The Impact of Legal and Illegal Downloading of Music on the Financial Performance of the Recording Companies

Matthias Duenner*

[May 2010]

* Matthias Duenner is an undergraduate student in the College of Business Administration Honors Program at California State University, Long Beach, CA 90840. This manuscript serves to fulfill his Honors Thesis requirement. Address correspondence to Matthias Duenner at MattDuenner@gmail.com.

ACKNOWLEDGEMENTS
First, I would like to thank Dr. Sam Min for all of his assistance, guidance, and encouragement during the process of writing this thesis. I am extremely grateful for his devotion of so much time and effort. The wealth of knowledge, expertise and dedication he shared with me allowed this research study to be completed. Thank you Dr. Min. Second, I would like to thank Dr.

Pamela Miles Homer for accepting me into the CBA honors program, introducing me to empirical research, and guiding me through the steps in learning and understanding the importance of research in our lives. Third, I would like to thank Dr. Melody Kiang for her
insights and for helping me to develop the concept of my study and encouraging me along the way. Finally, I would like to thank my wife, Amanda, for her support throughout this process. Her encouragement and help made it possible for me to continue with my education and to succeed in the CBA Honors Program. I would not have been able to complete this thesis without her continuous support, which allowed me to take the time I needed away from other obligations to complete this thesis and my degree.

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The Impact of Legal and Illegal Downloading of Music on the Financial Performance of the Recording Companies ABSTRACT Over the past two decades, illegal and legal downloading has affected the music industry in many ways. Reports suggest a decline in total units sold starting around the time the first big file-sharing program emerged. Reports also suggest an increase in total units sold starting around the time the first online music store opened for business. This study explores this phenomenon (1) to understand whether there is a direct relation between illegal and legal downloading and over a 15-year period starting in 1994 and ending in 2008; and (2) to determine whether illegal and legal downloading can affect the correlation between the consumer index and the sales revenue of individual companies in the music industry. The results show no direct link between the illegal and legal downloading of music and the financial performance of individual music companies. There is, however, a correlation between the sales revenue and the consumer index.
After the introduction of iTunes in 2003, this correlation gained in strength.

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INTRODUCTION Piracy, copying and unauthorized reproduction has been a problem for several thousand years. For as long as people have been able to create something of valueart or gold and silver coins, for examplethere has been someone trying to copy it. Initially, there were a lot of obstacles and labor involved, but all of that started changing significantly in the late 1950s. In 1959, Xerox introduced the photocopier, which allowed anyone to easily, efficiently and cheaply reproduce printed materials. In the 1970s, audio taping became popular. This new technology provided an easy and inexpensive way for people to copy sound recordings. Cassette-deck manufacturers started producing dual tape decks, designed for high-speed copying of audio materials. In the 1980s, videotaping became popular. All of a sudden, people were not only able to make their own films, but also able to easily copy movies and other broadcast materials. In the late 1980s and early 1990s, audiotapes gave way to CDs and videotapes were replaced by DVDs. Personal computers equipped with CD and DVD burners were not far behind. In the late 90s, with the release of Napster, the music industry became the next victim of people sharing and copying music, this time on a large scale using the internet. After enjoying steady growth in the total numbers of units sold in the early to mid-1990s, the music companies suddenly faced an abrupt downturn in the number of units sold (Zentner 2006). This downturn was present until 2003, when the number of units sold abruptly increased again. This change to positive growth seemed to happen at the same time that iTunes entered the market. The purpose of this study is to provide a summary account of the recent disruption in the music industry, and to take a closer look at the changes in sales revenue, margin, SGA expense1, and operating income among individual companies in the music recording industry over the last 15 years. Specifically, this study is trying to show that illegal and legal downloading not only
1

Selling and general administrative expenses.

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affected the total number of units sold, but had a similar effect on the on the financial performance of companies in the music industry. This study is not trying to show the effect of downloading on the music industry as a whole, but rather the effects of downloading on individual companies. To accomplish this, financial data was collected and grouped into three groups. The three groups were five years each, separated by two events: the emergence of Napster, considered the beginning of illegal downloading; and the launch of iTunes, considered the beginning of legal downloading. The financial data was then analyzed using t-test, and correlation analysis. The results did not show much significance or support for the proposed hypotheses. In summary, this study shows that even though illegal and legal downloading seems to have affected and continue to affect the music industry, especially the total number of units sold, it does not seem to have had any significant or lasting effect on the sales revenue, margin, SGA expenses or operating income of any of the three largest individual record companies. There does not seem to be a direct link between the illegal and legal downloading of music and the sales revenue of individual music companies. The study also shows that there is a correlation between the sales revenue of the big companies and the consumer index. This correlation grew stronger after the introduction of iTunes in 2003. BACKGROUND AND LITERATURE REVIEW As mentioned above, starting in 1959, Xerox changed the way people thought and felt about reproducing materials by inventing technology that allowed the mass reproduction of printed materials. Since then, many more and different technologies have emerged to reproduce art, movies, and music, just to name a few. Every time new technology with the potential to replicate copyright-protected materials emerged, the copyright industry met that technology with a negative reaction. The publishing industry initially complained about and fought the copy

