The music industry is in a radical time of change. The business model shifts from one that derived profit from the sale of recorded music, to one in which music has become free to all those who have internet access. there are drastic shifts in profitability and sustainability. With the classic business mindset no longer proving effective, survival necessitates the search for a different perspective. The industry is left scratching their heads as to where they may derive their value from. Even though the copyright infringement law has not changed at all, the vast number of consumers makes it nearly impossible to enforce. Game theory lends itself to framing these problems in a way that sheds light on possible solutions.
1. Prisoner’s Dilemma
The prisoner’s dilemma is a hypothetical situation in which there are two prisoners (call them prisoner A and B) and they have no way of communicating. They are each given the following offer. If they each betray the other, then they will each get 10 years in prison. If prisoner A betrays prisoner B, then prisoner A goes free and prisoner B gets 15 years in prison. The same goes for prisoner B betraying prisoner A. If they both stay silent then each gets 5 years in prison.
You can see that it’s in their best interest for each to stay silent, if they could communicate. But since they can’t, the rational decision is to betray. This is because the incentives are too great for the other person to betray (meaning the silent person would get the longest sentence). The prisoner’s dilemma elegantly shows when each individual pursues his or her own self-interest, the outcome is worse than if they had both cooperated. This dilemma, where the incentive to defect (not cooperate) is so strong even though cooperation may yield the best results, plays out in numerous ways in business and the economy, as discussed below.
Applications to Business
Consider the case of Coca-Cola versus PepsiCo, and assume the former is thinking of cutting the price of its iconic soda. If it does so, Pepsi may have no choice but to follow suit for its cola to retain its market share. This may result in a significant drop in profits for both companies. A price drop by either company may therefore be construed as defecting, since it breaks an implicit agreement to keep prices high and maximize profits. Thus, if Coca-Cola drops its price but Pepsi continues to keep prices high, the former is defecting while the latter is cooperating (by sticking to the spirit of the implicit agreement). In this scenario, Coca-Cola may win market share and earn incremental profits by selling more colas.
A good jumping off point is framing the crux of the problem itself, music piracy. As discussed by Will Page, one such dilemma comes about between the Internet service providers and the record label’s themselves. Just as in any prisoner’s dilemma, the highest payoff will arise when both the ISP cooperates to license the privilege of downloading, and the record labels license their music through many venues at variable prices. Record labels always like to receive a higher profit, so, for the most part they’re unwilling to license their music through multiple venues, because they know that selling records and licensing Itunes has a higher price tag.
Because of this inflexibility, they lose a consumer surplus of those willing to pay more than $0 for any given track but unwilling to pay as much as a $1. On the other side, ISPs have zero incentive to license the right to downloading in a separate package than the one they currently provide. If ISPs were to license in this manner, they would likely be able to charge more and profit more; without government action there’s no way there would be a unilateral change by all ISPs. Therefore, individual ISPs that tried to make the change would just loose out to other ISPs that operated at the status quo.
This discussion of the ISPs also leads directly into the dilemma of collective action. In the case of people paying more for internet to receive unfiltered download privileges, versus the rest of the internet- the current set up as we see it today constitutes a moral hazard. The cost to ISPs for bandwidth required frequent downloaders is passed onto consumers who don’t use the internet to download a lot. In the case of the government instituting such a policy which differentiates the two types of consumers, they would have to use punishments for ISPs that didn’t follow suit. These punishments may serve as the government’s incentive to institute such a program, because such a venture could be profitable.
Another way to frame the Prisoner’s Dilemma is from the perspective of artist versus the record label. Artists have been able to increasingly sell/distribute more of their music by themselves without the use of the record label, because of the propagation of newer technologies. While the record label would achieve their highest personal payoff by giving the artist a better deal they could only do this if they had a large number of artists cooperate and sign onto their roster. Artists could also receive their highest payoff if they signed with a cooperative record label that gave them a good deal. Because artists cannot assure that record label will give them a fair deal, they many times will choose not to get with a label- even though the label has a vast amount more resources and could make their name bigger. Record labels will not give artists good deals on the other hand, because they cannot assure success of the artist, and they cannot assure they will have a large number of artists in which some may get famous. Therefore both parties settle with their dominant strategy, which results in a sub optimal or inefficient equilibrium.
A third way to frame the Prisoner’s Dilemma is between the artists versus consumers. Artists and consumers can reach a Pareto Optimal solution when artists allow consumers to pay what they want to pay for their music, and consumers pay money to consume music. Consumers are unwilling to pay money for music- even though this will support their continual consumption from an artist that will continue to produce and release music. Their dominant strategy is to pay nothing for music because regardless of what the artist does, they’re always better off. On the other hand, the artist would sell more units if they offered a lower price or consumer choice price for their music, as more people would buy it.
