Dear Taylor: Don't Hate the Freemium, Hate the Game

Taylor Swift performs in Times Square during New Year's Eve celebrations on Wednesday, Dec. 31, 2014 in New York. (Photo by C
Taylor Swift performs in Times Square during New Year's Eve celebrations on Wednesday, Dec. 31, 2014 in New York. (Photo by Charles Sykes/Invision/AP)

Free music streaming has been much maligned recently. Taylor Swift not only pulled her albums last year from the popular music streaming service Spotify but also wrote a Wall Street Journal op-ed piece telling the world that she thinks "music should not be free."

Ms. Swift is certainly not alone in holding such a view. Amidst declining music sales, many record label executives, artists and outside observers have claimed that the current system of streaming music for free is broken, unsustainable, and -- according to Björk -- "insane."

But is it really? When we get down to the economics of it, the short answer is, no.

Let's take Spotify as an example. Spotify uses a so-called "freemium" model of pricing. Anybody can get a free subscription, which comes with advertisements; but for a fixed monthly fee, subscribers can get additional features, including not having to be hassled by ads.

Now, when we think about what Spotify's pricing structure does -- it doesn't make everybody pay the same price for the same stuff, and it doesn't make everybody choose the same option - -it sounds a lot like... the pricing schemes that movie theaters, gyms, grocery stores, cellphone companies and many, many other businesses use.

They follow the same general economic principle, which is: If there is variation among people in what they are willing to pay for a product, then it's good business not to treat everybody the same way. And good business here doesn't just mean making money -- it means making more money.

If some people are willing to pay a lot for something, then make them pay lot; for those who aren't willing to pay a lot, charge them a lower price, or make them buy something else. This principle--known as "price discrimination" -- is why when we go to the movies, the price we pay depends on which age group we fall into; why if you are the type of consumer who likes to collect and use coupons, you will pay a lower price for the goods for which you have coupons compared to someone who can't be bothered with them.

For the artists and the copyright holders of music, the 'free' part of freemium does not mean they get nothing out of what they create or own. Seventy percent of Spotify's revenue goes to the copyright holders. Presumably, they would not allow their music to be on Spotify unless they are able to work out a mutually beneficial deal with the streaming service. And, for many of the artists, being on Spotify widens their audience base and gives them a chance to cultivate new fans. The exposure they get from the streaming service can translate to more paying customers when they go on tour.

So why do some people in the music business want to get rid of the freemium model? Ms. Swift wrote in the Wall Street Journal, "Music is art, and art is important and rare. Important, rare things are valuable. Valuable things should be paid for." Jay Z told the New York Times when he announced his plans for his streaming service Tidal, "The challenge is to get everyone to respect music again, to recognize its value."

Such thinking, however, misses the point. Just like the price of an eggplant parmigiana is not a good indicator of the value of eggplants, the price people pay to Spotify is not the best indicator of the value of an artist's music.

What people pay to Spotify is a reflection of the value of Spotify's services to them. To find the value of an artist's creations in the streaming market, we should be looking at the prices that streaming services are paying to obtain the right to stream the artist's songs, not the prices that subscribers pay to the streaming services.

Now, if you realize that the market value of music in the streaming business is captured by the royalties and fees the streaming services pay to artists and record labels, you still might wonder how artists can get the most money they can from the streaming services if some subscribers aren't paying these companies.

I am guessing that when LeBron James, the superstar basketball player who currently plays for the Cleveland Cavaliers, was shopping for a team at the end of the 2013-2014 season, he considered what would be the best situation for him in terms of what a team can pay him, his chances of winning a championship, and his family's preferences. He probably did not think too much about what fans have to pay for a seat at Cleveland's Quicken Loans Arena. And there is no reason why he should have. The price of a seat in the basketball arena -- that's for the team that's paying for his services to figure out. His job is to play basketball and win games.

Same idea in music streaming. If Spotify thinks the best way to make money is to let some users listen to music without paying money, so be it. Let Spotify figure out how to come up with the money to pay the artists. In fact, because Spotify is using the principle of price discrimination, artists should actually feel reassured that Spotify seems to have read the playbook for making money.

Freemium is not why record sales are dropping and people aren't buying CDs anymore. If artists feel that their work is not being properly valued in the marketplace because some streaming companies are giving music away for free, well, that's because music became highly accessible to people when we ushered in the digital age. And if you want to make money off of distributing music to people nowadays, you have to make the price low enough given how cheap it is for people to get music elsewhere.

In fact, freemium is a rational market response to the easy accessibility of music in the digital age. Rather than devaluing artists' work, streaming companies with a freemium pricing model are, first, generating revenue from music -- the artists certainly aren't getting any money from music piracy -- and, second, generating more revenue by applying the principle of price discrimination. And, guess what? The bigger the streaming companies' pie is, the more pie artists can get from them.

Yes, it seems really unfair for the artists that the price of consuming recorded music has plummeted in recent years. But that's what happens when there is ease of access to a product. We don't pay for the air we breathe, and that's because it's hard to limit our access to it.

Ms. Swift, to go back to what you wrote in the Wall Street Journal, I agree with you wholeheartedly that music is important -- and I don't believe music has become less important these days -- but, because of how easily accessible it is now, music is no longer rare.