Assessing the Economic Impacts of Copyright Reform on Internet Service Providers

4.2 The Content Producing Industries

As noted elsewhere, the Internet represents an unprecedented challenge to the ability of content producers to control their products.33 It is not surprising, then, that content producers have responded to this threat by lobbying for stronger legal protection of their intellectual property rights, for example through the extension of the term of copyright from 50 to 70 years in the US through the so-called Mickey Mouse bill.34 However, there is an increasingly strong sentiment that the global thrust toward tightening intellectual property rights in favour of rights holders is destroying the balance that IPRs are designed to achieve.35 Even a publication as staunchly conservative as The Economist has recently called for a "radical rethink" of copyright, proposing a reduction in term from 70 years to the original 14-year term (renewable once).36

The social and economic issues surrounding copyright and other IPRs are too subtle to be comprehensively reviewed here, but a brief recap of their purposes will be provided. The fundamental problem is that "content"37 has the characteristics of public goods – particularly, it is non-rival in consumption and may be non-excludable.38 Non-rivalry implies that my "consumption" of an idea or a song does not impair the ability of others to consume that idea or song, contrary to most physical goods (e.g., an apple). Non-excludability means that it is impossible to exclude consumers from enjoying the benefits of the public good (e.g., police service). These public good characteristics of content mean that, because creators of content (whether artists, researchers, or inventors) cannot appropriate all of the value created by their work, content will tend to be undersupplied relative to the social optimum. Intellectual property rights were created to address this form of market failure. It is important to note that the purpose of IPRs is not to increase the appropriability of content for its own sake, or to guarantee "fair" remuneration to content creators, but rather to increase the supply of content in society.

The mechanism by which IPRs address this market failure is to give content creators exclusive rights over the reproduction and distribution of their content for a limited time. This temporary "monopoly" over their content provides content creators an ex ante incentive to invest in creating content in the first place. The tensions is, however, that once created, content is non-rival in consumption and hence could be shared with all consumers. Restricting the supply for the economic benefit of the creator, ex post, creates economic inefficiency. Pharmaceutical patents nicely illustrate the tension between providing incentives for research and development of new drugs (which typically span many years and cost tens or hundreds of millions of dollars), and the ex post economic loss of restricting distribution of the new drug to only those consumers who can afford to pay the "monopoly" price. The granting of exclusive rights has always been balanced against the need for efficient transfer of information, and exceptions made for "fair use" (e.g., use of copyrighted materials in review or education, personal backup copies of software, etc). Indeed, the patent process requires full public disclosure of an invention at the time of application so that others may learn from it, even before it has received patent protection.

Although created in "the age of manufacturers," IPRs have been shown to be quite robust to being adapted to new technologies. Certainly new technologies provide new challenges to IPR holders, but do not, in and of themselves, generally provide a reason to strengthen IPR regimes.39 Copyright holders, for example, have repeatedly raised the alarm over the impending devastation of their industry due to the emergence of a new technology. The photocopier, the audio cassette, and the VCR are particularly noteworthy examples. Each was predicted to spell doom for copyright holders. The now infamous quote by Jack Valenti, president of the Motion Picture Association of America (MPAA) summarizes Hollywood's initial assessment of the VCR: "[The VCR] is to the American film producer and the American public as the Boston Strangler is to the woman alone."40 However, each of these technologies ended up significantly increasing the value of copyrights and the revenues of copyright holders. Hollywood movies typically earn more in videocassette sales than in theatre box offices; thus, copyright holders have been accused of "crying wolf."41

Therefore, one must maintain a balanced level of skepticism in evaluating the claims of copyright holders surrounding the impact of the Internet on their industries. The economic properties of the Internet that "threaten" copyright – reduced reproduction and distribution costs – also provide opportunity for rights holders.42 In the US music industry, for example, the costs of producing, distributing, and retailing a compact disk (CD) are estimated to be $8.39, or nearly 50% of the typical retail price of a CD.43 Thus, alternate distribution strategies could enable profitable sale of music at significantly reduced prices.

A number of business methods for exploiting these opportunities have been proposed that do not require new or amended property rights. These are too large in number to be described fully here, but they include sampling, versioning, customization, frequent updates, zero pricing, volume pricing, and price discrimination.44 Alternate appropriability mechanisms, such as group pricing or selling complementary products or services, can also secure revenues for rights holders.45 As Shapiro and Varian nicely summarize it, rights holders should be concerned with maximizing the value of their intellectual property, not maximizing the protection of that property. Business methods offer a plethora of alternatives with which to go about maximizing value.

