University of California, Berkeley INFO 234 Information Technology Economics, Policy, and Strategy Analyzing Spotify s Business Author: Snaheth Thumathy Supervisors: John Chuang Andy Brooks May 8, 2017
1 Overview Spotify is a music streaming company which offers two subscription options. The first option is a freemium service, meaning the user pays nothing but has advertisements played periodically. The second option is a monthly, Premium service with ad-free streaming and offline availability of music. As of March 2017, Spotify has 50 million paying subscribers and 100 million total active users [3]. These metrics show that Spotify has more than two times the paying subscribers and fives times the total active users of Apple Music, its primary competitor [2]. 2 Basic Economics Outside of successful pricing models, there are a number of reasons why Spotify is the most popular and successful company in the music streaming industry. Notably, Spotify exhibits strong economies of scale. Spotify s cost per user decreases as more people are on the service because licensing will be cheaper and infrastructure expenses serve more people, meaning there is a lower cost per user. Spotify s fixed costs are minimal when compared to larger organizations. Example of fixed costs are: office space, employee payrolls (engineers, product managers, HR, etc), and the cost of making deals with advertising companies. The notable variable costs are infrastructure (servers, maintenance, deployments, etc) and music licensing fees. At one point when Spotify was unprofitable, around $64 million was spent on music licensing and around $63 million was made in revenue [1], meaning Spotify has been turning over a loss for a long time. Only recently has the company become profitable. It s important to know the Spotify does not exhibit economies of scope nor economies of density. Spotify is very focused on a sole service: music streaming. The company doesn t have other services to decrease costs, meaning economies of scope is not exhibited. Economies of density does not apply to Spotify s service because neither location nor proximity of users 1
impacts cost. Economies of density can apply to some of the services that Spotify uses, like servers, but not to Spotify itself. Because the success of a music streaming service depends a lot on the artists available on the service and the number of music listeners that interact with friends, it s important to consider network effects. Spotify has a network effect value function that is proportional to the order of n. Spotify has social network features, for example, users can see their friend s and artist s playlists and music. Also, a user s good experience with Spotify will have an impact on the number of people who join the service later. Some may argue that the presence of these features demand multiplying an order log(n) to the n order, but I think it s unjustified because, ultimately, a network value from an individual user is dependent mostly on the availability of their music, and not on social features. The social media features may add a little to the value of the network, but nowhere near the order log(n), which justifies describing the network effect by order of n. Spotify is the largest freemium service with vast artist selection. No competitor offers streaming like Spotify does at no cost to the user. Pandora and other services may offer free streaming, but these services do not allow users to play any song of their liking. This is why Spotify has the most dominant pricing strategy in the music streaming industry. 3 Users and Switching Costs There are two main types of users to consider when analyzing switching costs. The first type of music streaming user is someone who will switch to a service with a more suitable artist selection or a better price. This type of user includes the Taylor Swift fan who switches to Apple Music or the student discount switcher. In this case, there is an extremely low intrinsic switching cost because the user will switch as soon as a cheaper or a more interesting, fresh option is available. The second type of music streaming user is someone who is super attached to their current 2
service because they have a premium service, meaning they value their stored, offline music and listen to their curated playlists. In this case, there is a very high intrinsic cost because the user is dependent on their current service. Music streaming services aim to attract and keep as many of the latter as possible. Some services, like Apple Music, eliminate the need for the first type of user by completely eliminating the option of a freemium subscription. In the case of Spotify, users are locked-in by having their streaming needs met, which includes having multiple device accessibility, availability of their favorite artists music, curated playlists, social media features, and more. On top of this, Spotify users can be locked-in because the company has a lower or equivalent price to many of its competitors. If a company is a newcomer in the music streaming industry, then the most important lock-in to overcome is the price of Spotify. This means that a newcomer has a much better chance of gaining users if it s cheaper. The next lock-in to overcome is user education: users have to know the features that make a newcomer s service better than their current service. This is very hard for a newcomer to accomplish at the scale that Spotify already has with its network effects already in full effect. 4 Strategy Spotify does not utilize the following: market segmentation, personalized pricing, bundling, price skimming, penetration pricing, and price conditioning. Spotify chooses not to use these strategies because it s a completely online and democratically priced product. These traits don t go well with the aforementioned strategies because those strategies work better for other products, like fax machines. The practices that Spotify uses are: versioning/volume based pricing and pricing at zero. The previous practice works because it appeals to specific music listeners: students (half the price as usual), the common single user, and family users (4 accounts for a cheaper monthly price when distributed). The pricing at zero technique is 3
