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Question Description

I’m working on a management multi-part question and need an explanation to help me learn.

1. What industry conditions led to the revolution in audio distribution described above? Which stakeholders stand to benefit most (or least) from this revolution?

(Minimum 400 words)

2. Why did the music stores created by the record labels fail to attract many subscribers? What, if anything, should the record labels have done differently?

(Minimum 300 words)

3. What factors led iTunes to be successful?

(Minimum 400 words)

4. How do you think a move away from owning music led to record-setting music revenues?

(Minimum 300 words)

Chapter Nine
Protecting Innovation
The Digital Music Distribution Revolutiona
Fraunhofer and MP3
In 1991, Fraunhofer IIS of Germany developed an algorithm that would set in
motion a revolution in how music was distributed, stored, and consumed. The
algorithm (commonly referred to as a codec) allowed compression of digital
audio to approximately one-tenth of its original size with minimal compromise
in audible quality. The format also enabled song information such as the song
title and artist to be embedded within the file. This format for compressed audio
files was later dubbed MPEG-1 layer 3—a.k.a. MP3. By 1995, software programs
were available that enabled consumers to convert tracks from compact discs
to MP3 files. This technology transformed how music could be manipulated—a
song was now a file that could be kept on a hard drive, and the file was small
enough to be shared over the Internet. The MP3 format became wildly popular by users sharing their music online, and software companies began releasing many variants of MP3 encoders (utilities that compress files into MP3s) and
decoders (utilities that play back MP3s). Hardware manufacturers decided to
capitalize on this new trend and several hardware MP3 players began appearing
on the market.
With the growing popularity of the file format, Fraunhofer was faced with
a dilemma—should it enforce its patent on the use of the MP3 algorithm and
attempt to collect royalties for its use, or should it allow users and software/hardware manufacturers to make free use of the algorithm, allowing the momentum
of the format to build? If it was to limit the use of the algorithm, it faced the risk of
established rivals such as Microsoft and Sony developing competing formats, yet
if it allowed free use of the algorithm, it would be difficult to profit on its invention.
Fraunhofer decided to pursue a partially open licensing approach, partnering with Thomson Multimedia as the exclusive licensing representative of MP3
patents in 1995.b Thomson, in turn, negotiated agreements with several companies including Apple, Adobe, Creative Labs, Microsoft, and many others. Such a
broad base of MP3 licensees (100 by April 2001) provided consumers with easy
access to encoders, decoders, and the format in general. Licensees generally
197
198 Part Two Formulating Technological Innovation Strategy
opted to provide decoders free of charge, while charging a nominal fee to those
who wished to encode MP3s.
Fraunhofer continued to innovate, introducing the mp3PRO format and working on the Advanced Audio Coding (AAC) format with Dolby that Apple would
later use. Many other companies also developed or adapted their own audio
compression codecs including Sony (ATRAC codec, originally developed in 1991
for use with Mini Discsc) and Microsoft (WMA, launched in April 1999d). However,
by 1996, MP3s could be found on computers worldwide, and it appeared that
MP3 had won the battle for dominant design in compressed audio formats.
Napster Takes the Lead
In 1999, while a student at Northeastern University in Boston, Shawn Fanning
released Napster—a software program that allowed users with Internet access to
easily share MP3 files. Napster provided a user-friendly solution to music fans wishing to share and find music online. Napster provided a user interface with a search
box that pointed individuals to other users with the files they wished to download.
The Napster servers did not host any MP3 files; rather they hosted a database with
information on which users had which files to share and whether they were online,
and connected one computer to another for downloading. Napster was one of the
first widely adopted “peer-to-peer” applications, and helped popularize the term.
Napster was free, and as the growing number of people with Internet access
realized, so was the music that it allowed them to access. Users were increasingly trading copyrighted material—commercial records and songs. In fact, the
great majority of music downloaded through Napster was copyrighted material.
By March 2000, 5 million copies of Napster had already been downloaded.e At
its peak, there were 70 million Napster users.f
While “music pirates” around the world embraced Napster, the Recording
Industry Association of America (RIAA), the trade group that represents the leading music business entities in the United States, grew increasingly alarmed. The
RIAA worried that the growing illegal trade of music would result in a loss of profits for its constituents—record labels that owned the rights to much of the popular
commercial music that was being traded online. The RIAA initiated legal action
against Napster and Napster users in an effort to take the service offline and
curtail illegal file sharing. This move was controversial for several reasons. Some
analysts believed that it would be difficult to fight a technological advance such
as this by legal action alone, and that the RIAA would not be successful unless it
offered a legitimate alternative for users who wished to purchase music online.
Other analysts took an even stronger stance, arguing that the record labels were
not only fighting to protect the rights of artists, but to protect a business model
that had become outdated.g They argued that the popularity of Napster was partially due to the rigid and overpriced traditional music distribution model, where
fans were forced to buy albums for prices that some felt were inflated, and did
not have the choice to buy individual songs. This was not the first time the entertainment industry had resisted a change in business models and was reluctant
to embrace a new technology. A 2001 article in The Economist pointed out that
“Phonographs were going to kill sheet music, the rise of radio threatened to
Chapter 9 Protecting Innovation 199
undermine sales of phonograph discs, video recorders were going to wipe out
the film industry, and cassette recorders spelt doom for the music business. . . . In
each case, their fears proved unfounded. The new technologies expanded the
markets in unprecedented ways.”h Some commentators believed that the new
