Technological Change, Convergence and the

Strategic Struggle for Dominance

in the Entertainment Industry

 

 

Edward J. Deak, Ph.D.

Professor of Economics

Fairfield University

 

 

Presented at:

The 2003 Annual Meeting:

National Business and Economic Society

 

St. Thomas, U.S.V.I

Friday March 6, 2003

 

Abstract

The paper examines two disruptive and costly convergence trends in the entertainment industry that are destroying old business models, along with undermining existing market power and industry structure.  The first is the illegal digital duplication and Web trade of copyrighted video and music disks, while the second involves the entrepreneurial drive to vertically integrate the content and distribution parts of the media business.   The record industry has developed four strategic reactions to the piracy problem including legal challenges, the creation of a legislative shield, pressing for the adoption of a technology defense, and altering their current album-based business model.  Given the unlikely ability to halt the illegal exchange of their intellectual property, the most efficient course of action for the record firms may involve developing novel music delivery methods and pricing schemes, as well as the leveraging of music assets and talent to create new revenue streams.  Entertainment titans have historically engaged in horizontal acquisitions, assembling varied collections of media assets.  Now, the perceived technical convergence of media content and distribution has led them into a new phase of vertical integration.  Economic theory justifies vertical mergers either on the basis of economies of scope, with saving in transactions cost, or on the basis of enhancing market power through the creation of heightened entry barriers.  Conversely, media executives have justified their vertical mergers on the basis of synergy, where revenue creation and profits are enhance by joint operations.  To date, this synergy view has yet to be proven correct.

Technological Change, Convergence and the

Strategic Struggle for Dominance

In the Entertainment Industry[1]

 

Edward J. Deak, Ph.D.

Professor of Economics

Fairfield University

 

“Convergence may be the most expensive word in history.” – David Geffen[2]

 

1.   Introduction – Convergence and the Issue of Expense

 

David Geffen is an unquestioned leader in the entertainment industry, having founded the Asylum and Geffen record labels, produced the Broadway musical Cats, and combined with Stephen Spielberg and Jeffrey Katzenberg to create Dreamworks SKG, the first new successful Hollywood studio in fifty-five years.  His quote regarding technology “convergence” as it applies to the entertainment industry is insightful and can be interpreted on at least two levels.  The first, and most superficial interpretation involves the dollar cost associated with the nuts and bolts of introducing digital technology and adapting to the new modes of content production.  The quote’s second level of analysis is a more metaphysical or causal one encompassing the costs of dealing with a disruptive technology that changes the existing business model, alters firm strategy and industry structure, while at the same time undermining the existing sources of market power. 

 

It is this latter interpretation that serves as the driving force behind the following discussion, which examines two parts of the entertainment industry that have seen considerable strategic upheaval and financial expense as a result of both real and perceived convergence.  First, the union of digital technology with the speed and global reach of the Internet have threatened the copyright protection enjoyed by intellectual property and undermined the profitable business models adopted by both the recording and motion picture segments of the entertainment industry.  This challenge has placed the music and film industries in the position of having to defend their assets against illegal duplication and distribution, while at the same time finding new ways to leverage those assets to create new revenue streams.  Second, key media executives have perceived a change in technology that has led to a functional convergence between the content creation and electronic distribution components of the entertainment industry.  This perceived convergence has spawned a series of vertical mergers of content creators with broadcast, cable and Internet distributors.  It is not at all clear that these strategic mergers have increased efficiency and boosted shareholder value.

 

This paper begins with a short discussion of the Schumpetarian view of competitive markets that serves as a general model of the types of pressures being faced by the entertainment industry.  After discussing both the general nature of convergence and the concept of tension, the paper undertakes three tasks.  First, it briefly traces out the recent history of technology convergence as it applies to the entertainment industry.  Second, it identifies the strategic reactions to convergence and the tensions, or frictions that these strategic actions have created both within the industry and with third parties.  Finally, it looks at the efficiency and profitability of these strategies to date, along with their prospects for future success in dealing with the convergence caused by the appearance of a disruptive technology.

 

2.   Schumpeter’s Model of Capitalism and Change

 

The 20th century scholar Joseph Schumpeter was among the first economists to make the case that the essential feature of capitalism is its ability to serve as a method of economic change within a world where real markets are in constant turmoil.[3]  Rather than tending towards or resting at equilibrium, existing products, firms, business models and ways of doing business, along with positions of market power are under relentless assault.  Changes in technology, shifts in consumer tastes and preferences, the appearance of fresh sources of supply, the opening of new markets, or opportunities to alter the method of business organization, bring about this continuing onslaught.

 

These economic transformations create gaps or opportunities in the existing market that are seen by the profit-seeking entrepreneur, who is frequently an outsider as opposed to being a current supplier.[4]  The entrepreneur acts to close the perceived gap by creating and introducing a new vision into the marketplace that is designed to better satisfy consumer demand.  The market acts as a forum to test, validate, modify, or reject the new entrepreneurial concept.  By functioning in this capacity, capitalistic markets serve as more than just a place to facilitate the exchange of individual products.  Rather the marketplace serves a broader role as a proving ground for the launch, exchange and testing of new ideas.