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machine. In a 1985 study, however, Stan J. Liebowitz showed that the invention of the Xerox machine and the subsequent photocopying boom were actually beneficial to the industry (Liebowitz 1985). The movie and television industries sued to stop the video recorder, but the Supreme Court ruled against the movie and film industries (Sony Corp. of America v. Universal City Studios, 464 U.S. 417 [1984]). Out of this, a new, unanticipated market emerged prerecorded video. Now, revenues from prerecorded movie and video sales and rental revenues far exceed box-office revenues (Liebowitz 2006). The music industry, not to be outdone, reacted negatively to reproduction technology. Before becoming chairman of the Federal Reserve, Alan Greenspan addressed the U.S. senate with concerns about the legal and economic implications of the consumers ability to reproduce material at will (U.S. Senate 1983). Sales of music began to recover and entered a decade-long expansion shortly after his testimony (Leibowitz 2006). Time, however, did not stand still in the early 1990s. The Internet started growing exponentially and before long, people were communicating, researching and sharing files online. A specific point in time worth mentioning here is 1999, when Napster came to life (Liebowitz 2006) and changed the way Americans thought of piracy and copyrights forever. New terms such as peer-to-peer (P2P) and file-sharing were introduced into our language in order to help us describe and talk about what was going on. Until Napster, copying a CD meant getting possession of the original media and accumulating the software and hardware that would permit copying of the original. If said equipment was not available, one could still copy the CD by recording it to tape (which at the time was still widely available), but the original media still had to be available, and a substantial loss of quality was normal. The same problem is true for DVD and VCR tapes. Until Napster, expensive and sophisticated computers, DVD burners and software programs were necessary to copy DVDs and in order to copy a VHS tape one had to

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own two VCRs. The creation of Napster started a movement that changed all of that. Through the use of a simple, cheap computer, the internet and a P2P service such as Napster, anyone (who met the above three requirements) could get any song, album or recording on their computer, in electronic format, without quality loss, for free. The emergence of faster and cheaper computers, along with faster, cheaper and more readily available internet connections only fueled this trend. With P2P networks, piracy became a household practice. One recent estimate holds that that more than 60 million people were downloading nearly 12 billion songs a year. (Coleman 2003; Garland 2004). All of this was accomplished without even leaving the home. What are peer-to-peer (P2P) networks and how do they work? Simply put, P2P networks are networks in which any user or groups of users can connect with any other and share files on their computers. The only requirements are a computer, an Internet connection and most important, the same P2P software and server. The function of the P2P software and server is to bring music seekers and music providers together. They act as an index and list what user has which songs available. They also direct the user searching for a particular file to a user providing that file. What sets P2P apart from previous file-sharing is that in the past, a server with the ability to store the files was required. Users would upload files to the server, from which other users could then download. This system is expensive to implement not only because of the need for hardware (huge amounts of storage in particular) but also because of the need for major bandwidth because all users share that one server or group of servers. Finally, having one central server makes for an easy target to find and shut down. With the introduction of faster bandwidth for the home user and P2P technology, users could up- and download directly from each other. The only purpose of the P2P server was to index the available songs and which users had them available. As mentioned before, Napster was the first large-scale P2P service to draw global attention. Overnight, Napster became a media sensation. Everyone knew about Napster and its ability to

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provide high-quality music for free. Many Napster users were not aware of the copyright infringement they were committing by stealing or pirating this free music. In February 2001, the recording industry shut Napster down with a preliminary injunction (A&M Records v. Napster, 239 F.3d 1004 [9th Cir. 2001]) leaving behind a void for millions of Napster users (Liebowitz 2006). The recording industrys victory over file sharing in general and Napster in particular was shortlived because many other P2P programs stepped into the void left behind by Napster, including FastTrack, Audiogalaxy, Imesh, Gnutella, E-Mule, E-Donkey, LimeWire and Kazaa. The replacements however learned a lesson from Napster. Many of them were, unlike Napster, not based on the model of a central index server (Liebowitz 2006). It was this central index server that made bringing down Napster relatively simple. In its peak month, February 2001, Napster users shared 2.79 billion files, but by August 2001, the four leading Napster replacements (the first four listed) had enabled their users to move 3.05 billion files in one month (Geralds 2001). While Gnutella stayed true to the P2P or user-to-user approach to file sharing, it did not maintain a central file server and instead let its users query each other directly through the Gnutella network. This distributed query approach is also what makes Gnutella so resistant to attempts to shut it down. Since there is no central server, only individual client computers, one would have to either shut down all client computers or block all Gnutella traffic at the internet backbone level. P2P networks have certainly accelerated the pace of piracy in all environments. Their ease of use, together with the search options that they offer, offered easy, simple ways for computer users of all ability levels to acquire free music. This did not go unnoticed by the Recording Industry Association of America (RIAA). In 2005, the RIAA attempted to reduce the number of downloaders by threatening to sue. To prove that they were serious, the RIAA sued 14,000 file swappers and increased the negative consequences of file sharing by imposing excessive fines in

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the amount of $750 per copyright infringement (Reuters 2005). This could mean a penalty in the range of approximately $3 million for someone caught with 4,000 files on a hard drive (Barker 2004). The main goal behind this campaign is to increase the perceived risk associated with downloading music illegally. In other words, the many copyright infringement lawsuits were intended to produce fear of getting caught. (Sinha and Mandel 2008) Some users may believe that copyright owners have forgotten about the other ways to acquire free media, such as chatrooms, IRC clients, newsgroups, and FTPs. While it is true that these are for the more advanced users of the Internet, they do provide a means of finding all types of media online. With the RIAA cracking down and tracking P2P sharing, those techniques have made a major comeback. Software categories such as BitTorrent and Peer-Guardian have emerged over the last few years in a response to the RIAAs actions. How do these new protocols work and that are their advantages? BitTorrent is a protocol that enables fast downloading of large files using minimum internet bandwidth. It is free to use and does not contain any spyware or pop-up advertisements (Carmack 2005). Unlike P2P or other file-sharing techniques, BitTorrent maximizes transfer speed by gathering pieces of the desired file and downloading these pieces simultaneously from many other users who already have the file. This process makes it possible to very efficiently use the maximum download capability of the downloading peers internet connection. It also does not hinder the person sharing content, because only a tiny piece of the file is shared at a time. Not only does this increase the speed and efficiency of the download, but the downloader no longer has to rely on one user to have the whole file and stay online long enough to get the whole file. With this new speed and efficiency, combined with ever-increasing download speeds of home internet connections, very large files, such as videos, television shows and even software programs can now be downloaded much faster than was ever possible before.

