Diversification, cross subsidy and the transfer fallacy

MARCH 24, 2006

You often hear the following argument for retrospective term extensions put forward_[1]:

‘Retrospective term extensions will allows us to make more money on old artists we can then use to fund new talent’

This is a fallacy though all the more dangerous for being superficially plausible (for reasons we detail below). It is a fallacy for a simple reason:

  1. A retrospective term extension increases the return to past projects but makes no difference to the expected payoff of new projects.
  2. Investment in new projects is determined by their expected payoff alone_[2].

Point 1 is self-evident but point 2 perhaps deserves some elaboration.

In the (popular) music industry, just like many others, investors (labels) invest a variety of risky projects (bands). Some projects will be successful and some will not. Like any normal business investors will, in general and on average, invest in a project if its expected profit is positive.

This does not mean a given project will make money, in fact quite the contrary. Many projects, perhaps the majority, will lose money but the losses on these will be made up for by the successful ones so that on on average an investor makes money (averaged over its portfolio). In the music business, which is relatively risky, this is exactly the case. Most bands fail but a few make it big and return a large amount to the label.

Thus while successes do, in some sense, help to pay for failures this is only true prospectively – if one knew in advance which projects would be failures one would not invest in them. Making more money (or less money) on existing projects makes no difference_[3].


[1] See James Purnell, Minister for the Creative Industries as quoted in the Scotsman (excerpted on http://www.freeculture.org.uk/campaigns/14plus14/CopyrightTermExtension)

[2] This assumes that the investor is not credit constrained so that she or he can make the investment. This is a reasonable assumption for most investors in music (especially for the major labels) and in any case should credit-constraints be an issue they should be addressed directly (for example by providing special lending facilities) rather than by retrospective copyright term extensions.

[3] To illustrate take the extreme case an investor all of whose potential new projects are terrible (it’s clear none of them will make money). Suppose suddenly this investor receives £100 million extra for a past project. What wil the investor do? Any sane investor just put the money in the bank or return it to its shareholders. It certainly won’t use the money to invest in the guaranteed loss making projects.


Email to Creative Friends list:

On Wed, 8 Jun 2005, Rufus Pollock wrote:

The minister’s economic analysis in this latest announcement is very flawed. Any business supports projects on the basis of expected profits. It may use past profits to finance the initial outlay but only if it expects the project to (on average) pay that back. Thus the idea that money made on successful bands helps unsuccessful bands is fallacious. The fallacy can most easily be seen by taking the argument to its logical conclusion which is that we should simply hand over a £100 million to the record companies – which strangely no-one is suggesting.

Although the rest of your post was sound, this analysis is flawed. It is common practice in many industries to spend money on a portfolio of risky projects where it is expected that only some small proportion of the projects will actually turn a profit, but those that do will more than cover the costs of the failed projects. Examples: pharmaceutical companies; R&D departments at the likes of IBM, Intel, and Microsoft; the whole venture capital industry;, etc, etc. I doubt very much that someone signing a band can say with any reliability at all how much money they’ll make, so I’d be staggered if the same practice wasn’t common in the recording industry.

Your point about diversification over risky projects is a good one. However I think there has been a misunderstanding. Yes, revenues from successful bands cover losses on unsuccessful ones but I wouldn’t term this as ‘pay’ for or as cross-subsidization. Why?

Cross-subsidization to my mind denotes intentionally using profits from one area to fund an area that loses money, where this is /known in advance/. For example urban utility users cross-subsidize rural utility users.

But what happens in music and the other ‘risky’ ventures you describe I would term diversification. In advance it is unknown whether any given project will succeed only that it will succeed with some probability. By diversifying across projects we reduce variance while maintaining the average payout. It is of course true that successful projects cover the costs of unsuccessful projects but all projects are equally likely to succeed or fail in advance (the cross-subsidy is unintentional – and would be eliminated if it could be).

This distinction is essential for it explains the divergent effects of increasing payouts in the two cases.

  1. Increasing payouts in case of cross subsidy:

Suppose initially a successful project makes £X and that this is used to fund a loss-making project (for whatever reason). Now suppose due to changes the project makes £X + £Y there is no reason at all to think that this extra £Y would be used to pay for more loss-making projects, instead it should be just put in the bank. Moreover increasing the payoff in this situation by £Y is exactly the same as handing over £Y directly.

  1. Increasing payouts in case of diversification:

Suppose average payout is £X initially but will be £X + £Y after change (copyright term extension say). This means that the firm may now take on riskier or more costly projects. (now p * (X + Y) >= cost whereas before p * X >= cost)

Thus it is correct to say that money made on successful bands does not help unsuccessful bands since this would be cross-subsidy. However the prospect of making money on successful bands does result in investment in bands in general some of whom will lose money.

All this may seem academic but there is an important point. Retrospective term extensions increase income in the first manner, i.e. the increase the income to /known/ successful projects. Thus they should have no effect at all on the funding of new artists – they just increase the profits of record companies or the income of a few lucky descendants of very succesful artists.

Prospective term extensions are of the second kind and increase payout to individual projects in the /future/. Thus these can have a positive effect on funding. However since the extra revenues from term extensions are so distant their present value is very low (£1 in fifty years is worth less than 1p at a 10% discount rate). They are therefore not of much interest either to the labels or to individual artists.

My point about the minister’s statement (which hasn’t yet appeared in an official press release as far as I know) is that it conflates the two effects by suggesting that term extensions somehow relate to ‘diversification’ whereby the prospect of successes such as coldplay allow for investment in several groups many of which may fail. As we have seen this isn’t really the case since retrospective term extensions are ‘cross-subsidy-like’ and prospective term extensions increase revenue so minimally as to be practically irrelevant.