7/02/2004

CD Pricing Retreat

I found this article interesting because it helped to show the consequences of not accounting for externalities. Universal Music Group, one of Big Fives recording firms, decided to change their minds about permanently lowering the price of CDs. UMG attempted to increase sales and discourage music piracy by lowering their prices, but found their actions did not have the desired effect. Their inability to obtain their desired outcome was a result of a few contributing factors:

1. When UMG lowered prices for Retailers, Retailers continued to sell their CDs as high prices. Therefore customers were not persuaded to purchase UMG CDs over others because they were marked at the same price. Retailers were pocketing the extra cash instead of passing on the savings to their customers. This can be compared to when taxes are levied on one party, and then passed on to another party. The person intended to receive the cost or benefit is not necessarily the one that receives it.

2. Many of the Retailers could not afford to lower the prices and suffer even lower profit margins. The CD business has become highly competitive with smaller firms barely scraping by whereas large corporations like Walmart could afford to mark down prices to basically nothing and making the small business owners suffer. If small stores lowered their prices, like Walmart, they would go out of business.

3. The amount of piracy going on was not being decreased by their lowering of prices. Perhaps piracy would have decreased if lower prices had been implemented for a longer period of time, and if people preferred UMG’s music to other companies, but since these factors were not met piracy did not decrease.

4. Other recording firms did not lower their prices with Universal, but instead decided to step up their advertising “which curried favor with retailers just as Universal was alienating them.” Universal was forced to lower advertising prices because of their shortage of cash from the decrease of revenue from sales. In fact, “Universal stopped paying promotional fees, which helped prop up the teetering chains.”

UMG did not account for the prospect that retailers might decide against lowering their prices on CDs even though they were receiving them at discounted prices. UMGs attempted to increase output by decreasing price, but their objective was not obtained.

2 comments:

Dr. Tufte said...

My comments follow the numbered points.

1) This is one of the reasons that many industries are vertically organized. If the manufacturer owns a retailer they can control the retail price more directly, and get other independent retailers to follow them.
2) I don't agree with the analysis here. If the small retailers view their competition as Wal-Mart, then they will probably lose no matter what they do. If they view their competition as other small retailers, then lowering their price would be a good strategy to steal market share.
3) I'm not sure I believe anything the record companies say about piracy, so I'm not going to comment further on this point.
4) This is probably a huge factor. Universal tied their price cutting strategy to a marketing cutting strategy. If you think about it, how did they expect to find out if price cutting worked at all when they had it tied to something else? My guess is that this was some sort of compromise they made internally that should have been squashed by a more visionary person at the top. It's fairly common in business to have managers compete with each other internally, and to kill each other's ideas by adding incompatible strategies into the mix. Top managers are supposed to defuse this sort of internal conflict.

I'd add a fifth factor - they are being outcompeted on price by iTunes and others who sells downloads for under a dollar.

If you want to learn more about the promotional aspects of the record business, you should check out the posts at Marginal Revolution entitled Why is Payola Illegal?, Payola II and Mellencamp on Payola.

kavindavis said...

If these record companies are worried about lossing the business of small businesses, then they should sell there CDs to these small companies for the same price as they do Wall Mart.

I hate downloding songs of the computer becouse it takes forever. I also think that it's hard to believe that there lossing money, becouse now you have to pay for songs on the internet, its what, about a doller. so in that case if you get the hole album you end up paying more for it, if it has more than 15 songs. and dont forget the price of buying the blank cd, and my time is better spent doing somthing else than sitting on the computer.

And also to support my not losing money comment, my 1970 Chevy Nova has a record button on its tape deck, so people have been recording songs, be it the internet or the good old fashion radio forever.