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BitTorrent has gotten a bad rap because it is used for pirating music; however, it is worth mentioning that this technology can be used for ordinary, legal data transfer as well. There is potential for legal use in the business world and education, for example. If all universities were connected via BitTorrent, students and faculty could share knowledge and work together legally, quickly and efficiently across the world. This is not to say that this already occurs now, but rather that BitTorrent technology could increase speed and efficiency in this manner. PeerGuardian is another program that has gained popularity in recent months. It is not a filesharing protocol or program; it is used in combination with a file-share program (Phoenix Labs 2006). PeerGuardian hides or blocks the identity of the downloader. The way it works is by blocking ranges of IPs which are known to be unsafe. It protects in ranges of P2P where addresses are not good since they can be logged or even be RIAA/MPAA spy IP addresses. The blocked ranges are labeled with a name to let the downloader know what is being blocked or from what they are being protected. Simply put, PeerGuardian masks or hides the identity of the downloaders computer, making it extremely difficult for outside parties to track and find them. HYPOTHESIS DEVELOPMENT One might what effect illegal and legal downloading could have on the music industry as a whole. Is there any sort of visible trend that might correlate to certain time frames in recent history? In fact, there are three distinct timeframes in this field of study, separated by two events in the last 15 to 20 years. These timeframes are the early to mid-1990s, late 1990s to early 2000s and mid- to late 2000s. The events that can be used to define these three slices of time are the emergence of Napster in 1998 and the release and growth of iTunes in 2003. [Insert Figure 1 about here.]

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Downloading, Time and Number of Units Sold The early and mid-1990s were a prosperous time for the recording industry. These years were followed by five years of drought as illegal downloading put an end to this steady prosperity. Things started to get better and turn around for recorders with the introduction of iTunes and a way to make a profit from illegal downloading. This trend is easily seen when examining the numbers of units sold as they are available from the RIAA. [Insert Table 1 and Figure 2 about here.] Table 1 shows the number of total units sold, as well as a breakdown between physical units and digital units. Figure 2 is the graphic representation of the total number of units sold. Looking at the graph, it is quite easy to spot these time intervals. From 1994 to 1998, the number of units sold on an annual basis is relatively stable. There is a little fluctuation in 1997, but overall the trend is stable or slightly increasing. Starting in 1999, just one month after illegal downloading became widely known to the public, a sharp decline can be seen. This negative trend does not slow until 2002, the year the first pay download service was launched. A few months later, after legal downloading had a chance to become popular with the public, the trend abruptly turns and becomes positive. The rate actually increased through 2007, when it became a little less steep but remained positive. The overall positive trend continued through 2008, which is the last year for which the RIAA provides data. Examining the breakdown of physical vs. digital units sold, one can see that the first time the RIAA officially reports digital units sold is in 2004. The number of digital units sold increases astronomically over the next four years, while the number of physical units steadily declines after 2004. Starting in 2004, the sum of total physical units and total digital units does not equal the total number of units reported by the RIAA, even though all numbersphysical, digital and totalare supplied by the RIAA. This is believed to be caused by a failure to count mobile units, such as ringtones and ringback tones, as digital units.

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Fighting piracy has been an unending battle. The RIAA hoped to press downloaders to refrain from pirating by suing them and handing out notable fines, but the results were mixed at best, which is why the RIAA stopped suing all together in late 2009. Some people believe that fear of prosecution persuaded them to stop (Sinha and Mandel 2008); other seem to think that the wide availability of the capacity to purchase and then legally download specific songs turned the tide (Ziemann 2007). Industry Reaction and Regulation Attempts In order to help record companies in their fight against illegal downloading, Congress stepped in and passed a bill in 1998 called the Digital Millennium Act. This new piece of legislation had the main purpose of helping to enforce laws against infringers of copyrightprotected materials by making downloaders liable for copyright crimes even if they downloaded for their personal consumption and not for the increase of their personal wealth. The 1998 Digital Millennium Act has allowed the RIAA to sue downloaders all over the United States. The RIAA started major efforts in order to track, catch and sue people using services such as the Kazaa network, which allowed the sharing of thousands of files every day across the globe. Not only did the RIAA make piracy one of their major priorities, so did the FBI and other law enforcement. According to Jana Monroe, a director of the FBI Cyber Division, Cybercrime is the bureaus third priority behind terrorism and counterintelligence (Bond 2004, p. 1). Illegal Downloads and Firm Performance in the Music Industry Online piracy is most directly affecting three different industries: the music industry, the movie business, and the software industry. Interestingly, some industries have shown positive long-run effects from this activity, while others have negative long-run effects (Liebowitz 2006). The software industry has been able to profit from illegal downloading. Some people make statements such as, More people have downloaded cracked versions of his software than have

