August 01, 2005
Some Economics of Payola
Posted by Joshua Wright

Thanks for the kind introduction Vic.  I figured I would start off with a more substantive post about payola before I try to sell folks on our Poker and the Law project.

I spend a lot of thinking about payments for product distribution like slotting arrangements in grocery stores or payola in the music industry.  NY AG Eliot Spitzer’s investigaion of Sony BMG Music Entertainment resulted in an agreement prohibiting Sony BMG (others may follow) from making payments in exchange for radio airplay.  Others in the blogosphere have responded to the investigation (see Ribstein and Picker commenting here and here emphasizing the potential for Satellite Radio to alleviate competitive problems in the industry).

Competition for product distribution is crucial to a variety of industries: slotting allowances for grocery store shelf space, payments for inclusion in mutual fund “supermarkets,” and for listing preference in search engine results. Despite the widespread use of payments for distribution in markets, payola can lay claim to the most colorful history of regulation and controversy.  The arguments against payola appear to come in two flavors:

(1) payola is bad because it disfavors small music publishers (the “competition objection”); and


(2) payola is bad because it deceives the listening audience,who believes that music is chosen based on merit rather than payola (the “deception objection”).

Each objection has taken center stage at various stages of the payola debate. Spitzer’s investigation explicitly adopts the deception theory, stating that “Sony BMG and other labels present the public with a skewed picture of the country’s ‘best’ and ‘most popular’ music.”

Ronald Coase responded to both objections in his seminal paper “Payola in Radio and Television Broadcasting.” With respect to the “competition objection,” Coase argued that small publishers had thrived under payola and protested attempts to ban it by the FTC. Further, it is not likely that the competition objection would amount to much in the presence of healthy capital markets where investors are willing to get behind artists likely to produce popular music.

As to the second objection, Coase employed economic analysis to show that radio stations’ would respond to incentives, which for the stations meant playing the mix of records that would maximize the popularity of the station and therefore maximize advertising revenues (as well as future payola payments). Attempts to select music that the audience did not ultimately approve of would result in losing radio station traffic, which would in turn, reduce advertising revenues and future payola. The point of Coase’s analysis is that payola introduced a price system that would efficiently allocate resources in the music industry, and that a ban on payola would therefore reduce efficiency and community wealth. An ancillary point of Coase’s analysis was that a payola ban “may result in worse record programs” because station song selection will depend solely on maximizing advertising revenues. I am not confident that I know what the mix of songs that attracts the best demographic audience for radio commercials looks like. Nor am I confident that I, or any regulator for that matter, could figure out whether such a mix of songs would be better or worse than what we have now.

But Coase’s pathbreaking analysis of payola is not complete. While pointing out the benefits of a price mechanism for radio spins, it does not address a fundamental economic question: why do music publishers have to pay radio stations for playing music at all? The answer “because radio station spins are scarce” is not enough. Radio stations also benefit from playing a mix of songs that attract a larger audience. If radio stations are interested in selecting the songs that will maximize advertising revenues (and future payola), why does the music publisher need to pay at all? Why doesn’t competition result in the efficient level of spins (that which maximizes joint profits) without payments? This is an important and unanswered question that sheds light on the pro-competitive role of payola in the music industry.

The answer is that music publishers must pay radio stations to promote singles (give more airtime) than they would otherwise because radio stations do not take into account the marginal profits earned by the publisher as a result of record sales produced by the additional airtime. The publisher earns substantial profits from record sales with each incremental spin granted by the radio station. The radio station does not take into account these profits when determining the number of spins to give a particular record and will therefore undersupply spins of a particular song without further compensation. Therefore, the music publisher must pay for the additional spins in order to achieve the efficient (jointly profit-maximizing) solution.

