1. Music Industry Performance How has it changed in the digital age?

2. Profits: Warner Music Group “OIBDA reflects our operating income before non-cash depreciation of tangible assets, non- cash amortization of intangible assets, and non-cash impairment charges to reduce the carrying value of goodwill and intangible assets.” Net Loss results from subtracting interest expenses and income taxes from Operating Income.

3. Deadweight Loss DWL = ½ Δ P Δ Q = ½ (P-MC)(Q c -Q 1 ) Lerner Index and the Price-Cost Margin ◦ (P-MC)/P = -(1/E p ) ◦ Note: -E p = [P/(P-MC)] ◦ If we assume profit-maximizing behavior DWL = ½ PQ(-E p )[(P-MC)/P] 2 Substituting for (-E p ) gives DWL = ½ PQ[(P-MC)/P]

4. Price and Costs

5. DWL Calculations Physical CD ◦ DWL = ½ PQ[(P-MC)/P]  Price = $15.99, Q = 100,000  MC = $0.16 + $0.80 + $0.96 + $0.80 + $1.60 = $4.32  [(P-MC)/P] = ($15.99 - $4.32)/$15.99 = 0.73  DWL = (0.5)($1.599 million)(0.73) = $583,635 ◦ For Price = $11.99, Q = 1 million  [(P-MC)/P] = ($11.99 - $4.32)/$11.99 = 0.64  DWL = (0.5)($11.99 million)(0.64) = $3,837,120 Album Download ◦ DWL = ½ PQ[(P-MC)/P]  Price = $9.99, Q = 100,000  MC = $0.10 + $0.50 + $1.00 = $1.60  [(P-MC)/P] = ($9.99 - $1.60)/$9.99 = 0.84  DWL = (0.5)($999,000)(0.84) = $419,580

6. DWL with Revenue Sharing Labels split revenue with download retailers 70%/30% ◦ Labels prefer P & Q defined by (0.7-0.16)MR = MC = 0  Or that the retailer maximizes revenue, MR=0  E p = -1  DWL = ½ PQ(-E p )[(P-MC)/P] 2 = ½ PQ ◦ Retailers prefer P & Q defined by 0.3MR = MC  Learner Index becomes [(P – 3.33MC)/P] = -1/E p  DWL = ½ PQ(-E p ) [(P-3.33MC)/P] 2  Unless, MC = 0, then same P and DWL as label Suggests that retail price is negotiated along with the revenue sharing proportion

7. DWL with Revenue Sharing Suppose Price is set by Labels to maximize revenue (see graph). DWL = ½ PQ(-E p )[(P-MC)/P] 2, ◦ P = $9.99, Q = 100,000 ◦ DWL = ½(999,000)1[(9.99-0.1)/9.99] 2 ◦ DWL = (499,500)(0.9899) 2 = (499,500)(0.98) ◦ DWL = $489,510 For Q = 1 million, DWL = 10($489,510) = $4,895,100 Note: ◦ Higher MC reduces DWL ◦ See graph

8. Performance Conclusions Profit is an unreliable performance measure DWL appears to have fallen for digital downloads relative to physical CDs ◦ DWL even lower for file-sharing (graph) Product Variety? ◦ Does product variety offset DWL? Progressivity? ◦ Has the industry embraced new technology to reduce costs and introduce new products?

9. References “Warner Music Group Corp. Reports Results for the Fiscal Fourth Quarter and Full Year Ended September 30, 2012.” Dec. 13, 2012, http://www.wmg.com/.http://www.wmg.com/