Wednesday, July 25, 2007

Complements or Substitutes

It's not always obvious whether two goods are complements or substitutes. For example, is a radio play a complement or a substitute for a CD?

An economics professor at UT Dallas has tried to answer this question and reports that they are substitutes, ie. radio listeners seem to buy less music(NYTimes)
It found that, very roughly, an hour’s worth of radio listening per person per day, over the course of a year, corresponded with a 0.75 drop in the number of albums purchased per capita in a given city.
Clearly the cross-product elasticities are more complicated. Radio play undoubtedly helps create hit songs (positive cross elasticity: complements) but I can also believe that having really really good radio may make you buy fewer albums overall (negative cross elasticity: substitutes).

From this, it seems that it's efficient for music owners to pay radio stations to play songs that are likely to become hits (sadly outlawed under "payola" rules) while radio stations should play music owners when playing more obscure music that will likely never become a hit. Maybe it all works out in the wash.

(Interesting related article on new pricing scheme that is likely to shut down web radio [NYTimes]. Bummer -- I like Pandora and Last.fm)

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