 

Entrepreneurial success is never guaranteed.  Rather, it is a function of how the market gap is filled, the economic strategy adopted, and the nature of the business model that is employed.  Entrepreneurial timing too is an important ingredient, such that the right strategy introduced at the wrong moment can be just as potentially ineffective as the introduction of the wrong strategy.  If it is successful, the entrepreneurial idea alters the existing economic structure from within by evolving a new product, a new technology, a new source of supply, or a new type of organization.  In the end, the entrepreneur destroys the old economic system, replacing it with a market tested and potentially superior structure, which is in turn tested and challenged by future gaps.

 

Schumpeter saw this capitalistic reality of industrial mutation as being continuous, economically efficient and generally beneficial.  He thereby christened it as the “perennial gale of creative destruction”, avowing that “every piece of business strategy acquires its true significance only against the background of that process and within the situation created by it”.[5]

 

3.   Details of the Convergence Challenge

 

This brief summary of the essential features of Schumpetarian competition serves as a theoretical backdrop for the following discussion of convergence.  The concept of convergence has affected both contemporary communication technology and the current state of most media conglomerates in the entertainment industry.  Technology convergence has taken what were historically separate products such as telephone, television as well as computers, and blended them into a single, increasingly seamless, network.  Originally, telephones carried analog voice signals over direct circuits, televisions displayed analog sound and video signals transmitted over the airways, while computers recorded and acted upon text and data in self-contained digital form.  While some blurring at the fringes appeared with the introduction of facsimile machines and cable distribution of TV signals, for the most part, the products and markets were separate and distinct.  Within each market, giant firms such as AT&T, NBC, CBS, ABC, IBM and Microsoft grew to dominate various parts of the business.  Except for rivals within their own markets, the entrenched giants didn’t compete much with one another or with other information and entertainment suppliers such as movie studios, publishing houses, or record firms.

 

Two innovations helped to change this noncompetitive structure of segmented markets.  The first was the growing ability to digitize all types of information in the form of electronic computer code.  Now, not just text and data but still pictures, video, sound, and animation could be reduced to a string of zeros and ones.  The code could then be transmitted electronically from origin to final destination where it would be reconverted into its original form.  In a relatively brief period, the monopolistic and regulated 90-year-old telephone industry was transformed into a set of potentially competing telecommunications firms.  The second innovation involved the introduction of the Internet and its most prominent application the World Wide Web.  These events affected both the pace and direction of telecom technology convergence.  The Internet began as a Department of Defense communications alternative to vulnerable telephone connections.  It was a more secure means of transmitting sensitive military information based upon packet switching technology rather than direct telephone circuits that might be either tapped or disrupted.  The Internet remained primarily a defense and scientific communications link until 1991, when the physicist Tim Berners-Lee assemble the technical rudiments of what grew to be called the World Wide Web.  Through the introduction and use of a browser along with hyperlink technology, individuals of average skill and ability could gain access to the Web via the Internet, move around effortlessly, send messages, and gain access to any and all types of information listed at an exploding number of Web sites. 

 

Throughout the 1990’s, the Web grew to include tens of thousands of commercial applications, eventually becoming the global entity that it is today.  Visions of profits arising from unrestrained Internet growth in both hardware connections and commercial potential spawned one of the greatest investment bubble-burst cycles of all time.  It involved the creation and destruction of some 5 trillion dollars of equity value.  While the aftermath of the failed investment cycle is still being felt today, the fact remains that the technology innovation of the Internet has forever changed the ways in which individuals and firms obtain information and communicate with one another.  The technology has removed industry barriers, spawned a significant number of market gaps and intensified competitive pressures.  These gaps will be filled by new entrepreneurial strategies created by some combination of existing companies, startup firms, and hybrid organizations.  

 

The innovation based technology convergence has altered the competitive landscape, creating a number of conflicts or tensions among firms whose competitive spirits were previously constrained by or protected behind technology barriers.  Firms that were dominant in one market segment and saw other dominant businesses as mere distant shadows often find themselves in direct competition and conflict with these unrestrained giants.  Others may see firms in related industries spreading into the newly opened markets, or face competition from emerging entrepreneurial organizations.  The number of strategies or business models that entrants might adopt as possible ways to fill the perceived market gaps multiplies the array of potential conflicts among participants.  One goal of this paper is to identify a few of these key strategic frictions and to cast them in the form of tensions that are pulling the possible solutions to the conflicts in different directions.  Defining these convergence based conflicts in the form of tension creation and resolution is a way to organize and emphasize the clash of ideas and business models, which often underlies the more visible struggle among individual firms, products, or personalities.

 

Many of the tensions identified in the following pages will be resolved in the market, where potentially the best solution wins out based upon an ability to satisfy a profitable segment of consumer demand.  In crowning a victor, impersonal markets most highly value efficiency, in both the static and dynamic senses.  The superior idea leads to the production of desired product at the lowest possible cost.  Nonprice attributes such as quality, image, reliability, and convenience, interact to determine the acceptability of the product, which is then selected on the basis of low price.  Occasionally, the market result can be swayed in the direction of the firm with the most financial backing or the market power to overwhelm their opponent.[6]  But absent pervasive amounts of market power, this latter result is less likely in situations where rapid change makes entrepreneurial opportunities more prevalent.  The market also values efficiency in the dynamic sense of successfully anticipating and reacting to changing market and technology conditions.  Despite the typical reliance on the market as an arbiter, some tensions may be resolved, at least in part, outside of the market through legislative, judicial or regulatory actions.  In these venues, the efficiency criteria plays a far lesser role, while resolution criteria based upon compromise, a balancing of conflicting interests, ideology, and judicial precedent have more to do with the final outcome.[7] 