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purchased the software (Bradbury, Nick-Bradbury Blog, comment posted January 2, 2004). If OEM installs such as Dell and HP are ignored, this is probably true in the home market. In the business world, it is a different story. Businesses and corporations cant afford to put up with the legal and monetary implications associated with piracy. They purchase the product. Piracy shows its good side when the business is trying to decide what software to buy. More than likely it will pick software with which its employees are familiar with and which they use at home. As mentioned previously, this home software has possibly been pirated, but now the software developer gets to sell directly to the businesses or corporations, which normally buy multiple copies. In the end, the software companies, such as Microsoft, make their money by selling to large organizations and OEMs such as Dell and HP. It is a simple economic concept: in order to survive, grow and make profits, they have to increase their market share. Piracy can be a great tool to indirectly increase market share. Industries that face negative effects due to piracy include the music industry. Music piracy has been adopted by many for several different reasons. According to the U.S. Census Bureau, the average American listens to music for 3 hours every day (US Census Bureau 2003). This simply creates a demand that file-sharing can meet for free. Thanks to the relatively small size of music files and the growing availability of broadband internet connections, acquiring a pirated song over the internet is now faster and easier than ever. In fact, as connection speeds increase, file sharing is likely to encompass larger files such as movies and software programs more and more (Liebowitz 2006). Sales history shows a steady increase in sales numbers of about 10% across the music industry between 1993 and 1999 (the year Napster was born). Between 2000 and 2003, sales numbers fell 16% (Rob and Waldfogel 2006). According to the RIAA, Each year, the industry loses about $4.2 billion to piracy worldwide (RIAA 2003). In 2002, about 3.6 billion files were downloaded, about two-thirds of which were music files (Zentner 2006).

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According to the International Federation of the Phonographic Industry (IFPI), in 2005 about 37% or 1 in every 3 CDs sold was an illegal copy (IFPI 2007). If consumers stop buying music for any reason, the sales of the music companies will decline. This is true of music in electronic format as well. The downloading of music that otherwise would have been purchased is lost revenue to the music companies and therefore falls into this category. One needs to distinguish, however, between two different types of lost sales. One is the actual loss from music that was downloaded illegally and would otherwise have been purchased. These consumers were able but unwilling to pay for music or were able and willing to pay but did not have a way to download legally. The other group includes consumers that are willing or unwilling but unable to pay for downloaded music. Since these consumers do not have the money to buy music, there would be no revenue to be made from these consumers. Therefore, one has to be careful when claiming downloads by these consumers as lost revenue. For the purpose of this study, we are going to assume that what the record companies claimed, namely that all downloaders were able to pay for music but chose not to do so, is correct. The revenue which would have been generated by selling to those consumers, if illegal downloading had not been an option, was not realized and therefore lost. This not realizing of revenue will show as a loss or at least decreased revenues for those years. Margins will decline as a result of declining sales. (Margin is calculated by subtracting cost from sales and then dividing the result by sales.) Even if sales go down, costs will not decrease in proportion because of fixed costs associated with production, marketing, and other activities. This means that there will be less sales revenue from which to subtract costs. The result of this is a smaller difference between the new sales revenue and the new cost compared to the difference in the old sales revenue and old cost. This difference is then divided by the revenue in order to calculate the margin. This is why the margin is expected to be lower. Operating income is calculated by taking revenue and

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subtracting operating expenses such as cost of goods sold, SGA, depreciation and other expenses. If there is less revenue from which to subtract these costs, there will be less operating income. If revenue falls, SGA is likely to fall as well, but at a lesser rate because of fixed costs such as labor and rent. From the above discussion H1 is formulated. H1: Illegal downloading will cause sales revenue, margin, SGA expenses and operating income of record companies to decline from 1998 to 2003, compared to that from 1993 to 1998. Some people might try to claim that illegal downloading did not affect the music industry at all and that all the claims made by the RIAA are false (Ziemann 2007). They might argue that if there really was a decline in sales revenue, that it was brought on by economic forces, not illegal downloading. If this was the case, then the general trend of sales revenue or the graph of the sales revenue should mirror or at least correlate strongly with the consumer index, since the consumer index represents the overall performance of economic trends. H2 argues that this will not be the case. What H2 expects is to see a decline in the correlation between the consumer index and the sales revenue of the companies. From the above discussion H2 is formulated. H2: The correlation between the consumer index and the sales revenue will not exist from 1998 to 2003, where illegal downloads caused additional hardship to the music industry. Legal Downloading and Firm Performance in the Music Industry 2003 was the year a new variable undertook to help combat piracy and bring revenue back. iTunes, the first large, easy-to-use online store where music could be purchased for $0.99 per song and be downloaded legally, was launched (http://www.apple.com, 2003). Since then, a large variety of online stores have sprouted, giving people a legal and usually affordable alternative to piracy. By the end of 2003, these music downloads reported earning nearly $30 million (Burt, 2004). By March 2004, iTunes had sold 50 million songs for $0.99 each, making it a huge hit (Fried 2004).

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By 2006, just three years after iTunes was introduced to the world, the revenue from downloaded music totaled $2 billion worldwide or about 10% of all music industry sales (Cuadrado, Miquel, and Montoro 2009). Current sales of iTunes have just reached a new landmark. According to Apple.com, iTunes has sold over 10 billion songs (www.Apple.com, 2010). One of the main reasons why iTunes and the like did and are doing so well is that they offer the same convenience as illegal downloading without the fear of prosecution. Until iTunes, people did not have an alternative to illegal downloading that was widely available and offered the same comforts that internet piracy did. The latest additions to the legal download family are services such as Rhapsody.com and We7.com. Here the user can stream and play all the music he or she desires for a low monthly subscription fee. When the user stops paying the monthly fee, he or she loses access to all music; even music that has been streamed before will no longer be available. This model is hugely popular. Two of the newest providers, We7.com and Spotify.com, gained over 5 million new users within their first year of business (Keegan 2009). They use so-called freemium business models offering streamed tracks for free if users accept an advert or without advertising if users take out a monthly subscription. The freemium model is free to the user, as long as they are willing to be interrupted by popups and other advertising. This advertising is what pays for the free account. In this instance, however, the free music is legal. The movie industry is using the new online technology and ever-increasing internet bandwidth at home to offer video on demand on a pay-per-view basis. The end user does not need to go to a store to rent a video. He or she can download movies directly from services such as Netflix, for example. Netflix will play on any computer, and now the latest DVD players and gaming consoles (X-Box, PlayStation, etc.) are able to interface with services such as Netflix. TV, satellite and cable companies, not to be outdone by Netflix and the like, now offer the ability

