Eric de Fontenay; de Fontemay, Savin & Kiss and Tag It,USA
contact: fontenay@aol.com

Much has been written on the transformation the Internet has wrought on all manners of industries. From the obvious telecommunications sector to airline ticket retailing and financial services, the Internet has had a profound effect on existing market structures as well as traditional production and distribution processes. As such, the Internet has not only changed the manner in which we communicate, but in which business interact among themselves and with consumers.

No industry has been more impacted by the emergence of New Media/Internet than the media/entertainment industry. Although entertainment-related products and services have progressively evolved over the decades to take advantage of digital technology and better respond to changing consumer taste, the industry's structure has remained relatively unchanged. This is due to several factors common to most media/entertainment sectors including: (i) the traditionally high cost of content creation, (ii) the role of content ownership and licensing rights, (iii) the necessity of a near-ubiquitous distribution network in the applicable market, and (iv) scarcity of distribution outlets.

In the case of the music sector, this has resulted in an industry structure characterized by (i) a highly competitive upstream market of content creators (the artist), (ii) a tight, vertically integrated oligopoly in production, ownership and distribution (major record labels ^* ), and (iii) scarcity in available retail and media outlets (TV, radio…). As such, the major labels have acted as a bottleneck in the sector, mediating between the competitive upstream and scarce distribution outlets. This has traditionally placed record labels in a near-monopsony role, permitting them to extract supra-competitive rents from upstream actors and limiting product control and innovation both in the upstream and downstream market.

The Internet though has challenged this entrenched structure by shifting the supplier-distributor relationship from a hierarchically layered structure to an open structure where traditional roles of manufacturing, distribution and retail are being fundamentally requestioned and redefined.

These transformations are intrinsincly linked to the open nature of the Internet and its ability to act as a uniform platform able to support any number of competing application and media. This is intrinsically different from traditional processes which depend on (i) closed, proprietary systems with high transaction costs, (ii) high sunk cost associated with entry in key sector of the production processes, especially in distribution and marketing/branding, (iii) high barriers to associated with vertical and horizontal integration.

In the case of the music industry, the Internet/New Media has hit the sector like a freight train by fundamentally restructuring costs throughout the sector, reducing entry barriers and significantly increasing the number and nature of downstream outlets while providing upstream actors with greater control over content ownership, production and distribution. This presents the record labels with the threat of being bypassed altogether by the downstream and upstream market.

This is symptomatic to what we refer to as the ‘legacy paradox’ where traditional firms with legacy systems characterized by high sunk costs face those systems’ obsolescence to emerging technology while finding themselves at a competitive disadvantage as compared to the new breed of entrants. This is analogous to telephone companies’ often reluctance to widespread deployment of xDSL for fear on cannibalizing their higher-margin T1 services.

As such, the reaction of traditional industry players has been to attempt to impose existing rules and processes to the new medium in order to leverage their market power. They have adopted a two-pronged strategy of using legal channels to attempt to erect barriers to the availability and use of emerging technology while themselves proposing technologies to tackle potential threats in the law to their control of the market power derived from their legacy systems. A result of this strategy is that they have had little presence in this new market, allowing new player such as AOL, Microsoft, E.Music and MP3.com to take advantage of this vacuum to aggressively build the infrastructure and processes for the marketing, distribution and retailing of music online.

The paper will examine the changing structure and evolution of the music industry by considering key factors shaping the industry including: (i) shift from physical to virtual distribution, (ii) decreasing transaction cost among the different segments of the industry, (iii) proliferation of new, competing distribution formats, (iv) emergence of new downstream and intermediary players, (v) flattening of industry's hierarchical structure. In addition, the paper will incorporate results from recent online sector surveys conducted by Tag It to provide a clearer understanding of the trends characterizing the new online music industry.

*  The major labels consist of five players including Universal (which recently merged with Polygram), Sony Music, BMG, EMI and Warner Brothers, although Virgin Records is increasingly being included in this group.