 

4.   Digital Music: A Case of Technology Induced Convergence and Tensions

 

In the 1950’s, the age of vinyl recordings, singles songs selling at 45 rpm and albums selling at 33 1/3rd rpm were available side by side in record stores.  This mix of music delivery forms served as the basic profit model for the music industry.  But with the introduction of cassette and later CD delivery technology the economics of the industry changed radically.  Now, between ten and fourteen songs from the same artist were easily loaded onto a single cassette or later a compact disk, which was then sold as an indivisible unit to the buying public for a price that currently averages $14.21 per CD.[8]  On the one hand, this bundled album business model was of substantial benefit to the record companies.  It allowed them to sell an aggregated product for a much higher per unit price and gross revenue than might be secured for the sale of the songs individually, while doing so at a much lower incremental cost per CD sold. 

 

However, the bundling model created a tension with music fans, who found it to be an excessively expensive approach to music acquisition.  Buyers might have wanted just one or two songs from the CD.  But they were denied single song access because the power over music form and distribution was in the hands of the record companies.  The principle recourse for an unhappy music fan was to turn to an early act of music piracy, involving the unauthorized tape duplication and exchange of copyrighted material.   Fortunately for the record firms, this music piracy was limited in both economic scale and scope.  The unbundling of songs by music fans was an inconvenient and cumbersome activity, restricted to the making of one-at-a-time tape copies of diminished sound quality.  The sharing or swapping of song files was usually limited to a narrow circle of known individuals, who were located in fairly close geographic proximity.  Given these obstacles, the loss in revenue for the producers and artists resulting from the theft of intellectual property was minimal. 

 

The appearance of digital file compression technology, the Internet, and Napster et al. collection of song sharing software have significantly altered the economics of the music industry.  The technologies shifted the balance of power within the tension towards the consumer, changing both the potential scale and scope of music piracy.  The one time transfer and storage of a song in digital MP3 format onto a computer hard drive yielded a perfect copy that was readily exchangeable.  The introduction of Napster and other file sharing software made it easier to find holders of desired songs and to transfer music over the Internet.  Lastly, the global reach of the Internet raised the scope of illegal file sharing to the level of an international activity.  Together, the Internet and Napster were a disruptive technology that reduced the cost of music piracy, while simultaneously creating a global market for music exchange.  They also had the effect of creating an ethical disconnect in the minds of consumers towards their participation in the illegal exchange of copyrighted music.  Individuals who would never think of stealing a CD from a record store didn’t see the free exchange of legally purchased music via the Internet as a form of theft.  After all, the music had been paid for, and the owners had the right under the “fair use exception” to the U.S. copyright laws to make copies of the music for their own personal and non-commercial use.  This right to make legal copies had been further protected by the Audio Home Recording Act of 1992. 

 

While the exchange of the music files with or without payment is clearly illegal, that part of the transaction was easy to overlook in light of the legality of the first two steps.  The spread of high-speed broadband Internet connections, especially on college campuses, accelerated the rate of music piracy.  As of February 2001, there were 58 million persons worldwide registered on the Napster system, with 300,000 new users being added on a daily basis.  On any given day, there was an average of 1.57 million users connected to Napster, who were sharing some 220 MP3 music files each.  The electronic exchange of music files had become a killer app of the Internet, employing some five percent of the total operable bandwidth.  However, this electronic exchange was both a violation of the copyright laws and economically injurious to the record firms.  To make matters worse, the technology that allowed the theft of music files could be used to swap any digital material including DVD files containing the code for movie sound and video.  Only the current quality and speed of movie transmission over the Internet limited this newer and more expensive form of copyright violation.

 

How serious a problem is CD piracy?  And how might the recording industry meet this technology challenge, resume control over its intellectual property, and resolve the tension between the record firms and their customer base?  The problem of illegal file sharing appears to be both financially serious and growing in magnitude.  In 2002, sales of compact disks fell by 9.3% after having declined 2.1% in 2001.[9]  This was the first back-to-back fall in album sales in over 10 years, and was primarily attributed to music piracy.[10]  At this rate, song piracy would quickly undermine the economics of the recording industry. 

 

To reverse the file-sharing trend, the industry has employed four options (legal, legislative, technical and strategic), each of which has been met with a varying degree of success.  The first was a legal option where in one approach, individual artists, including Metallica, along with the Recording Industry Association of America (RIAA), the industry umbrella organization, have gone after individual copyright violators.  Metallica collected and included the screen names of more than 335,000 registered Napster users who were offering to exchange the band’s music in its suit against the software firm.  In early 2003, the RIAA has secured a federal court ruling requiring that the Internet service provider (ISP), Verizon Communications, to turn over to the RIAA the name address and telephone number of an individual where there is evidence that the person is using the Internet to illegally send or receive copyrighted material.[11]  Given that there were an estimated 63 million U.S. music downloaders in 2002, addressing individual copyright violators on a case-by-case basis is clearly an unworkable, excessively costly and inefficient tactic.  Then again, the individual case approach may be intended to throw a scare into large-scale violators with 600 or more songs available for swapping.  If so,  then a few high visibility cases might alert music fans to the illegality and dangers of file swapping and slow the pace of peer-to-peer exchanges. 