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to rent movies by downloading them to the cable box and watching them instantly and conveniently on the users TV. The customer is billed at the end of the month with the regular bill. TV providers even go one step further and offer free downloadable programming, allowing the customer to download and watch a show he or she missed or forgot to record. In late 2002 and early 2003, the downloading options changed. The emergence of iTunes presented a legal way to acquire and pay for downloaded music. This service created an option for the consumer group that was willing and able to pay for downloaded music. Until now, the only option these consumers had was to download illegally in order to acquire music in electronic format. Since this consumer group was not only willing but also had the means to pay for music, they became realizable revenue for the music companies. Since the price for each song was kept at a low $0.99, the size of the consumer group that was able to pay for the music was large. Adding to this revenue were all the users that were unwilling to pay but deterred from piracy by the efforts of the music industry and the RIAA. Because there was now a way for the music companies to realize this previously lost revenue, sales should show an increase shortly after the inception of the first pay music download service was introduced. This realized revenue is expected to increase revenue levels and flatten or reverse the negative trend that revenue, margin and SGA expenses have been following. Margins will increase as a result of rising sales. If sales go up, cost will not go up equally because fixed costs can now be spread over a larger amount of revenue. This means that there will be more sales revenue from which to subtract costs, which will not have increased proportionately. The result of this is a larger difference between the new sales revenue and the new cost compared to the difference between the old sales revenue and old cost. This difference is then divided by the revenue in order to calculate the margin. This is why the margin is expected to be higher. Operating income is calculated by taking revenue and subtracting operating expenses such as cost of goods sold, SGA expenses,

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depreciation and other expenses. If there is more revenue from which to subtract these costs, there will be more operating income. If revenue increases, SGA expenses are likely to increase as well, but at a lesser rate because fixed costs such as labor and rent can now be spread over more revenue. From the above discussion H3 is formulated. H3: Illegal downloading will cause the sales revenues, margins, SGA expenses and operating income of record companies to increase from 2004 to 2008, compared to that from 1998 to 2003. iTunes gave the music industry a way to realize revenue from consumers who were able and willing to pay but did not have a way to do so. Customers who wanted to pay for their music, but were not willing to give up the convenience of getting music without leaving the house or paying for shipping, could now do so. These customers now created sales and revenue for the music industry. This new revenue being added to the sales revenue should cause the revenue trend to increase or at least be less negative. This should cause the overall sales revenue trend correlate more closely with the overall trend of the consumer index. This is what H4 argues. H4: The introduction of legal downloads will cause the positive correlation between the consumer index and the sales revenue to come back starting in 2003. DATA AND METHODOLOGY A t-test and correlation analysis were used to test the hypotheses and determine whether the sales revenue of the big four music companies was affected by illegal and legal downloading, and to test whether the sales revenue of those companies correlated to the consumer index during certain periods of time.

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Data The study uses financial data of the four largest music-producing companies. They are Sony, EMI, Vivendi (Universal Music Group), and Warner Music Group (WMG). Combined, these companies make up over 80% of the music industry, which means that together they sign, produce and release over 80% of all commercial music. Because WMG did not exist before 2002, there was not enough data available and WMG was excluded from the sample. Using the financials of the remaining three companies, a database was constructed. The database contains the financial data of the big three from 1993 to 2008. The specific fields in table1 are: Sales Revenue, Consumer Index, Time Variable 1999-2003, Time Variable 2004-2008, Percent Margin Selling and General Administrative Expense (SGA expense), and Operating Income (OI). Margin is calculated by

. Secondary data was used in this study. The data was

collected from Mergant Online, Compustat and annual statements of the companies in question. The consumer index was retrieved from the Bureau of Labor and Statistics. [Insert Table 2 about here.] Hypothesis Testing A t-test was used for H1 and H3. For this purpose, sales revenue, revenue, SGA expenses, and operating income were grouped by time period and data (the data was grouped into four categories during the three time periods). This resulted in a total of 12 data samples. For each of the three time frames, there were four samples consisting of the combination of sales revenue, margin, SGA expenses or operating income of the three companies. The t-test was then run between those groups of data. For example, all the sales revenue of Sony, EMI and Vivendi from 1994 to 1998 was run with all the sales revenue of Sony, EMI and Vivendi from 1999 to 2003. Then the sales revenue group of the three companies from 1999 to 2003 was compared to that

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from 2004 to 2008. These steps were repeated for margin, SGA expenses, and operating income. This yielded in eight results tables, which were combined into Table 3. A correlation analysis was used to test H2 and H4. The consumer index as well as the sales revenue for the three companies was separated according to the three time intervals defined above. The sales revenues for each year were then added in order to get one aggregate sales revenue figure per time period. This created three revenue segments total. Each of the segments was then used in a correlation analysis with the appropriate segment from the consumer index. The results of those correlation analyses are displayed in Table 4. RESULTS In summary, the t-test shows no support for H1 or H3. See Table 3 for the results of the mean comparison across the three different timeframes (1994-1998, 1999-2003, 2004-2008). [Insert Table 3 here] The t-test showed that the means in general were statistically indifferent. Evaluation of the individual results shows that all of the results with the exception of one are statistically indifferent. This means that, statistically speaking, the means are not different from each other. For Sony, in the two time intervals, the results are (1994-1998: M= 37721.89, 1999-2003 M = 42548.26, 2004-2008 M = 34815.30, for interval 1: |t|= 0.48, for interval2: |t|= 0.71) but (p>0.1) for both. The same is true for the margin (1994-1998: M = .26, 1999-2003 M = .28, 2004-2008 M =.32 for interval 1: |t|= .31, for interval2: |t|= 0.67) and operating income (1994-1998: M = 3519.84, 1999-2003 M = 4498.53, 2004-2008 M = 5082.15, for interval 1: |t|= 1.11, for interval: |t|= 0.5). For SGA ratio for the first interval, the results (1994-1998: M = .21, 1999-2003 M =.23, |t|= 0.78) is not significant as well. For the second interval however, the result (1998-2003: M =
.23, 2004-2008 M =.277, |t|= 2.39***) has a p-value of less than .01, as indicated by the *** and

it is therefore statistically significant at the 1% level. Out of the eight t-tests, this is the only one

