Abolishing Used CD Sales Would Benefit Neither Musicians nor Record Companies
Mr. Schlager is a financial and investment consultant in Norcross. Georgia, The inspiration for this article comes from Armen A. Alchian and William R. Allen, whose economics textbook, Exchange and Production, he purchased used for $14.20.
Garth Brooks has received considerable publicity in recent years, and deservedly so. The country music star has been one of the most popular celebrities in any field. His income over the last two years placed him ninth on Forbes’ 1993 survey of the highest paid athletes and entertainers. However, he also made news for attempting to prohibit the sale of his latest compact disc recording at stores that sell both used compact discs and new ones. The reason, of course, is that selling used CDs would cheat him out of royalty income.
His position seems to be somewhat paradoxical for someone who:
• earned $47 million the last two years,
• has already retired once, and
• stated in previous interviews that he already had more money than his grand-children’s grandchildren could spend.
NBC’s Dateline recently noted Mr. Brooks’ business savvy, attributing it to his having received a college degree in marketing. However, judging by his stance on used CDs, he falls short in his knowledge of free markets. Basic economic laws explain why selling used CDs will not reduce his precious royalties. Economic principles tell us that the value of a capital good equals the present value of all future benefits the good provides. Future benefits are discounted by an interest rate, whose components are the pure rate of interest, the inflation premium, the tax premium, and the risk premium.
The pure rate of interest is the market price of credit in a world without risk, inflation, and taxes. It indicates the market’s preference for spending today versus spending a year from now. Stated differently, it’s the market-clearing price of credit that causes the supply of savings to equal the demand for borrowing.
Added to the pure rate are inflation, tax, and risk premiums. The market sets the inflation and tax premiums based primarily on government policies. The risk premium is the market’s perception of uncertainty of future benefits.
Of these four components, only the risk premium is a function of the good itself. Thus, in discounting future benefits to establish current market values, the discount rate varies only as a result of uncertainty of the future benefits, not the nature of the asset. (The item itself is significant when there are different tax rates on capital gains and ordinary income. However, the tax rates and definitions of capital assets are arbitrarily set by government policy rather than the nature of the good in question.)
To illustrate, consider a bottle of wine, which will not be ready to drink for ten years. Assume that its value as a consumable good will be $100 a decade hence. Anyone purchasing the wine today will not pay $100, but will discount the value at the market rate of interest. If that rate is 10 percent, the bottle of wine would sell for $38.50, as that is amount of money invested today at 10 percent which would grow to $100 in ten years.
In others words, the bottle of wine is the same as a $100 zero coupon bond which yields a 10 percent rate of return. If the risk of owning the bond is perceived by the market to be the same as the risk of holding the wine, consumers would be indifferent to holding the bottle of wine or the $100 bond that matures in ten years. Since they are substitutes in terms of monetary value, both the bottle of wine and the bond would sell for $38.50 today, and be worth $100 ten years from now.
This principle applies to all goods. No matter what asset you consider, its capital value change plus its net service flow must be equal to the rate of interest, after adjusting for the risk involved. In short, all assets are valued at the present value of all future benefits. The value of any share of stock is the present value of all expected future dividends. The value of a bond is the expected value of all future interest payments plus the return of principal. The value of a college education is the expected increase in future income resulting from that education.
Of course, there may be some consumption value in addition to the investment value. College can be fun for a lot of people and provide psychic benefits (such as prestige), which cannot be measured in monetary terms. A college degree may also serve as an insurance policy—as something on which to fall back. This would be especially true for athletes and entertainers, such as Garth Brooks. Their market values, as measured by their incomes, generally have little to do with academic knowledge or intelligence. However, there is also a very high rate of failure in these professions, and the possibility of quickly fading into oblivion for those who do achieve success. As a result, it would not be irrational for athletes who expect to make millions of dollars to obtain a college degree as a kind of insurance against a career-ending injury.
The value of an asset may also include non-monetary personal services derived in the interim. For example, if a tree yields no personal service in the interim, its value must rise at the market rate of interest, just as the bottle of wine. But a tree may also yield personal service by providing shade and beauty, just as stocks pay dividends, houses give shelter, and works of art give aesthetic pleasure. (Unlike the wine, the tree may also increase in value through biological growth.) In these instances, the total return—the increase in value plus the value of the services provided—adds up to the risk adjusted interest rate.
Why must all goods provide the same rate of return? Because investors (or speculators) will buy and sell various goods to take advantage of any mispricing. If they can earn 10 percent in a zero-coupon bond, but can purchase the bottle of wine for only $10, they will buy all the wine they can get their hands on, with the intention of selling it for $100 per bottle in ten years. Soon, the demand generated by these investors, combined with the limited supply of wine, will push the price up to the equilibrium price of $38.50, thereby generating the equilibrium rate of return of 10 percent on the purchases of wine.
Now, suppose you’re the author of a book. You don’t like used-book stores, because you think they cut into your book royalties. You collect royalties on the sale of new books, not on used ones. Based on economic logic, this simply is not true.
The initial sale price of a book includes the second person’s usage. While some people undoubtedly will pay twenty dollars for a new book, a larger number would be willing to buy it if the price was only twelve dollars. Someone who pays twenty dollars for the book, and then sells it to a used-book store for eight dollars, has, in effect, purchased the book for a net cost of only twelve dollars.
Unless people are consistently irrational and thereby defy the laws of economics—as Mr. Brooks’ theory of human behavior seems to assert—some people who pay the full price for the book would not have done so without the opportunity to resell it in the secondary market. Lacking this alternative, they would have three others, each of which reduces or eliminates the author’s royalties:
1) Borrow the book from a library and pay nothing.
2) Wait for the paperback and pay perhaps six dollars instead of twelve dollars.
3) Decide to not read it at all.
Compact discs are no different from books and other goods. Just as some consumers factor in the resale value when choosing which new car to purchase, some consumers will purchase compact discs only if there is a secondary market for them. Certainly you would not pay as much for a car if the only choices were to store or destroy it when it was no longer useful to you.
The same is true with CDs. One reason CDs can command a higher price than phonograph records is their greater durability. This certainly increases their value in the secondary market. If royalties are calculated based on sales dollars rather than the number of units sold, the higher prices that result from greater durability would also increase the artist’s income.
Trying to abolish used CD sales benefits neither musicians nor record companies. This fact, while apparently unknown to Garth Brooks, has been known to book publishers for many years. It should also be known to record companies.
If Mr. Brooks makes good on his recent promise to retire again, perhaps he will spend some of his free time and $47 million on a good economics textbook, and pass along the wisdom contained therein to his grandchildren’s grandchildren.