 

However, both the reality and threat of action against individual copyright violators poses a problem for the artists and record producers.  The collecting of screen names placed Metallic in the very delicate position of being in opposition to and possibly alienating some of their most loyal fans that might have illegally exchanged only a few songs.  Also, having the RIAA sue music fans is not the best long run policy for the record industry that wants the same fans to pay for their favorite music.  Individual suits are especially problematic when it is impossible to know the precise identity of the individual who is doing the file swapping under the screen name of the ISP account holder.

 

A second branch of the legal approach involves the RIAA suing the creators of the software and support services that make it possible for music fans to engage in illegal file swapping.  The most highly visible and successful of the support services cases was the one against Napster, where the RIAA won a court victory against the firm’s central information storage and file locating system that facilitated the exchange of music files.  The Appellate Court ordered Napster to cease and desist its music sharing operations, but stopped short of banning the Napster software and information system outright, noting that the technology could valid for “commercially significant, noninfringing uses.”[12]  Even with the financial assistance from Bertelsmann, the German entertainment conglomerate, Napster was unable to transform its music downloading system into a legal commercial venture, and the firm ceased operations in the summer of 2002.

 

Despite the legal triumph over Napster and a similar result against another file sharing support firm Aimster, the RIAA was not able to stop the illicit exchange of music files given the appearance of other file sharing software programs such as KaZaa, eDonkey, and Gnutella.[13]  These programs rely on a non-centralized system of direct peer-to-peer file sharing and are not as easy to shutdown as was Napster.[14]  The RIAA in conjunction with the Motion Picture Association of America (MPAA) have filed suit against Sharman Networks, Streamcast Networks and Grokster, which are firms that employ the KaZaa technology in support of illegal file sharing.  The suit against Sharman Networks was recently given standing in the U.S. by the U.S. District Court in Los Angles despite the fact that the firm is headquartered in Australia, it is incorporation in the Pacific Island of Vanuatu, and has no assets in the U.S.[15] 

 

The legal approach against software support firms is both long and expensive.  Also, it has resulted in decisions like Napster, which allow the existence or distribution of file-sharing software as an exercise in free speech and only prohibit its specific use for the duplication of copyrighted material.  In pursuing the legal approach, the RIAA is ignoring the fact that file-sharing software exists, that it is readily available, and can never be eliminated as a method to exchange music files over the Internet.  As such, the technology poses a permanent challenge to the record industry’s album based business model, which in turn requires either greater protection against copying if it is to survive, or its abandonment in favor of another method of selling music.

 

The second option followed by the RIAA and MPAA was to seek a legislative shield against electronic copying by securing Congressional passage of the Digital Millennium Copyright Act (DMCA) of 1998.[16]   This Act spelled out the boundaries for electronic copyright protection and substantially raised the level of safeguard against illegal file sharing.  Two provisions were central to this protection.  The first was an anti-circumvention provision, which made it a criminal offense to circumvent anti-piracy measures built into commercial software including music and films.  The second was an anti-device provision, which prohibits the manufacture or distribution of any device designed to circumvent technological copyright protection.  Together, these provisions would allow the owners of intellectual property to add anti-copying technology to their material and make it illegal for anyone to break the code or sell equipment that would support the duplication of the material. 

 

While the law yields greater legal protection for the copyright holders, it creates a number of new tensions with other legal statutes.  First, the DMCA creates a tension with legitimate owners of the material who wish to exercise their rights to make copies for their own use under the fair use provisions of the U.S. copyright laws.  If the material is technology protected against duplication, and the breaking of the duplication code is illegal, then legitimate owners of the material are effectively barred from exercising their duplication rights.  Second, the DMCA creates a tension with the time provisions of the U.S. Constitution, which specifically restricts the power of Congress to extend patent or copyright protections for a limited period of time.  While the Supreme Court has recently upheld Congress’s 1998 decision to extend copyright protection for up to 95 years,[17] the DCMA provisions allow an additional layering of technology protection on top of the copyright laws that in effect prohibits the copying of the material forever. 

 

Third, the DMCA creates a tension with the First Amendment right of free speech.  Computer code, which has the power to circumvent copyright protected technology, can be considered a form of free speech that can be listed, linked to, and distributed over the Internet.  The 2nd U.S. Circuit Court of Appeals in New York has upheld the application of the Act to limit the posting of or linking to computer code, known as DeCSS, which cracks the Content Scrambling Code inserted on DVDs and designed to limit the illegal duplication of copyrighted movies.[18]  But a California state appeals court sided with a person who was distributing the DeCSS program saying that a “ prohibition of future disclosures of DeCSS was a prior restraint on (the defendant’s) First Amendment right to publish the DeCSS program.”[19]  To date, the tension between the free speech interpretation of the computer code and the language of the DMCA is unresolved in the courts and may become an issue for the U.S. Supreme Court.  In a possible preview to that decision is contained within another DeCSS distribution case where Justice Sandra Day O’Connor has ordered the California Supreme Court to lift its prohibition on the distribution of the DeCSS utility by an out-of-state individual.[20]  While the specifics of the case may have weighed more heavily on Justice O’Connor’s decision than the legal balance within the free speech tension, the fact remains that judicial resolution of this tension remains as an important and complex action.