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that is significant and therefore we can say that statistically speaking, the averages of the data in the three time periods, separated into the four categories, are not different from each other. If sales revenue, margin, SGA expenses and operating income were affected by illegal and legal downloading, then the means of the data during those time periods should not be statistically indifferent, but they are. The correlation analysis does not show support for H2 but it does show support for H4. See Table 4 for the correlation analysis results. [Insert Table 4 about here.] H2 argues that the introduction of illegal downloading would cause a decrease in the correlation of sales revenue and the consumer index. The correlation coefficients for the time frame 1999-2003 were (Sony: =.5, EMI: =-.37, and Vivendi: =-.01). All of them had a pvalue of (p>.1) and were therefore not significant. H4 argued that the correlation would increase from time frame 1999-2003 to 2004-2008. The respective correlation coefficients were (Sony: =.74*, EMI: =-.09**, and Vivendi: =.97***). All three were significant, Sony at the 10% level, EMI at the 5% level and Vivendi at the 1% level. Sony and Vivendi showed an increasing positive correlation, which is what H4 predicted. EMI showed a significant, yet negative correlation which means that as the consumer index increased, EMIs sales revenue actually decreased. This shows support for H4 in the cases of Sony and Vivendi. Additional Analysis To help understand whether illegal downloading affected sales revenue after controlling for the other factors, regression models were specified. The dependent variable is sales revenue and the independent variables include customer index, two time dummy variables (1998-2003, and 2003-2008), margin and SGA expenses (selling and general administrative expenses). Three models were constructed for each of the big three. Model I was a simple regression with sales

P a g e | 20

revenue being the dependent variable and customer index representing the independent variable. Model II was a regression with other independent variables such as customer index, time dummy variable 1999-2003 and time dummy variable 2003-2008. Model three was a multiple regression, just like Model II but with SGA expenses and margin added to the independent variables. The regression results do not support the hypotheses H1 and H3 either. That is, the coefficients for the time dummies are not significant (Sony: 1999-2003 b=668.61, t=.95, 20042008 b=-1226.30, t=-.13; EMI: 1999-2003 b=-239.22, t=-.69, 2004-2008 b=-174.97, t=-.31; Vivendi: 1999-2003 b=6562.43, t=-.67, 2004-2008 b=-23941.96, t=-1.50 ), even after controlling for consumer index, margin and SGA expenses. See Tables 4, 5 and 6 for the regression results. This means that the time periods defined in Figure 1 did not have an effect on sales revenue for the individual record companies. This is consistent with the results of the mean comparison analysis. [Insert Tables 5, 6, and 7 about here.] DISCUSSION Broadly speaking, the intent of this study is to enhance understanding of what effects piracy had on the sales revenues of the record companies on an individual basis. Specifically, it explores and tests the effects of illegal downloading on sales revenue, margin, and SGA expenses before and after the first large-scale file sharing service became widely known and used. It also looks at the effects of legal downloading on sales revenue, margin and SGA expenses before and after the legal, for-pay download services became popular and people started using them instead of downloading illegally. This study investigates whether illegal downloading caused a decline in sales revenue, margin, SGA expenses and operating income from 1998 to 2003, compared to that from 1993 to 1998. The predicted interaction between illegal downloading and collected data in general is

P a g e | 21

insignificant, with all four companies not showing any significant and/or sustained negative impact that could be linked to or caused by illegal downloads during the five years from 1999 to 2003. This also goes against expectations drawn from the steady decline of total units sold in numbers reported by the RIAA. A decline in the total number of units sold was expected to indicate a decline in the collected data of the big music companies. For the time period from 2004 to 2008, this study expected to find an increase in sales revenue, margin, SGA expenses and operating income. The emergence of legal ways for consumers to download and ways for the record companies to explore a new online market were expected to have a significant interaction. This was unexpected, considering the increase in the total numbers of units sold, reported by the RIAA. Economic Forces Perhaps materialism lacked relative importance for the consumers. The economic recession following the burst of the dotcom bubble in the United States has led to a decrease in consumer spending, especially on luxury goods. Music, being a consumable good with no profit potential for the consumer, could be considered a luxury good, but the fact that many people listen to music for several hours a day and that music seems to put many people at ease could be reasons why sales revenue did not diminish. Lower Cost of Production for Digital Music Another reason why the company sales revenue didnt behave as expected could be that with the emergence of digital music, the companies profit margins for music could have increased substantially. The reason behind this could be that the cost of producing or replicating digital music is extremely low. Essentially, all a music company has to do is copy the digital music file, just like a person can copy electronic files on a personal computer, and then establish a web server from which the customer can download the file after paying for the usage rights. This low

P a g e | 22

cost of production, causing a much higher margin, could be one reason why some of the record companies reported increased sales revenue even though the RIAA reported a decrease in the total number of units sold. Even if the total number of units sold went down, if the increase in profit due to the extra margin is larger than the loss of profit, the company will end up with more. Realizable Income Consideration should be given to the fact that many of the people downloading music illegally after 1999 were high school and college students (Ziemann 2007). These people might not fall into the willing and able category of consumer, but rather into the willing and unable. A lot of students are on a budget, and therefore their spending for luxury items such as music is limited. Therefore these people should not be counted in the lost revenue category for the simple reason that they did not have the money to spend on music in the first place. If there were no way for them to download illegally, they still would not have spent more money purchasing music, simply because they were unable to do so. Customer Tastes An alternative but very plausible explanation for the absence of any significant data could be simple customer taste. If one record company signs and releases multiple hot artists and therefore is able to sell many records, while another record label strikes out and signs very few or even no high-selling artists, there would be a significant difference between the two companies as well as between the numbers of the same company from different years. These events would not be related to legal or illegal downloading but to how much consumers like and buy the product of the individual record companies.