Looking briefly at the phenomenon of digital music downloads, it is clear that the music industry is facing a significant challenge.46 A recent study reports that peer-to-peer (P2P) file sharing networks are growing rapidly, and estimates place the number of digital music files downloaded last year at 5 billion.47 Although the Recording Industry Association of America (RIAA) claims significant economic harm has occurred due to downloads of digital music from the Internet, such claims are far from being conclusively established. Earlier claims by industry associations regarding the economic impact of physical piracy of CDs turn out to be significant over-estimations when subject to economic scrutiny.48 While CD unit sales have slipped in the past four years, prices have increased and the number of new releases of has decreased, all at a time of macroeconomic slowdown.49 Thus, while it is reasonable to conclude that part of the reduction in sales of CDs is due to digital music downloads, there are clearly other forces at play as well. The fact that CD's are a "luxury" good (i.e., income elasticity is greater than 1.0) would lead us to expect a significant decrease in unit sales as a result of price increases.50

The economic relationship between digital music downloads (typically encoded as MP3 files) and CD purchases has not been conclusively established. Clearly, MP3 files on the Internet are not a perfect substitute for CDs, for a variety of reasons discussed below. It has also been suggested that the relationship between digital downloads and CD sales is complementary, i.e., that after "trying out" songs downloaded from the Internet, consumers choose to purchase some of the music in CD form for a variety of reasons, including higher quality, portability, and even a desire to support the artists. Thus, MP3s, to some level at least, function as free "samples" much the way limited access to online content is used to entice consumers to subscribe to the full service. While the sampling argument has some merit, it is likely that the net effect of MP3s on demand for CDs is negative. However, the magnitude of the effect has not been clearly established, but it is certainly an over-exaggeration to equate one downloaded song with one lost sale of that song on a CD.51 The ratio of 8:1 (i.e., eight downloaded MP3s result in one lost song sale) have been suggested, but, given the data limitations, this estimate is based on a very informal analysis.52

Reasons that online digital music downloads are not a perfect substitute for a CD include the following:

  • finding and downloading MP3 files requires a significant investment of user time (and therefore opportunity cost), especially for rarer songs or for whole albums;
  • recording quality of MP3 files is variable, but nearly all versions suffer some loss of audio quality relative to CDs;
  • playback of MP3 files is limited to PCs or special devices (MP3 players) or they must be "burned" to blank CDs using a CD writer, a process that requires a significant investment in complementary assets and blank media;
  • MP3 download exposes the user's PC to an unknown level of risk to hacking and viruses;
  • downloading, installing, configuring and using P2P software takes considerable time and expertise, and the lack of user support makes these programs quite difficult to use effectively, in addition, these software programs often install "associated" programs that either collect information on users and upload it for analysis and marketing purposes (so-called "spyware") or stream a high volume of advertisements toward users (termed "adware"), or in some cases, both;
  • many of these "networks" don't work at all or have almost no content on them, and thus require users to download and try multiple P2P networks (indeed, there are estimated to be 130 separate P2P applications53) each of which may install adware or spyware on the user's PC; effective use of P2P networks often require users to search out ancillary programs that improve the effectiveness of the searching or downloading, each of which takes time to locate, install, and configure and may require explicit payment or installation of adware or spyware;
  • many users then go on to locate, download, install, configure (and possibly purchase), and update software that searches for and uninstalls spyware and adware – albeit at the expense, in some cases, of rendering the original P2P program 54inoperative;
  • finally, MP3 downloads obviously require not only a personal computer but also a (typically broadband) Internet connection.

It is these differences that should give copyright holders hope, in that they represent a whole host of ways that the digital music experience could be improved for consumers. Ultimately, it is by providing a better digital music download service than what is available for free that will entice consumers to pay. Indeed, there appears to be a considerable selection of attributes on which copyright holders could version their legitimate, pay-per-use access to digital music, including: ease of use, lack of additional software, customer support, file format, music quality, search cost, download time, and additional features (album art, lyrics, online chat with artists, contests for concert tickets, etc). The very fact that users are willing to endure significant expense (in terms of Internet access, computing hardware, blank media, risk of damage to their pc, intrusive software and advertisements, and opportunity cost) to download music in admittedly inferior formats indicates that consumer valuation of digital music is quite high. The challenge for copyright holders is to exploit that willingness-to-pay through an appropriate combination of business methods and technology. If the music industry were to enter a "battle" with illegal P2P networks, the nearly complete lack of revenues for unauthorized P2P networks means that they would be unlikely to be able to sustain a serious round of competition to improve features.

Indeed, the music industry has recently developed their own digital music services. The five largest music labels have collaborated on two pay-per-use digital music download services, MusicNet and pressplay, both of which launched in late 2002. Both services appear to be continuing to evolve in terms of service attributes and prices, albeit with very little apparent marketing effort. Likewise, a consortia of music retailers (including Tower Records and Best Buy) has been established to sell digital music online.55

Note that these sites represent a potentially very important source of information regarding customer tastes for the music industry. A consequence of widespread use of (legal, industry-sponsored) music download sites would be the generation of vast amounts of data regarding who was downloading what sort of music and when; this data amounts to, in effect, free real-time market research. For example, the effectiveness of radio and other advertising mechanisms could be rapidly and nearly costlessly ascertained by looking at their impact on music searches and downloads. Thus, digital music has the potential to provide new sources of value not only to consumers, but also to the industry as well.

