Sympathy for the IP Industry

February 14, 2012 at 12:48 pm 20 comments

| Gabriel|

[Cross-posted at NR's Agenda blog]

In the arguments over SOPA, I’ve seen a few arguments from people I respect that piracy basically doesn’t matter. These arguments strike me as somewhat plausible but probably wrong and grounded in wishful thinking that a solution being unpleasant means that the problem it addresses is nonexistent. This is not to say that I support SOPA, for I do not. My main intuition on this is that an industry that sponsored the Sonny Bono Copyright Term Extension Act has forfeited its claim to our sympathies. Thus even when it has a legitimate grievance, I am inclined to give it only mild weight. Thus I tentatively favor the Megaupload suit but I’m gonna say “sucks to be you” when the industry demands escalating the fight against piracy into the top priority of US trade diplomacy and a total war waged on the terrain of the internet’s low-level infrastructure. Nonetheless I think it’s important to clarify just how complicated estimating the effects of piracy are.

Much of the debate centers on first-order effects of immediately displaced sales. That is, at a micro-economic level how much does a pirated copy of work i substitute for a legitimate copy of work i. Early on the IP industries had some estimates premised on the idea that each pirated transfer represented a foregone retail sale, which implied the absurd counterfactual that absent piracy we would have seen a massive boom in sales. Critics have appropriately rebutted these studies with the reminder that demand curves slope downwards so quantity demanded at price $0 will be considerably higher than quantity demanded at price $14.99 (at least if we assume low search costs).

I would say that a more important issue is the second-order effects. This appears in some of the anti-anti-piracy arguments as some variation of “people won’t pirate if you make content available in a convenient format at a reasonable price” or “piracy is a customer service issue.” I think this is basically true as an empirical matter and it’s certainly a very parsimonious description of my own behavior. The trick is that you can rephrase the argument as “the threat of piracy has forced distributors to lower their price points and adopt formats that are less desirable to the producer.” As Kernfeld notes in Pop Music Piracy, this is a very old pattern. Basically, producers create some kind of format at a high price point and consumers buy it until a pirate comes along and both undercuts them on price and introduces format innovations. At this point the incumbents try for awhile to suppress it, before giving up by adopting the pirate’s format innovations and dropping their price point. That is, the incumbents ultimately realize that the only way to deal with piracy is a “convenient format at a reasonable price.” Kernfeld emphasizes mid-20th century pirated songbooks as competition for legitimate individual pieces of sheet music but he also applies it to the more familiar case that the music industry only gave in to low price (and eventually DRM free) digital singles to replace high price CDs as a desperate rearguard action against music file-sharing.

Recorded music revenues have dropped precipitously since the late 1990s but only a minority of this was the direct result of sales substituted by piracy. Rather the great bulk of the drop was from the shift from CD albums at a price point of $15 to digital singles at a price point of $1. We have in fact seen a large increase in units shipped, but mostly in digital singles at the low price point. You can see this clearly by looking at Census Statistical Abstract table 1140 and contrasting the unit sales in the top half with the dollar value in the bottom half. To fully make up retail sales we would’ve needed a 15-fold increase in volume and this has not happened. Even if we appreciate that there digital implies lower costs (no inventory) and think about wholesale rather than retail, we’d still need something like a 5-fold increase in sales to make up for lower revenues.

One important consideration of second-order effect is that it means you have to think at the macro rather than the micro and this makes analysis difficult. That is, many researchers have looked at how often a song is pirated and tried to estimate elasticities with legitimate sales. This is a good way to estimate the proximate effects of piracy but it misses the much more substantial second-order effects since the record industry has not dropped its price point only for heavily pirated songs, but for all songs. Let’s assume that lots of people would pirate Eminem but nobody would pirate Norah Jones. If the record industry switches to a digital downloads model to protect sales of Eminem, this will still decrease the dollar value of Jones’s sales. Conversely if higher concert revenue helps make up for declining recorded music revenue this shift applies in nontrivial ways at the micro level.