 

The third anti-piracy option involves the introduction of one or more technology methods, such as digital watermarking or encryption, as a way to protect against the digital reproduction of copyrighted material.  A digital watermark is an electronic signal or “flag” imbedded throughout the work signifying copyright protection.  Devices that read or copy digitized files could be programmed to detect the digital watermark and deny access to anyone for purposes of duplication.  Marking the copyrighted files in this way could put an end to illegal file sharing of music, films or books.  But the digital watermark approach sets up a tension with the makers of playback and reproduction equipment.  Watermark technology transfers the responsibility and expense of developing and installing copyright protection technology from the holder of the copyright to the makers of the playback devices.[21]  As a result, device makers have created a technology impasse by openly opposing the implementation of the watermark approach for at least two altruistic reasons.  First it would make existing computers and playback equipment obsolete and second, it would potentially violate the case based copying rights of consumers established under the fair use doctrine.  In addition, equipment manufacturers have been accused of a more self-serving motive for their opposition to watermarking.  The introduction of Watermark detection technology could inhibit the rise in long-term profits derived from the sales growth of copying devices, which are in turn fueled by the owner’s ability to transfer digital material to a number of compatible playback systems.

 

This microeconomic tension based upon responsibility transfer, cost allocation and profit impacts has a macroeconomic implication as well.  Some members of Congress feel that the inability to agree on technology safeguards for copyrighted material makes the movie studios unwilling to offer “high-quality programming for digital television and broadband Internet services that would generate consumer interest and, in turn, economic growth.”[22]  Therefore, the conflict between copyright holders and equipment manufacturers creates an additional tension on the national level between the priorities of protecting intellectual property and promoting growth enhancing technological innovation. 

 

The potential here is for Congress to step in and legislate some form of solution to the impasse, if the parties themselves cannot agree on a way to resolve their tension.  One quasi-legislative solution employing a financial as opposed to technical answer was recently introduced in Germany.[23]  There, the Patent Office ordered the markers of personal computers to pay the U.S. equivalent of a $13 copyright or royalty fee to the local collecting societies that gather funds in the name of copyright holding authors, publishers and artists.  The fee is to be levied on the production of each machine under the presumption that the PCs are being used to illegally copy and store works that would otherwise be subject to royalty payments.  A similar royalty fee has for years been levied throughout Europe on the sale of blank audio and videotapes.  Also, “some countries already have extended copyright levies to blank compact disks, record able video disks and CD writers.”[24]  The German societies are trying to expand the reach of the collection process to cover the range of digital equipment including PCs, printers, scanners and any devices that can be used to facilitate the illegal duplication of copyrighted material.  While such royalty levies are not yet part of the U.S. compensation proposals, they offer one quick way to deal with the problem.

 

Encryption, as opposed to watermarking, is a second technology that can serve as a way to protect copyrighted digital material.  Encryption is a software approach that involves scrambling or degrading the copyrighted content and unlocking the scramble only to those who have an authorized key.  As with watermarking, music encryption might render some portion of the existing stock of CD playback equipment obsolete.  Also, given that encryption is a software based technology solution, the code is subject to decryption by countervailing software.  Legitimate device makers say that it would be easy to write code that would allow the transfer of encrypted material.  However, such an act would expose any manufacturer to prosecution under the provisions of the DMCA.[25]  Despite its simple appeal, music encryption ultimately leads to many of the same kinds of problems associated with the film industry’s attempt to stifle the usage and spread of the DeCSS technology that counters the encryption code on DVD movies.

 

The fourth approach is a strategic option and involves the record industry modifying its existing album-based business model, for example by allowing the e-commerce sale of individual songs or CDs over the Internet.  But what would be the nature of the new e-commerce business model and how would it be implemented?  One of the strengths of Schumpeter’s marketplace is that creative destruction frequently provides more than a single answer to those kinds of questions.  In one response, the five dominant record companies have created two rival e-commerce alliances designed to bring fee-based music services directly to Internet consumers.  Pressplay markets the songs from Sony Music and Universal Music, whereas MusicNet, in alliance with RealNetworks, uses the RealOne file transfer technology to license the music of BMG (Bertelsmann), EMI , and AOL Time Warner on a subscription basis. 

 

These joint ventures signal the willingness of the major record firms to face the reality of the marketplace and unbundled the songs from the CD format, making them available individually.  But while this is an important first step, it is an entirely different issue to determine the form in which they are going to allow their music content to be distributed as an e-commerce product.  In theory, the two alliances permit the record companies to maintain their full control over both the content and distribution system.  The firms can dictate the prices and terms of music distribution.  They can minimize the adverse impact of the Internet service on CD sales, optimize the profit stream from the dual revenue flows, and also secure valuable direct access to their customers.  This direct control model of Internet music distribution allows the record companies to project their existing economic power over the music industry onto the Internet.