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Limitations and Future Research One obvious limitation is the sample of companies used for this study. Because there are only four large record companies, which account for 80% of all released music, only a limited amount of financial data exists. To make things more complicated, Warner Music Group did not exist until 2002. This limits the usable sample of companies with at least 15 years of financial history to only three. A more diversified market with smaller but more numerous companies, and therefore a larger sample size, would be preferable. As mentioned, Warner Music Group didnt exist before 2002, which means that there is no financial data available for that company before 2002. Since there were only three other big companies, WMG was used in the sample and to run the regression. The problem that presented itself by doing that is that of incomplete data. Measures such as only using one time variable (2004-2008) were taken in an effort to deal with this problem as much as possible and still use WMG as a sample. Future research might investigate strictly the influence legal downloading had and still has on the industry. Currently the trend seems to be that of declining numbers of total physical units sold and an increase in the number of total digital units sold. It would also be interesting to further analyze how the lower production cost of digital units affected the industry, the individual companies and the customer (price of music).

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REFERENCES Apple.com (2003), Apple Launches the iTunes Music Store. http://www.apple.com/pr/library/2003/apr/28musicstore.html (accessed April 28, 2010). Apple.com (2010), 10 billion songs downloaded from iTunes and counting, http://www.apple.com/iTunes/10-billion-song-countdown/, February 24. Bond, Paul (2004), No Title, The Hollywood Reporter, February 20. Bradburry, Nick (2004), On Piracy., http://nick.typepad.com/blog/2004/01/on_piracy.html, January 2. Carmack, Carmen (2005) "How BitTorrent Works," HowStuffWorks.com, http://computer.howstuffworks.com/bittorrent.htm, March 26. Coleman, Norm (2003), The RIAA and the Music Piracy Debate, Newsbytes, 20 (October). Cuadrado, Manuel, Maria Jose Miquel, and Juan Montoro (2009), Consumer attitudes towards music piracy: A Spanish case study, International Journal of Arts Management, 11 (3), 415. Fried, Ina (2004), Apple's iTunes sales hit 50 million, CNET News, http://news.cnet.com/21001027_3-5173115.html, March 15. Geralds, John (2001), Music Downloads on the Rise, http://www.infomaticsonline.co.uk/news/1125301. IFPI (2001), Recording Industry World Sales, London, International Federation of the Phonographic Industry. IFPI (2007), Digital music in 2007 a brave new world, Digital Music Report in 2007, http://www.ifpi.org/content/library/digital-music-report-2007.pdf. Keegan, Victor (2009), The strange death of illegal downloading, Guardian Newspapers Limited, November 19. Liebowitz, Stan J. (2006), File Sharing: Creative destruction or just plain destruction? Journal of Law & Economics, 49 (1), 1-28. Liebowitz, Stan J. (1985), Copying and indirect appropriability: Photocopying of journals, Journal of Political Economy, 93 (5), 945-57. Phoenix Labs (2006), PeerGuardian 2: Manual, Phoenix Labs, http://wiki.phoenixlabs.org/wiki/PeerGuardian_2:Manual#How_PeerGuardian_Works

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Rafael, Rob and Joel Waldfogel (2006), Piracy on the high Cs: Music downloading, sales displacement, and social welfare in a sample of college students, Journal of Law & Economics, 49 (29), 29-62. Reuters 2007, "Music industry wins song-download case," Reuters. http://www.reuters.com/article/technology-media-telco-SP/idUSN0541841120071005. RIAA (2009), Facts and figures: Manufacturers unit shipments and dollar value charts, http://www.riaa.com/keystatistics.php, November 11. RIAA (2003), Recording industry begins suing P2P file sharers who illegally offer copyrighted music online, http://www.riaa.com/news/marketingdata/facts.adpt#unit, September 8. Sinha, Rajiv and Naomi Mandel (2008), Preventing digital music piracy: The carrot and the stick, Journal of Marketing, 72 (January), 1-15. U.S. Census Bureau (2003), Media usage and consumer spending: 1998 to 2006, Table 1125 in Statistical Abstract of the United States. Washington, DC: Census Bureau. U.S. Senate. (1983), Committee on the Judiciary. Video and Audio Home Taping., Hearing before the Subcommittee on Patents, Copyrights, and Trademarks (testimony of Allan Greenspan). 98th Congress, 1st Session, October 25. Zentner, Alejandro (2006), Measuring the effects of file sharing on music purchases, Journal of Law & Economics, 49 (63). Ziemann, George (2007), RIAA's Statistics Don't Add Up to Piracy, http://www.azoz.com/music/features/0008.html#2007, October 8.