We also see second-order effect in the film industry. As Reihan has noted (in discussing Doctorow’s summary of Waldfogel and Danaher), one of the ways the movie industry has responded to piracy is by accelerated releases. It would be a mistake to claim that opening wide is driven entirely by piracy. The fact is that it’s a long-term trend since the mid-1970s and also has to do with supply side issues of promotion and a screen glut. However piracy is a part of opening wide, particularly in terms of major releases opening simultaneously world-wide. Dubbing, prints, and promotion on a global scale is extremely expensive and if studios had their druthers they’d rather postpone it until they had an estimate of how well the film does domestically. As you can see by looking at the breadth of release dates, they did in fact drag out foreign releases in the 1970s and 1980s, but in the 1990s and 2000s they’ve been getting increasingly close to a simultaneous world-wide release. This is not so much an issue of foregone sales as it is of increased expenses but it is a way that providing better customer service so as to avoid piracy does cost the industry. That’s not to say that this is conclusive, as Reihan and Doctorow observe it is probably more efficient and just to have Hollywood bear the private cost of accelerated release than to have governments (and private ISP companies) worldwide bear the costs of aggressive enforcement.

Now for the sake of argument let’s take as granted that direct costs of piracy and indirect costs in the form of better “customer service” are costly to the industry and ask what are the consequences for what gets made? We actually have some evidence that this has not much affected the quantity and quality of music but I find it difficult to be as optimistic about film.

The difference has to do with how money gets spent in both industries and in particular appreciating how promotion is the key resource in the entertainment industry. In the music industry the ratio of promotion to production costs is about 10:1. Some of this is about creating fame, but much of it is about allocating fame. This is important because to a first approximation fame is inherently scarce. As Ricardo argued in his analysis of the Corn Laws, when quantity is fixed any change in demand accrues to factor producers. That is, if the sales of pop music decline over the long-run this will cash out as increased consumer surplus and declining value prices for advertising. A very high proportion of music promotion costs does not occur in the general advertising market but in specialized markets, including payola. This means that over the long-run a drop in music revenues will in large part be felt by radio stations and others who specialize in promoting music.

In contrast, the promotion to production ratio in Hollywood is about 1:2. That is, the rule of thumb is that prints and promotion are about half again the cost of getting the film in the can. This means that decreased profits will mostly hit Hollywood itself rather than a related industry. Since stars are residual claimants and below-the-line workers make solid middle class livings, some of the pain will hit in the form of lower labor compensation, however you can’t lower production costs without eventually hurting production values. [Update: Also see Yglesias and my own follow-up on this issue].

More broadly, I think we need to be skeptical of free lunch thinking that if a policy has undesirable consequences this doesn’t mean we have to pretend there is no real problem it is addressing. It’s a common position to say “I don’t like bullying tactics, bad faith arguments, and rent-seeking of the IP industry, therefore piracy is not a problem.” I sympathize with this frustration but it’s more intellectually honest to take seriously that there might be a problem that we decide it is better to leave unsolved.

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That depends on the meaning of “all” Do declining Hollywood revenues mean fewer movies or smaller mansions?

20 Comments

  • 1. Noah  |  February 14, 2012 at 2:09 pm

    Gabriel, it seems a bit unclear just how much of the foreign release dates can be attributed to piracy as opposed to other factors. Even though all hits are flukes, studios can still learn something about what types of movies are likely to succeed outside of the US, which reduces uncertainty. Governments are somewhat more accepting of foreign (i.e. Hollywood) films taking a significant percentage of screens. As technology reduces technical barriers, audiences may be less patient to wait for a film (OK, this last point is a “demand for pirated work” argument).

    You make a good point that simultaneous worldwide release means a bigger ad budget and therefore higher risk if a movie bombs. But there are many reasons studios would seek worldwide release, outside of piracy. Even if IP laws were dramatically tightened (and enforceable), I doubt this would put a stop to simultaneous worldwide release. Studios feel like they have a fairly good sense of which genres of film will do well internationally. Take The Green Lantern, which was released in the US, UK, Canada, Russia and East Asia (but not China) at the same time. The $53 million US opening weekend was disappointing given the estimated $200 million budget (not including promotion). Word of mouth came out that the movie stunk: second weekend gross was only $18 million in the US. Warner Brothers still does a staggered worldwide release, adding a large number of foreign markets after the film has proved to be a bomb in the US. There are lots of reasons why WB may go ahead with the wider international release. How much do you think piracy played a role, either as a first order or second order concern?