The radio station cannot just take payments to play horrible music and ultimately survive. This is implicit in the popular claim that payola is the cause of the rise of “bad” music, or is only necessary for such music. This was the claim with respect to rock n roll in the 1950s, and more recently, rap music (where payola is quite popular) and the musical stylings of J-Lo. But payola has always been a part of the music industry, even when the songs performed did not raise the same type of criticism. This suggests that economic forces other than bribery must be at work. The radio station is constrained by selecting those singles that will not cause a substantial reduction in its audience, while it does retain some discretion over its overall song mix because it faces a downward sloping demand curve (i.e. the station is able to allocate spins such that playing song X rather than song Y will typically not result in a substantial loss of radio traffic).

The key economic point is that supply of these incremental spins (promoting sale of one record over another) are not likely to have a large impact on inter-radio station competition, but they are significant forces in competition between music publishers. Of course, radio stations do not have unlimited discretion to play any record they want for an unlimited number of spins --- at some point, the radio station’s disregard for its listening audience will induce closely monitored station switching. In general, however, radio stations have an insufficient incentive to promote a particular single without compensation from the publisher. One can think of payola as the record company sharing the profits created by the incremental record spins with the radio station.

Benjamin Klein and I lay out the details of this theory in our forthcoming analysis of slotting allowances (payments for shelf space) in the grocery industry (an older draft is available here).

The analogy to grocery store shelf space is instructive. Like radio stations, grocery stores face downward sloping demand curves (and therefore can change the allocation of products without losing all customers) and seek to maximize store traffic. The manufacturers of brand name products sold in grocery stores where we observe slotting allowances earn large incremental profits on additional sales created as a result of the supermarket allocating the product preferential shelf space (because the wholesale price is significantly greater than the manufacturer’s marginal cost) as the music publishers earn additional incremental profit from the record sales created by incremental spins. In each case, it is the distributor that does not take into account these additional profits in choosing the promotional resources to dedicate to a particular album or product. Therefore, the manufacturer must compensate the distributor for this additional promotion in order to achieve the efficient solution.

Once one understands why record company and radio station incentives do not coincide with respect to airtime, the logic of payola payments and their important role in the competitive process for music distribution is easier to digest. But other questions remain. Would a ban or mandatory disclosure of payola improve the outcome?

Most economists would be suspicious of an argument that more disclosure is a bad thing, although the Spitzer settlement goes beyond mandating disclosure and bans payola. What is interesting is that many feel more “deceived” by payments in the music industry then by slotting allowances or other payments for product placement. Why is this? Perhaps there is something different about radio. It could just be that consumers feel differently about music than about their groceries. From an economic standpoint, one could argue that consumers perceive the radio station has having something closer to a fiduciary duty to select the best products than does the supermarket. But at first glance it appears that radio stations ought to be more concerned with offering poor products since a consumer listening to that station can switch stations with the push of a finger rather than driving to a new supermarket. Perhaps paradoxically, both consumers and regulators seem to believe that competition is more likely to deceive consumers in the music industry. Let me be clear that I am not against a regulation demanding disclosure of these payments, but am merely suggesting that there are some very interesting questions surrounding this issue that have not been resolved.

The fact that payola is an important part of the competitive process did not escape Coase. Coase’s account includes a detailed history of payola tracing back to 1867 when public performers were paid to perform songs from a publisher’s catalog. The most striking feature of the history of payola is the series of unsuccessful attempts, each initiated by the music industry, to stop payola on their own (at least one attempt in 1890, 1916-17, 1933, the more well-known attempts to amend the Communications Act in 1960, and the shortlived suspension of independent promoters in 1986 following a 1984 Senate investigation).

Because radio airtime is a substitute for advertising, it is completely unsurprising that music publishers desired to collude to stop advertising --- an important dimension of competition for record sales. Collusion is notoriously difficult to accomplish in the first instance, and even harder to sustain because members of the cartel increase profits by deviating from the collusive agreement. Successful collusion often takes a third party to regulate the agreement and punish defectors. Occasionally, would-be cartel members are able to persuade the government to take the job. It appears that Spitzer may succeed where the recording industry has failed for over a century by stepping up to police the industry restriction on competitive payments for spins.

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