Earl and Wakeley Business Economics: A Contemporary Approach Notes for

students on essay/case questions for chapter 8

1.

In the summer of 2001 the footballer Ruud van Nistelrooy was bought by
Manchester United Football Club from the Dutch football club PSV Eindhoven for
19.5 million. His contract specified that he would be paid around 35,000 45,000 per week. To December 2003 van Nistelrooy had scored a record-breaking
97 goals in 118 games. In January 2004 the acting chief executive of Chelsea
Football Club was reported to have said that Chelsea would be prepared to buy van
Nistelrooy for 60 million if they considered him to be a good investment. The
Spanish giants Real Madrid also expressed an interest in securing his services.
Later that month Manchester United increased van Nistelrooys weekly wage to
around 80,000.
Can you use the resources and capabilities approach to explain Manchester
Uniteds decision to double van Nistelrooys wages?

This question can be related both to the material on Ricardian rents in Chapter 8 on
sustainable competitive advantage or to material on high pay in Chapter 9, both of which
offer much the same message: high earners with unique pulling power may generate net
revenues much higher than cheaper but less revered substitute. However, the
organization that hires them needs to beware of paying them the extra revenue that they
generate. In this example, we clearly have a case of a heterogeneous resource a
uniquely gifted soccer player, whose talents may have been under-estimated by his
previous employer, Eindhoven and by other clubs, enabling Manchester United to obtain
his services for a price that did not reflect his ability (i.e. a case of ex-ante limits to
competition). His ability then became more evident over the next couple of years. Given
the bids of the other clubs, and the success of his previous move, it is evident that he is
not a team-specific resource, so he could be mobile to other clubs if the right deal were
offered, and there is now strong competition for his services. In terms of the analysis in
Chapter 8 from Peteraf, it therefore looks questionable whether, in financial terms,
Manchester United has much of a chance of getting a sustained competitive advantage
from having this player in the team: he may increase the clubs performance but is in a
strong position to capture the marginal revenue that he brings to the club.
It would be worth considering whether this players performance might be contextdependent, i.e., that his ability to score so many goals might be a consequence of being
in Manchester Uniteds team, whose other members are able to put him in a position
where he has the chance to score such goals. In a different team he might get fewer
chances to score and be less able to make so much of an impact on the teams
performance and hence on its revenue. If so, the extra payment offered by Manchester
United to keep him from defecting might still leave him being paid less than his value to
Manchester United.
Also worth discussing are the opportunity costs of both the player and Manchester
United, given the scale of the transfer fee proposed by Chelsea. If the player were able
to extra a proportion of the transfer fee this would leave Manchester United less able to
spend on replacement players that it valued more highly than the market, but it might
offset the extra weekly pay being offered (40,000 extra per week for a year is
2,080,000, which is only 3.5% of the transfer fee Chelsea were offering).

2.

The market for CDs is now in decline due to competition from other electronics
products, piracy and on-line sharing of music. In the light of this, critically
evaluate the pricing strategies that major recording companies have employed
since the introduction of the CD two decades ago. In the long run, whose position
do you judge to be the most vulnerable: the recording companies or the record
stores? Explain your reasoning.

When CDs were introduced two decades ago, they typically cost twice the price of a
vinyl LP record and offered not merely superior sound quality but also greater portability
(in-car use was possible) and reliability of quality (chances of a poor pressing were much
reduced and the products were much less prone to damage). Record companies were
taken by surprise by the extent of the demand for CDs in their early years, despite their
premium prices.
Initially CDs were presented as much more expensive to manufacture than LPs,
requiring advanced capital equipment and a clean air environment, but clearly, with the
advent of domestic CD burners and with the growing volume of back-catalogue
recordings coming out at bargain prices, the music consumers increasingly could be
rightly sceptical of any claim that CD prices had anything much to do with the
manufacturing of the disks themselves.
As far as fixed costs were concerned, it is somewhat unclear how things have changed
during the life of the CD so far. Certainly, the playing time of a CD is around twice that of
an LP and many recordings run close to the maximum possible time. This might imply
that studio costs a major fixed cost element would be twice that of an LP. However,
there have also been major changes in costs of recording owing to the application of
digital technology to recording, editing and sound production which has, in effect,
democratized hi-fi sound recording: a home studio based around a PC can make
recordings of very high quality.
It is also unclear what has happened to the earnings of recording artists compared with
the days of LPs. If these were based on a percentage of sales rather than a flat fee per
recording sold, then artists could have been achieving higher earnings for a particular
volume of sales.
Quite what margin the record stores were making on CDs compared with LPs is also a
major issue in terms of working out who managed to capture the rents from the product
in its prime and who is suffering most now. It might reasonably be expected that CDs
would include a bigger absolute margin in their prices for retailers than LPs did, insofar
as the higher prices charged by manufacturers increased costs of working capital and
gave them a greater risk of loss should an album fail to sell and end up being
remaindered at a knockdown price. However, the quality advantages of CD technology
would have reduced costs of handling returns of defective discs to the manufacturers
and enabled manufacturers to recommend somewhat lower margins and prices on this
basis.
One might see the fat profits (and royalties) of the first decade of the CD as reflecting a
classic market skimming strategies in the early years of a product lifecycle, followed by
price discrimination in terms of budget reissues of 1980s recordings and re-releases of
classic LP albums on CD for the not-quite-so-committed buyers and for fans (often
affluent people well into their careers) replacing worn-out vinyl recordings). Even if the