technology could be beneficial for the recording industry. If harnessed appropriately, it could enable an inexpensive distribution method, as well as direct
intimate interaction with consumers that allowed for targeted marketing.
In 2001, Napster offered the RIAA a partnership that included a legitimate digital distribution model that would make online music available via a subscription
service. The RIAA declined, and instead continued to pursue a legal judgment
against Napster. In July 2001, the court ruled in the RIAA’s favor, and the Napster
service was taken offline. It was a blow to peer-to-peer fans worldwide.
Though the record labels had won the battle against Napster, they began to
realize the war was far from over. Services similar to Napster began to sprout up
online, offering “users in the know” the opportunity to continue pirating music.
The record labels continued to pursue legal action against peer-to-peer services and users who engaged in illegal file trading, while coming to terms with
the need to offer a legitimate alternative service. Subsequently, Warner Music
teamed up with BMG, EMI, and RealNetworks to introduce MusicNet, and Sony
Entertainment and Universal created Pressplay, both of which were subscription services that enabled individuals to download music legally from the Web.
However, in an attempt to control their music catalogs, the labels used proprietary file formats and severely limiting digital rights management (DRM) schemes
that confused users. Furthermore, neither service offered the breadth of selection offered by unauthorized peer-to-peer services such Kazaa or Gnutella. The
popularity of peer-to-peer music swapping continued to grow. The RIAA needed
a savior. Steve Jobs offered to be that guy.
iTunes Just in Time
On April 28, 2003, Apple opened its iTunes Music Store. After striking agreements
with the five major record labels (Sony, Universal, BMG, Warner Music Group, and
EMI), iTunes launched with an initial catalogs of 200,000 songs for purchase at
99 cents per song.i iTunes showed immediate signs of success, boasting 50 ­million
downloads within the first year, and quickly became the leading distributor of music
online.j Apple got the blessing of the recording industry after guaranteeing them
that the files offered via the Music Store would allow for protection against illegal
sharing thanks to the “FairPlay” DRM scheme. In essence, the iTunes Music Store
offered audio in two file formats—Advanced Audio Coding (AAC) and modified
MP3s. With Apple’s Fairplay DRM, song files could be loaded on up to five computers only, and could not be played on non-iPod MP3 players. In addition, the files
could not be e-mailed or distributed over the Web, and files were “hidden” on the
iPod through a subdirectory structure that made it difficult to copy songs from a
friend’s iPod. All of these features helped to prevent users from mass-distributing
songs to others, helping to ease the minds of record company executives.
The success of iTunes was fueled by a number of factors. The company
had a “cool” image that was attractive to the recording industry and users alike.
200 Part Two Formulating Technological Innovation Strategy
The company also used the familiar MP3 format, offered an attractive price tag
for online music, and its licensing agreements with all five major labels enabled
it to offer a one-stop source for customers. In addition, the FairPlay DRM was not
as restrictive as other competing formats,k and this was important to many users.
The success of iTunes was also accelerated by the success of Apple’s iPods.
iPods are hard-disk–based portable MP3 players that are well designed, well
marketed, and user-friendly. Though there had been some criticisms concerning their dependability (chiefly related to battery life)l and sound quality issues,m
casual music consumers took to these players in large numbers. To the appreciation of the RIAA, the iPods required synchronization with one’s music collection
via the iTunes application, thereby making it difficult to share music stored on the
iPod, or purchased from iTunes.
The recording industry had found a new channel of distribution that earned
significant revenues (about $0.70 of every $0.99 sale on iTunes is delivered
directly to the record labelsn), and Apple had licensing agreements with all the
major labels, which afforded Apple access to huge catalogs. Apple leveraged
these catalogs to entice users to buy music through its iTunes Music Store, and
this in turn helped drive sales of the Apple iPod, since files bought on iTunes
could not be played on rival MP3 players. Apple was well positioned, but threats
loomed on the horizon.
In March 2006, the French National Assembly approved a bill requiring Apple
to open its FairPlay DRM technology to industry rivals in France.o This meant that
Apple would have to allow songs downloaded from the French iTunes Music
Store to be played on non-iPod MP3 players, and that iPods would need to play
competing file formats, such as Sony’s ATRAC3 files purchased through the Sony
Connect online music store. Many users could appreciate this interoperability, yet
it would challenge the “single operator license model” that had eased the minds
of the recording industry and created a large and loyal customer base for Apple.
Initially analysts speculated that Apple would withdraw from the French market,
but instead Apple began working on negotiating fewer DRM restrictions from
the record labels. By March of 2009, Apple had convinced all the major labels
to permit their songs to be sold through iTunes without DRM. In return, Apple
adopted the tiered pricing model that the major labels had long requested.
The rise of smartphones that could hold users’ music digital libraries in addition
to offering a host of other useful functions helped to fuel the growth of digital music
sales. By 2011, digital music sales exceeded physical sales in both the United
States and South Korea, and by 2016 digital music sales exceeded physical music
sales in roughly half of the major music markets of the world.p However, an even
bigger transition was also changing the landscape of music. Rapidly growing services such as Spotify, Pandora, and Apple Music were now streaming music over
the Internet, enabling listeners to hear whatever music they wanted, whenever they
wanted, on a wide range of devices, without the user ever taking ownership of the
music. Though many had feared that a transition to streaming would be disastrous
to the recorded music industry, instead paid music streaming subscriptions fueled
record-setting market growth. In 2016, the global recorded music market grew by
almost 6 percent—the highest rate since 1997—to a total of US$15.7 billion.

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