falling, the group of people that can afford to buy music players and recorded music is likely to grow. However there is plenty of bad news. Yes, illegal downloading has hurt record sales. But there’s more. First, in a digital environment consumers are not forced to buy whole albums and are transitioning to purchasing single tracks instead. If many customers just want to buy one or two songs instead of a whole album (which we assume they do), the money they used to spend on the “unwanted” tracks will now stay in their pockets. To use a geek term, some people are saying that the so-called “atomic unit of consumption” has changed, and that we’ve gone back to the days of the 7-inch vinyl. Another characteristic of music in a standardized digital format is that consumers are using the same files when switching between hardware. Your smartphone, MP3 player and (burned) CD can all convert and play the same audio files. Replacement purchases, which were common when CDs replaced old vinyls and cassettes, are likely to be much smaller than before. A third factor affecting demand for recorded music is more of a hypothesis than a tested fact: considering the many forms of entertainment available to consumers, what if people have become less attached to recorded music than before? We know there has been a huge increase in time spent on video (Youtube), gaming (World of Warcraft, Farmville, Casual Games), and social media (Facebook, Twitter). We also know that new album releases no longer cause any real riots at retail anymore, with people queueing up in front of the record store the night before being a thing of the past. Instead they wait for Apple and Google products – remember Google Wave invites? Nexus One? IPad? The ‘stolen’ new IPhone? This doesn’t necessarily mean they like music less, but it definitely feels like there is more competition for the customer’s attention and money than before. And on top of this, a lot of these other forms of entertainment are free, or feel free per unit due to a subscription model. An example of the latter would be watching TV. Very few people break down their cable bill per program watched, or think of a single episode of The Office as $1 of the $79 monthly subscription bill.

The Same, But Different

Our problems in the music industry are similar to those in other industries. Better, cheaper and smaller camera equipment affected the bottom line for professional photographers, and film manufacturers like Kodak and Fuji. The difference was that their choice between resisting change and reinventing themselves has been easier, though not less painful. Magazine publishers are also struggling to translate their weekly or monthly physical editions and long articles into blog-like online versions. In the newspaper industry, News Corp.’s Rupert Murdoch is trying everything in his power to make a paid subscription model work and Google News is accused of “stealing” news, while at the same time people are Tweeting breaking news faster than Reuters can report it. The problem is not so much that consumers are stealing pictures, news articles or music, but that the added value of many traditional media companies has dropped significantly, often as a result of newer technologies. The worst case scenario is that raising pay walls will drive consumers away from your products and into the hands of your competitors, as there are plenty of substitutes. What would John Mayer’s Twitter followers do if they would have to pay for the guitar virtuoso’s Tweets? Might they switch over to read Ashton Kutcher’s instead, or spend more time reading other free content? Or is their brand loyalty strong enough to resist the pay wall change.

Tech companies, like Apple, seem better at responding to changed market conditions and behaviors in the music industry. With fresh eyes and no preconception of how the world ought to be, they are turning old industry “truths” upside down. Where traditional media companies like Sony sell their players and game consoles cheaply and make most of their money selling expensive CDs and games, Apple sells expensive hardware and provides content cheaply and seamlessly. At the same time sales of video games are dropping rapidly due to the rise of free games on Facebook and other websites. Who’s going to come out ahead here? Sony or Apple?
It’s not easy to create innovative products that customer want to pay for, but focusing all energy on illegal file-sharing instead of providing a better customer experience, is unlikely to get any artist or company ahead. If the artist helps the customer win and monetizes the relationship, the artist also wins.

(This is the fifth part in an on-going series of articles written together with McKinsey & Co’sErik Rutten*. Through regular brainstorms we will examining the music industry starting from an outsider’s perspective as business men and music lovers, and working our way through the different aspects during the next six weeks. *Erik is on sabbatical and the views expressed are his own, not his employer’s.)