Working in the favour of these pay-per-use music sites is the increasing trend toward pay, rather than "free" (or advertising-supported) content on the Internet. A variety of content providers have recently demonstrated an ability to charge users for content on the Internet, albeit in some cases after experimenting with a variety of business models. (e.g., The Wall Street Journal, The Economist,, ESPN, Playboy, Yahoo!). Some of this now pay-per-use content used to be available to consumers for free. Likewise, firms are experimenting with pay-per-use digital download of movies and other broadband content. As the "everything on the Internet is free" mentality of consumers (in part a result of the easy access to cash enjoyed by dot com companies during the Internet bubble) continues to fade, willingness to pay for content will likely continue to rise.

In addition to these business-method approaches to exploiting content, a variety of technical methods are available as well. These include ever-evolving digital rights management (DRM) technologies, such as superdistribution.56 These methods have long been proposed, but not widely used. However, with the incorporation of DRM technology in Microsoft's latest release of Windows Media Player (version 9), DRM appears to be becoming mainstream. While these methods, on their own, are unlikely to completely prevent unauthorised copying of content, they can be used to raise the difficulty of doing so. Thus, a combination of technical and business method approaches will likely be required for content holders to maximize their revenues. This combination may be a significant departure from the traditional ways of doing business in some content producing industries, and may require some time to unfold. Finally, note that content holders can use technical methods to "attack" digital download networks (peer-to-peer), which have been shown to be vulnerable to such attacks as a result of their design.57 Indeed, there are patent applications under consideration for technologies that flood peer-to-peer networks with degraded content, thereby making it difficult for users to locate and download content.58

To summarize, although the music industry is currently a focal point for issues surrounding digital copyright, the Internet is probably not the catastrophe that industry associations are promulgating, for several reasons. First, history tells us that copyright holders have been robust to adapting to new technologies in the past and have ultimately benefited from them. Second, even if the Internet is "different" from other technological innovations, copyright holders have a broad array of business methods and technologies at their disposal by which to exploit the new capabilities of the Internet as a distribution medium (as well as frustrate illegal downloads). Eventually, adapting to the Internet may significantly redefine the value chain of the music industry, but that reorganization is not necessarily a bad thing. Indeed, musical artists have long felt exploited by record labels, and the Internet may raise their bargaining power.59 Ultimately, the hardest hit portion of the industry may not be artists or record labels, but retailers – already a significant number of music retail outlets have closed or are closing.60 Third, existing copyright laws already give copyright holders legal options to pursue violators of copyright, as was effectively demonstrated in the court-ordered shutdown of Napster in 2001.

33 Shapiro and Varian (1998)

34 Greenberger and Orwall (2003)

35 See, for example, Gross (2002), Lessig (2001), Litman (2001), and Vaidhyanathan (2001).

36 Anonymous (2003)

37 The terms "content, "information," "ideas," and "knowledge" are considered interchangeable.

38 See, Liebowitz (2002) or Yen (2001) for an introduction to the public goods nature of content.

39 Cockburn and Chwelos (2001)

40 As quoted in Yen (2001).

41 See Liebowitz (2002) for a more lengthy discussion of these issues.

42 Shapiro and Varian (1998)

43 HBS (2002)

44 See, for example, Shapiro and Varian (1998), Lessig (2001), Cockburn and Chwelos (2001), Galloway and Kinnear (2001), and Chellappa and Shivendu (2002).

45 Shapiro and Varian (1998), Leibowitz (2002)

46 The issues are summarized nicely in HBS (2002) and Liebowitz (2002a, 2002b).

47 Websense (2003)

48 Hui and Png (2002)

49 However, one could argue that the reduction in new releases is a conscious choice to reduce investment in producing new releases as a result of reduced (perceived) appropriability.

50 The figures quoted here are taken from the RIAA's press releases, as well as from secondary analyses, such as Liebowitz (2002b) and Ziemann (2002).

51 Liebowitz (2002a) provides a detailed discussion of the evidence, including expert testimony, surrounding Napster's (alleged) impact on CD sales.

52 Liebowitz (2002b) contains an extended discussion of this issue.

53 Websense (2003)

54 See Hansen and Borland (2002) for a description of adware and spyware and the surrounding legal and technical issues.

55 Wingfield (2003)

56 Cockburn and Chwelos (2001)

57 Biddle et al. (2002)

58 See, for example, US Patent Application 20020082999, "Method of preventing reproduction of sales amount of records due to digital music file illegally distributed through communications network."