Moving from Units to Eunuchs
While Napster, Scour, and Gnutella grab all the headlines, the entertainment industry
has a much bigger headache in store. Even if all of these services were banished
tomorrow, the economics of Internet media would be unchanged. With the Internet, there
is no such thing as a "distribution network" as it’s traditionally understood, and
without the ability to exploit distribution as a bottleneck, all the current "per-unit"
pricing models–payments per CD, videocassette, or book–collapse.
Selling physical packages–CDs, say–always incurs some per-unit cost in production,
storage, shipping, and display. This minimum unit cost gives the entertainment companies
three big advantages: First, it makes distribution networks–comprised of warehouses,
retail outlets, and staff members–expensive to create and maintain, thus limiting
competition. Second, the minimum per-unit cost means that there is always a base to add
a mark-up to. Third, and perhaps most important, competitors also incur per-unit costs,
tempering any price wars that might break out.
Since this minimum per-unit cost is best spread over a large number of titles (the
"economies of scale" effect), the current system favors a handful of major labels, all
of which are stuck with roughly the same magnitude of distribution costs.
The Internet upends all of that, because payment for distribution has been completely
decoupled from the data delivered. Your monthly ISP bill doesn’t fluctuate, whether you
download every Grateful Dead MP3 ever made or only send email to your mother on Sundays.
When compared to the physical world, there is no such thing as online "distribution,"
in that Sony and Time Warner can’t base their markup on the costs of delivery. As
Napster demonstrates, there is no distribution cost linked to individual file transfers,
so once the original is created, the per-unit cost of each additional copy is zero
dollars and zero cents.
Warning: Cliffs ahead
These economics drag entertainment companies to the brink of a terrifying precipice:
the end of per-unit pricing. While the real per-unit costs of the offline world have
enforced a minimum cost, the first real price war that breaks out online will bring about
a race to the bottom, and in this case the bottom is zero. The end of per-unit pricing
begets sponsorships, subscription fees–which distribute fixed costs per user–or
advertising, which encourages maximum use since each new user costs nothing.
Rather than accept this fate, the industry has introduced over the last months myriad
schemes to make downloading music and video even more inconvenient, inflexible, and
expensive than buying tapes and CDs. Entertainment sites increasingly force users to
pay for product access without determining whether consumers are willing to put up with
These are storm-trooper business models, designed to protect the entertainment empire as
it exists today. We know how this scenario plays out, because we’ve seen it in the
software world. In the days when Egghead.com was an offline company, software was a
distinctly shrink-wrapped, per-unit business, and both the cost and profit structures
were similar to those erected by the entertainment industry, including the ability of the
big players to marginalize small-player access to shelf space at retail outlets.
When the growth of the Internet first threatened this system, the software industry
adopted a stance identical to the entertainment industry today: copy protection and
hardware dongles, coupled with a propaganda campaign to "educate" users by suggesting
that the Internet’s ability to make unlimited perfect copies was never to be taken
This lasted a few years, until a crop of upstarts decided that the Internet’s power to
distribute software was something to build a business on instead of something to fight.
They developed the ASP model. Even Microsoft, which has arguably benefited more than
anyone from per-unit pricing, is now pursuing an ASP model.
Spin the bottleneck
The entertainment business is currently in phase two of that three-phase transition,
attempting to make online music more inconvenient and expensive than it needs to be to
preserve the distribution bottleneck it enjoys offline and save per-unit pricing. The
economics of the Internet are intractable, however, and as the software industry
discovered, the longer the entertainment industry waits, the more likely it is that
players who embrace a model of entertainment based on subscription fees, advertising,
or sponsorship, will gain market share.
Sometime in the next 12 months, someone with a large enough catalog of popular
entertainment–probably music, because video isn’t yet ready for prime time–is going to
begin an online price war. When that happens, all the players will quickly realize that
the old pricing models no longer apply. The only question left is whether that company
is going to be one of the major entertainment companies, which have the catalog but lack
a real understanding of the medium, or one of the upstarts, which have the understanding
but lack the catalog. Either way, because the economics won’t support any per-unit price
at all, once the change begins, look for it to be swifter than almost anyone imagines.