 

In practice, the initial versions of the direct control model were generally unsuccessful in signing up large numbers of subscribers.  Both services allow subscribers an unlimited amount of “streaming” or listening to songs selected from the available play list.  However, the attractiveness of the services is limited by play restrictions.  For example, currently MusicNet allows subscribers to download songs to a computer hard drive, but denies the subscriber the ability to “burn” or copy computer music to an external CD.  This limits the transfer of songs to a portable play device, which rules out the exchange of songs with friends.  The service also causes the downloaded songs to be erased from the computer hard drive if future membership payments in the service are discontinued.  In comparison, illegal file-sharing services allow all of the above for a zero fee as opposed to the $9.95 per month rate charged by MusicNet.  On the Pressplay service, some of the more expensive subscription plans allow the CD burning of songs, but only in limited numbers.  Additional burns can be purchased in blocks (bundles?) of 5, 10 or 20 songs for an added fee of approximately $1 per song.  Next, there are substantial content gaps in the play list that is available on the rival services.  For example, MusicNet and Pressplay have been slow to carry songs by artists who are under contract to the rival firm.

 

Independent Internet startup music firms have created an alternative to the e-music firms controlled by the record industry.  The Rhapsody Digital Music Service division of Listen.com became the first Internet music firm to license the music catalogue of all five major music labels.[26]  For a monthly fee of $9.95, the Rhapsody subscriber can listen to any number of songs from some the 282,000 tracks contained in the play list.  And where the record company that licenses the songs has given permission, the Rhapsody subscriber can also burn any choice of approximately 116,000 songs onto a CD for an additional fee of $.99 each.[27]  These CD tracks can then be fairly easily transformed into unrestricted MP3 music files for loading onto a computer hard drive, thereby yielding a process that comes close to the unrestricted music downloading flexibility offered by the illegal pirate model.

 

Antitrust concerns may well have led the major record firms to license songs to Rhapsody.  As such, the firm represents the first to activate an intermediate control model of Internet music distribution.  Interestingly, this intermediary music model not only stands in opposition to the direct control model adopted by the record firms, but it is also contradictory of the prevailing wisdom that the Internet would do away with the intermediary function.  Clearly the Internet is leading to disintermediation in some product markets such as the booking of travel arrangements and hotel reservations, along with the delivery of some financial services including insurance and stock trading.  However, the Internet holds the potential to stimulate the growth of new intermediaries with a global reach in other area where special skills, brand identity or legal constraints are key issues.  For example, eBay is the most successful Internet intermediary to date, but Amazon.com and Microsoft’s new .Net Passport online authentication system are other cases of intermediary activity.  The Rhapsody model, which allows song licensing from any willing music firm, helps to solve some of the content gap problems making the legitimate pay-for-play Internet music system a more attractive and competitive alternative to illegal music pirating.

 

Pressure for the record firms to change their business model has also been coming from another source.  The revenues of music retailers too have been diminished by the peer-to-peer piracy of songs.  Therefore, in January 2003, a group of major retailers including Best Buy and Tower Records announced the formation of the Echo consortium, which is designed to license and sell music via the Internet as part of their own retail sites.  Also, Anderson Merchandisers, which is one of the largest music distributors in the U.S., has acquired technology from Liquid Audio to allow the distribution of digital audio.  Both of these actions are further evidence that the current business model just doesn’t work.[28]

 

The licensing of third party music intermediaries leads to the ultimate tension for the big five music firms in that they have created a viable competitor for their own Internet music efforts.  This tensions posses a series of strategic and behavioral problems for the big five.  For example, what combination of direct and indirect distribution, along with the optimal pricing structure, will maximize the profits of the record firms?  Is it in the best interests of the record firms to encourage the entry of music intermediaries and the broadest possible distribution of their products?  Does wider distribution of lower music cost stimulate greater consumer interest in a larger number and variety of artists, thereby allowing higher Internet and CD sales volume to compensate for lower competitive prices?  Or will the Internet sales of songs simply cannibalize the bulk of the market for traditional CDs?  Should the big five limit the number of indirect distributors and their downloading options, keep the bulk of the sales and profits for themselves, and run the risk of being challenged by either antitrust enforcement or Congress for stifling competition?  Will music fans be moved to change their behavior and convert to a pay-for-play music model as opposed to the current illegal copy-and-skip pirate model?  Where Napster users really looking for freedom from music cost as opposed to freedom of music choice?  Will music fans avoid the limitations and expense of an Internet subscription service and continue to use the free, peer-to-peer, file-sharing technologies?  There is no ready response for any of these questions, which will ultimately be answered though the trial and error process of the market.  Change and tension resolution is clearly in the offing.  But that’s what the process of creative destruction is all about.

 

Another facet of changing the business model involves moving control of the record companies away from those on the creative side of the business and into the hands of individuals with greater fiscal experience.[29]  Both Sony and the BMG music division of Bertelsmann have recently replaced less cost conscious executives with leaders who intend to implement a more business-like approach to the management of the record company.  Staff reductions, the consolidation of operations and cuts in the number of artists under contract are some of the resulting changes.  While this strategy may help the firm’s profit picture in the very short run, it does little to deal with the fundamentals of piracy and the change in consumer attitudes towards music acquisition.  An alternative means to potentially improve cost control would be through consolidations among the top five record firms.  EMI is the smallest of the five and had previously engaged in take over talks with both Warner Music and BMG.  However the talks were terminated in the face of European antitrust objections to the mergers.  The changing economics of the industry may lead to a change in heart on the part of regulators.[30]

 

Given the above strategic discussion, what are the prospects for the record industry?  Is it enough just to tinker around the edges of the old business mode and modify it in modest ways, or is a totally new approach the best way to deal with the challenge.  It is tempting to say that the focus of the industry should be directed towards stopping the piracy.  But the success of that effort is in serious doubt.  As an alternative strategy, Lyor Cohen the CEO of Island Def Jam Records, a division of Universal Music Group is taking a more aggressive approach to the sale of music and the merchandizing of music talent.[31]  His music labels employ variable pricing systems for CD sales of music by new artists and new CDs from established performers.  His creation of a separate branding unit gives artists greater exposure with advertising and sponsorship agreements.  And he has started a movie soundtrack division to produce high profile songs for artists already in the fold.  In general, he looks to do something positive that is under his control by selling music in new ways, rather than concentrating his efforts on thwarting music piracy, which is an action that is beyond his control.