Because there’s no way to be sure whether the majority of consumers will pay nothing for it, their safer option is to charge a higher amount to their consistent consumers; they can sustainably continue their career. The result of these are artists who sell overpriced music, and consumers who pay nothing for music. In terms of an iterated game, which this absolutely is- this is not a long term equilibrium. Eventually the artist’s pocket will dry up and they will no longer be able to release music to the public. Clearly this is not what the consumer wants either- but as it would appear now they are only concerned with the short term.
A great example of the optimal equilibrium playing out within the real world is the historic sales of the Radiohead album “In Rainbows.” The band released the album through their webpage, and each consumer could pay whatever price they want for the sale whether that’s $0 or $10,000. The result was record breaking sales- $10 million their first day of sales. What do these Prisoner’s Dilemmas lead to for the market? A market price of zero for the sale of music. As for the consumer market, the consumer will in most cases play their dominant strategy, pay nothing for music.
2. Race to the Bottom
A “race to the bottom” occurs when states (or other entities) lower regulations or taxes on an industry in an effort to attract financial interests from that industry. States might compete with each other in deregulation (thus making it cheaper to do business there) until the given industry faces little or no regulation from the government. It isn’t always state to state, however. It can be any situation in which entities in a given geographic region compete for business through deregulation, lower taxes, etc. Free trade is another example of this, where the competing entities are countries.
It’s easy to see the negative repercussions of this situation. Consider lowering environmental regulations on energy companies, relaxing labor laws (like those pertaining to working conditions, for example), lowering minimum wages, or loss of tax revenue and how those things would impact the citizenry of the state.
This “regulatory dilemma” is sometimes called the “Race to the Bottom” because each government has an incentive to under regulate the phenomena of interest (say air pollution). It is for this reason that treaties may, for example, have no effect on international air pollution. Notice also that this problem can, however, be solved by penalizing weak regulation in some sense. This may be difficult to arrange in an international setting although it can be done within a federal system by higher levels of government..
3. Free Rider Problem / Tragedy of the Commons / Collective Action
Suppose that you live in a village of sheep herders and there’s a common area where anyone can let their sheep graze. Now, if everyone is mindful of the scarcity of the resource then each would be careful to only let a limited number of their animals graze for a limited amount of time. However, a rational agent might decide that if he let’s only his animals overgraze, it might not be noticed by the rest of the community. He could get greater benefit from the resource without an added cost.
However, if everyone acts in this way the outcome is clear. The resource gets overused and will ultimately be used up, thereby not benefitting anyone. This pattern can be seen in countless situations in economics, healthcare, environmental resources, and more. This shows up especially when communication and accountability between parties is difficult or impossible. If each of the herders had a way to know if another herder was letting their animals overgraze, there’d be much less incentive for any one of them to take advantage of the situation.
Contemporary society has a number of current examples of the tragedy of the commons: the depletion of fish stocks in international waters, congestion on urban highways, and the rise of resistant diseases due to careless use of antibiotics.
While it holds no truth, many consumers have the impression that because they’ve heard the artist on the radio that the artist is already very rich. Logically the assumption would follow that if the artist is very wealthy than there are already enough people that pay for the music, as one person they wont make a difference, so why should they pay? Consumers believe that they as an individual will not make a difference by downloading illegally, which results in almost no consumers paying for music for all- even though this mentality eventually ruins the benefits for everyone. Royalty Statement Example of an Artist that’s gone Gold (500K Records Sold):While this may have been an excuse a number of years ago, its now common knowledge that the music industry is dying; a result of consumers playing their dominant strategy in a zero sum game.
Regardless of what the music industry does, they are always better off paying nothing for music. Consumers will almost always prefer to pay nothing over pay something for recorded music when the option is presented; there’s not too much that can be done short of preventing access to paying nothing, and because of the internet’s current structure, there’s virtually no way to do this. Between the forces of technology and consumer mindset, a very dismal shift for the industry is occurring; music is shifting from a private good to a pure public good. Because media is so easily replicated with no constraints or quality loss music is both non excludable and non rival
The market reality of this shift is music’s price shifting closer and closer to zero. So how can the industry respond to this shift and avoid going bankrupt? The key lies in identifying, and capitalizing on where the added value exists within the market. Complementors are defined as a partner that causes customers to value your product more when they have both your products, than when they have just your product alone. In the case of a record label this list has a fairly extensive scope: merchandising (clothing, backpacks, lunchboxes, figure toys, etc.),radio stations, pop culture magazines, television stations, music web pages, social networking web pages, etc. In the case of suppliers, for the most part we can narrow the list to artists, producers, and managers. A Competitor is defined as a player which causes customers to value your product less when they have that players product in addition to yours, than when they have your product alone. As for competitors, one might say that any other form of entertainment can be considered, as well as other major record labels, independent labels, and websites that allow the artist to distribute their content by themselves (ie. Myspace, youtube, facebook, P2P torrents, etc.)