    • 2. gabrielrossman  |  February 14, 2012 at 10:27 pm

      I think piracy accounts for most of the simultaneous global release pattern because that’s what I’ve read in the trade press. Not that I think the trade press is infallible, but I trust it unless I see social science indicating otherwise.
      I do agree though both that studios have a reasonably good idea of how well films will do in different markets and that it can make sense to open wide in anticipation of bad word-of-mouth (another example is the Ang Lee version of Hulk).
      Another reason which I didn’t mention that they’d prefer a staggered release is it makes it possible to have spectacular premieres in each country. It’s simply not possible to have your stars on red carpets all over the world in the space of a single weekend. As such the worldwide simultaneous pattern requires you to either skip important markets or to have the spectacle premieres well in advance of the public opening. Either way you get less free media coverage out of the premieres than you would if you staggered the releases to allow celebrity appearances on opening weekend in each market. This in turn means either less box office or more paid advertising.
      Yet another thing is that simultaneous release implies delays for dubbing, censorship board review, etc. I’d imagine none of this can be done until you have the domestic version’s negative in the can, which means it adds delay during which you’re paying interest on your production debt.

  • 3. Yoram Gat  |  February 14, 2012 at 9:03 pm

    > it’s more intellectually honest to take seriously that there might be a problem that we decide it is better to leave unsolved.

    It seems you argued that there is an effect, not that there is a problem. Reduced profits of radio stations or of movie studios are a problem for the owners of those organizations, but are not clearly a problem for society at large.

    • 4. gabrielrossman  |  February 14, 2012 at 10:59 pm

      That’s a good distinction but I was trying to fall on your side of it. It might be overly subtle, but I think if you reread carefully you’ll see how I was trying to puzzle out whether piracy directly or indirectly leads to less quantity or quality of art (that is an issue for society as a whole) and to distinguish this from reduced profits or reduced wages for people and firms in those industries. For instance, I’m pretty explicit that I don’t see the (direct and indirect effects of) music piracy as a particularly serious problem precisely because most of the effect is in terms of lower profits for radio stations rather than a reduction in music production.

      • 5. Yoram Gat  |  February 15, 2012 at 8:20 am

        Right. But even if we assume that, in the case of movie studios, reduced revenues translate to fewer or less lavishly produced movies and further assuming that this is indeed a cost for society, we would still be short of showing that this is a problem, in the sense that there is a large number of human activities that would be enhanced by diverting more resources to those activities and there is no reason to prefer movie making over other activities.

        The way resources are assigned to various activities is supposedly determined by free-market-supply-and-demand, but as your discussion demonstrates, this supposedly natural force is to a large extent determined by legal arrangements. Are we really going to examine those arrangements and re-design them so that the overall benefit to society is maximized? This would take us very far afield from the original question posed here.

      • 6. gabrielrossman  |  February 15, 2012 at 8:41 am

        I think if we’ve shown that consumers/society value lots of lavish films and that piracy reduces the production of lots of lavish films then by definition this is market failure and hence a problem. However I agree with you that this may be a relatively small problem that is swamped by questions of opportunity cost and enforcement cost. The difference between our positions is basically between whether we take a “net” or “gross” meaning of the word “problem,” but aside from that semantic issue we’re broadly in agreement.
        Also, I totally agree w you that market institutions structure and are even constitutive of market dynamics.

  • 7. Peter Klein  |  February 15, 2012 at 8:06 am

    Gabriel, this is a very nice summary of recent research on this. Not sure if this was your intention, but one of my main takeaways is that it is really hard to justify using the strong arm of the law — fines, imprisonment, etc. — to remedy some potential, but virtually impossible to measure, second-order effects. The burden of proof on the plaintiffs here is extremely high and, despite some reasonable arguments on their side, they haven’t even come close to meeting that burden, given the complexity and ambiguity of the evidence.

    The real issue for me is the moral one and, perhaps for the first time in my life, I find myself agreeing with Yglesias: copying is simply not stealing.

    • 8. gabrielrossman  |  February 15, 2012 at 8:52 am

      Gordon Tullock’s argument against both theft and regulatory rents is also based mostly on hard-to-measure second-order effects. Are you OK w having private security, fences, alarms, cops, and prisons?

      I’m talking on principle here, as far as the specifics go I think there’s a prudential case (enforcement is expensive but not efficacious) and a moral case (revenge for CTEA) for not expanding IP enforcement and even dialing it back on some margins.

      • 9. Peter Klein  |  February 15, 2012 at 8:57 am

        “Are you OK w having private security, fences, alarms, cops, and prisons?” Is that a rhetorical question? Of course I am!

        But, in any case, the strongest argument for state action against (e.g.) theft has nothing to do with Tullock’s argument, IMHO. (I’m a natural-rights guy, not a consequentionalist.)