 

5.   Media Conglomerates: A Case of Strategic Convergence Involving

      Entertainment Content and Distribution

 

Few if any industries have experienced the magnitude of change that has surrounded the relatively recent pattern of growth of the media/entertainment conglomerates.  Many of their business entities are household names such as Disney, AOL Time Warner, News Corp, Bertelsmann, Viacom, and Vivendi Universal.  Rarely does a day go by when there isn’t some word of the successes or failures being experienced by one or more of these media titans.  While they are few in number, the media giants have a substantial affect on what the public sees, reads, hears, and how it is entertained.  They have been assembled over the past decade or so through a series of mergers that have been undertaken in two phases, each of which was driven a different view of evolving markets and the optimal business strategy that would take advantage of those changes.

 

Phase one of the growth process was based upon the entrepreneurial vision that firm value could be increased if different kinds of content creation properties were united and managed together under a single corporate structure.  Higher values might arise because the assets might be managed more efficiently by a single decision-making body that could better coordinate their efforts drawing synergies from lower cost and the cross management of the properties.  This led to the horizontal acquisition of a disparate set of content creation assets, in sometimes random associations, without any obvious connections or an underlying organizational structure other than they were all media or entertainment properties.   Publishers of magazines and books were merged with movie studios and record firms; other movie studio assets were merged with newspaper, radio and video retail properties; while theme parks were combined with cable TV networks. 

 

While the resulting conglomerate combinations might have been seen as arising through a series of product extension mergers, in most cases it was difficult to identify how the pieces of the business fit together to enhance shareholder value.  Even though the resulting firms might all be loosely identified as media firms, they were so diverse in the nature of their content creation elements that it was hard to see how they might be coordinated to create profit-generating synergies, or could be efficiently managed together.  Surely, no single business strategy could explain the range and combination of parts assembled by the media conglomerates.  It was as if properties were acquired primarily because they had at least some connection to content creation and because they were available at an attractive price.

 

Phase two of the growth process was based upon a second entrepreneurial vision involving the convergence of media content and distribution. Here, a combination of financial imperatives, alterations in communications technology, and changes in strategy were viewed as compelling the forward integration of the content creation assets with the methods and channels of content distribution.  This second vision triggered a race among the mostly horizontal media giants to vertically integrate by acquiring distribution assets.  In this phase, the following transactions, mostly vertical, occurred as shown in Table 1.

 

Table 1

Media Acquisitions and Extensions 1986-2003

 

  1986  News Corp creates the Fox Television Network (Broadcast distribution)

1989     Time Acquires Warner Brothers (Content extension)

1994     Viacom acquires Paramount Pictures (Content + distribution extension)

1994      Viacom acquires Blockbuster Video (Video rentals and retail distribution)

1995      Paramount (Viacom) forms UPN television network (Broadcast distribution)

  1995   Disney acquires ABC/Capital Cities (Broadcast distribution)

  1995   Time-Warner creates the WB television network (Broadcast distribution)

  1996  Time-Warner buys Turner Broadcasting (Cable content + network distribution)

  2000   Viacom acquires CBS Television (Broadcast distribution)

  2000  Vivendi acquires the Universal (Content extension)

  2001  America Online Acquires Time Warner (Internet distribution)

 

Prior to this vertical integration, the content-centric media firms found themselves in a series of frequent conflicts and tension with the distribution-centric firms.  The content-centric firms including Disney, Viacom and News Corp derived their leverage from control over the talent and programming.  Distribution-centric firms including the broadcast networks, cable operators, and satellite signal distributors derived their leverage on the basis of their control over direct access to customers.  Their relationship was both symbiotic and confrontational.  On the one hand, they were interdependent because the success of either arm of the media business depended upon the quality of the product supplied by the other.  On the other hand, they were adversarial in that the firms had to resolve particularly fractious issues including programming rights, product pricing and the division of profits resulting from the consumption of the final product. 

 

The number of conflicts escalated, with some being petty, while others were more serious.  On the petty side, Charter Cable clashed with the ESPNnews cable channel over the latter’s free Internet streaming of much of the content carried and paid for by Charter.[32]  On the more serious side, on May 1, 2000, Time Warner (TW) cable pulled the Disney owned ABC broadcasting stations off of the TW cable systems in a number of large cities including New York and Los Angeles.[33]  The TW action was strategically timed just prior to the critical “sweeps week” with the intent of injuring the network ratings for ABC.  Sweeps week is a time period when network and program audiences are carefully measured to determine network rankings that affect current and future advertising rates.  The loss of the cable audience would have been crucial for ABC.  The source of the conflict was over the terms of the negotiations that are required by the Cable Television Consumer Protection and Competition Act of 1992.[34]  The Act vests certain rights and options in local broadcast TV stations relative to their signal being carried by the local cable TV system.[35]  The first option is that the local station may invoke a must carry provision.  This requires the cable operator to retransmit the station’s signal in the cable basic tier, but without paying compensation to the local station for carrying the signal.  The second option is a retransmission consent provision.  Here the two parties enter into negotiations to determine the terms, including compensation, on which the local station will permit the cable operator to rebroadcast the signal.  Compensation can take many forms including cash payment or the payment of in-kind services. 

