# Economic reality check: price elasticity and the music business

by Matthew Gast

Hilary Rosen, the head of the Recording Industry Association of America (RIAA), received a bachelor's degree in International Business from George Washington University in 1981. GWU's International Business department continues to offer a bachelor's degree by the same name, and requires that first-year students take both "Econ 11 (Microeconomics) and Econ 12 (Macroeconomics), which provide basic economics skills and principles that are critical to later coursework."

Price elasticity is a basic principle of economics. I first learned about it my high school economics class, and it appears early in introductory economics classes. (It's chapter 5 out of 40 in my introductory economics textbook from college.) Statements made by the RIAA and Ms. Rosen display a lack of understanding of the concept on her part. (To be fair, this lack of understanding is likely political posturing.)

Price elasticity measures the sensitivity of consumers to changes in prices. Formally, it is defined as the ratio of the percentage change in quantity, divided by the percentage change in price. (Yes, it is a bit weird to divide two percentages, but bear with me.) Price and quantity tend to move in different directions, and it is customary to speak of price elasticity in terms of the absolute value of the ratio.

An item that sees a 20% boost in shipments after a 5% price reduction is said to have an elasticity of 4:

(+20% / -5%) = 4

Another product which sees quantity fall by 10% after a price increase of 25% has an elasticity of 0.4:

(-10% / +25%) = 0.4.

Goods which have a price elasticity below 1.0 are called inelastic goods, and consumers are price-insensitive. Typical inelastic goods are food (0.4), tobacco (0.45), and gasoline (0.2, short term). When the price of inelastic goods rises, consumers will cut back on the quantity purchased. However, the increased price does not discourage consumption enough to decrease revenue.

Goods with a price elasticity above 1.0 are called elastic goods, and consumers are price-sensitive. When prices rise, consumers cut back. However, the reduction in quantities more than offsets the price increase, so total revenue falls. Examples of elastic goods are restaurant meals (2.3) and electricity (1.3).

(Note: The elasticity numbers for food and electricity are from Economics (10th Edition) by Lipsey, Courant, Purvis, and Steiner, HarperCollins, 1993. Others are cited from a section of a report by the Mackinac Center for Public Policy Research.)

Elasticity is often a reflection of the necessity of an item. Inelastic items usually are basic elements of everyday life. Staple foods usually have very low elasticities because there are few substitutes. (The previously mentioned economics textbook lists the price elasticity of potatoes as 0.3.) Goods with few substitutes also tend to have low elasticities. For example, in the modern American economy, driving is a fact of life, and there is simply no way for most people in this country to avoid buying gasoline. When prices increase, there will be widespread grumbling, but most people will continue to shell out for gas. In contrast, items with high price elasticity items are less essential items or items with a wide range of substitutes, and are frequently considered luxuries.

From a strictly economic perspective, what should we expect to find out about music products? Recorded music is certainly a part of life, but it is only one component of overall spending on entertainment. A wide range of legal substitutes for purchasing new recorded music products exists (listening to the radio and used CD shops are two that come to mind). It is reasonable to expect that the products of RIAA member companies are elastic goods because music is not a basic requirement for life.

What does the data say about the price elasticity of music? Consider the RIAA's announcement of 2001 shipments. In the announcment, the RIAA notes that total music unit shipments in the United States fell 10%, while total revenue decreased only 4%. This strongly suggests that recorded music products are an elastic good, but some further analysis is necessary to make a definite conclusion.

To dig a bit deeper, I analyzed the RIAA's market data, in particular, the 2001 year-end statistics. The RIAA gives permission to "cite or copy these statistics ... as long as proper attribution is given to the Recording Industry Association of America." Therefore, I would like to note that all the data on music shipments and market size is taken from the above link, which is data supplied by the RIAA. All following analysis is mine.

First off, unit shipments and revenue were both down. What a focus on total revenue hides is that the per unit revenue rose almost 7%, from \$13.27 to \$14.19. (In inflation-adjusted 1992 dollars, the price rose a less dramatic 0.8% from \$11.42 to \$11.60) That puts in familiar economic territory, where a price increase leads to a decline in quantity purchased. I think that even Ms. Rosen would agree with the theory that if the price rises, we should expect quantity to fall. If she could dig out her introductory economics textbook, I am sure she would find that if the price of an elastic good rises, the total revenue falls. (If she still doesn't believe me, I'll loan her my textbook, or have her call up airline industry executives or restauranteurs.)

I conducted an analysis of the RIAA's market data from 1992 through 2001. After adjusting their market figures for inflation using the Consumer Price Index, I found that the industry has experienced an average price elasticity of 6.3 (CDs taken alone have an average price elasticity over the period of 2.8). 2001's price elasticity was broadly in line with historical norms.

What is the real issue? Perhaps it's that in 1998, the recording industry was able to eke out both a small inflation-adjusted price increase and an increase in unit shipments, and desperately wants to believe that the return to historic norms was due to illicit file sharing rather than the market returning to historical norms of the past decade.

Economics teaches any would-be monopolist or cartel organizer that it is possible to control price or quantity, but not both. The RIAA's remarks seem to indicate they feel the right to set prices and simultaneously dictate to consumers how much music is bought. Price or quantity: pick one, and learn the lesson before your customers force you into irrelevance, or worse, remedial economics classes with OPEC oil ministers from the 1970s.