pandora-topples-radioTwo years ago, Pandora went public and Spotify launched in the US. If 2011 was the year streaming music exploded, then 2012 was the year of the backlash. Artists, labels, bloggers, and the music industry in general have criticized these new, popular services for not paying enough in royalties to the rights holders.

It escalated into a debate with Congress in the form of the Internet Radio Fairness Act, a bill that aims to change the way royalty rates are set. It created some interesting bedfellows when traditional radio giant Clear Channel joined forces with its digital disruptors to push the act forward. Clear Channel is also paying royalties out the nose on its iHeartRadio service, which is free and currently does not monetize with ads. The latest on the act is that Congress killed it without a vote after an initial hearing, because it was introduced too late to be voted on. It will likely be re-introduced in 2013 under a different name.

In preparation for a SXSW panel called “The Fight for Fair Fees,” featuring reps from Pandora, Triton Digital, and RCA Records, I’ve had many discussions about the definition of “fair.” If digital pennies — or really, fractions of pennies — are killing the music industry, then how much should streaming sites like Spotify and Pandora pay artists?

Right now they’re paying so much they’re not even profitable. Pandora pays out more than 60 percent of its revenues to artists. Spotify’s rate is closer to 70 percent, paying out $500 million last year. Up until 2012, Spotify had paid out $500 million total between 2008 and 2012. The services often point to these numbers, and their own balance sheets, as evidence that they are compensating artists well. Perhaps more importantly, they note that the sums they pay are vastly higher than terrestrial radio’s going rate of zero dollars, or satellite radio, which pays a rate slightly higher than zero.

But all of that doesn’t change the reality of a shrinking music industry. It’s a third of what it was just 10 years ago, and artists are waiting for something to make up for the lost income. Spotify and Pandora were heralded as their saviors. Looking at a $7 check from Spotify, it’s clear that hasn’t happened yet.

Dave Allen, the bass player from Gang of Four, has been vocal about his dissatisfaction with the current streaming solutions. I asked him how he can be angry when this money is incremental to what he would have gotten. Any check he gets from Pandora is new money he wasn’t making from traditional radio, right? But speaking to him, I realized that it’s not about whether Spotify and Pandora are paying a fair rate. It’s that they’re not paying enough to make up for what has been lost in the transition to digital.

“Our recording royalties dropped off the map with Napster, and this was supposed to incrementally fill that gap,” Allen said. “At least 75 percent of (musicians) relied on that income in some capacity,” he said. His recording royalties once brought in thousands of dollars a year; now it’s closer to hundreds of dollars. “It’s not livable,” he said.

A valid point, which plenty of other artists support. Billy Joel, Rihanna, Missy Elliott, and 123 other artists spoke out against Pandora and Clear Channel’s Internet Radio Fairness Act. Indie artists like Erin McKeown, Damon Krukowski and Grizzly Bear have spoken out about the fractions of pennies they get from streaming services. These arguments all ignore two important points:

1. Digital markets are simply smaller than analog ones. Consumers are smart enough to know that a download of a file should not cost as much as a physical CD that had to be manufactured and shipped. And so they cost less, and the margins are smaller. That fact is difficult for traditional incumbents to accept. How can they invest in new markets knowing they’ll make less money from them?

This is not unique to the music industry. It happened in media when journalists traded their cushy one-feature-a-month jobs for HuffPo-style aggregation factories. And in graphic design, crowdsourcing sites like 99Designs dramatically lowered the cost of design work. A similar thing happened in software through the open source movement: Martin Mikos of open source pioneer MYSQL famously said he wanted to shrink the database market from $8 billion to $3 billion and take a third of it. It’s even happening with venture capital now — digital platforms like AngelList has made investing so efficient that the head of the NVCA believes VC’s have worked themselves out of a job. Why should musicians get to be the exception?

2. The labels are still taking the same rate they did from artists when they were selling CDs, and artists haven’t pushed for better terms.

Yesterday at SXSW, Daniel Ek hinted that the labels need to reconsider their business models. He did so subtly, because if he so much as upsets one of them, he could lose a third of his library. He’s always taken the very careful tactic of being an ally, not adversary, to the industry. It’s hard enough with major artists like Taylor Swift, the Black Keys, and Adele withholding their new releases from the service. He suggested that some artists might want to forgo a label altogether, because the cost of recording music is lower than ever. Likewise, the cost of distributing music digitally on Spotify, Pandora, iTunes, and YouTube is basically zero. The marketing piece of the equation is the most difficult part, he said, but some artists are great marketers themselves. They don’t need labels at all.

The most well-known example of this is Amanda Palmer. She released her first album on a major label, and it only sold 25,000 copies. The label wasn’t impressed, and she made very little money on it. As described in her recent TED Talk, with the next one, she went direct to her fans through a Kickstarter campaign. That campaign had around the same number of supporters, but generated $1.2 million for her personally. Not every artist is as savvy as Palmer, and many just want to focus on making music without the distraction of promoting themselves. But her story speaks to the decreasing relevance of the major labels.

David Pakman, founder of eMusic and now a partner at Venrock, was more blunt about the major labels’ business models: Yes, we’re living in a world of analog dollars turning to digital pennies, he told me. But the incumbents haven’t changed their cost structure to adapt. “I want artists to survive and make money but the industry has to accept less and labels need to restructure their contracts,” he said. “The labels do not like to think about making less money to have a healthier music industry.”

From what I understand, labels typically offer a very small cut — 15 percent to 20 percent — to the artists. The costs for label like Warner Music are just over half of its revenue. Meaning that the amount of money they pay out to artists combined with the cost of making CDs and distributing them is only half of their revenue. Compared to the 60 percent or higher in royalties alone that streaming sites pay, which does not include the cost of doing business, and it’s not surprising that these sites aren’t profitable. It also makes the definition of “fair” even murkier.

Spotify CEO Daniel Ek believes he can grow digital to be bigger than what analog once was. Perhaps he’s naive. But he’s also managed to get a generation of Web users to start paying for music for the first time. Those of us that came of age with Napster and Kazaa have never really purchased music; now Spotify has convinced 6 million of us to pay $120 a year for it. That is huge — better than analog, even. At the peak of the CD boom, the average US purchaser of music spend something like $68 a year on music — Spotify is asking them to double that. The problem with Spotify’s model is that the money is spread across a lot more songs.

But Ek believes he can increase music consumption enough to make up for that too. Yesterday he made the case that Spotify’s easy access and all-you-can-eat offering means people consume more music than they did without it. “People listen to more music on an access-based model than in normal cases,” he said. “You don’t get paid once with streaming services, you get paid in perpetuity.”

His top focus is how to increase streaming so artists can make meaningful money, he said. That’s how he grew Spotify’s payouts from $500 million across three years to $500 million in just one year. If successful, Ek says he is “100 percent sure” that the overall music industry can be bigger than it is today.

We’re going to cover all of these issues on the panel today. I don’t believe it will be livestreamed, but I’ll post a wrap-up afterwards. Email me or comment below with suggestions for additional questions or issues. Update: here’s the recap.