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By Carl Howe

Michael Arrington has penned a thought-provoking essay titled, "The Inevitable March of Recorded Music Towards Free". In that article, he argues the following:

The economics of recorded music are fairly simple. Marginal production costs are zero: Like software, it doesn’t cost anything to produce another digital copy that is just as good as the original as soon as the first copy exists, and anyone can create those copies (meaning there is perfect competition and zero barriers to entry). Unless effective legal (copyright), technical [DRM] or other artificial impediments to production can be created, simple economic theory dictates that the price of music, like its marginal cost, must also fall to zero as more “competitors” (in this case, listeners who copy) enter the market. The evidence is unmistakable already. In April 2007 the benchmark price for a DRM-free song was $1.29. Today it is $0.89, a drop of 31% in just six months.

P2P networks just exacerbate the problem (or opportunity) further, giving people a way to speed up the process of creating free copies almost to the point of being ridiculous. Today, a billion or so songs are downloaded monthly via BitTorrent, mostly illegally.

Eventually, unless governments are willing to take drastic measures to protect the industry (such as a mandatory music tax), economic theory will win out and the price of music will fall towards zero.

Michael makes it sound so inevitable. Too bad it is also wrong. Michael misses an essential point in business: prices are not and should not be set by marginal production costs.Now to be fair, nearly every person who has come up with a product idea gets this wrong. How many times have you heard someone say, "Well, this costs us $20 in parts to make, so we'll sell it for $100 and we'll clean up. Woot!" The guy from marketing usually isn't much better -- only the multiplier gets changed to more like a factor of 15 or 20 rather than 5.The problem is not with the multiplier. The problem is with the concept of price. Because price is determined by what a consumer is willing to pay for the product/service/experience delivered. Nothing more. Nothing less.Joseph Pine and James Gilmore set this up beautifully in the first chapter of their book The Experience Economy. There, they address how coffee is priced.

Consider, however, a true commodity: the coffee bean. Companies that harvest coffee or trade it on the futures market receive -- at the time of this writing -- a little more than $1 a pound, which translates into one or two cents a cup. Whena manufacturer grinds, packages, and sells those same beans in a grocery store, turning them into a good, the price to a consumer jumps to between 5 and 25 cents a cup (depending on brand and package size). Brew the ground beans in a run-of-the-mill diner, corner coffee shop, or bodega, and that service now sells for 50 cents to a dollar a cup.

So depending on what a business does with it, coffee can be any of three economic offerings -- commodity, good, or service -- with three distinct ranges of value customers attach to the offering. But wait: Serve that same coffee in a five-star restaurant or expresso bar, where the ordering, creation, and consumption of the cup embodies a heightened ambience or sense of theatre, and consumers gladly pay anywhere from $2 to $5 for each cup. Businesses that ascend to this fourth level of value establish a distinctive experience that envelops the purchase of coffee, increasing its value (and therefore its price) by two orders of magnitude over the original commodity.

Or more. Immediately upon arriving in Venice, Italy, a friend asked a hotel concierge where he and his wife could go to enjoy the city's best. Without hesitation, they were directed to the Cafe Florian in St. Mark's Square. The two of them were soon at the cafe in the crisp morning air, sipping cups of steaming coffee, fully immersed in the sights and sounds of the most remarkable of Old World cities. More than an hour later, our friend received the bill and discovered the experience had cost more than $15 a cup. Was the coffee worth it, we asked? "Assolutamente!" he replied.

The value of any commodity, good, service, or experience is nearly unrelated to the marginal cost of production. It is related to how much value a consumer perceives and is willing to pay for that experience, and how aware the consumer is of the experience and its value; clearly consumers can't easily pay for products or experiences they don't know about. And that process of making the consumer aware of the value of a product or service and having them pay for it is called marketing. And it costs money.Now at the end of the day, I agree with Michael's assertion that the price of albums and tracks will decrease. But the real reason it will decrease is not because of lower marginal cost of production, but lower distribution costs from digital delivery. Middlemen (read music labels) will be paid less money over time, because artists can go around them (do their own marketing and distribution). But imagining that an Internet Web site and some MP3s that a consumer has to search and find is a substitute for organized marketing and distribution efforts in retail stores, music venues, and publications is just naive. It will work for artists that are already well-known; it won't work for the up-and-coming artists competing for venues in which to play. They are the ones that need marketing the most and have the least money to pay. Those are the artists that actually need the services the labels provide.Now, I'm no big fan of the music label businesses, and I do think that we are seeing a gradual reallocation of the money spent for digital music. Up until this point, most consumer money went to music labels and distributors, with less than 5% usually going to the artists. Those artists who master the new power of the Internet to do their own marketing and distribution -- to disintermediate the labels -- will get more of the money that consumers pay for music. This is the phenomenon that Michael is referring to.But that doesn't mean that consumers will no longer pay for the music experience. After all, Yo Yo Ma is still Yo Yo Ma, and there are hundreds of thousands of people who will pay real money to hear his mastery of the cello, no matter if it is sold off his Web site or put out by Death-Eaters Music. Artists want to be artists and typically don't want to be bothered with the nitty gritty of hiring Web developers, signing distribution deals, and working with advertisers. So long as there are consumers willing to pay for an experience, some artists will still hire professional marketers to help them get their art into the hands of consumers, no matter how much we may dislike those marketers.

The marginal cost of producing music may be trending toward free. But so is the coffee in your $4 Starbucks latte. And last time I checked, Starbucks prices were going up, not down. The reason you willingly pay $4 for a cup of coffee that costs Starbucks (SBUX) $0.10 to make is that Starbucks isn't confused about the difference between experiences, cost, and price. I doubt the music industry is either.

Source: Digital Music Will Be Free When Your Coffee Is