record companies are howling now they may fully have expected to be lowering the price
of CDs in real terms as time passed and other technologies such as computer games
and DVDs came along based on related technologies but at a premium price.
If we are to criticize the record companies strategies, the most obvious area to do so is
in terms of their lack of foresight regarding the rise of the Internet (permitting sharing of
recordings) and cheap domestic CD burners. Rather more fairly, instead of criticizing
them for failing to anticipate precisely the technologies that emerged, we should criticize
them on the basis that they did not refuse to be party to the CD technology unless it
included copyright protection. Despite the uniform standard of CDs in terms of sound
recording technology, size, etc., there was no uniform attempt to make it impossible to
copy CDs at the time of their launch. There was no use of keyed-in access codes
specific to individual CDs of the kind that were developed for some CD-ROMs for PCs,
nor the kind of copyright protection that prevents DVD movies from being recorded
successfully on a VCR, or the one-copy-only limitations that the record companies
successfully lobbied for with digital audio tape (DAT) players. Nor was there the zonal
differentiation used with DVDs and videogames such as PlayStation to enforce price
discrimination internationally to some degree in these markets as international
purchasing via the Internet took off.
Having failed to get copyright protection as part of the CD standard at the outset, it was
difficult to retrofit it to the system if copyright protected CDs were incompatible with the
CD players in which people had invested.
The initial mistake over copyright protection, once made, was not something that could
be profitably reversed by lower CD prices once the possibility of home-pirated CDs was
recognized. The basic economics are very simple: the fixed cost element faced by the
record company, plus the variable cost element of royalties and production of the CD
plus retail margins may be difficult to cover if one has to undercut the home product
whose fixed costs are collapsing and whose variable costs are trivial. The economics
look even worse as CD writers become a standard part of computer bundles and pay for
themselves for other uses (i.e. they become a sunk cost even before some computer
buyers turn their minds to the possibility of pirating CDs). Given this, it made sense for
the record companies to make hay while the sun shines and maintain their prices in the
face of decreasing sales, as they continued to pick up sales from those who could afford
to buy the real thing and were willing to do so because their CD players would not play
CD-R disks, were not computer literature or judged their time more valuable if spent on
other things than downloading music to a home-made recording, or were ethically
committed to avoiding being involved in piracy.
If music downloading can be simplified, and if copy-protected downloads become the
normal way of accessing recorded music, then the record companies may be able to
continue to capture rents from recordings, for themselves and for their recording artists.
In that case the main long-run losers would be the record stores, except to the extent
that some consumers continue to buy copy-proof CDs or record stores offer print on
demand downloading services.
In terms of containment of the fixed costs of making recordings, it is useful to include a
discussion of vertical integration into recording studios. Traditionally, recording artists
produced demo recordings cheaply using independent studios and then, having won a
recording contract, re-recorded everything to a high standard. This could be in in-house

studios (as with the Beatles at EMIs Abbey Road studio) or high-grade independent
studios. Such studios entailed highly specific assets (they could only record music) in
one sense but were not specific in the sense that they could record many types of music
and could be used by different companies. It is hard to see that vertical integration would
be necessary to assure supply, since there are many independent studios, who would
have an incentive to avoid opportunism because of the impact of problems on their
reputation. However vertical integration might be desirable (or at least a good
relationship with a studio) in order to ensure access to the latest equipment or locations
that appealed to established artists who tended to write their music whilst in the studio. It
is in these circumstances that the risks of a budget blowout are acute as artists strive for
perfection or suffer creative blocks, personnel and personal difficulties, and so on. With
the advent of PC based digital recording, the record companies can increasingly offload
the fixed costs to the recording artists, much as academic publishers now demand
camera ready copy from authors as a condition of accepting a manuscript for
publication. The main complicating factor here would be the role of the external (non
band-member) producer, which may be incompatible with piecemeal recording in home
studios, but which may play a key role in determining the sound of the recording and its
market appeal. Hybrid arrangement may be a solution to this, aided by the scope for
editing and adding tracks recorded in a low budget environment through further work
elsewhere (for example, recording the drums again to get a bigger sound).
If self-recording and distribution via the internet, rather than via the use of record
companies as intermediaries becomes the norm, the musicians still risk having their
products pirated. However, the moral side of consumer behaviour may impinge here:
under the previous system, someone copying a CD could tell themselves that the record
companies and shops bore almost all the costs, since the artists would have got very
little anyway. In the internet delivery mode, the artist is being more directly hit and hence
consumers may feel much more guilty about depriving artists of income.
Record companies may continue to sell CDs to those who are too busy to engage in
piracy and those who collect CDs for their cover art; if so, record companies might be
wise to stop short of allowing online purchases to download cover materials and thereby
these companies might be able to engage in price discrimination between older and
younger generations who opportunity costs differ, along with their tendencies to collect
and display CDs rather than cram music onto iPOD devices and suchlike.