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Table 1
Recording Industry Association of America (RIAA) Year-End Shipment Statistics Total Year Units* Physical* Digital* 1994 1122.7 1122.7 0 1995 1112.7 1112.7 0 1996 1137.2 1137.2 0 1997 1063.4 1063.4 0 1998 1123.9 1123.9 0 1999 1160.6 1160.6 0 2000 1079.2 1079.2 0 2001 968.5 968.5 0 2002 859.7 859.7 0 2003 798.4 798.4 0 2004 958.0 814.1 143.9 2005 1301.8 748.7 383.1 2006 1588.5 648.2 625.3 2007 1773.3 543.9 868.4 2008 1852.5 401.8 1,112.30 *In Millions, net after returns Source: http://www.riaa.com/keystatistics.php

P a g e | 27 Table 2 Variable Definitions Sales Revenue Value of annual sales in millions of US dollars, as reported in the annual report of the company. A measure estimating the average price of consumer goods and services purchased by households. Time dummy variable for the time period of 1999 to 2003. 1 if the year = 1999-2003, 0 if otherwise. Time dummy variable for the time period of 2004 to 2008. 1 if the year = 1999-2003, 0 if otherwise The difference between the sales and the cost of goods sold, divided by sales. % Margin = [(Revenue - Cogs)/Revenue]*100 Expenses which consist of the combined costs of operating the company Operating income is calculated by taking the revenue and subtracting operating expenses such as cost of goods sold, SGA, depreciation and other expenses.

Consumer Index

Time 1999-2003

Time 2004-2008

Percent Margin

SGA-Expense

Operating Income

P a g e | 28 Table 3 Mean Comparison between 1994-1998 and 1999-2003 Variable 1994-1998 1999-2003 |t-Stat| Sales Revenue 37721.89 42548.26 .48 Margin .26 .28 .31 SGA-Expense 9037.78 10118.45 -.42 Operating 3519.84 4498.53 1.11 Income Mean Comparison between 1999-2003 and 2004-2008 Variable 1999-2003 2004-2008 |t-Stat| Sales Revenue 42548.26 34815.30 Margin .28 .32 SGA-Expense 10640.51 8394.71 Operating 4498.53 5082.15 Income ** Statistic is significant at the 5% level .71 .67 .69 .50

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Table 4 Correlation between Sales Revenue and Consumer Index 1994-1998 1999-2003 2004-2008 0.74* -0.9** 0.97*** Sony 0.86* 0.5 EMI -0.95** -0.36 Vivendi -0.09 -0.01 * Statistic is significant at the 10% level ** Statistic is significant at the 5% level *** Statistic is significant at the 1% level

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Table 5 Sony Regression Results (N=15) Model I Variable Constant Consumer Index Time 1999-2003 Time 2004-2008 Margin SGA-Expense R2
2

Model II Estimate -56504.67 (-1.79) 671.03 *** (3.34) 1043.41 (.20) -5127.29 (-.52)

Model III Estimate -16692.06 (-.74) 188.30 (1.75) 668.61 (.95) -1226.30 (-.13) 3.42 *** (6.93) 1406.07 (.03) .98 .97

Estimate -39358.30 *** (-3.15) 567.03 *** (8.12)

.84

.85

R (Adjusted) .82 .82 Dependent Variable is Sales Revenue in Million Dollars ** Statistic is significant at the 5% level *** Statistic is significant at the 1% level

P a g e | 31 Table 6 EMI Regression Results (N=15) Variable Constant Consumer Index Time 1999-2003 Time 2004-2008 Margin SGA-Expense R2 .72 .75 R2 (Adjusted) .70 .68 Dependent Variable is Sales Revenue in Million Dollars ** Statistic is significant at the 5% level *** Statistic is significant at the 1% level Model I Estimate 8555.99 *** (8.35) -32.89 *** (-5.75) Model II Estimate 10145.30*** (3.92) -43.84** (-2.65) 488.63 (1.13) 590.07 (.73) Model III Estimate 2671.05 (.92) -.54 (-.03) -239.22 (-.69) 174.97 (.31) -207.25 (.24) 5.39*** (3.83) .92 .86

P a g e | 32 Table 7 Vivendi Regression Results (N=15) Variable Constant Consumer Index Time 1999-2003 Time 2004-2008 Margin SGA-Expense R2 .40 0.61 R2 (Adjusted) .35 0.51 Dependent Variable is Sales Revenue in Million Dollars ** Statistic is significant at the 5% level *** Statistic is significant at the 1% level Model I Estimate Model II Estimate Model III Estimate -36128.22 (-.65) 328.76 (.96) 6562.43 (-.67) -23941.96 (-1.50) 2.60** (2.53) -4525.09 (-.16) 0.79 0.67

119904.54*** 27551.72 (4.24) (.45) -465.45** (-2.95) 110.95 (.29) -1626.43 (-.16) -29037.75 (-1.54)

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Figure 1

Time Frame and Expectations

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Figure 2

Total Units Sold (in millions)

2000.0 1800.0 1600.0 1400.0 1200.0 1000.0 800.0 600.0 400.0 Total Units

Total Units in million

200.0 0.0
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Calendar Year

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Figure 3a Sony Sales Revenue and Operating Income

100000 90000 80000 70000 60000 50000 40000 30000 20000 10000 0 Sony Revenue in million Operating Income in million

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Figure 3b Sony Margin and SGA-Ratio

0.35 0.3 0.25 0.2 0.15 0.1 0.05 0 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Margin SGA-Ratio

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Figure 4a EMI Sales Revenue and Operating Income

4500 4000 3500 3000 2500 2000 1500 1000 500 0 -500 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 EMI Operating Income in million EMI Revenue in million

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Figure 4b EMI Margin and SGA-Ratio

0.6 0.5 0.4 0.3 0.2 0.1 0 -0.1 -0.2 -0.3 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Margin SGA Ratio

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Figure 5a Vivendi Sales Revenue and Operating Income

70000 60000 50000 40000 30000 20000 10000 0 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Vivendi Operating Income in millions Vivendi Revenue in million

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Figure 5b Vivendi Margin and SGA-Ratio

0.6 0.5 0.4 0.3 0.2 0.1 0 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Margin SGA Ratio