Thursday, December 13, 2012

Congress Should Make Way for a Free and Disruptive Digital Music Market

Free markets are driven by innovation. But regulation tends to discourage disruptive changes that bring about breakthrough products and services to consumers. The current clash over copyright licensing royalties for webcasting shows a stark contrast between the pro-market approach and the pro-regulatory approach to dynamic markets.

The variety of emerging technologies and platforms for providing digital music services suggests a marketplace environment that is innovative and competitive. Webcasting services like Pandora, Spotify, and iHeartRadio are the market's latest breakthroughs. Yet digital music content is currently subject to a regulatory regime of forced access mandates and price controls. Music copyright owners are compelled to license their content to music service providers, typically subject to different rates depending on the type of service involved.
When it comes to digital music content, federal policy has the effect of insulating the status quo from disruptive changes. But if anything deserves to be disrupted or changed, it's the current regime of regulatory controls. Transitioning to a free market framework for music copyright licensing royalties would best unleash the forces of innovative change, to the benefit of consumers.
On November 28, the House Subcommittee on Intellectual Property, Competition and the Internet held a hearing on webcasting of digital music and copyright licensing royalties. Testimony focused on rate-setting standards governing royalties that webcasting services should pay to copyright owners. The so-called "Internet Radio Fairness Act of 2012" (H.R. 6480/S.3609), which was under discussion at the House Subcommittee's hearing, would move webcasting from under the "willing buyer/seller" rate standard to the 801(b) standard that applies to certain other music services.
Federal law charges the Copyright Royalty Board to determine "reasonable terms and rates" for such royalties. The Board applies the "willing buyer/willing seller" standard to webcasting services. That is, the Board determines what royalty rates "most clearly represent the rates and terms that would have been negotiated in the marketplace between a willing buyer and a willing seller."
However, the Board applies the different Section 801(b)(1) rate standard to other services, such as cable and satellite providers. Under the so-called 801(b) standard, "reasonable terms and rates" are those calculated to: (A) maximize availability of creative works to the public; (B) afford copyright holders a fair return and copyright users a fair income under existing economic conditions; (C) reflect the roles of the copyright holders and users with respect to creative contribution, technological contribution, capital investment, cost, risk, and contribution to the opening of new markets; and (D) "minimize any disruptive impact on the structure of the industries involved and on generally prevailing industry practices."
This anti-disruption proviso epitomizes what is wrong with the existing regulatory regime controlling music copyright royalties. Indeed, this aspect of the Section 801(b) was the subject of intense debate in House Subcommittee hearing testimony.  And it should be a focal point for rolling back and eventually eliminating the compulsory licensing and rate-setting regime rather than expanding it.
New ideas and novel applications of knowledge are what sustain and drive free markets. That disruption enhances consumer welfare has become so widely recognized it has all but attained axiomatic status. Disruption is the result of successful investment and innovation. Unpredictable and rapid changes in technologies and business models lead to new products and services, overthrowing old industry patterns. This includes the dramatic rise of new entrants, creating new demand through supply and overthrowing complacent incumbents.
The critical role of disruption in modern markets has also been explained by a myriad of entrepreneurs and academics. Former Intel CEO Andrew Grove, for example, popularized the concept of "strategic inflection points" in describing when the fundamental rules of industry and business operations are dramatically altered by "10X changes" in competitive forces, technology, or consumer behavior. In his book, The Innovator's Dilemma, Harvard Business School's Clayton Christensen brought into sharp focus the role of disruptive innovation in markets, resulting from changes in business models and technology. For that matter, House Subcommittee hearing testimony by SoundExchange President Michael J. Huppe offered several other examples of leaders in technology markets, including music services, extolling the benefits of disruptive change in enhancing economic well-being.
Of course, no one should want regulatory standards to determine the future direction of market disruption. But neither should regulation seek to forestall or banish it. As economist Jeffrey Eisenach pointed out in his hearing testimony, 801(b)'s ratemaking provision grants to users "a de facto right to perpetual profitability based on their current business models."
The existing regulatory regime governing music copyright royalties supplants market freedom by controlling access to and prices for the primary input for many music services – that is, digital music content. These problematic aspects of price controls were the focus of my Perspectives from FSF Scholars paper, "Putting Music Copyright Policy on a Free Market Footing." Although the willing buyer/seller standard is intended to mimic market-based prices, like the 801(b) standard it still involves an onerous displacement of free market mechanisms of adjustment to changing circumstances. Section 801(b)(1)(D) takes regulatory intrusion a step further, however, by expressly seeking to impose stasis in pricing.
Moreover, the current compulsory licensing and ratemaking regulation for digital music content regulation tends to foster a market environment that is inhospitable to experimentation and to further waves of innovation. Government-prescribed rules constrain or even displace the risk-taking and knowledge-based decisions of diverse market providers. The difficulty is that when regulation prompts providers to forego promising innovations, the opportunity costs to consumer welfare are impossible to measure.
Forced access and rate regulations of digital music are particularly unjustifiable in light of today's market conditions. Long gone are the days when radio and cassette tapes were the only ways to access music. CDs and vinyl are still widely available for music aficionados, along with broadcast radio. But consumers now have ample choice among cable music services, satellite radio, online on-demand services, as well as webcasting services relying on ad-based or subscription models.
House subcommittee hearing testimony by Pandora Chairman and CEO Joseph J. Kennedy, raised understandable complaints about the "lack of a level playing field." After all, webcasting services are subjected to a different rate standard than other services, such as cable and satellite. (Commercial radio broadcasters, for that matter, are exempt from having to pay music copyright royalties at all.) But these fights regarding fairness and favoritism are an inevitable by-product of unnecessary over-regulation. In a dynamic market, such as the market for music content, such disputes are best left for the market to sort out.
In the end, the Internet Radio Fairness Act marks a move in the wrong direction. Rather than readjust rate standards for webcasting, Congress should seek to reduce regulation in this space for all music services. The ultimate aim of federal policy for digital music content and copyright licensing royalties should be a truly free market. That means eventual elimination of compulsory licensing and ratemaking.
In the New Year, FSF hopes to continue addressing some of the basic constitutional and free market principles that should guide any transition to a free market in digital music content.