Bundling is the practice of selling two or more services or products in a package. It increases the chances of purchase because there is a higher chance of the package holding a product that entices the consumer to purchase, that they wouldn’t purchase by itself. In the case of selling music- this idea makes sense because people are no longer willing to pay much for music by itself, but if they get a free t-shirt, concert ticket, artist promo package, etc. than the chances for purchase are much greater. In game theory bundling can be analyzed as a cooperative game referred to as a coupling game. A coupling game “considers the influences of cooperation or hostility, and then make decisions according to the new game and existing non cooperative game theory. After the new coupling game is constructed, the algorithm for determining equilibrium is exactly the same as that for Nash Equilibria in existing pure strategy or mixed strategy non cooperative game theory.
However, the commons that is likely to have the greatest impact on our lives in the new century is the digital commons, the information available on the Internet through the portals that provide access. The problem with digital information is the mirror image of the original grazing commons:
Information is costly to generate and organize, but its value to individual consumers is too dispersed and small to establish an effective market. The information that is provided is inadequately catalogued and organized. Furthermore, the Internet tends to fill with low-value information: The products that have high commercial value are marketed through revenue-producing channels, and the Internet becomes inundated with products that cannot command these values. Self-published books and music are cases in point.
If the scenarios I have outlined seem dismal, it gets worse. The evolving information market models are bad news for innovation. If you expect your ISP to encourage innovation, remember that these guys are your local telephone or cable company, organizations not known for their inventiveness. Microsoft or AOL might do a little better, but monopolists have little incentive to innovate unless they feel the hot breath of potential competitors on their backs. A monopolized information market, tightly bound with restrictive intellectual property rights and exclusivity arrangements, is likely to present formidable barriers to potential competitors.
4. Zero Sum vs. Non-Zero Sum
Zero-sum, positive-sum, and negative-sum refer to the outcomes of a dispute or negotiation. These situations typically arise in distributive bargaining cases where a “fixed pie” must be divided between the parties. For example, if two departments are splitting up a fixed amount of money, the more one gets, the less available to the other. Or, if there is only one job, one person will get it and the other person will not. (One job won and one job lost equals zero.)
They refer to the actual amount of wealth (money, land, vacation time) — measurable rewards — that each party receives. Though similar, these terms differ from the terms “win-win, win-lose, and lose-lose” which refer to wins or losses relative to expectations. In a zero-sum situation, it is impossible for one party to advance its position without the other party suffering a corresponding loss. If one side gets $1,000 more, that means the other side gets $1,000 less. The wins and losses add up to zero.
“Positive-sum” outcomes are those in which the sum of winnings and losses is greater than zero. This becomes possible when the size of the pie is somehow enlarged so that there is more wealth to distribute between the parties than there was originally, or some other way is devised so everyone gets what they want or need. This can be done in a variety of ways. Extra funds might be obtained from an outside source allowing both departments to meet their budgets. Or it might be done with integrative bargaining, where different interests are negotiated to meet every sides’ needs.
For example, one department might agree to take over some of the jobs of another department that it could do at a lower cost. This would make up for some of the lost money, even though the absolute amount of money was not expanded. The more different interests that are on the table for discussion, the more likely a positive sum solution can be worked out.
The most difficult problems are negative-sum situations, where the pie is shrinking. In the end, the gains and losses will all add up to less than zero. This means that the only way for a party to maintain its position is to take something from another party, and even if everyone takes his or her share of the “losses,” everyone still loses in comparison to what they currently have or really need. This type of situation often sparks serious competition.
Morton Deutsch talks about Deutsch’s “first commandment of conflict:” know what kind of conflict you are in. However, negative-sum disputes are not always lose-lose because if the parties know the pie is shrinking, it is possible their expectations will be low. A perfect example of a negative-sum dispute is the allocation of budget cuts within an organization. In this case, each department expects to have some funds taken away, but whether the outcome is a win or loss depends on how much money a particular branch gets in comparison to what they expected to have cut from their budget. So, if a branch was expecting to get a 30 percent cut and they only got cut 20 percent, which would be a win, even in a diminishing resource situation.