great, because it still generates revenue for Spotify and it incentivizes upgrading. The main problem with the $0 pricing practice is that many sophisticated users will delete cookies, use ad-blockers, and do more which ends up making it very difficult for Spotify to make money via advertising. 5 Complementors Spotify has complementors: businesses that gain value by complementing another business value. Spotify derives value from mobile networks because of mutually beneficially data deals. Let me explain: since Spotify uses a significant amount of data, networks will find it advantageous to make a deal because such a deal would attract more mobile customers. Spotify would find it advantageous because it means more people would use the service, leading to increased ad revenue and more Premium users. Spotify s integration with Twitter and Facebook makes the product exhibit strong network exhibits, as discussed earlier. Users can share music and create playlist which attracts more customers to use the product. Spotify s availability of specific artists music on its service means it will attract more customers. Spotify also incentivizes artists merchandise and concert tickets, meaning it probably takes a cut of purchased merchandise and ticket sales. 6 Privacy and Platform Neutrality A result of Spotify s earlier viral, word of mouth marketing strategy and network effects is its privacy issues. Because many users, skewing younger, have their social media accounts connected to Spotify, other people can see their Spotify listening history at ease. Some people see this as a cool feature that encourages music exploration, but many see it as a privacy violation since other people can see what you re listening to at a specific time. To offset this, Spotify has a private listening feature. The problem is, there is no way for a user 4
to keep his or her private listening permanently enabled. This shows that, at this moment, Spotify is prioritizing the maximization of its network effects rather than caring about its users privacy. On the subject of platform neutrality, there appears to be no pricing discrimination or bias from Spotify, but it s interesting to look at Spotify s most important suppliers: music licensing companies. These companies, which control artists decisions and payouts, dictate royalties for streams also. The lack of neutrality aspect comes into play when different artists receive different royalty packages or decide not to be available on a service. The most known example of this is the lack of Taylor Swift s music on Spotify. It should also be noted that artists receive different packages on different streaming services, which is a problem when there should be platform neutrality. This is why Taylor Swift s music is available on Apple Music. 7 Data Plan Spotify s most important data is the data of its users music. Spotify has to use this data to develop and improve its recommendation algorithms. These algorithms need to be very accurate to the user s interests so that every time a user opens up the Spotify app or website, he or she is compelled to click on the curated playlists and actually play the music that is displayed. Another set of data that can be very useful for Spotify is the custom, user imported music metadata. This data, based on music files that users add to their Spotify app manually, is a competitive advantage since Spotify is one of the only music streaming services that offers this feature. Spotify can use this data to learn what changes to make to music licensing deals and what artists and albums to focus on marketing to users. When I say it is useful to utilize the metadata on the music files, it is very important that Spotify not mine the actual files themselves since that is an invasion of privacy to many. This is toxic and can be a huge 5
liability if there is a mistake in the algorithm and a user finds out that his or her personal audio files, that are not all music, are used to recommend Spotify titles. In addition, it is important to remember that connected social media accounts and users ability to share playlists means Spotify has a lot of data to develop machine learning models. Spotify can use these models to develop A/B tests and optimize the network effects of the product. 8 Conclusion Hopefully, all this information has helped you develop a better understanding of the economics, strategy, and policy behind the music streaming industry s leading company, Spotify. 6
References [1] Pascal-Emmanuel Gobry. How spotify s business works. http://www.businessinsider.com/how-spotifys-business-works-2011-10, Oct 2011. [2] Hugh McIntyre. Apple music hits 20 million paid subscribers. https://www.forbes.com/sites/hughmcintyre/2016/12/07/apple-music-hits- 20-million-subscribers, Dec 2016. [3] Spotify. Press. https://press.spotify.com/us/about, 2017. 7