Edexcel Exam Paper Data Response (Unit 4 Industrial Economics, June 2009)

(a)   (i) With reference to Figure 1, outline the market structure of the UK music industry.

The music industry in the UK is an oligopoly market. It is made up of a few large interdependent firms. The oligopoly market is characterized by the kinked demand curve and game theory. The four firm concentration ratio of the UK music industry is 74.5%, very high. It could be argued that Universal has a monopoly over the market as it has 31.9% market share (monopoly is defined as a firm which owns over 25% of the market) but there are three other large firms in the industry (owning over 10% each) so I think that it is more likely to be an oligopoly.

(ii) To what extent might the market structure you have identified enable firms to collude?

Collusion is where a group of firms agree to set prices at a certain level to maximise joint profits. This is an anti-competitive and therefore illegal practice. They, in effect, create a monopoly in an oligopoly market. The oligopoly market enables firms to collude because there are only a few large buyers and sellers. In a perfectly competitive or monopolistic market, there are usually tens of thousands of buyers and sellers, so trying to coordinate collusive practices would be impractical, if not impossible. If there are only 4 or 5 main sellers in the industry it is easier for them to coordinate agreements amongst one another. There are 3 main types of collusion – overt, where the firms operate as a cartel (illegal with a few exceptions, the most famous being OPEC) , covert where the firms try to hide their behaviour and meet in secret, and tacit where firms follow one another with no formal agreement. However firms in this market may not want to collude, or more importantly, they may agree to collude and then undercut one another. This is known as game theory. If firms agree to set prices at a certain level and then one of them sets prices lower than another, that firm will gain more revenue (as, ceteris paribus, the consumers will choose the brand with lower prices).

(b)  With reference to Figures 2 and 3, explain the contrasting trends in CD sales and CD revenue for music companies between 2001 and 2005.

One reason whilst music CD sales are low in 2001 as opposed to high revenue (sales: 175 million, revenue £2,000 million) is because downloading songs off of the Internet was less common in 2001 compared to 2005. There was less competition for sources of music for CD sellers therefore they could charge high prices and consumers would still buy the CDs due to relatively inelastic demand (meaning it was hard for them to get music in any other format). In 2005 sales were much higher (183 million) as opposed to revenue which was much lower (£1900 million). This is because downloading off of the internet had become a substitute for buying CDs so the manufacturers had assumedly lowered prices considerably to attract demand leading to a loss of revenue.

c) Using an appropriate diagram, examine the likely effects on the price, output and profits of a music company experiencing a fall in demand for its CDs in 2007.

diagram 1:

(I cant find a diagram showing a fall in revenue, so just imagine this in reverse)

A fall in demand leads to a shift to the left of the average revenue and marginal revenue cost curves. This leads to a fall in price from p2 to p1 (on this diagram) and a fall in quantity from Q2 to Q1. Profit also falls from the area of the grey box to the area of the green box.
The impact that this fall in demand has on the profits price and output of a music company depends on several factors. Firstly it is important to consider the size in the fall of demand. If the fall was very small, then the impact on the firm will be minimal compared to if the size of the fall was large. In this case the demand fall is likely to be large because the downloading songs off of the internet is such a good substitute for buying CDs. If the fall in demand is only temporary and consumers return to normal demand after a few days/weeks, there may be no need for firms to reduce supply to meet this new demand as it is so short lived. In this case the internet is a very long term competitor so it would be in the firms interest to adjust their supply or look into innovative ways of selling their products/diversification. The impact also depends on the elasticity of the supply curve where the demand shifts. If supply is inelastic, then a shift in demand could lead to a large fall in price but a small fall in output. If supply is very elastic then the shift in demand could cause a large fall in output and a small fall in price.

The firm could cut its costs in order to minimize the impact, however by cutting costs (by, for example, reducing investment in capital goods or making employees redundant) the firms will still experience falling profit and output as supply will shift to the left (from s1 to s2). 

If the firm is profit maximizing (selling where price is equal to marginal cost, see diagram 1), then perhaps they could choose another pricing policy in order to increase demand e.g. sales maximization. It seems as though the CD selling firms did try this in 2005 (based on figures 2 & 3) , their sales were at their highest point (183 million) and revenue was at its second lowest point (£1,900 million).

(d)     Discuss the impact of the internet on

(i)      The music industry and

(ii)     Music consumers 

(i)             The effect of the internet on the music industry is overall positive. It has made it easier to advertise their songs via websites like youtube, and also made it easier for tracks to be sold internationally as people from all over the world have access to the music produced by a company, say, in the UK. The industry has access to a easier and cheaper method of distribution. Previously making manufacturing and distributing a CD would have involved a lot more work then doing it all on a computer using the internet. More workers are able to work from home using the internet to communicate with the firm, which means that the firms do not need to provide as many offices (although they may choose to do this anyway). In any case the firms no longer need their manufacturing plants to produce CDs, and can gain revenue from their sale (unless they choose to continue producing CDs in which case they will.) The internet does have negative side effects for the music industry however. Downloading songs for free (effectively stealing music) is a lot easier thanks to internet pirating sites. Consumers can just as easily purchase the song for free as they can pay for it. Previously, when music was bought in stores it was a lot harder for people to steal music and it seems as though consumers consider stealing an actual good is different from stealing a good online. The industry is said to lose 10% (£175 million) in revenue each year from illegal downloads. In this way the internet has had a negative impact on the music industry. Also CD selling shops will have lost many customers and therefore may find it difficult to stay in business when the consumers have switched to online downloads (although they can cope with this by diversifying. Many CD shops sell a range of other products). Lastly the industry suffers from the loss in revenue caused by the fact that consumers can simply buy the song they wish to buy instead of the whole album. Although this increases consumer surplus it reduces consumer surplus.

(ii)           The effect of the internet on consumers is positive. Consumer now have a wider range of choice as they aren’t limited to the CDs sold in their particular branch of music stores. They have access to all kinds of music from all over the world. They can also only buy the track which they are interested in purchasing without having to buy the entire album with many songs that they will not be interested in. This lowers the price paid by the consumers and therefore raises consumer surplus. The price per song is most likely higher than if the whole CD was bought, but since consumers don’t often want to purchase every song on the CD, this does not really benefit them. Asymmetric information was likely to have been reduced by the internet because consumers have access to most information that they would like to find out simply by searching online. It is much more convenient for a consumer to buy a song online then to have to go out and buy it from a store.

(e) Discuss two barriers a firm might experience in attempting to enter the music recording industry.

One barrier which a firm may encounter when entering the music industry is the economies of scale which the incumbent firms are benefiting from. Economies of scale are falling long run average costs. Large firms can take out cheaper loans (financial economies of scale) as well as delegating tasks and dividing labour (managerial economies of scale). Lastly they can diversify into other products to cover risk as the firms in the UK music market have done (online legal downloads, ringtones etc). This gives the firms scope to lower prices to prevent new firms from entering the market with their high prices. If prices are set at an unprofitable level this is called limit pricing, however this is illegal and anti-competitive. This is a large barrier to entry as the new firms entering the market will usually have to take out expensive loans (unless they are a large firm diversifying from another market) and high set up costs (e.g. setting up a distribution network) and so will most likely have to set high prices initially to prevent making heavy losses in the short run.

Secondly the incumbent firms have artists who are signed to their label so are therefore unavailable to new firms. These new firms will have to scout ‘new talent’ in order to sell records as artists in the industry nearly all already have recording labels. This involves scouting and research which again costs a lot.