What DRM does for them is attempts to reduce the added value of music that was not sold on a CD but in its pure digital form on the computer, IE a song bought on Itunes. In theory this makes buying files on the internet less valuable not only because you don’t get a CD cover, and booklet, but because you have limited rights as to the distribution of that music. In contrast if you were to buy a CD you can simply rip it to your CD, and have DRM free files. The reality of this ineffective strategy is that people who are trying to get files that are DRM protected onto their Mp3 player simply use the latest FairUse Program, or any other freeware that strips the file of its DRM.
5. Externalities / Principal Agent
The principal-agent problem occurs when a principal creates an environment in which an agent’s incentives don’t align with those of the principle. Generally, the onus is on the principal to create incentives for the agent to ensure they act as the principal wants. This includes everything from financial incentives to avoidance of information asymmetry. A classic example of this is politicians (agents) and voters (principals). The incentives and resulting actions of the politicians may not align with those of the voters. Other examples include lawyers (agent) and their clients (principal) or mechanics (agent) and customers (principal).
This situation is often accompanied by an asymmetry in information between the two players (the agent has more). This can cause the principal not to trust the agent, especially when the there are sufficient barriers to understanding the motivations of the agent’s actions. It’s easy to see variations of this problem. Gerrymandering is a case that can be applied to the previous example. If the politician is operating in a gerrymandered district and there is no fear from a primary challenger, their incentives could be completely misaligned with their constituency. The agent’s actions could undercut the interests of the principal and the principal would have no recourse.
A more common example would be when a person (principle) takes in their car to be serviced by a mechanic (agent). That agent knows more than the typical principle, and the agent has the ability to charge at their own discretion.
6. Diminishing Returns
Suppose you own a factory that’s purpose is to make cds. As you add people to the factory you start to make more and more cds. Your output increases the more workers you add, but that can’t continue indefinitely. At some point adding more workers will complicate the process and your factory’s productivity will decrease. The law of diminishing marginal returns states that, at some point, adding an additional factor of production results in smaller increases in output. The idea is essentially adding more of a particular variable to a system, while other factors are held constant, will eventually result in a diminishing of returns.
Weinstein explains this a bit differently in one of his discussions with Joe Rogan. He explains it this way: “The message of diminishing returns is that you can very often get 90% of a solution that you want and not disrupt other things unduly. But if you say ‘I want 100% of the solution to this problem’ you’ll cause a catastrophe. Getting people to realize, don’t shoot for a utopia in which the problem you are talking about is 100% solved. If you can accept a 90% solution then you can have a whole bunch of other things that you don’t even realize you’re using.”
7. Evolutionarily Stable Strategy / Nash Equilibrium
A Nash Equilibrium can be defined as “a set of strategies in which no player has an incentive to change his or her strategy given what the other players are doing”. The easiest way to understand this is as a set of strategies that people would follow in the absence of some authority forcing them to use those strategies. Spaniel uses the example of a stoplight. Suppose two people arrive at a stoplight. The options available to them are to both go, both stop, or abide by the stoplight (person A goes and B stops, or vice versa).
The situation in which either A goes and B stops, or B goes and A stops represents a Nash Equilibrium. There are no incentives to use a strategy other than “heed to the stoplight’s instructions”. If they both stop, neither person gets to where they’re going in the fastest amount of time. If they both go, then they crash (which is the worst possible outcome). The latter two situations do not represent a Nash Equilibrium because there are incentives to change strategies.
The easiest example to understand is the pie game. It’s a game of 2 players who can share a pie if they follow 2 rules:
1. One player cuts the pie any way they want
2. The other player has the first choice of slices
The winning strategy for Player 1 is to cut the pie exactly in half. Player 1 maximized the minimum size of the piece of pie that would be left after Player 2 chose.
Can game theory explain setlist?: the concertgoer has a choice between new material and old hits. choice is made by minimizing the maximum regret and suggests that the concertgoer’s winning strategy is to choose the Bach recital since he/she knows they won’t regret hearing Bach but could regret hearing the new piece. So it doesn’t matter how good the new music might be, mathematically the optimum choice is Bach!
Unfortunately, the concertgoer’s choice is further determined by the paucity of new music in mainstream programmes and venues. It comes back to the argument that if we are not exposed to new music, how can we decide if we like it? For promoters, agents and venue managers, a rather more straightforward strategy is at work: that it is simply too risky to programme new music when a concert featuring familiar works by Bach is likely to ensure a full house, a contented audience and decent revenue from ticket sales.