 

For the rights to retransmit the local ABC signal, Disney wanted extensive compensations including cash payment, the shifting of The Disney Channel from the premium to the basic tier, and for TW to add two minor Disney channels to their system.  Disney also wanted to retain the ability to exploit the convergence of TV and the Internet by having access to interactive features such as commercials with links to the Internet or digital TV that would allow viewers to purchase goods.  Disney feared that the proposed merger of AOL and Time Warner would reserve interactive access in ways that would favor the integrated company.  Up to this point, Disney had always assumed that the quality and popularity of its cable programming (ESPN, Disney Channel, etc.) would ensure cable carriage.  Now they weren’t so sure, foreclosure was a looming possibility.  Therefore, they were negotiating to leverage the retransmission of the popular ABC broadcast signal as a way to guarantee long-term access for Disney cable channels and on favorable terms.  Conversely, TW saw itself as being strong-armed by Disney in a way that would pack added channels onto its limited channel space and force it to incur hundreds of millions of dollars of additional costs over the 10-year life of the agreement.

 

The two parties settled the dispute fairly quickly on terms that were not made public.[36]  But Disney took the opportunity to appear before the FTC and request that, as a condition of its approval of the AOL Time Warner merger, competitors be guaranteed access to consumers via cable in ways and on terms equal to those any other AOL or Time Warner company might receive.  They feared that a merged AOL-TW would exercise too much control over cable distribution of independent programming and interactive access to the Internet via cable channels.  Despite this warning neither the FTC nor the FCC imposed any such conditions.

 

The ongoing tension between the YES Network and Cable Vision with its 2.9 million subscribers within the Greater New York television market is a second example of the kind of conflicts over rights and profits that can arise between content generators and signal distribution firms.[37]  The YES Network provides 24-hour sports programming including the majority of New York Yankee baseball games and New Jersey Nets basketball games.  The Yankee games were previously carried in the area via the Madison Square Garden (MSG) Cable Network, which is wholly owned by the local cable operator Cable Vision.  YES insists that its programming be listed by Cable Vision as part of the extended basic package in the same way that MSG and Fox Sports New York, the former source for Nets games, are carried.  The YES monthly fee of approximately $1.80 per subscriber would lead to maximum revenues and come closet to maximizing the firm’s profits. 

 

Cable Vision however, sees the YES Network as a competitor to both the MSG and Fox channels, where other sports contests are still carried.  Therefore, it insists on listing YES as a premium service, and therefore an optional network, rather than as part of the larger extended basic package.  Under this scheme, fewer cable customers would buy the YES signal, thereby reducing the competitive diversion of viewers away from programming on MSG and Fox.  In fairness to Cable Vision, their expressed position is that carrying YES on extended basic forces the cost off onto some larger number of cable customers who don’t care to buy the service or watch the programming.  Therefore, Cable Vision sees it as being fairer for viewers to voluntarily elect to buy the YES programming if they want to watch the games.  The two adversaries are clearly at loggerheads with neither having sufficient leverage to force the other to concede.  As a result, both the Yankee and Nets sports programming were unavailable to Cable Vision subscribers during the 2002-03 seasons, and they seem unlikely to be offered as part of the 2003-04 season either. 

 

One way to avoid these conflicts and to gain sufficient leverage to prevail, when conflicts did appear, was for the content-centric firms to integrate forward into a variety of channels of entertainment distribution.  Table 2 lists the six dominant global media conglomerates that have been the most prominent participants in the vertical integration effort.  Some media firms such as NBC, owned by General Electric, Sony, MGM, and

 

 

                                    Table 2

 

 

 

 

 

 

 

 

 

 

 

 

      Global Media/Entertainment Conglomerates

 

 

 

 Asset Holdings: Major Content and Distribution Fields

 

 

 

        C = Content    D = Distribution   C/D = Both

 

 

 

 

 

 

 

 

 

 

AOL

Walt Disney

Bertelsmann

Vivendi

News Corp

  Viacom

 

  Time Warner

 

 

 Universal

 

 

 

 

 

 

 

 

 

Books/Publishing

       C/D

         C/D

       C/D

         C/D

     C/D

     C/D

Cable Networks

       C/D

         C/D

 

 

     C/D

     C/D

Cable Delivery System

                  D

 

 

 

 

 

Internet Connection

                  D

 

 

 

 

 

Magazines

       C/D

         C/D

       C/D

 

     C/D

 

Movie Production

 C

 C

 

 C

 C

 C

Movie Distribution

                  D 

                 D

 

                 D

             D

            D

Music

       C/D

 

 

         C/D

 

 

Newspapers

 

         C/D

       C/D

 

     C/D

 

Online Services

       C/D

         C/D

       C/D

         C/D

 

     C/D

Public Utilities

 

 

 

         C/D

 

 

Radio

       C/D

         C/D

       C/D