  • 11. Peter Klein  |  February 15, 2012 at 8:08 am

    Dang, not enough coffee this morning. This is the right one:

    http://www.slate.com/articles/business/moneybox/2012/01/matthew_yglesias_caleb_crain_and_i_actually_agree_on_copyright_law_.html

    • 12. gabrielrossman  |  February 15, 2012 at 8:56 am

      You can never be too rich, too thin, or too wired up on coffee.
      Good link. On this as on so many regulatory issues Yglesias is great.

  • 13. Michael Bishop  |  February 16, 2012 at 10:36 am

    Gabriel, another great post explaining economics better than economists do. I think I agree in principle with everything you say, but I’d state explicitly that I don’t worry at all about reductions in quality or quantity of music created. The cost of a quality recording is just too low to concern us. Some empirical evidence that it hasn’t suffered here: http://www.voxeu.org/index.php?q=node/7274

    But I do worry a bit about movies since they cost so much to make. How would we expect Hollywood to respond to piracy? Pay fewer actors less? Spend less on CGI or marketing? Does anyone other than the studios have a dataset which breaks down movies’ expenses?

    • 14. gabrielrossman  |  February 16, 2012 at 10:43 am

      Yglesias has a good post on your question. I’m gonna write a follow-up post today or tomorrow fleshing out these issues

      The studios not only don’t publish their books but the books are notoriously byzantine, largely to screw their stakeholders. The best overview is in Vogel’s book

  • [...] Yglesias has a characteristically smart reply to my post on the effects of piracy in Hollywood vs music. Specifically, he notes that movie stars make a lot of money and we can expect losses to piracy to [...]

  • 16. James Lee  |  February 16, 2012 at 11:13 pm

    Just read this comic: http://www.nerfnow.com/comic/532.

    Copying entertainment (not piracy) makes society as a whole richer. Besides every “lost dollar through piracy” is a dollar that will go elsewhere. If I can save an extra $20 by pirating Skyrim, than that money will be either saved or spent on something else. So from a big picture view, the economy as a whole doesn’t suffer from “piracy”.

    You basically explained that the real costs of producing entertainment are almost always negative in your third paragraph. So can you tell me why I am obligated in any way to recoup those costs? The fact of the matter is that people create works of art because they want to and they feel compelled to share an experience with the rest of the world. Even in the world of Ghost in the Shell, where everything is digitized, artists of all stripes were still making art. And it was pretty convincing too!

    You also did not address the exponentially shrinking costs of storage. Can’t you store about 9,000 MB for every dollar? Just how the hell do you expect to make a profit off that?!
    [http://www.slate.com/blogs/moneybox/2012/01/26/cost_of_storage.html]

    As you can probably tell, I read Yglesias too…

    • 17. gabrielrossman  |  February 17, 2012 at 8:55 am

      I don’t have time to rebut all of this nonsense so I’ll just say that if you don’t create a market institution that allows producers to recoup high fixed you will soon cease to have producers expending those fixed costs — the rest is commentary.

      As for the idea that people naturally produce art, that’s true for YouTube videos but not for blockbuster films. Hobbyist art is of a very different type from commercially produced culture and most people prefer the latter.

      • 18. James Lee  |  February 17, 2012 at 11:27 am

        Everybody always says, “if you don’t create a market institution that allows producers to recoup high fixed [costs], you will soon cease to have producers expending those fixed costs”. But we have never before been more entertained than we are now. There is no shortage of entertainment for people to experience, there has been no curtailing of people willing to produce works, and clearly the movie industry is more profitable than ever before.
        I think I’m gonna agree with Matt in saying that even though the wages of actors will probably go down along with the revenue lost to “piracy”, it’s hard to argue that this would somehow devestate or collapse the quality of acting. I’ve never understood art all that well myself, but people love doing that stuff and expressing themselves. I don’t think it is inconceivable to find an actor who is just as good as, say Will Smith, who is willing to work for far less. All the better for everybody else I say.

      • 19. gabrielrossman  |  February 17, 2012 at 11:30 am

        If you read my next post you’ll see that I agree with you and Yglesias on the issue of elasticity of supply for movie stars but I worry a lot about elasticity of supply for crews and technical collaborators.

  • [...] Sympathy for the IP Industry…my favorite quote pretty much hits all I had to say about the controversy: [...]


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