Recently, Chris Sprigman published an article called the 99 Cent Question in the Journal on Telecommunications and High Technology Law. He asked a simple question: Why are almost all major-label songs sold online for exactly 99 cents? More to the point, why don't music labels price discriminate? They can probably sell higher quality songs at a higher price or intentionally degraded versions for less. They can try charging more for DRM-free music, or they can offer a menu of DRM restrictions; the more restrictions you'll accept, the less you'll pay.

Maybe law professors sometimes can influence decision-making, or at least maybe Professor Sprigman can. With last week's announcements from EMI and Apple, price discrimination is coming to online music in the form of $1.29, DRM-free, higher quality downloads. The songs won't be available for sale for a few more weeks, but many predict that they will sell well.

Unfortunately for economists, Apple decided to alter two variables at the same time -- DRM and audio quality -- so this won't be a pure price discrimination experiment. Even if people show up in droves to pay 30 cents more for these tracks, will they be doing it for the freedom from DRM, the quality, or both?

This brings me back to our paper. We tested whether consumers would be willing to pay different prices for different sound quality. But instead of asking whether higher quality was worth more, as Apple and EMI are asking, we asked whether consumers would pay less for lower quality music. If yes, how much less? We also used this survey to answer some fundamental questions about the analog hole and signal degradation. Before I get to our results, a few words about signal degradation:

Debates about the analog hole inevitably turn to signal degradation. Each trip through an analog-to-digital converter or digital-to-analog converter degrades the signal, as information is lost in the process. For example, ambient noise and distortion can be introduced and stereo information and bass can be lost.

If it is typical for analog hole copies to be significantly degraded, perhaps they are a poor substitute for traditional fair use and First Amendment rights, and maybe the content industry should not worry so much about the analog hole being a "DRM loophole."

In reality, it is hard to say what is "typical" signal degradation. Some analog hole copies are horribly degraded (aim your digital tape recorder out the window in the direction of your neighbor's blaring boombox) and others are near perfect (spend thousands of dollars on professional-grade equipment). We chose to use the "line-out to line-in" and "speaker to microphone" tests I described yesterday, with the understanding that they were just two types of a wide variety.

We generated an online survey, asking respondents to listen to pairs of recordings of songs, and to compare their subjective quality. For each song, there were three different recordings, the digital original, the line-out/line-in copy and the speaker-to-microphone copy. These were played to the respondent in pairs, and each respondent heard and was asked to compare all nine possible pairwise combinations. (In other words, if the three recordings were A, B, and C, each respondent heard AA, AB, AC, BA, BB, BC, CA, CB, CC in some random order during the survey.)

Seventy participants completed the survey. The results suggest first that our listeners could tell the difference between the analog hole copies and the original digital files, but perhaps not on the scale we had anticipated. In side-by-side preference tests, the digital original was picked approximately 51 percent more often than the line-out/line-in copies and 42 percent more often than the speaker-to-microphone copies.

But we didn't stop there. We also randomly assigned hypothetical prices to each song in each pair, and asked our respondents to select based on both quality and price. For example, if A was played alongside B, we would ask "If A cost $0.55 and B cost $0.25, which do you prefer?" In this way, we set up a stated preferences econometric model. This statistical technique allowed us to isolate specific consumer preferences when many factors—utility, cost, and quality—interacted. Read the paper if you want more detail.

The bottom line is the model allowed us to calculate the population's willingness to pay for quality. How much less, if any amount, were listeners willing to pay for signal-degraded, analog hole copies than for their digital originals?

The answer is tantalizingly specific: our respondents found the difference in quality in the analog hole copies to be worth 24 cents (23.9828 cents to more significant digits). In other words, if ordinary digital tracks cost 99 cents, these respondents would be willing to pay 75 cents for a lower-quality copy.

What does this all mean? If it wanted to, the music industry could probably price discriminate in the way we've described. If it offered lower-quality music downloads for less money, it would probably find a market. Although lower-quality tracks are no cheaper to produce than the standard-quality tracks sold today, lower-quality files are usually smaller, resulting in less bandwidth to distribute, leading to possible cost savings. Also, lower-quality tracks may be good enough for an iPod but not for a home audio system, which could possibly spur multiple purchases of the same song by the same consumer.

More likely, the music industry will follow the lead of the EMI/Apple deal, and attempt to price discriminate for higher prices, if at all. It is unclear whether our result is generalizable to that situation.

My stay here is almost up. This weekend, I'll try to post once or twice with some reflections about this week's stimulating discussions.